Does ARM Still Have Momentum?
Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
While Apple's share price took a precipitous tumble in the fourth quarter last year, the shares of ARM Holdings were moving in the opposite direction, gaining 40% in Q4 alone. ARMH shares have had huge momentum since the middle of last year, primarily on the expectation that no matter who wins the war for mobile internet devices, ARM Holdings also wins.
ARM (NASDAQ: ARMH) is uniquely well positioned to benefit from the mobile device wars currently being fought between Google, Apple and Microsoft (NASDAQ: MSFT), since better than 90% of all smart phones use SOCs (systems on chip) based on ARM designs. Furthermore, all iOS and most Android tablets use ARM processors as well. ARM's complete dominance of the mobile device world is a tremendous accomplishment, given that ARM doesn't actually make any hardware.
ARM's business model is also unique in the semiconductor world in that its revenues consist almost entirely of licensing fees and royalties. Besides mobile phones and tablets, ARM-based devices appear in a host of smart appliances, including TVs, coffeemakers, and automotive infotainment systems. In many ways, ARM is positioned at the top of the mobile device food chain, but is it's share price/earnings ratio of about 290 really justified?
The following chart provides historical data on share price, revenue, operating income, and ARM-based semiconductor shipment volume going back to the end of Q4 2009. In the chart, I use end of Q4 2009 as a set of initial conditions, and express changes relative to that as percent changes. The starting conditions were:
Share Price: $8.56 (Nasdaq)
Revenue: $ 140 m
Operating Income: $32.2 m
Semiconductor shipments: 1.3 billion
As can be seen in the chart, revenue growth tracks semiconductor shipment growth fairly well. The steady growth of the ARM ecosystem has translated into steady revenue growth. Operating income grew fairly dramatically in 2011, primarily on the strength of cost cutting of operating costs such as R&D and G&A. However, since ARM lives by the value of its IP, I don't foresee any dramatic reductions in these areas in the future, and in fact, operating income has tracked revenue growth through most of 2012. The share price growth has far outpaced revenue and earnings growth. Does this represent “irrational exuberance” on the part of investors?
Not entirely. Certainly ARM continues to grow at a healthy clip, and its future appears bright. Nevertheless, the share price jumps that occurred in Q1 2011 and Q4 2012 must have been predicated on significant revenue growth over and above what had been historically demonstrated. What gave rise to these expectations?
It was probably the announcements by Microsoft of ARM based products that drove investor optimism. In January of 2011 came the first announcement of Windows on ARM at CES. In October and November of 2012 came the roll out of Microsoft's ARM based tablet, Surface RT, and the new Windows Phone 8 devices from Nokia, also based on ARM processors. The expectation that Microsoft would greatly expand the market for ARM-based semiconductors clearly weighed on investors minds.
Back when I wrote Microsoft's Mobile Crisis, I predicted disappointing results for Microsoft's ARM initiatives, Surface RT and Windows Phone 8, based on what was then sketchy information, inference and deduction. Since then, much more information has become available. According to IDC, only 900,000 Surface RT devices were shipped in Q4, giving Surface a worldwide market share of just 1.7%. Furthermore, there is the widely reported statement by Microsoft CFO Tami Reller that “New devices that run on Windows RT . . . won't be released this spring.” This quote and the paucity of available Windows RT devices led Woody Leonhard of InfoWorld to describe Windows RT as “circling the drain”.
Windows Phone 8 has fared little better. I estimate in Myths of the Nokia Turnaround that only 5.5 million Windows Phones were shipped in Q4, giving it a 2.5% market share. As I've said elsewhere, I think Windows Phone 8 is a good product, but it's in an uphill battle against the better established Android and iOS ecosystems, so I don't see much hope for a dramatic expansion of Windows Phone market share.
If the expansion in ARM processor shipments is not to come from Microsoft, is there any other potential source of market gains? Last October ARM announced a new generation of Cortex processors, which are the main CPU cores used in smart phones and tablets. The generation, dubbed the Cortex A50 series, will feature 64 bit processing capability, and use the new 64 bit augmented ARMv8 instruction set. This 64 bit capability will enable faster performance, especially for integer math computations often used for 2D graphics, as well as allow the operating system to address a larger memory space. ARM is positioning the Cortex A50 series initially for low power server applications, but eventually these chips will find their way into tablets and even smart phones.
However, it generally takes manufacturers 1 1/2 – 2 years to bring a new Cortex series processor into full production, so I don't expect A50 series chips to begin to appear before next year. In the meantime, the Haswell series of Intel (NASDAQ: INTC) Core processors is expected to begin arriving this June. Low power versions of Haswell will enable slim form factor tablets like Microsoft's Surface RT, but be able to run Windows 8 Pro.
I expect Haswell based Windows 8 tablets to give ARM based tablets some serious competition. The successor to Haswell is Broadwell, a shrinking of the Haswell architecture with an even smaller process, 14 nm vs. Haswell's 22nm. I expect Broadwell to provide even more competition for ARM. With Intel steadily improving the power efficiency of their processors, and ARM improving the computational efficiency of theirs, Intel and ARM are clearly on a collision course, with the outcome by no means certain. A battle to be the dominant mobile processor architecture is brewing, for which Haswell's arrival is the opening shot. When that shot is heard, ARM investors are likely to duck and cover.
MarkHibben has a position in Apple. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!