ARM Holdings is King of the Hill, but Keep an Eye on the Mountain

Nihar is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Other than its valuation, there is a lot to like about ARM Holdings (NASDAQ: ARMH), but I do think the market may have lost its mind a little. There might still be significant upside after the market cools down a little. My ideal trade would be to sit back by writing some puts, and I either get in where I want it with the premium or I get paid to miss the chance.

If it rockets even more, I'll have walked away losing nothing. I do not like to get into the prices I like, since it varies depending on your situation, but I would probably go around $38-$40 and choose my expiry based on the premiums, future catalysts, and previous price action. The initial draft of this article was written almost two months earlier, and ARM has risen even higher since then.

With the trade and my tentative approach to ARM behind me, I would rather focus on its business and its future. I also would like to look at the larger market it helps facilitate, and the companies that benefit.

It is not clear to some people that every ARM-based chip is not necessarily made by the company. Apple designed its own processor for the A5 chip utilizing ARM's instruction set. Companies license the right to use the instruction set that ARM has, but they can develop their own chips.

Licensing is an interesting business model, because it can keep costs low and remove the need for large inventories. ARM does make its own processors, but that is not its entire business. The thing about license fees and royalties for ARM have translated into billions for a company like Apple, that uses an ARM-based processor, but ARM probably only made millions from Apple. It is important not to forget the companies that benefit from ARM, because they might be making far more money.

Whodunit: NVIDIA with the ARM processor in the handheld device

NVIDIA's (NASDAQ: NVDA) Tegra chip system uses ARM processors. Speaking of Tegra, NVIDIA announced the Tegra 4, which will help the company continue to grow that product line. These will utilize ARM processors, so some of the benefit will go to ARM. That is the interesting thing about ARM. It has its success tied onto a ton of companies, but it really does not stand to lose much if a company that uses its processors or instruction set fails.

NVIDIA's Project Shield is an interesting handheld console that will run Steam games, and who knows what else. It is a bit early to judge the product, but it will utilize the Tegra 4 chip. The company is using a flexible operating system. That flexibility makes me feel good about the device, because it is providing a platform only. That allows content to come to it, and if barriers to content are kept low, it will have a lot of it.

There are two ways of going about a hardware system. You can push quality concerns onto the developers, or you can act as the gatekeeper. Apple acts as the gatekeeper for quality and very lightly on content. It is not so black and white, but companies will choose different places on the spectrum. Steam tends to have low barriers, and I have played extremely buggy games on Steam before.

I think Shield is a good move for NVIDIA. The Tegra chip is already a success, and this will give NVIDIA its own product utilizing its component. Making a handheld device for gaming could help offset loss of revenue from the shrinking PC market, which could mean fewer GPUs sold.

NVIDIA has a strong cash balance, low debt, and good margins. The share price has been irritatingly flat, though. At least it has a dividend, though its yield is under 3%. Perhaps, the jump into a high-profile consumer market will rouse the stock. Despite the past performance, I do like the direction of the company. I need to do more research before I come with specific trades, but considering how flat the company has been, I think this place is as good as any if you believe in NVIDIA.

AMD rounds a corner with ARM underarm

Instead of discussing another company that works with tablets or phones, and the occasional electric car, I would rather look at the potential of a new-ish part of Advanced Micro Devices(NYSE: AMD) business. I can't believe how much I have talked about the company. It is backing ARM-based processors for the microserver environment, which would be in opposition to the x86 instruction set that Intel would use.

Microservers are extremely dense servers with entire systems in a small unit, and numerous units are put into a box that forms the server. That is a lot of cores, some of the boxes will have 64 processors with 8 cores each. That is just one box, and these massive data centers will employ far more.

This presents a great opportunity for AMD since the microserver space is new, but still part of the lucrative server space. Server revenue in 2011 was over $50 billion, which is substantial. AMD does not need to grow for microservers to be victorious. Those servers will just have to displace normal servers and take those revenues. If AMD can establish ARM as the preferred architecture, then even AMD's competition will be using ARM-based designs. Both companies stand to profit. The difference is that AMD's last shot is just one more avenue for ARM.

Microservers are a play on the future needs of the server market, and that market is pretty massive. Both companies stand to benefit substantially from establishing themselves in the market, if it really is the revolution that some hope for. AMD has potential, but will not make for peaceful nights. NVIDIA is better for sleep at night, and ARM is in a big gray area due to its valuation.

TheArchivist has no position in any stocks mentioned. The Motley Fool recommends NVIDIA. 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!

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