The Secret Stock Powering Apple's Wild Ride

John Grgurich, The Motley Fool
Updated

Ask people on the street what company makes the semiconductors that drive their computers, and chances are they'll be able to tell you it's Intel (NAS: INTC) . Ask the same people what company makes the chips that drive their iPad or iPhone, however, and chances are they won't have a clue.

The mystery company is ARM Holdings (NAS: ARMH) , a U.K. firm whose chip designs are used exclusively in Apple's (NAS: AAPL) phenomenally successful iPhones and iPads. ARM just released fourth-quarter results, and as Apple's fortunes have risen, so have ARM's. Here's a look at the company, the numbers, and the reason investors should be very interested in this stock.

Digital design
"Architecture for the digital world" is ARM's tagline and does a pretty good job of concisely describing what it is the company does. Founded in 1990, ARM designs and licenses the intellectual property, or IP, behind semiconductors rather than manufacturing and selling semiconductors.

The company then licenses said IP to a network of partners that use it to physically manufacture the chips. In the process, ARM receives a license fee for the original IP work and a royalty on every chip produced. Currently the company:

  • Is the world's leading semiconductor IP company.

  • Has shipped more than 20 billion ARM-designed chips to date.

  • Has sold more than 800 processor licenses to more than 250 companies.

As goes Apple, so goes ARM
As Apple's sales skyrocketed in the fourth quarter of 2011, so have ARM's profits. The launch of the iPhone 4S has been particularly profitable for ARM. The phone uses a processor design that analysts believe brings in almost double the royalties per unit than previous models.

ARM just released 2011 fourth-quarter earnings, which handily beat market expectations:

  • Quarterly revenue grew a very healthy 21% YOY, from $179.6 million to $217.0 million.

  • Operating margin increased from 41.1% to 48.2% YOY, a significant move and one that demonstrates the company is becoming more and more efficient and hence more profitable.

  • Earnings per share jumped 28%, from $4.60 to $5.88.

Beyond the company from Cupertino
It's all well and good to have the chip monopoly on iPhones and iPads, but what if Apple decides to switch suppliers? Warren East, the company's chief executive, has a good answer, reporting that fourth-quarter sales had also been boosted by new manufacturers that chose to license the company's chip technology. The company signed 25 new licenses in the fourth quarter.

Hewlett-Packard (NYS: HPQ) wants to use ARM-based chips in servers, the first time the U.K. company has moved into this segment of the mainstream computing market. Microsoft (NAS: MSFT) has announced that it's adapting its Windows operating system, which is still the dominant OS found on computers around the world, so it can run on ARM-based machines.

Intel: down, but not out
ARM's specialty, and the reason it dominates its niche, is that its chip designs don't use much power. Intel chips have traditionally used too much power to be viable in portable devices, but that might be changing. The company is going head to head against ARM with its own Medfield low-power chips, specifically designed to be used in mobile phones.

Motorola and Lenovo have both recently announced plans to use new Intel chips in their handsets. "It was disappointing to see the announcements," East admitted. "In the short term it will not have an effect, but don't think that I am complacent about it."

A lot of company for the multiple
The day after ARM released its blistering earnings report, the stock price jumped considerably, but it's now down to about where it started: $28. That's the good news. The less-than-good news is that the multiple the company is trading at is high: 76.

But you're getting a lot of company for that slightly dizzying number, a company with chip monopolies in the two best-selling and most-influential handheld devices of the day, and a company that's forging ahead and building its business in new market spaces as well. In the constantly changing consumer technology space, where every company's best moat is its ability to innovate, ARM looks to be a winner. And with a low per-share-price of $28, a price that's bound to increase, now might be as good a time as any to jump onboard.

But ARM's not the only mystery stock powering the big players in the consumer technology sector. Learn about three more sleeper stocks perfectly positioned to cash in on the booming and tablet smartphone market in this Motley Fool special free report" "3 Hidden Winners of the iPhone, iPad, and Android Revolution." Get your copy while the stocks are hot.

At the time thisarticle was published Fool contributorJohn Grgurichfervently wishes The Motley Fool would send him on an all-expenses-paid, 14-day trip to the U.K. to personally check out ARM Holdings, but he owns no shares of any of the companies mentioned in this column. The Motley Fool, however, owns shares of Microsoft, Apple, and Intel. Motley Fool newsletter services have recommended buying shares of Apple, Intel, and Microsoft and creating bull call spread positions in Microsoft and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has a scintillatingdisclosure policy.

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