ARM Holdings Should Continue to Outperform

Chip design specialist ARM Holdings has been a regular outperformer on the Street, having recorded solid revenue growth for five straight years. The company's recently reported third-quarter results did not deviate from this trend.

ARM Holdings, whose chips power smartphones and tablets made by market leaders Apple and Samsung, among a host of others, reported a 27% rise in third-quarter revenue at $286.7 million, exceeding analyst expectations by a wide margin. The company's estimate-beating pre-tax profit rose even further by as much as 36% to $149.6 million. Yet, the stellar performance failed to enthuse investors, and the stock price fell by a substantial 7.5%. The reason seemed to be centered on ARM's revenue generation model.

What actually happened?
ARM Holdings does not manufacture chips by itself. It simply licenses its chip designs to companies such as Qualcomm and NVIDIA for manufacturing. This means ARM makes its money from chip design licensing fees that its customers pay upfront. Additionally, ARM also extracts a royalty fee for every chip shipped by its customers that uses the licensed technology.

It's this latter aspect that's making some investors a bit jittery, as ARM's royalty revenue for the quarter did not match analyst expectations, thanks to a "small inventory correction" acknowledged by management. This leads to the big question: Will this inventory re-adjustment get bigger with time, given the perceived notion of slowing smartphone sales?

Ready for the future
For starters, it would be incorrect to say that smartphone sales are entirely slowing down, as it's actually the premium smartphone category that seems to be experiencing declining sales figures in developed markets. The mid-range smartphone category, on the other hand, seems to be doing very well, particularly in emerging nations like China and India that have a majority of cost-conscious consumers. After all, for every Samsung Galaxy S4 or Apple iPhone 5s, there's also the Galaxy S4 Mini and the iPhone 5c for those who cannot afford the premium segment. This rebalancing of the smartphone categories seems to be the main reason for lower royalties from ARM's high-end chips.

However, investors should keep in mind that ARM is actually well-prepared to change gears and cater to the mid-range chip category if the situation so demands. In fact, the company has already predicted that the real future action will be in the mid-range smartphone segment, and its Cortex-A12 processor is specifically designed for this purpose. Although low-end chips generate lower profit margins, the sheer volume of sales should make up for that shortfall.

The other piece of good news
On the other hand, ARM's chip licensing revenue posted a whopping 52% increase YoY, helped by a record number of licenses signed during the quarter. Out of the 24 companies that signed processor licenses with ARM during the third quarter, 11 were doing so for the first time, which will equate to incremental revenue addition.

The good part is that some of the licenses signed include those that apply to the company's newest chip designs, ones that typically require higher royalties. With ARM declaring royalty revenue as arrears during the next quarter, the benefits will only become apparent when the company reports its earnings for the current quarter.

Anything else?
The company is a leading designer of chips enabled for next-generation LTE technology. ARM's designs for LTE-enabled chips are perceived as generations ahead of market rival Intel and are preferred by the majority of the world's mobile device manufacturers. Intel, on the other hand, has less than 1% share of the overall smartphone processor market, according to research firm Strategy Analytics.

Intel is also facing stiff competition from fellow chip manufacturer, Qualcomm, one of ARM's biggest customers. Qualcomm is the undisputed leader of the global smartphone chip market with 53% revenue share, as per Strategy Analytics. Manufacture of LTE-enabled baseband chips comprises Qualcomm's core area of strength, and the company enjoys near-total market domination with approximately 97% share of global LTE-based revenue.

Foolish parting thoughts
As smart investors have probably realized by now, the party is far from over for ARM Holdings. This is a company with huge possibilities, as it licenses its chip designs to other companies, some of which have already ventured into emerging areas like fingerprint recognition and wearable computing.

ARM also has a strong presence in the area of embedded processing, where its business grew as much as 25% in 2012. The company's chips are widely used in applications as diverse as automobile technology and home electronic appliances. This is certainly not the time to let go of ARM Holdings, and investors would do well to keep a watch on the company's future course of action over the next few quarters.

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Subhadeep Ghose has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and Qualcomm. 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.

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