|Investors Are Likely to Find A Bargain in Arm Holdings|
By DAVID REILLY
Staff Reporter of THE WALL STREET JOURNAL
The pain isn't over yet for chip-design company Arm Holdings.
Despite a 60% fall in just two months, the United Kingdom company's stock will likely sink further if, as expected, it is removed this week from the Financial Times-Stock Exchange 100 Share Index. Plus, Nokia will add to Arm's downward momentum if its trading update due Tuesday is weak.
The Intel-inspired wave of selling dragged Arm down 5.2% Friday to 163.50 pence ($2.39 or €2.53) in London. But the seemingly unending gloom may be good news for those who have been waiting for an opportunity to jump into the chip designer.
At Friday's levels, Arm was trading at about 37 times estimated 2002 consensus earnings. That is still pricey, but it is a far cry from the multiple of about 60 times it traded at earlier in the year when it was billed as the FT-SE 100's most expensive stock. That rich valuation has combined with concerns about anemic growth rates due to the mobile- and tech-spending slowdowns to dog the shares this year.
"It's been a question of valuation throughout," said Steve Woolf, technology analyst at Commerzbank Securities. "At previous levels, the stock was pricing in a level of growth above its long-term potential."
Mr. Woolf has a "sell" recommendation on the stock and a price target of 130 pence a share, or about 15% below current levels. Other bears think the mauling could stop once the shares fall to about 150 pence a share. At this level, Arm would trade at about 34 times 2002 earnings. That isn't a fire-sale valuation, but a premium of about 25% to software shares is justified, according to UBS Warburg, which late last month downgraded it to a "sell" based on concerns about long-term licensing revenue growth. (While Arm is in the semiconductor sector, its model of licensing the architecture for chip designs and then collecting future royalties is in many ways more akin to that of a software company.)
Bulls argue that Arm deserves such a premium, and more, because of its strong net margins, cash flow and balance sheet. It is also the dominant player in designing RISC (reduced instruction set computing) microprocessors used in mobile computing devices and phones, and sells to just about every semiconductor maker.
The company is now a "broken stock" that is trading at historically low forward price/earnings multiples compared to earnings-per-share growth potential, said Gunnar Miller, European semiconductor analyst at Goldman Sachs who upgraded the shares at the end of last month to "trading buy." He is forecasting full-year earnings of 4.6 pence a share, compared with a consensus estimate of 4.3 pence, and argues that the company has one of the best business models to withstand the semiconductor downturn.
So far, that appears to be the case. In the first quarter, revenue of £42.1 million was up 5% from the fourth quarter and 30% compared to the year earlier. Net income grew some 37% compared with the first quarter of 2001, while operating margins increased to 35% from 32% in the fourth quarter.
But the results also provided some food for the bears to munch on. The company generally makes money in two ways. First, it licenses its chip designs to manufacturers, then it receives a royalty every time a chip using its architecture is sold. While licensing revenue has continued to grow, royalty revenue in the first quarter of £6.4 million fell 6% compared to the fourth quarter.
The company argues that this should come as no surprise. "The issue is that the semiconductor industry is in the biggest downturn it's ever seen," said Robin Saxby, Arm's executive chairman. "We have something like 90 semi partners, of whom only a third were shipping products. What's amazing is that Arm's royalties aren't down even more."
Once those semiconductor makers start shipping chips, royalty revenue should rebound sharply.
Another first-quarter issue related to deferred revenue, which dropped in the first quarter to £13.1 million, compared with £19.4 million in the fourth quarter. Arm doesn't immediately book revenue from license agreements: These deals can take as long as 12 months to gestate because of engineering work that has to take place on a design. As a result, a portion of the revenue is deferred and only booked as the project progresses.
The fear was that Arm brought some deferred revenue forward to bolster first-quarter sales, in effect robbing Peter to pay Paul. If so, this could lead to lower revenue in subsequent quarters, or even worse, charges if problems force the cancellation of some projects.
The company emphatically denies that this is the case. Mr. Saxby said that in the fourth quarter the company had shipped a new chip design to 12 customers. At that time this was recognized as deferred revenue because the design was still an "immature" product. But the design proved to be workable in the first quarter and it was then considered "mature," so sales were booked as revenue at this time. Mr. Saxby added that the company will be shipping additional new designs in the second half of the year and "deferred revenue will go back up, absolutely, on the year."
Mr. Saxby also said that fears about Nokia are overdone as it relates to less than 5% of Arm's revenue.
In the short term, Nokia's relatively small effect on Arm's revenue will be ignored if Nokia comes out with a poor outlook Tuesday. But Arm's broad customer base will continue to be a strength going forward. The company is also looking to open new markets such as consumer products, and remains positioned to reap the rewards of recovery in the tech and mobile sectors.
Write to David Reilly at firstname.lastname@example.org