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The Pros And Cons Of Investing In ARM Holdings plc

Stock market selections are never black-and-white decisions, and investors often have to plough through a mountain of conflicting arguments before coming to a sound conclusion.

Today I am looking at ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) and assessing whether the positives surrounding the firm’s investment case outweigh the negatives.

Licencing revenues continue to climb…

ARM Holdings’ has carefully cultivated its position as a top tier supplier to the world’s biggest technological firms, its industry-leading architecture resulting in a continuous stream of contract wins from the likes of Apple and Samsung

Indeed, October’s financials showed revenues from processor licences rise to $102.6m during July-September, a colossal 52% advance from the corresponding 2012 period. And ARM Holdings’ decision to diversify into other markets, such as networking and servers, promises to keep turnover from licences moving higher.

… but royalties threaten to dip

Still, signs of massive structural concerns in ARM Holdings’ critical tablet PC and smartphone markets leaves it exposed to severe royalties weakness looking ahead. Fears of consumer saturation, combined with the rising popularity of budget devices and thus lower revenue prospects for chipbuilders, are casting a long shadow over the firm’s ability to keep revenues rolling.

ARM Holdings noted in October’s interims that royalties per share remained flat during the third quarter, at 4.9 US cents per chip.

Double-digit earnings growth expected

However, City brokers anticipate that earnings will continue rumbling higher at a rate of knots into the medium term at least. For 2013, ARM Holdings is expected to punch earnings per share growth of 39%, to 20.7p, before advancing an additional 21% next year to 25.1p.

Meanwhile, news that the company had inked 48 new licensing agreements during July-September has built confidence that the chip giant can keep earnings growing strongly well into the future — Barclays Capital expects ARM Holdings to maintain an earnings compound annual growth rate above 25% for the medium-to-long term.

Too pricey a pick?

But fears remain that the stock remains excessively expensive. Shares in ARM Holdings have crept steadily higher, after a less-than-convincing growth presentation prompted June’s heavy collapse, and were recently seen dealing above 1,000p once again.

Based on current earnings projections, this leaves the firm trading on P/E multiples of 48.3 and 39.9 for 2013 and 2014 respectively, sailing above a forward average of 22.3 for the whole technology hardware and equipment segment.

An underwhelming stock selection

As the summer’s price collapse illustrated, companies dealing on elevated earnings multiples can be prone to severe share price shocks in the event of even the most meagre concerns over growth levels. Given rising worries over reduced royalties and the onset of increased competition, I believe that ARM Holding’s stunning earnings outlook could come under the cosh.

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> Royston does not own shares in any of the companies mentioned in this article.