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Still mourning ARM? Why not replace it with IQE plc and Imagination Technologies Group plc?

Image: Imagination Technologies: Fair use

ARM Holdings is one of the UK’s biggest business success stories. For years it has supplied the likes of Apple and Samsung with top-of-the-range microchips. The company delivered for shareholders too. If you’d bought ARM at its IPO and held it until it was acquired by SoftBank Group back in September you’d have racked up a total return of over 4,400%!

If you’re evaluating your portfolio this Christmas and find yourself mourning ARM, or regret missing out on those gains like I am, a combination of IQE Group (LSE: IQE) and Imagination Technologies (LSE: IMG) could be the perfect start to the New Year.

IQE

IQE is one of the leading global suppliers of wafer products and services to the semiconductor industry. In plain English, this means it supplies manufacturers in the wireless communications, solar power, infrared and LED tech spaces with customised wafers, which are then used to create microchips. If you want to start your research by finding out more about its manufacturing process, just click here.

The company has grown revenue from £73m in 2010 to £114m last year, with operating margins increasing from 9.9% to 13.3% in the same period. The company is creating more profitable intellectual property, for which it then receives licensing fees in a model similar to ARM’s.

So far so good. But the business only generated £3.5m, or 5.5%, of revenues through licensing in the first half. Yet it could be a very scalable, and thus profitable, operation for IQE.

In a trading update, it said it will beat earnings forecasts this year thanks to the strong performances across “across multiple markets, particularly in the photonics business.”

IQE is a niche player with plenty of tailwinds behind it, including the fact that smartphones are now an indispensable part of all our lives, as well as the internet of things (IoT) and LED technology. At only 13 times last year’s earnings, the company could deliver impressive returns from here.

Imagination Technologies

Imagination Technologies shares more similarities with ARM. Its tagline is Developing and Licensing Core IPs.

Like ARM, it designs chips for use in smartphones and tablets. It also makes its cash purely from licensing, allowing it to dodge the high capex costs that saddle anyone who actually creates products.

Imagination has had a tough year or so, swinging from a £5.7m operating profit to a £61.5m loss in 2016 due to poor performance in a number of non-core businesses.

I appreciate the decisive moves made by management, including the ongoing disposal of those non-core assets such as Pure, IMGsystems and IMGworks. The company is now focusing on the areas where it has the greatest advantages.

Its restructure should result in a return to profit next year, but with a market cap of £700m, a purchase at these prices requires unwavering faith in its IP.

If Imagination and IQE don't take your fancy, maybe our top small-cap stock will. It's helmed by an incentivised British founder who's overseen 20 years of success. You can pick up the double-digit earnings growth at a PE of only seven and the analyst behind the report believes the share price should be 70% higher today

To download the free report, click here

Zach Coffell has no position in any shares mentioned. The Motley Fool UK owns shares of Imagination Technologies. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.