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In its last set of figures ARM disclosed a 175% rise in shipments, a 60% rise in turnover and a 117% rise in profit in before tax. Although the shares have not done much in the last three months they are still on a pretty demanding rating. It is currently valued at £7.33b, yet last year it made a net profit of £16m. ARM needs many years of strong growth to justify that premium. We have seen recently in the US how statements by a number of companies that growth will be lower than previously expected has had dramatic effects on the share prices. These are not really profit warnings, merely reduced growth rates.
One factor that is common to high growth stocks in the US and the UK is the under-reporting of profits through the use of share options. A firm like ARM is essentially a 100% people business. Its designers and technicians are its key assets. But these small companies can't afford to pay huge salaries to the brightest chip designers. Instead they offer employees shares in the company. This might sound like a great deal for everyone; after all it is essentially free money isn't it?
Well, not really. You see each time a new share is issued every other shareholder is diluted, albeit only a little bit. That means they own less of the company than they did before. Perhaps a simplified and exaggerated analogy will help. Imagine that every year you had your house windows cleaned and you paid the window cleaner by giving him 1% of the value of the house. Twenty years ago, when the house was worth £10,000, it wasn't too bad. But now that the house is worth £100,000 you actually gave him £1,000 in the first year, and now he owns 20% of your house. That doesn't look quite so smart today.
For high growth businesses like ARM, their equity, the ownership of the company, is the most valuable thing it has. And therefore the most expensive. ARM's balance sheet might look great because it is stuffed full of cash. But, in reality, using shares instead of real money from the £52m in the bank to pay its employees is costing shareholders a fortune.
To be fair to ARM it has actually quantified the cost to shareholders of using this form of compensation. In the notes to the accounts it says that the fair value of the options on the stock granted to employees was worth £736,000 at December 31st 1999. If the full cost of those options had been charged to the accounts it would have actually reduced the net income for 1999 from £16.2m to £13.6m and reduced earnings per share from 8.6p to 7.2p. In the context of a price earnings ratio of 463, those changes really don't alter the story very much. But don't forget that employees still have options over another 16m shares, and presumably are getting more every year. With only 189m shares outstanding giving away 8% of the company for an average price of 159p is going to cost all the other shareholders a substantial sum in years to come. Something to bear in mind when analysing next week's figures.
Send your thoughts on this issue to the ARM discussion board.