Exchange rates and expansion plans dampen enthusiasm for investment.
ARM
(LSE: ARM)
is without doubt one of the most successful UK technology companies of all time in terms of everyday worldwide use, however it has not managed to translate this success into decent returns for shareholders for a long time.
The first challenge that ARM faces is that the majority of its costs are incurred in pounds sterling, whereas the majority of its revenues are earned in dollars. In the current year the pound has strengthened from $1.75 at the beginning of the year to $1.92 by the end, making growth hard to achieve.
Indeed, in yesterday's annual results, fourth quarter sales were up 20% in dollar terms but only 8% up in pound terms. This makes predicting the future difficult for ARM shareholders.
Exchange rate issues also make it very hard to understand the ARM financial results. For example, a £79m negative movement in Capital & Reserves under IFRS more than wiped out profit for the year of £49m.
The results also highlight the natural upside in the business model from royalty revenue. Royalties accounted for 41% of total revenues and yield extremely high margins.
Basically, as more ARM based products are sold onto the market more royalty revenue is received and this should theoretically yield more return for shareholders. 2.45bn products contained ARM technology in 2006, a 45% increase year on year and this is expected to increase to 4.5bn in 2010. The royalty rates are already determined in contracts and this gives senior management extremely good visibility of future revenues.
One of the potential downsides to the business model is if investment in people expands more quickly than return to shareholders. In 2006, there was a huge 25% increase in the number of employees as ARM invested in developing new product lines. It is promised that a brake will be applied to this expansion in 2007.
The other potential downside is that management might make poor acquisitions. ARM's largest recent acquisition was of Artisan, which helped ARM expand from microprocessor design into physical semiconductor design.
It is too early to judge the success of the Artisan deal or expansion in other non-core areas. The potential worry is that the ARM balance sheet now contains £364m of goodwill which is subjected to a regular impairment test and will result in write-offs if the expansion plans do not meet expectations.
ARM has a dividend and share buyback programme which means they now return a large proportion of any cash generated. The total returns since July 2005 have been £125m which includes a share buy back of 5.6% of issued capital which more than balances the issue of shares from share option schemes.
In summary, ARM carries a huge risk in terms of currency exposure and business expansion plans. Balancing this, the management team has proved extremely successful in the past and present in carving out niche markets. ARM is probably the best share on the LSE for anyone looking for exposure to the semiconductor sector and all the risk that brings.
