Is ARM Holdings plc Still A Buy Today?

ARM Holdings plc (LON:ARM) always looks expensive but keeps performing. Roland Head asks whether the chip designer is still a buy.

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ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) isn’t the most obvious choice for a buy. After all, the chip designer’s shares trade on a lofty 81 times last year’s earnings, and boast a 2013 forecast P/E of 47. Cheap, they ain’t.

In the past, I’ve been fairly bearish on ARM, and earlier this year, I thought I was being proved right: after peaking at around 1,100p, ARM shares descended rapidly to a low of 758p. However, they’ve since regained almost all of their earlier losses and remain up by 26% so far this year, at 990p. So what’s happening?

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Am I wrong?

It seems that I may simply have underestimated the growth potential of ARM’s customers. ARM published its third-quarter results yesterday, and compared to the same period last year, pre-tax profits were up by 36% and sales were up by 26%. In three months, the company generated £111.6m in net cash, and 2.5 billion ARM-based chips were shipped.

ARM’s balance sheet also remains very strong, with no debt, and cash and short-term deposits of £567m. I was initially concerned by the fall in ARM’s operating margin, which was 27% for the first nine months of this year, down from 37% for the same period last year, but last year’s margin seems to have been exceptional, as in 2011, the firm’s operating margin was ‘only’ 30%.

It’s also worth remembering that ARM’s profits are heavily affected by the sterling-dollar exchange rate, as 95% of ARM’s invoicing is in US dollars, but it reports in pounds sterling. This year’s weaker dollar will have reduced ARM’s sterling profits, even if US dollar profit margins remained unchanged.

Is ARM a buy?

How long can ARM’s rapid growth continue, without the firm sacrificing either profit margins or volumes? ARM’s royalty-based business model is brilliant, but it does mean that actual profits are petty minimal — just £144.6m for the last quarter, for example.

ARM’s value is in its intellectual property, and its footprint in key, high-margin devices, such as the Apple iPhone and iPad, where I only expect to see incremental growth.

I think that any serious weakness in ARM’s share price would result in it becoming a buyout target, but in the meantime I expect a fairly flat performance unless the firm manages to make serious progress in the server market, where it has to find a way of displacing the incumbent, Intel.

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> Roland does not own shares in any of the companies mentioned in this article. The Motley Fool owns shares in Apple.

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