How Will ARM Holdings Plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

• Prospects
• Risks
• Valuation

Today, I’m looking at semiconductor intellectual property (IP) supplier ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) .

Track record

With the shares at 982p, ARM’s market cap. is £13,779 million.

This table summarises the firm’s recent financial record:

1) Prospects

ARM licenses its technology to a network of partners who are mostly leading semiconductor manufacturers. Those customers incorporate ARM’s chip designs alongside their own technology to create what the firm describes as smart, energy‑efficient chips suitable for modern electronic devices such as smartphones.

The CEO reckons that opportunities for ARM’s high-performance, low-power technology are increasing thanks to escalating demand for inter-device connectivity. With the autumn three-quarter results, the company revealed year-to-date revenue up 27% compared to the year-ago figure, earnings per share up 44%, and operating margins up 9% to a healthy looking 49.2%.

A strong operating margin like that underlines the robust position the firm enjoys in its sector.  ARM has secured a strongly defended economic position for itself at the very heart of the hardware market in today’s mass-consumer digital communications world. With the directors seeing increasing demand, and given ARM’s apparent pricing power, it’s easy to imagine ARM enjoying robust trading in 2014 and beyond.

Full-year results for 2013 are due around 4^th February. Investors’ expectations will be high, as in the autumn, the directors said the company had a record order backlog and a sturdy opportunity pipeline.

2) Risks

ARM’s own risk statement says that the semiconductor industry is characterised by price erosion, rapid technological change, short product life cycles, cyclical market patterns, and intense competition. As such, technological changes in the industry could affect the firm’s operating results.

The company mitigates such risks by keeping a healthy looking cash-cushion of around £567m at the most recent count, which is about equal to the firm’s annual turnover and around three times operating profit. Should any part of its business start to slip, or if any other event threatens trading, the firm’s liquid resources should buy time to address the challenge.

3) Valuation

Looking forward to 2015, consensus earnings’ forecasts throw up a P/E rating of about 32. City analysts following the company expect earnings’ growth to come in at around 24%.

Meanwhile, the forward yield is running at 0.9% with earnings expected to cover the dividend 3.6 times.

To understand ARM’s valuation, it’s worth drawing on the ideas of legendary growth investor Philip A Fisher. If a company has outstanding business and economic characteristics, as has ARM, P/E ratings become a quality mark. In other words, cheap is cheap but value is what you get.

So, in the same way that an Apple computer costs more than an Acer computer, a premium company can cost more than one with lesser business prospects. As long as the qualities of the company don’t diminish, the P/E rating is unlikely to fall in the future. As such, a high, yet stable P/E rating then becomes a pattern against which to judge any over- or under valuation.

What now?

ARM enjoys a stout market position underlined by recent improvements in operating margin. However, should earnings’ growth or margins start to slip the firm’s P/E rating could adjust downwards, although the outlook is good now.