Should You Buy Imagination Technologies Group plc Or ARM Holdings plc For Tech Exposure?

Roland Head asks if Imagination Technologies Group plc (LON:IMG) could soon start to gain ground on larger peer ARM Holdings plc (LON:ARM).

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Shares in Imagination Technologies Group (LSE: IMG) rose by 5% during the opening hour of trading this morning after the group published its 2015 results.

The results themselves weren’t all that great. Imagination reported revenue of £177m and a pre-tax loss of £12m, missing consensus forecasts for revenue of £179m and a pre-tax profit of £12m.

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However, the firm’s outlook for 2015/16 was better than expected. Imagination expects licencing revenue to rise by 10% in the current financial year. Unit shipments of chips and royalty revenues are also expected to rise.

Commenting on the results, chief executive Hossein Yassaie said that “major design wins for our graphics and processor IP with new high volume mobile players” would drive medium-term growth.

Mr Yassaie also said that the company expected operating margins to expand “significantly” in the medium term.

Time to buy?

All of this sounds very positive, but Imagination has disappointed investors hoping for growth before. The firm’s shares have fallen by 20% over the last five years, during which those of its profitable peer, ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), have risen by 272%.

Even using Imagination’s adjusted operating profit of £21.1m, the firm only managed an operating margin of 12% last year. That’s a far cry from the 39% margin reported by ARM in 2014.

In theory, Imagination’s profit margins should rise as volumes rise due to operational gearing. This is the effect achieved when sales rise faster than costs, driving an increase in profit margins.

However, it’s clear that Imaginations business lags well behind ARM in actually delivering this benefit to shareholders.

Valuation question

ARM and Imagination both trade on a 2016 forecast P/E of about 28. Neither company offers a significant dividend yield. For investors considering buying the shares today, the choice is down to growth — which company can deliver the strongest earnings growth?

Interestingly, analysts’ consensus forecasts for the 2015/16 financial year show earnings per share growth of about 20% for both companies. The market is clearly bullish on both ARM and Imagination and believes that the outlook for both firms is improving.

The difference is that ARM already has a long track record of steady growth. ARM’s earnings per share have risen by an average of 22% since 2010, whereas Imagination’s have risen by an average of just 2% per year over the same period.

Imagination’s strategy and new contract wins look promising, but next year’s earnings per share are only expected to equal those reported in 2011. What’s more, while ARM has net cash of £691m and generated surplus cash of £122m last year. Imagination has net debt of £27m and has reported significant cash outflows over both of the last two years.

Based on past performance, ARM is a superior quality business in every way. Given the firms’ similar valuations, I would buy ARM shares rather than those of Imagination.

I’d only buy Imagination if I really believed its growth would outpace that of ARM. This doesn’t seem likely to me, given that both firms serve similar markets and customers.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has recommended ARM Holdings. 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.

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