4.9 Reasons That May Make ARM Holdings plc A Sell

Today I am explaining why I believe ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) is showing worrying signs of slowing revenue potential.

Royalties outlook set to become gloomier

At first glance, ARM Holdings’ October interims made for chipper reading, with revenues rising 27% during July-September to £184m and  pre-tax profits increasing 36% to £93m. But drill down a little lower, and royalties of just 4.9 US cents per microchip underlined the momentum slowdown that is becoming an increasing headache for the firm.

These average royalty revenue per unit figures for quarter three showed no growth from the corresponding 2012 period. Looking ahead, the threat of slowdown in consumer uptake in the critical tablet PC and smartphone markets, coupled with the switch to lower-priced products therein and consequent effect on royalty rates, is casting huge concerns over whether ARM Holdings can arrest this downturn in performance.

As well, the growing threat from heavyweight tech rivals — Liberum Capital expects Intel to snatch market share of between 15% and 20% of the tablet and smartphone markets in coming years, for example, from currently modest levels — is also likely to hamper turnover projections looking ahead.

And although ARM Holdings signed a record 48 new processor licences during the third quarter, Liberum notes that “many of the new licenses are in areas like networking, embedded microcontrollers and the internet of things… They are not expected to compensate for potential weakness in smartphone and tablet-related revenues which we estimate to account for about 70% of ARM’s PD royalties.”

Shares in ARM Holdings collapsed almost a third in the space of a month from May’s record summit around 1,100p, illustrating the volatility which can rapidly beset stocks carrying high valuations. Prices have since recovered strongly, worsening the firm’s already-bloated multiples and leading to fresh speculation of further weakness.

Indeed, the company currently deals on a P/E rating of 47.5 and 38.9 for 2013 and 2014 correspondingly, based on current City earnings projections. This is well above an average prospective multiple of 27.4 for the entire technology hardware and equipment sector.

And although bulls can point to bubbly earnings per share growth forecasts of 38% for this year and 22% in 2014 as justification for these high readings, the firm’s price to earnings to growth (PEG) multiples show that the stock’s price is no longer decent relative to its growth potential. These currently come in at 1.2 and 1.8 for 2013 and 2014 respectively — any reading below 1 suggests acceptable value for money.

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> Royston does not own shares in ARM Holdings.