The Hidden Nasty In ARM Holdings plc’s Latest Results

ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) is a firm that I rate highly as a technology business, but would not touch with a barge pole as an investor.

Unlike many investing hidden nasties, ARM’s problem isn’t hard to find — in fact, it screams at you from the top of the firm’s annual results.

Despite this, I’m concerned that many investors have become so used to ARM’s habit of beating market expectations, that they are blind to the colossal risk attached to ARM’s shares — their outlandish valuation.

Are you an ARM bull?

ARM’s shares have risen by around 1,100% over the last five years, so shareholders who bought in at the start of the smartphone boom are now sitting on big capital gains. However, I don’t think that the bull case for the firm’s shares is as strong as it was.

This table shows ARM’s approximate P/E rating at the end of each of the last five years:

Year Year-end P/E
2009 47
2010 64
2011 67
2012 66
2013 (forecast earnings) 52

At this stage, if you’re an ARM bull, you’ll probably be reminding yourself of how ARM’s earnings per share are expected to rise by 75% this year, and of how they’ve risen by an average of 34% per year since 2007. Surely the good times will just keep on rolling?

Rising earnings aren’t enough

I’m not convinced. In response to this bullish argument, I’d like to make two points.

Firstly, even if ARM’s earnings do keep on rising, they’d have to double again before ARM’s P/E ratio came down to a more reasonable 26, without ARM’s share price making any further gains.

Secondly, ARM faces ongoing challenges to its business on at least two sides — Intel, which continues to invest in low-power chip designs, and which has the lion’s share of the server business, and Imagination Technologies, which owns the MIPS processor technology that also represents a challenge to ARM’s designs in some markets.  ARM also has other indirect competitors, such as Qualcomm and NVIDIA.

I don’t think that significant further capital gains are likely for ARM shareholders over the next couple of years, but the potential for the firm’s shares to slip lower on bad news is considerable. In my view, a 0.5% prospective yield is not a good enough reason for taking the risk involved in owning shares that trade on a forecast P/E of 52.

I believe that long-time ARM shareholders should probably sell and take profits, while new shareholders should re-examine their buying case.

A better alternative to ARM?

Investors looking for ARM-style capital gains of more than 1,000% need to turn their attention to smaller companies, which can easily double or triple in size over a 12-18 month period.

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> Roland does not own shares in ARM Holdings. The Motley Fool owns shares in Imagination Technologies.