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Why ARM Holdings plc Has Great Growth Prospects

appleARM Holdings (LSE: ARM) (NASDAQ:ARMH) has been pretty much a byword for earnings growth over the past decade, with its chip designs being used in just about every imaginable kind of portable computing device — the power behind iPhones and iPads is clearly something to be reckoned with.

And with the share price having nine-bagged over the past five years, to 908p, shareholders have done very nicely out of it.

For the year just ended in December 2013, ARM reported a 40% boost in earnings per share (EPS) to 20.9p — and though EPS rises are forecast to slow a little over the next two years, we’re still looking at very strong growth. Here’s last year’s key figures together with forecasts for 2014 and 2015:

Mar EPS Change P/E Dividend Change Yield Cover
2013 20.9p +40% 53 5.7p +27% 0.5% 3.7x
2014* 24.2p +16% 37 6.7p +17% 0.7% 3.6x
2015* 30.1p +24% 30 8.3p +24% 0.9% 3.6x

* forecast

The first questions to ask are whether those earnings growth prospects are realistic, and for how long can it continue?

A great 2013

Well, with ARM last week having reported an overall 15% rise in revenues in US dollar terms, and with the growth in mobile phones, computers and the like looking nowhere near ready to slow down just yet, it’s pretty certain that ARM is going to carry on selling a lot more stuff.

But it’s interesting to see the split in those revenues.

In the fourth quarter, ARM enjoyed a 7% year-on-year rise in royalty revenue from the continuing use of its processor designs, against an estimated 2-3% for the industry in general. But more impressively, ARM saw a 26% rise in licensing revenue, having agreed 26 new processor licences in the quarter — covering medical uses and the upcoming market in wearable devices, in addition to the usual smartphones and tablets. And ARM’s inroads into the server and network markets gained momentum, too.

In fact, a total of 2.9 billion ARM-based chips were shipped in the fourth quarter alone, which is a pretty staggering number.

The current year looks set to continue the trend, with the company saying “…we enter 2014 with a strong opening order backlog and a healthy pipeline of licensing opportunities“.

Too expensive?

EPS growth, then, seems pretty much assured. But at what price?

A year-end price to earnings ratio of 53 for 2103 is, erm, a bit high by conventional standards — and a 2-year-out drop to 30 would still leave ARM shares priced at about twice the long-term FTSE average. But ARM shares have always been highly-priced, and you’d need to be pretty pessimistic to believe the growth supporting that valuation is going to falter any time soon.

It is important to remember, mind, that the ARM share price has been flat over the past 12 months, so investors’ appetites for such a high P/E multiple might have topped out.

Weak dividends?

The dividend yield isn’t anything to shout about, but the yield does hide the fact that ARM is actually paying out a reasonable portion of its earnings.

Suppose ARM’s earnings growth suddenly stopped right now and that lofty P/E collapsed to the current FTSE average of about 17 — what would happen? The share price would have to come down to about 290p. And at that price, the forecast 2015 dividend of 8.3p per share would yield nearly 3%!

So ARM even has the potential to become an attractive income investment in years to come — but it’s surely not going to be for a while yet.

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> Alan does not own any shares in ARM Holdings.