ARM Holdings plc’s 2 Greatest Weaknesses

appleWhen I think of semiconductor intellectual property (IP) supplier ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.

1) Valuation

A strong operating margin running at just over 49% underlines the resilience of ARM’s economic franchise within the consumer electronics industry. The firm licenses its chip designs to digital equipment manufacturers around the world and its technology appears in smartphones and other devices whatever the brand name on the front. The balance sheet is strong and the firm has the equivalent of a year’s turnover in cash. Growth prospects remain perky and ARM’s purple existence seems set to continue.

Such sterling business performance rarely comes cheap, however, and ARM’s P/E rating is running at around 31 for 2015. City analysts expect earnings to grow about 24% that year. That’s a hefty price tag, but ARM is a quality proposition as an investment; we are not sifting through the bargain-bin here. Nevertheless, a high valuation brings its own kinds of risk (so does a low valuation, but that’s for another day). If earnings miss expectations, investors should expect a slump in the share price as the P/E rating adjusts downwards to accommodate revised assumptions on growth.

So ARM is an obvious investment no-no, right? Not so fast; ARM’s valuation has looked as high as this for as long as I’ve been actively investing but, had I bitten the high P/E bullet when I first considered the shares around 2005 I’d be sitting on a ten-bagger by now.  If a company has outstanding business and economic characteristics, as has ARM, P/E ratings become a quality mark.  If forward earnings’ growth comes in at today’s levels in 2015, there’s every reason to expect ARM’s P/E rating to be as high then as it is now.  Yes, if earnings miss expectations the share price will slip, but I’ve bought value situations with low P/E ratings and discounts to net asset value and they seem just as prone to slipping share prices. So, what would you rather have, cheap or quality. Personally, I’m moving more and more to quality both in general life and in my share purchases.

2) Visibility

Lifting the bonnet and looking at ARM’s business really is like looking at the engine of a modern car for me: there’s a big block and you can’t see what’s going on inside. The technical stuff that ARM designs is well outside my knowledge-zone and ARM’s ‘engine’ is not like Greggs‘ for example, which would compare more with the Ford Escort I used to own a few decades ago and happily fix if it went wrong.

I understand the numbers ARM throws out, though: profits rising, strong cash flow, money in the bank, high margins and the like. It’s just that, unlike Greggs’ buns, I have to take ARM’s product on faith and I’d be slow to spot negative trends in the industry.

What now?

ARM enjoys a strong economic franchise underlined by recent improvements in operating margin. However, robust business performance comes at a price and ARM shares look expensive.

A high P/E ratio may lead to a 'slightly down' earnings quarter knocking the shares. Indeed, such an event may present investors with a better buying opportunity in the future. In the meantime, I'm enthusiastic about five companies with strong economic franchises and, seemingly, well-defended operating niches analysed in a well-researched Fool report. 

I recommend the five shares for your own due diligence and research, as they surely deserve consideration by investors aiming to build wealth in the long run. To download the report click here.

> Kevin does not own shares in ARM Holdings or Greggs.