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How Safe Is Your Money In ARM Holdings plc?

The UK’s largest listed technology firm, ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), has an impressive, cash-rich balance sheet and no debt.

It also has low capital expenditure commitments and high profit margins, thanks to its licensing-based business model, which helps it avoid the high costs and risks of manufacturing.

This means that on the face of it, ARM shares are a very safe place for your money. However, the firm’s growth record has given it an ambitious premium valuation that looks increasingly precarious. ARM shares are down by 11% so far this year, compared to just 2% for the FTSE 100.

As a result of ARM’s recent falls, I’ve been taking a closer look at the firm’s finances, to see whether shareholders should think about reducing their exposure to ARM.

Debt free, cash rich

ARM has no debt, and has cash and short-term deposits totalling £587.9m. It also has long-term deposits of a further £125m.

All in all, ARM has ‘savings’ of £713.5m, roughly equivalent to one year’s revenue.

As a result, ARM received net interest of £13.1m in 2013, an amount which equates to 8.5% of its operating profits.

Although ARM’s bulletproof finances are impressive, you could argue that they should be putting some of this cash to good use, or perhaps returning a little more of it to shareholders as dividends.

Fat margins, declining?

ARM’s operating margin in 2013 was a healthy 21.5%, but once a £59.5m non-cash impairment of certain assets is adjusted out of these figures, the firm’s operating margin rises to 29.8%.

Although this is impressive, it’s worth noting that it is 7% lower than the 36% operating margin the chip designer achieved in 2012. As a result, ARM’s adjusted operating profits were broadly flat this year, despite a 24% increase in revenues.

Valuation risk

In my view, the biggest financial risk facing ARM investors doesn’t relate to the company at all — it relates to the market’s current valuation of ARM shares.

ARM stock currently trades on a forecast P/E of 40 that already prices in sales growth of 12% this year, along with earnings per share of 24.2p — double last year’s 12.8p per share.

Any failure to deliver on these ambitious forecasts could result in sharp re-rating of ARM’s shares. Indeed, in my view, this is almost inevitable at some point, unless something unexpected happens to transform the scale of ARM’s business.

If you invested in ARM shares five years ago, your investment has risen by 785%. The firm's explosive growth has probably created a number of millionaires -- but I believe that opportunity has now passed.

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> Roland does not own shares in any of the companies mentioned in this article.