What ARM Holdings plc’s Investment Plans Mean For Earnings Growth

Today I am looking at why I believe ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) is a risky proposition for stocks selectors.

Huge cash pile facilities product development

Like all tech specialists, ARM Holdings is required to chuck large sums of money into developing the next generation of technologies for the smartphone and tablet computer markets. Recent overtures into the computer networking and servers markets are also swallowing up vast reserves of capital.

Promisingly, a backdrop of surging profits has helped the company to deliver stunning cash growth in recent times, an essential applerequirement to deliver a steady stream of cutting-edge products and maintain its position as a prime supplier to the likes of Apple and Samsung.

Last year the company printed a 32% advance in pre-tax profits — to £364m — a result which pushed net cash generation to £344.5m from £267.3m in 2012. Thanks to this steady performance, the company recruited 441 new staff last year, taking the total to 2,833 and of which 70% were planted into its R&D operations.

ARM Holdings has also been busy on the M&A stage in recent months to supplement in-house development. Indeed, in December the business purchased Geomerics, a specialist in lighting technology in computer games, for £13.4m from medical technology firm ANGLE.

ARM Holdings  commented that “the acquisition expands [our] position at the forefront of the visual computing and graphics industries,” and the company expects Geomerics’ innovative technologies to revolutinise the graphics capabilities of smartphones for mobile gaming, a critical requirement for today’s devices.

Chipbuilder in jeopardy of sizeable price correction

ARM Holdings has printed gargantuan earnings expansion in each of the past four years, and sports a compound annual growth rate of 30.8% for the period. And City analysts expect this momentum to continue through the medium term at least, with growth of 16% and 25% anticipated for 2014 and 2015 respectively.

However, these projections leave the chip specialist changing on heady P/E multiples of 41.5 for this year and 33.2 for 2015, comfortably ahead of a forward average of 27.2 for the entire technology hardware and equipment sector.

Elevated ratings are part and parcel of the world’s tech specialists, big and small, which makes them prime targets for sudden and catastrophic sell-offs. Indeed, this week’s panic selling of such stocks illustrates the high-risk associated with companies trading on such high multiples.

I have long argued that a backdrop of slowing smartphone and tablet PC adoption rates, not to mention the onset of intensifying competition in ARM Holdings’ key markets from the likes of Intel, could put the company’s earnings outlook under intense scrutiny.

Given these problems I believe that the chip designer is in severe danger of further waves of stock price weakness, even in spite of the vast sums of capital the firm is devoting to R&D to drive growth.

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Royston does not own shares in ARM Holdings. The Motley Fool owns shares in Apple.