Growth is usually the main driver of value for tech companies, but for ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), growth is just one part of the story — and that?s not the most appealing right now.
In fact, ARM stock becomes a truly compelling investment proposition once the British chip designer?s appeal as a takeover target is being considered. At this point in time, shareholder-friendly activity shouldn?t be ruled out, either. Both elements signal that ARM is a resounding buy at this level, in my view.
Second-quarter results released on Tuesday…
Growth is usually the main driver of value for tech companies, but for ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), growth is just one part of the story — and that’s not the most appealing right now.
In fact, ARM stock becomes a truly compelling investment proposition once the British chip designer’s appeal as a takeover target is being considered. At this point in time, shareholder-friendly activity shouldn’t be ruled out, either. Both elements signal that ARM is a resounding buy at this level, in my view.
Second-quarter results released on Tuesday were better than expected. ARM stock was up 4.1% at 9.10am, and is greatly outperforming the market (0.6%).
ARM’s Q2 revenues were up 17% to $309m — although top-line growth in British pounds was 9%. That’s a respectable performance. The operating margin came in at 48.9%, i.e. some 30 basis points higher than in Q2 2013. Earnings per share were 11% higher. Guidance for the year has been confirmed.
As expected, currency swings had an impact on ARM’s performance, yet ARM may surprise on the upside to the end of 2014 if, as I expect, the $ strengthens.
Growth in licensing (“licensing revenue in US$ up 42% year-on-year”) was offset by lower figures for royalties, which were a tad disappointing, (“royalty revenue in US$ up 2% year-on-year), although the company pointed out that “market data indicates improving semiconductor industry conditions, leading to the expectation of an acceleration in royalty revenue growth in H2 2014.”
a) As demand for tablets and smartphones sputters, it’s an uphill struggle out there for ARM and the likes.
b) Intel may become a real threat, which suggests the next few weeks of trading won’t be a stroll for ARM shareholders.
c) A strong British pound also puts pressure on ARM’s revenue and earnings, for about all of ARM revenue are booked in $ dollars, while roughly half of its cost base is in British pounds. A 5% move up or down in the $/£ exchange rate may impact earnings per share by about 8%, one way or another.
That said, ARM could still surprise the market on Tuesday by taking a page out of Intel’s playbook, stating its intention to undertake shareholder-friendly activity.
Intel reported upbeat figures for the second quarter last week, which partly contributed to a surge in its stock price on 16 July. The big piece of news, however, was the $20 billion increase in its share buyback program. Intel plans to buy back $4 billion of its own shares in the third quarter.
It’s tempting to suggest that ARM should take heed. The difference between ARM stock and Intel stock is that former trades at a 52-week low, while the latter trades at a multi-year high. So, ARM may be able to deliver more value via a stock buyback than Intel if it decided to repurchase up to 10% of its own equity capital.
A Takeover Of ARM
As I argued in May, a takeover of the ARM is a distinct possibility if weakness in its valuation persists. After all, ARM would be a small bite both for Intel and Oracle, the two most likely suitors. The UK’s largest tech company by market cap has a market value of about £11bn and is net cash. There’s lots to like in it.
Growth in tech-land sputters, true. Rich valuations point to downside risk, true.
But ARM’s relative valuation signals that: a) ARM stock is still a bargain, based on fundamentals (the business is capex-light, debt-free, and boasts hefty operating margins) and prospects; b) ARM’s intention to get deeper into the enterprise networking market is not properly priced into the stock; c) investors who do not expect strength in the $ dollar against the British pound may be proved wrong.
Our analysts believe, just as I do, that there are several undervalued shares in the marketplace. These shares are associated to companies that may benefit if the recovery continues, but may also be able to withstand much buffeting if the recovery falters.
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool has recommended shares in ARM Holdings.