Is ARM Holdings plc About To Hit £10?

The shares of ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) are on a roll.

If you followed my advice on 21 July, you would be able to sell out now and take home more than one British pound for each ARM share you had bought back then. That’s a 12.6% pre-tax return in less than one month. Call it shameless self-promotion…

£10 A Share

ARM Holdings

There are risks associated to this equity investment, but ARM shares could easily shoot above £10 before the end 2014. I’d stay put for a few weeks if I were invested below £9 a share.

ARM shares are up 5.75% for the year. They change hands at £9.37 on Wednesday. At £10, ARM shares would be valued at about 53x, 41x and 32x ARM’s earnings for 2014, 2015, and 2016, respectively, according to my estimates. These trading multiples should imply a steep growth rate for revenue — say above 20% annually.

But ARM is expected to grow sales only by about 9%, 9%, and 15% in 2014, 2015, and 2016, respectively. Revenue growth is only one part of the story, however. What happens next hinges on ARM’s capital-allocation strategy, which should include shareholder-friendly activity such as stock buybacks. That’s not a given, of course, but a rising cash pile offers plenty of options to a company whose managers know exactly what they are doing in difficult trading conditions.

Estimates & Fundamentals

Sales are expected to come in just below £800m in 2014, while ARM’s net income is forecast to hit £264m, which implies a net income margin above 30%. Its adjusted operating cash flow margin is likely to hover around 50% for some time. I expect more pressure on margins, but such a high level of profitability is reassuring. As competition rises, ARM faces challenges to grow it market share, and needs to explore alternative markets. That’s precisely what management are doing.

ARM’s gross cash pile is expected to double to almost £1bn in 2016. Its free-cash-flow yield stood around 2% in 2013, and it will be higher by the end of 2014. Capex requirements, which are projected at 2.5% of sales, are relatively low. Need to know more?

ARM is a debt-free entity. Yes, its dividend yield is below the market’s — but so what? If ARM continues to accumulate cash, it’ll be able to reward shareholders either chasing growth via M&A or returning cash via accretive buybacks and/or special dividends. Its relative valuation, as gauged by trading multiples, isn’t attractive because its growth prospects have deteriorated in recent years — yet ARM’s valuation should factor in several other elements, including its appeal as a takeover target for Intel.

If you think ARM shares are overpriced, you should learn more about a few alternatives that could offer plenty of upside to the end of the year. In fact, our analysts have identified five shares that are currently undervalued and would likely outperform the market in more challenging trading conditions. 

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool has recommended shares in ARM Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.