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Why ARM Holdings plc Is Cheaper And A Better Buy Than Vodafone Group plc

For the first time I can remember — indeed, perhaps for the first time ever — world-leading chip designer ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) is cheaper than mobile giant Vodafone (LSE: VOD) (NASDAQ: VOD.US).

Vodafone’s shares have been buoyant in the last couple of weeks, following comments from John Malone, chairman of cable group Liberty Global. Malone spoke about the attractiveness of Vodafone’s assets in western Europe. Some kind of deal may or may not happen, but viewed on a standalone basis Vodafone looks much less appealing to me than ARM at their current share prices.

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Business models

Vodafone has to spend huge sums on investment, particularly at the moment as it seeks to replace lost earnings from the sale of its stake in US firm Verizon Wireless. As well as exiting the US mobile market, Vodafone is also in the midst of transforming its business in Europe, through heavy organic and acquisition investment, as it seeks to become a “quad-play” provider, packaging mobile, landline, broadband and TV.

In contrast, ARM’s business is capital-light. ARM licenses and receives royalties on the microchips it designs. The company doesn’t do the manufacturing, so no heavy investment is required in factories and so on. ARM’s biggest investment is in talented engineers. The company’s operating costs are covered by licensing revenue, leaving a rising tide of royalties to swell profits as the number of licences increases.

While Vodafone is attempting to transform itself in a competitive market, ARM simply has to go on doing what it’s always done — designing great products and selling them at a great profit margin.

Debt and cash

Vodafone has net debt of £22.3bn, on which the interest paid last year was £1.6bn — almost the entire operating profit of the business. Debt is only going to increase in the next couple of years as Vodafone continues heavy capital investment and meets its commitment of paying a rising dividend, currently running at £2.9bn a year.

ARM has no borrowings, and the surplus cash on its balance sheet is increasing at a rate of knots: from £79m in 2008 to £922m today.

Earnings multiples

Vodafone trades on a forecast P/E of 45 for its financial year ending March 2016, falling to 39 for the year to March 2017. ARM has a December year-end, and a current-year forecast P/E of 36, falling to 30 next year.

ARM’s multiples are attractively in line with their historical norms, while Vodafone’s ratings, which clearly have a bid premium baked in, seem to require the company’s investment strategy to deliver in spades (if no bid is received), with nothing in the way of a margin of safety for investors at the current share price.

Dividends

Of course, Vodafone’s dividend has long been a big attraction. The forward yield is 4.6% compared with ARM’s 0.8%. However, recently-updated analyst forecasts, show a new consensus that Vodafone’s management will renege on its commitment to dividend growth. The consensus is for an 11.7p dividend this year (uncovered by earnings of 5.7p), cut to 11.6p next year (and still uncovered by earnings of 6.6p).

To put the dividends of Vodafone and ARM into context, Vodafone’s debt is equivalent to 7.7 times its current annual dividend. ARM’s cash is equivalent to 10.7 times its current annual dividend. The income risk for Vodafone shareholders is all to the downside; for ARM shareholders, all to the upside.

Foolish bottom line

Vodafone’s massive investment programme could deliver in years to come, or a takeover bid could send the shares higher. But it seems there’s little margin of safety for investors today. I believe that cash-machine ARM, on a cheaper earnings multiple — and with no reliance on the success of a business reconfiguration (or merger and acquisition activity) — is currently the better buy.

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G A Chester has no position in any shares mentioned. The Motley Fool UK has recommended 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.