Is Iomart Group Plc A Buy Or Should You Play It Safe With ARM Holdings plc?

Cloud computing firm Iomart Group (LSE: IOM) published its full-year results this morning. Sales rose by 18% last year, while pre-tax profits were up 14%.

The results seemed pretty reasonable to me, so I was surprised when the share price collapsed when the market opened, falling by more than 10% at one point.

The shares have since largely recovered, but this morning’s market reaction highlights the greater volatility that often characterises the shares of smaller companies.

In this case, I believe it’s also the result of Iomart’s failure to convert a 300p per share bid proposal into a takeover deal in August 2014. The shares now trade 26% below this level.

Some good news

The good news for Iomart shareholders is that they appear to own shares in a good quality company.

Iomart’s adjusted diluted earnings per share rose by 16% to 12.6p last year, in-line with analysts’ expectations. This puts the shares on a P/E of 17.6, falling to 15.2 in 2016 if the firm hits current forecasts.

Two of the firm’s key attractions are its profitability and strong cash generation. Iomart reported an operating profit margin of 18.5% last year. As a result, net cash from operating activities rose by 10.5% to £23.9m, with free cash flow of £8m, which seems to have been used to reduce debt.

Iomart has grown through regular acquisitions and is expected to deliver earnings per share growth of about 15% next year. Is this enough to justify a buy at current prices?

I’m not sure. This is a business that requires regular investment in new equipment and is prone to technological disruption and intense competition.

On balance, I’d only buy Iomart if it was a bit cheaper.

Is ARM a better choice?

However, many investors (including me) have said that ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) was too expensive to buy, and been proved wrong.

When I first started covering ARM in 2012, I though the shares looked too expensive to buy. They’ve since risen by 120% in just four years. Sometimes paying a premium for quality can deliver outstanding returns.

The question is whether Iomart has any of the characteristics that make ARM so valuable and consistently successful.

ARM vs Iomart

Iomart appears to be a leading and successful operator in the cloud computing market, but this is inevitably a business where competition will be intense and price sensitive.

My feeling is that ARM faces less hostile competition, as the capabilities of its market-leading designs are hard to emulate with cheaper alternatives.

ARM also has a second big advantage. The beauty of the firm’s business model is that it needs very few assets to generate the chip designs it licences to manufacturers. In contrast, Iomart needs to invest in new equipment regularly to ensure its services remain best-in-class.

ARM’s shares do reflect this rich appeal, trading on a 2015 forecast P/E of 36 and with a yield of less than 1%. However, ARM has so far been able to grow into its valuation, and could well continue to do this, given the growth in demand for internet-connected devices.

Ultimately, I believe Iomart and ARM are both good companies, but they’re both already quite fully valued.

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Roland Head 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.