Why You Should — And Shouldn’t — Invest In ARM Holdings plc

Today I am running the rule over the drivers and drawbacks that should influence any potential investment in ARM Holdings (LSE: ARM).

Rolling along on the Apple cart

One of ARM Holdings’ main strengths is its top-tier supplier status with tech leviathan Apple. The multi-year alliance between the firms has been underlined by persistent chatter that the California company is planning to acquire a massive stake in the British chipbuilder, a deal that would make sense given that the fortunes of Apple’s products are tied so closely to those of ARM Holdings’.

But whether or not a bid is made, the Cambridge should continue to benefit from surging demand for iPads and iPhones the world over. Latest numbers from Apple showed 47.5 million smartphones sold during April-June, up 35% year-on-year, a result that helped power group revenues 33% higher to $49.6bn. And the launch of the company’s next iPhone in the coming months should keep lighting up the top line.

Smartphone demand in decline

Still, Apple’s continuing success in the mobile device market is bucking the wider industry trend as growing market saturation in the West dents the sales performance of other major operators like Samsung and Microsoft. Indeed, just this month the latter announced it was slashing the headcount of its phone division by 7,800, as well as booking a $7.6bn writedown on the unit.

Naturally this is a major worry for ARM Holdings, whose hardware is used by all of the world’s major phone manufacturers. On top of this, the English business also faces growing pressure as mobile phone users increasingly switch to cheaper devices from premium items, a situation that is likely to cause escalating headaches for future royalties.

Diversification promises rich rewards?

ARM Holdings can hardly be accused of resting on its laurels, however, and has for some time been diversifying its operations into the rapidly-growing networks and servers market. Indeed, the business advised earlier this month that “the number of chips going into networking equipment increased by 30% [in April-June], mainly driven by shipments… into base-station and office-networking equipment.”

On top of this, semiconductor builder recently Cavium announced that industry heavyweights ASUS, Gigabyte and Wiwynn were releasing new servers and server boards, Cavium platforms that utilise ARM Holdings’ Thunder-X products. Although these areas still represent a small percentage of total revenues, ARM Holdings’ investors should still be encouraged by this early success.

A pricey stock pick

But whether ARM Holdings deserve a premium rating given the ongoing troubles across its core smartphone and tablet PC markets remains a bone of contention. While share prices have eroded 12% in little more than a month, current earnings projections still leave the chipbuilder dealing on elevated P/E multiples of 33 times and 27.7 times for 2015 and 2016 correspondingly.

These figures sail well above the yardstick of 15 times that indicates decent value, and while the City expects ARM Holdings to enjoy earnings growth of 69% this year and 19% in 2016, should these numbers come under scrutiny then the Cambridge firm could see its stock price experience further significant weakness.

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Royston Wild 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.