Here’s why ARM Holdings plc is a buy but Burberry Group plc is a sell

A well-defined growth path

In recent times bullishness in Apple has translated into bullishness in ARM Holdings (LSE:ARM). Traders and investors alike would get interested in ARM whenever Apple released strong earnings. It’s not difficult to understand why — Apple is one of ARM’s biggest customers. Thus, the larger sales of smartphones using ARM’s components, the larger amount of royalties for ARM.

However, the exponential growth of the smartphone and tablet market was not going to last forever, with both high and low end smartphones vying  for market share, resulting in many now believing that the smartphone and tablet market is close to saturation.

Companies with good management tend to adopt a proactive approach. Luckily for ARM, its revenues are more diversified than they were six or seven years ago. The growth of the ‘Internet of Things’  has seen rising demand for chips that are able to operate on low power, as devices get ever-smaller.  Producing chips that operate on low power is one of ARM’s key skills. ARM’s long-term prospects will be further enhanced if autonomous cars and mobile computing turn out to be key growth markets, as they will help firm up long-term licensing and royalty revenues.  

Strong licensing pipeline

In the short-to-medium term, any sign of a slowdown in consumer demand for high-end consumer electronics — especially in the US — will limit ARM’s growth. Fortunately, for investors,  during the most recent earnings release on 20 April, ARM’s CEO, Simon Segars, expressed his optimism concerning the short-term outlook. He reiterated that “the licensing pipeline for the rest of year is robust” and confirmed that the group is on track to meet market expectations for the full year.  

Although ARM’s current annual yield of 1.05% doesn’t make it a top choice among income investors, the UK chip designer certainly ticks the growth box, as analysts expect 16% earnings-per-share growth by 2017. Thus, investors have reason to expect capital gains over the next 12 months as the share price firms.

More than a just a blip for Burberry

In stark contrast to ARM’s growth path, Burberry‘s (LSE:BRBY) growth path is somewhat clouded, as was evident during the most recent trading update, released 14 April. It proved to be a catwalk straight down to the bottom, as total revenue was down 1% to £1.41bn, licensing revenue also down 1%, and retail revenues flat at £1.06bn, when compared to the same period a year ago. Importantly, this performance faux pas is far from over as CEO, Christopher Bailey warned that the “external environment remains challenging”.

A huge blow to Burberry is the decline in spending among Chinese consumers. The firm could always count on the fact that luxury customers tend to be resilient whatever the economic weather. But the spending drag from the potential Chinese slowdown and the crackdown on extravagant gift giving in China is a bigger problem for Burberry than for other luxury retailer, as Chinese consumers account for more than a third of its global sales.

So, is it time to stick, buy or twist?

At 2.99%, Burberry offers a significantly better annual yield than ARM, and trades on a P/E ratio of 15.4, which is below the industry average of 25. However, don’t be fooled by the low multiple. It reflects the lack of confidence the market has concerning the company’s growth prospects rather than any undervaluation.

Until we see a semblance of stability in Chinese consumption or, better yet, a solid plan for how Burberry will lessen its dependence on Chinese consumption, you would do well to steer clear.

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Yasin Ebrahim, CAIA, FRM has no position in any shares mentioned. The Motley Fool UK owns shares of Apple. The Motley Fool UK has recommended ARM Holdings and Burberry. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.