Where Will ARM Holdings plc (ADR) (NASDAQ:ARMH)’s Growth Come From?
ARM Holdings plc (ADR) (NASDAQ:ARMH) sounded the alarm during its 4Q2015 earnings release that global economic uncertainty could lead to soft consumers and enterprise spending. If that happens, demand for semiconductors could cool, making it difficult for the company to meet its growth targets. Does ARM Holdings have a strategy to sidestep challenges of global economic slowdown?
In its 4Q2015, ARM Holdings reported largely positive results as revenue of $407.9 million increased 14% YoY and 8.3% sequentially. The growth was attained despite difficult conditions in the smartphone space where market saturation and economic slowdown have combined to restrict sales. ARM Holdings’ 4Q topline benefited from $9 million in the form of catch-up royalty payment. Royalty revenue in the quarter rose 6.7%, driven largely by growing adoption of the 64-bit ARM v8-A processor design. Adjusted EPS (non-IFRS earnings) for the quarter was $0.365.
The chart below depicts ARM’s revenue trend for the last five quarters:
Management of ARM Holdings didn’t provide specific guidance for the current quarter or year, but warned of possible growth slowdown because of tough macroeconomic conditions. Nevertheless, management is expecting royalties to grow at compound annual growth rate (CAGR) of 15% through 2020, a growth that is expected to defy the general trend in the smartphone market where slowdown in demand could persist for some time. The reason the management expects growth even if smartphone demand remains weak is that they expect the company to benefit from its diversification beyond mobile into wearables, cars and IoT markets.
What are the growth catalysts in ARM?
- Strong licensing trend
ARM Holdings plc (ADR) (NASDAQ:ARMH) has continued to sign more licensing contracts for its higher royalty rate ARM v8-A chip technology. Of the 51 license deals signed in 4Q2015, eight were for the 64-bit ARM v8-A processor design, which is seeing incredible adoption rate in budget smartphones including sub-$50 handsets.
With smartphone manufacturers using low-cost handsets fuel penetration of developing markets, demand for ARM Holdings’ inexpensive v8-A processor is likely to remain strong over a long time. Additionally, the company stands to benefit from the conversion to 64-bit from 32-bit.
The 51 licenses ARM Holdings inked in 4Q exceeded 38 licenses in the previous quarter. As for v8-A design, ARM now boasts 89 licensing contracts.The management models licensing deals to grow in the range of 5% to 10% over the medium term.
- Royalty improve
The transition to 64-bit from 32-bit is promising to pave the way for higher royalty rates for ARM Holdings. In the meantime, the company is artificially holding rates low to encourage uptake to the point where it has an ecosystem-like penetration. From there the company can start offering technologies with higher royalty rates and combined with the conversion to 64-bit mode, royalty rates should rise sharply over time.
- Inexpensive technology
ARM Holdings plc (ADR) (NASDAQ:ARMH)’s strategy is to undercut rivals through cheaper technology, a strategy that is helping the company to widen its install by displacing rivals. Initially, ARM Holdings is sacrificing profits for market share gain. However, there exists a huge profit opportunity for ARM Holdings once it deepens its penetration in the target markets.
- Enhance collaboration
During 4Q, ARM Holdings launcheda special type of licensing agreement dubbed Built on ARM Cortex Technology. That is an enhanced type of license that brings together ARM and partners including Qualcomm, Inc. (NASDAQ:QCOM). It appears the new license is for server processors, at least initially. If that is the case, it could support Qualcomm’s penetration in the data center market, a segment that is presently controlled by Intel Corporation (NASDAQ:INTC).
- Opportunity in server market
ARM Holdings plc (ADR) (NASDAQ:ARMH) presently has almost negligible share in the low-cost server market. However, the company is working towards taking share in the market from Intel, which presently dominates the space. Over the coming few years, ARM Holdings should have measurable share of the microserver market. The action in server market is likely to benefit from collaboration with Qualcomm, which is looking to diversify into data centers as it faces a slowdown in its core smartphone market.
Besides data center, ARM Holdings is also set to gain share in PC market, especially in the low-cost PC segment. Part of the support for ARM in PC is likely to come from Microsoft Corporation (NASDAQ:MSFT) making its Windows OS compatible with ARM chips.
- IoT and wearable opportunity
ARM Holdings stands to benefit from the Internet of Things and wearable markets. The main reasons ARM stands a better chance to dominate the two markets are that it offers low-cost and its energy efficient chips that are suitable for IoT and wearable devices.
- Automotive industry
Car industry is another market that ARM Holdings is eyeing with its chips as the core smartphone market cools due to peak penetration and economic slowdown. ARM Holdings’ CEO, Simon Segars, estimates that demand for semiconductors in the vehicle manufacturing industry will increase 50% to reach $15 billion by 2020. That suggests a huge new growth market opportunity for the chip designer. Of the 51 license agreements ARM signed in 4Q2015, nine of them are from automotive industry.
What could hold ARM Holdings back?
- Currency headwinds
The fact that ARM Holdings plc (ADR) (NASDAQ:ARMH) generates most of its revenue in U.S. dollar but meets substantial portion of its expenses in sterling pounds means that the company is vulnerable to adverse currency fluctuations.
- Intense competition
While selling to mobile market generates most of the royalty revenue for ARM Holdings, the company faces the risk of being displaced by Intel in some mobile markets. Intel is using incentives aggressively to woo mobile manufacturers to use its chips and that could squeeze ARM Holdings’ mobile market share. Additionally, the rise of more nimble rival chip designs providers could restrict ARM Holdings’ growth.
Because of competition, ARM Holdings is under constant pressure to innovate and that can have adverse impact on its bottom-line.
- Macroeconomic pressures
Demand for chips fluctuates. The fluctuation typically tracks macroeconomic trends. When demand in the end market is weak, OEMs tend to cool production and that adversely impacts ARM Holdings’ royalty income.
- Weakness in smartphone market
Besides the macroeconomic health, ARM Holdings plc (ADR) (NASDAQ:ARMH) is also sensitive to the demand for smartphones. Over 50% of its royalty revenue is generated in the mobile market and more specifically smartphone market. As such, a slowdown in smartphone sales could have far-reaching negative impact on ARM’s financial performance.
If the management executes properly, ARM Holdings plc (ADR) (NASDAQ:ARMH) is able to weather the storms in its industry.
Disclaimer: The opinions and data expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisory capacity, nor is this an investment research report. The author’s opinions expressed herein address only select aspects of potential investment in securities of the company or companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice.
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