Investors Are Betting Too Much on a Bionic ARM

NEW YORK (TheStreet) -- I recently talked about the disconnect that exists between the share price reaction of Texas Instruments (TXN) and the company's actual performance, which hasn't been particularly impressive in terms of growth. TXN's stock continues to soar despite unimpressive growth.

It seems ARM Holdings ( ARMH) now deserves similar consideration -- in the inverse order.

There's no disputing ARM's impressive business model and the company's unparalleled chip performance technology. But there's also no disputing the stock is expensive.

The fact ARM trades at a stout P/E of 82, which is almost five times Qualcomm ( QCOM) and three times Broadcom ( BRCM), suggests investors are betting heavily on future gains.

So far the wager has been very rewarding. ARM has posted solid growth over the past couple of years. However, increased competition from (among others) a resurgent Intel ( INTC) and Nvidia ( NVDA) may weigh upon ARM's prospects.

With that in mind, I would adopt cautious optimism about how much should be expected from this company in the long term.

Another Solid Quarter

The company reported revenue of about $263 million, beating expectations handily, growing 26% year over year. When compared to what other chip companies within the sector have done, ARM's performance seems bionic.

ARM posted a 24% increase in license revenue while royalties shot up 33%. Surprisingly, license revenue was down more than 5% sequentially. Even though royalties did well year over year, royalties only grew 1% sequentially. This is an area where the company has consistently posted solid results.

Even though the overall performance of the chip sector has been soft this quarter relative to other quarters, the performance didn't sway that much. Besides, ARM has always outperformed in its license business regardless of what the sector did. Should investors be alarmed? This is one of the chief reasons I caution about taking a position in this stock today.

I'm not suggesting that ARM is not a worthwhile holding. But would you want to take a position now after a 5% sequential decline in license revenue without knowing yo what it may lead?

The good news is ARM was able to offset some of that weakness in service and development systems revenue, which posted growth of 11% year over year and 7% sequentially.

These are two important ARM components that set the company apart from rivals. However, profitability was a bit mixed. Gross margin was virtually flat year over year -- that's being generous -- while falling by one point sequentially. The company made up for this in operating margin, which advanced six percentage points from last year and by more than four percentage points sequentially, which led to a 58% jump in earnings per share.

Although ARM is known primarily for its presence in smartphones and mobile devices, the company still derives a good portion of its revenue from hard-drive controllers. The company remains aggressive in growing its exposure. ARM said that it signed a total of 22 processor licenses during the quarter.

Management said that nine of the licenses were for the company's ARM Cortex-A series processors, which are used primarily in smartphone and tablet applications. Of the remaining 13 licenses, seven were for the company's Cortex-A50 series processors, which have now brought the company's license total in that series to 16.

These are certainly impressive advancements and demonstrate how highly regarded ARM's technology remains on the market. To date, chips manufactured by Broadcom, Qualcomm and Samsung account for more than 90% market share in smartphones. But Intel is beginning to make its own advancements to acquire market share.

It remains to be seen, however, to what extent Intel can reassert itself in smartphones and tablets. But given Intel's strong R&D position and capabilities, I wouldn't be so quick to bet against a determined tech giant that is out to prove it is relevant is a growing market. To that end, it seems dangerous to bet against Intel. As it stands ARM's valuation suggest that Intel has no shot.

Here's Making Sense

ARM is certainly "strong-arming" the chip business. But the soft license revenue results may be a sign the tide is beginning to shift. In that regard, it seems risky to bet that there will be no slowing down at all, which is presumed by the stock's valuation.

It's not too farfetched to believe a majority of ARM's good news has already been priced into the stock. Accordingly, now would be a good time to take some profits.

At the time of publication, the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a private investor with an information technology and engineering background and the founder and producer of the investor Web site Saint's Sense. He has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.

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