Another week… another bout of C.H.A.O.S.
You know the drill… rather than the idle guesswork that financial pundits use when talking about technology stocks, I’ve devised a much better system.
One that cuts through the fluff and gets right down to the nitty-gritty. After all, I’ve ripped the best parts of it from no-nonsense technology venture capital firms – applying the very same metrics that they use to evaluate and identify the best tech stocks.
It answers crucial questions like:
- What’s the company’s technology? (And is it any good?)
- What’s its impact on consumers and the chances of scaling its business higher?
- What are the company’s core financials?
- What are the catalysts for igniting the share price?
It’s rigorous. It’s hard-hitting. And it’s foolproof.
I call it C.H.A.O.S., based on the fact that chaos in the tech sector is a beautiful thing.
A force that vaporizes the status quo, and carves new markets and industries.
And the companies that pioneer such chaos make fortunes for themselves and their investors.
You can find out how C.H.A.O.S. works here.
But for now, let’s get to today’s company…
The Semiconductor Industry’s Most Important Ally
Last Saturday, I covered little-known semiconductor company, PLX Technology (PLXT). Today, I’m going big by looking at one of its rivals and an unquestioned semiconductor market leader – ARM Holdings (ARMH).
Does it pass the C.H.A.O.S. test?
ARM’s financials are rock solid.
It boasts almost $1 billion in cash and has virtually no debt.
Not only that, its free cash flow has jumped by 26% over the last five years, and by 20% over the last decade.
Revenue and earnings are rising each year, too. In fact, ARM has beaten its consensus estimates in its last 16-straight earnings reports, with forecasts trending upwards through 2015.
With a recent 20% jump in year-over-year quarterly earnings growth, it added to a robust 15% profit margin and 37% operating margin.
If C.H.A.O.S. valued companies on fundamentals alone, ARM would be one of the strongest firms around.
C.H.A.O.S. Meter: 19/20
Want high-impact technology? You got it.
ARM boasts one of the most in-demand technologies that semiconductor companies license today.
You see, before semiconductor firms can even begin their manufacturing processes, they need even tinier bits of technology to get started.
Things like microprocessors, embedded operating systems, plus software and platform development tools.
Look at it this way: If semiconductor companies make the building blocks inside electronic devices, then ARM makes the building blocks inside semiconductor firms’ products.
And because it offers a wide range of high-performance, low-cost solutions, ARM’s architecture is incorporated across a plethora of devices.
It’s embedded in just about everything you own. Consider…
- Over 95% of the world’s smartphones operate on ARM’s Cortex-A processor…
- Over 70% of smartphones integrate ARM’s app processors and modems…
- Over 86% of the tablet market uses ARM’s technology…
I guess you could say that ARM has its “hands” in just about everything. Which is precisely why the company has a massive impact on the mobile market.
ARM’s low-cost, low-power chips quite literally make our smartphones and tablets possible.
C.H.A.O.S. Meter: 18/20
While ARM has the mobile world covered, its acceleration lies in its ability to quickly expand outside of it.
But it’s struggling.
For example, Advanced Micro Devices (AMD) revealed that the latest version of its accelerated processing units (APUs) – made for the tablet, notebook and hybrid PC markets – would operate with ARM core processors.
But the news has done little for ARM shares.
The other main catalyst for stock acceleration is analyst upgrades.
For example, Bernstein Research analyst, Pierre Ferragu, raised his rating on ARM’s stock to “market perform” on news that the company’s technology is being incorporated into Qualcomm’s (QCOM) v8 chip.
Shares rose by 3.5%… but that’s nowhere near C.H.A.O.S. standards. And in any case, depending on analyst upgrades is extremely unreliable.
In short, while ARM has the potential for strong future catalysts, its share price tends to lag.
C.H.A.O.S. Meter: 7/20
ARM doesn’t just boast innovative technology, it also has an innovative business model.
Instead of bearing manufacturing costs, ARM licenses its technology to large-scale semiconductor manufacturers and OEM partners.
Those companies then incorporate ARM’s technologies into their own.
It’s a convenient marriage.
You see, before ARM came along, semiconductor companies had to develop the technology themselves – an expensive venture that cost (on average) between $50 million and $150 million every year.
So to replicate the technology that ARM designs and licenses, the semiconductor industry would have to shell out approximately $20 billion in additional annual costs.
ARM currently works with about 1,000 companies within the semiconductor supply chain and pulls in revenue that’s either:
- Product Revenue: licensing fees, sales of development systems and royalties.
- Service Revenue: support, maintenance and training.
So a company that adopts ARM’s technology pays an up-front license fee for ARM’s design, plus a royalty on every chip that uses the licensed design.
Over the term of a license (which may be perpetual or limited), payments can range from hundreds of thousands of dollars to several millions of dollars.
But here’s the rub…
On average, a client can take anywhere from six to 15 months to validate ARM’s technology. And it takes even longer for royalties!
Once a semiconductor company signs a licensing contract, it takes three to four years to start paying royalties.
Now, look… ARM’s clients are the world’s largest semiconductor manufacturers. And in turn, their royalty payments are a large and highly reliable revenue stream. (ARM’s licensing strategy accounted for 90% of the company’s fiscal 2013 revenue.)
But time is money. And that’s a long time to wait for licensing and royalty revenue to hit the books. The validation and payoff makes ARM a tough sell in the “Orders” department.
C.H.A.O.S. Meter: 13/20
ARM essentially owns the mobile market, with its technology present in 95% of the chips found inside today’s mobile handsets.
But as I said, to expand its business and drive future growth, ARM needs to penetrate other markets, too.
Is it doing so?
Well, over the last few years, ARM has targeted the hard drives and microcontrollers inside desktop computers and the chips inside smart TVs.
The PC market is dying a slow, painful death, with sales down 10%, to 314 million units in 2013. And the decline is expected to continue.
And TV shipments shrunk by nearly one billion units in 2013.
Consider also that the semiconductor industry is notoriously cyclical, and tends to consolidate during prolonged periods of declining revenue growth. When that happens, it means ARM’s potential client base shrinks, too, as there are fewer stand-alone companies in the industry.
This trend is occurring in the wireless broadband business, where ARM has a large market share, as well as the microcontroller area, which ARM is looking to break into.
So while the company’s future is bright, ARM won’t be able to maximize its revenue here until conditions improve.
C.H.A.O.S. Meter: 11/20
Final Verdict: ARM is a large and wildly successful company. By successfully monopolizing the massive mobile market, ARM has accomplished a significant feat.
But its domination took 10 years, and in terms of creating the next wave of chaos today, ARM has hit a ceiling.
However, while this isn’t a blockbuster stock, it’s still a decent one. Especially given this month’s tech selloff, which offers an opportunity to buy a fundamentally strong company with a proven record of steady, consistent growth.
Your eyes in the Pipeline,