10 iconic UK shares: ARM

The next in our series of articles using fundamental analysis to examine the prospects of 10 iconic FTSE companies.

ARM logo held up by an Android figure
Source: Bloomberg

Reasons to watch

  1. Strong market share in smartphone processors
  2. Excelling EBITDA margins
  3. New iPhone sales going well

History

ARM Holdings traces its history back to 1983 when the key processor in Acorn computers was called ‘Acorn RISC Machine’. This catchy title served as the genesis of company’s name when it was founded in 1990, before being shortened to simply ‘ARM Holdings’, or more usually, just ARM.

The firm first listed on the London stock market in 1998 and since then has become one of the key microprocessor suppliers. In 2010 the firm boasted market share of over 95% in the smartphone arena and 10% in mobile computers. By 2014 the company had its chips in over 50 billion devices, with around 60% of the world’s mobile devices containing ARM chips. 

Fundamental analysis*

ARM’s latest revenue figures showed that the firm made pre-tax profits of £101.2 million for the first quarter, up 9% over the previous year. Revenues were 6% higher at £195.5 million, and the outlook for the final quarter indicates the company will continue to enjoy strong revenues with a ‘robust’ pipeline underpinning trading.

As a long term investment, ARM has done well. The reasons to hold on to the shares are compelling. Over the past four years, earnings have grown at an annualised rate of around 40%. A growth rate of this magnitude cannot be ignored, even if it is likely to drop back from these rather stratospheric levels. Earnings are still expected to rise by over 20% in the coming year, which should help ARM to justify its rather pricey current valuation of around 36 times earnings. The period of rapid and forecast-smashing growth from Apple may be over, but its presence in the ever-growing world of smartphones and other mobile devices does seem to suggest that there is further good growth to come along the line.

However, there are clouds on the horizon. A recent warning by the CEO of a fellow microchip company, Microchip Technology, suggested that the broader market for ARM’s products might be entering a more difficult phase. The news caused a sharp drop in shares of Microchip, ARM and Intel as investors reacted, and given that Microchip has a shorter supply chain versus its rivals the conditions it has experienced are likely to be replicated across the industry at a later stage, with ARM unlikely to be immune.

ARM cannot be described as a value play. Its current PE of 36 is well above the global sector average of 18.9 and far in excess of the media around the 15 mark. In its favour, however, is the EBITDA margin of 39.3%, a stratospheric number compared to the global median of closer to 15%. If ARM investors are looking for a ‘moat’ that will give the company an edge over rivals, this is probably it.

Looking at the chart, we can see how £11 has been the big upside resistance for ARM shares. Meanwhile, buyers in 2014 have stepped in around the 800p mark, as two dips in that direction have so far been bought. For the time being the short-term trend down from the September high of £10 is still intact, but any move back through the £9.20 area should be an indication that optimism is returning. 

*What is fundamental analysis?

Fundamental analysis seeks to examine a security by measuring its value through the use of financial and qualitative factors. Essentially, fundamental investors believe that each share is a piece of a company, and that the company can be analysed to determine whether the current share price indicates whether the company itself is undervalued (trading at a discount) or overvalued (trading at a premium).

The overall objective is to determine the underlying value of a company, and use comparisons with similar companies to determine if the business is likely to be successful or otherwise. Crucially, a company cannot be overvalued or undervalued in isolation. Instead, fundamental analysis compares a company to its peers in the sector, to the broader market, and to past valuations, to determine whether the current valuations are appropriate. 

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