ARM Holdings (LSE: ARM) is one of London’s market darlings, and one of the UK’s greatest success stories. Over the past ten years, ARM’s shares have risen seven-fold, and there seems to be no end to the company’s growth.
What’s more, ARM has been able to accomplish this growth without taking on any debt. The company has around £700m of cash on its balance sheet at present and is generating cash at a rate of £90m per quarter.
Unfortunately, ARM’s prospects are currently tied to the success of Apple. When Apple reported sales results that missed expectations earlier this week, the company, along with many of its supplies, including ARM, saw billions wiped off their market values in the space of a few hours.
Apple’s third quarter iPhone sales increased by 35%. However, analysts were expecting a better result. ARM’s first-half pre-tax profits rose by 28%, on a 15% increase in revenues, but even this growth wasn’t enough to stop the chipmaker’s shares falling in sympathy with Apple.
ARM is heavily reliant upon smartphone sales for growth and is banking on continued strong growth in this sector. Management estimates that half of all smartphones sold this year will contain ARM’s latest chips but the fact that Apple’s sales missed expectations, could be interpreted as a warning.
Indeed, as one of the largest players in the global smartphone market, Apple is a bellwether for industry sales.
So, as Apple missed Wall Street’s forecasts, it could be the case that industry sales are slowing, and analysts have been over-optimistic about smartphone market’s growth.
Diversification
ARM is currently working to diversify away from its traditional smartphone market and Apple. The company is looking to the internet of things (IoT) market, where its high-performance, low-power chips are in demand.
And ARM signed a record 54 new processor licences during the second quarter of this year as IoT technology really started to take off. However, ARM’s revenues from licencing during the quarter only expanded 3% to $151m as much of the financial benefit from these deals will come in later years.
Still, the figures show that ARM is working hard to diversify away from its traditional smartphone market. Nevertheless, it will take several years before the company has grown out of its reliance on Apple.
High expectations
ARM needs to sustain its current rate of growth to justify its high valuation.
For example, at present levels ARM is trading at a forward P/E 36.2. Earnings per share growth of 73% is expected this year. This rich valuation does not leave much room for error if ARM’s growth rate starts to slow. But with Apple’s sales already coming in below expectations, ARM’s growth could also take a hit.