As manufacturers rush to install wireless Internet of Things (IoT) devices in your cars, houses and watches, do ARM Holdings Plc (LSE:ARM) and Telit Communications Plc (LSE:TCM) represent your best opportunity to profit from this huge growth market?
Relative minnow Telit specialises in creating the wireless communication modules necessary for IoT devices and has also begun to reposition itself as an end-to-end operator of these devices for customers. The new focus on the relatively high-margin services division is an important step for Telit. It diversifies revenue streams away from the high R&D costs associated with developing and marketing their products, ties customers into their ecosystem and provides recurring revenue streams.
Lowered profit guidance and questions over the accounting of R&D expenses caused share prices to plunge from 356p in October to today’s price of 218p. The shares now trade at 28 times earnings, an unheard of valuation for a tech company with a growth story. Five straight years of over 10% revenue growth and proven profitability from a founder-led company in a growth market makes me think that Telit is one company investors would be wise to add to their watch lists.
Safety first
For more risk-averse investors, ARM Holdings presents a safer path to investing in the IoT market. While Telit booked close to $300m in revenue in the past year, ARM has three times that amount sitting in cash alone. Although the company is best known for providing the processors for almost every smartphone shipped worldwide, it has moved aggressively into the IoT market and a 2014 Canalys survey found 80% of wearable devices contained ARM products.
While Telit focuses on creating hardware for IoT devices, ARM’s strategy is to develop processor designs and then sell the license to manufacturers who pay a royalty on each unit shipped. This allowed ARM’s operating margins for the third quarter to increase to an astonishing 51.7%. Rightly or wrongly, the market has tied ARM to the fortunes of smartphone customers such as Apple and share prices have been hit lately on news of slowing demand for Apple’s iPhones. An IDC report predicts global growth in the smartphone market to slow each of the next five years as Western markets reach saturation and adoption slows in developing countries. This has caused many investors to balk at the lofty valuation of ARM as royalty revenue from smartphone sales will grow much more slowly than in the past.
Looking ahead, ARM remains an appealing company as it continues to increase revenue and profits, maintains high margins and is diversifying into markets such as IoT devices. Despite this, I would be leery of buying-in at today’s valuations as shares may be in for a flat-to-rough year as more investors price-in slower growth in key product markets. However, I believe Telit provides a compelling story with proven organic and acquisitive growth and a huge market to be exploited, making it a company worth further researching for long-term investors seeking high growth potential.