The Allure Of ARM Holdings Plc

A takeover of ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), the UK’s largest tech company by market cap, is a distinct possibility if weakness in its valuation persists. That said, the company is a sound investment even if it continues to operate as a standalone entity. 

Value?

Its stock has dropped 22% so far this year in the wake of uncertainty surrounding the outlook for growth in tech-land and rich valuations for the main players in the industry.

As risk-off trades may prevail, further weakness should be expected in 2014, but long-term value resides in ARM.

The British chip designer has a market cap of about £11.9bn and a net cash position of more than half a billion pounds, which yields an enterprise value of about £11.3bn.

ARM Is Not Expensive

Those in the bear camp argue that ARM is still expensive despite the recent decline in its equity value, but ARM becomes truly appealing once the trend for its trading multiples is considered.

With an enterprise value (EV) of 38.8x earnings before interest, taxes, depreciation, and amortisation (EBITDA) for the last 12 months ended in March 2014, AMR’s relative valuation is close to its three-year low of 33.9x. The trading multiple plummets to 28x on a forward basis.

ARM stock hit a record £11.11 in December. Back then, it traded at an EV/EBITDA of 58x – a relative valuation lower than the one ARM recorded when its stock traded at £6 three years ago.

Investors have been less willing to pay up for ARM’s incremental cash flow generation in the last 12 months, but the opposite occurred before the summer of 2012. If multiples revert to mean, upside could be 20% or more.

Moreover, if 2014 estimates are met — and there are reasons to believe management will hit their targets — ARM’s EV/EBITDA will soon be 50% lower than the value it recorded at its peak.

ARM is cheap.

And its fundamentals are solid, which is not a given for a tech company.

A Sound Business

ARM held its investor and analyst day yesterday, when it confirmed its guidance for 2014 — which suggests strength into the second half of the year — and stated its intention to get deeper into the enterprise networking market, which would help it diversify its revenue stream.

ARM is a capex-light and debt-free business with hefty operating margins.

Its growth trajectory has been virtually immune to the downturn until the second half of last year, when market trends proved less favourable, but executives seem to know exactly what they are doing.

If Oracle and Intel – competition from the latter is intense, but consider this chart – get involved in a bidding war for ARM, these two will have a chance to prove that they have learned the lesson from Hewlett-Packard’s pricey takeover of British software company Autonomy.

But ARM is cheap, so the price won’t be an issue – will it?