Will ARM Holdings cash in its chips?

Way back in the early spring, Arm Holdings, the Cambridge ‘chip’ (semiconductor) company met the big ‘OR’ of overhead resistance. It tried to break through the 1,200p level on several occasions but unlike the panzers in the Ardennes, in the 1940 battle for France, it did not pull it off.

Having failed to get into new share price territory at the commencement of the current year, the share price headed south, bottoming out in August at around 850p or so, having refused to go to the low point of 778p reached last October. Last seen, the share price has bounced up to 980 – a 15% jump from the August low point.

The chart looks interesting. Although the share price is arguably still within the downtrend that began last spring (that depends on where you draw the upper and lower out-swings from the central trend – a bit of subjectivity, which makes charting as much an imaginative art as it is a ‘science’), the energy and power of the recent bounce invites reasoned interest. On Tuesday 15th September, the company had its annual institutional analysts get together.

Will that provide the dry tinder for further bullish conflagration? Is there real fundamental fire behind the smoke of Monday’s 1.5% increase in the share price, prompted by the weekend news of strong Apple iPhone sales? My interpretation of the share price chart (a bit more subjectivity, so have a look for yourself) is that ‘technically’ the share price will need to move up to somewhere near 1,100p to establish a breakout from the recent downtrend that began at the beginning if this year. On the way to that prospect, the shares have broken out of three month and six month trends.

If it does break out from the last year’s downtrend, it would be reasonable to conclude that the share price should head north, breaking through the previous resistance at around 1,200p. So what do we have in the way of evidence to make that a reasoned prospect? Or to put it another way, is there enough value in the shares to justify a purchase?

One hearsay bullish view is based on market estimates of the company’s ability to generate cash flow. Some of the reported estimates are of a next year’s estimated cash flow as a 3.5% (based on a recent share price, I assume) cash flow yield, rising to 6% by 2020. That puts the current dividend yield of under 1% in a much more attractive context, suggesting that the company may have more cash than it needs for operational purposes and enough to keep shareholders happy and loyal, should the boys in the corporate finance departments attempt to flog off Arm to a Chinese entity, to generate bonus money.

I have reminded myself of the financial numbers by going through those recently reported by the company. They seem to be better than the rumour. Annual operating cash flow in 2014 had grown to £342 million, which is just under 42% of sales. Yes, a spectacular operating cash flow margin of 42% on sales revenue and 2.6% on the share price of 960p (when I did the arithmetic). Providing sales keep growing, Arm will continue to be a cash, profit and dividend machine of some significance with a net profit margin on sales of 34% and a gross margin (indicating the scarcity value of its products) of 95%. It is into that context you fit its market dividend yield of less than 1%.

It is well known that ARM has traditionally enjoyed a defence against corporate predators through its sensitive relationships with its big intellectual property conscious customers. They like to buy the security of commercial fidelity, along with the chip technology itself. However, inevitably, rumours of such a sell off attempt will rise heavenwards again, leading to the expectation that ARM will be able to defend itself with the distribution of more cash to shareholders over the next few years.

Last seen, the market consensus of estimates and forecasts does not suggest that the company will be dishing out the cash as dividends; quite the reverse. According to consensus estimates and analysis the dividend cover of 2.6 times last year rises to 3.5 this year and next. However, that does strongly suggest that they see growing earnings that could be paid out in dividends this year and next, simply by reducing the dividend cover. A cover of two times on an estimated consensus earnings estimate of 36.4p for next year raises the annual dividend forecast from the currently expected (at a 960p share price) 1.1% to 1.9%. Not bad for a company that has grown dividends over the last five years by about 25% compound, on the back of a 19% annual compound growth in top line product revenue. On that score, it is to be noted that the consensus estimates that sales revenue will grow 20% for the current year and 13.5% next year, when ARM sales are expected to go through £1 billion for the first time. In 2010 they were only 37% of that estimate at £409 million.

My conclusion is a simple one: if sales revenue continues to grow significantly, as the consensus estimates suggest it will, and given the net margin of 34%, one should rationally buy the shares on a set back, because there is already some disappointment discounted. The company at its annual analyst shindig yesterday stated that it was going to put its cash into more R&D to expand into more product markets. That seems in line with bullish analysis about the impact of growing sales on the bottom line through the 34% margin of net profit. Remind yourself that the market consensus estimated PER’s forecast for this year and next are 32 and 27 times. Those ratings look good value against consensus forecasts of annual earnings growth of 69% and 18% this year and next. However, bear in mind that any investment should be part of a balanced portfolio. As the good book says, high ratings brook no disappointment – something that always comes from an unknowable future. So, you may do yourself some good by buying some shares whilst avoiding the risk of buying too many.