Stock pick: ARM Holdings
The technology company looks like one of the winners from Apple’s iPhone 5S
I’m still poking through the details of the iPhone 5S and 5C that Apple (AAPL) introduced on Tuesday, looking for winners and losers.
One of the biggest winners I’ve found so far is ARM Holdings (ARMH). Apple uses ARM’s technology in the processors that run the iPhone. Until Tuesday’s announcement, that meant the 32-bit technology in the A6 processor. But the iPhone 5S will use ARM’s faster 64-bit technology in it's A7 processor. (Apple says the move to 64-bit technology will make the 5S twice as fast as the iPhone 5.)
Apple’s move to 64-bit technology means ARM will gain more royalty revenue from Apple. UBS estimates that ARM’s royalties from each iPhone will rise to 60 cents for the 5S from 50 cents for the iPhone 5.
But besides the 20% increase in royalty revenue from Apple, Apple’s adoption of 64-bit technology will push other smartphone makers such as Samsung (SSNLF) to move to the faster 64-bit technology earlier than expected. And that should accelerate what was already looking like a big increase in royalty rates and EBIT margins for ARM Holdings that began in 2012.
Before Apple’s announcement, Credit Suisse had projected blended royalty rates at ARM Holdings would climb to 2% by 2015 from 1.5% in 2012. That would drive EBIT margins to 56% in 2015 from 46% in 2012. Before Apple’s introduction of the iPhone 5S, earnings looked likely to grow by an annual compounded 25% from 2012 to 2017, according to Credit Suisse.
Shares of ARM Holdings always look expensive because of the company’s business model, and that’s certainly true right now. At the Wednesday close, the shares traded at 49.3 times projected 2013 earnings per share. But I don’t think you can apply normal PE ratio parameters to a company that makes its revenue from collecting royalties on technology it licenses to other chip makers, rather than from making and selling chips itself. That results in an extraordinary portion of revenue turning into profit. In 2012, for example, ARM Holdings saw revenue of 577 million pounds and pre-tax adjusted profit of 279 million pounds.
I think the near-term upside on these shares is at least 20% even after Wednesday's bump on the news that Apple has moved to 64-bit technology in the iPhone 5S.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did own shares of Apple as of the end of June. For a complete list of the fund’s holdings as of the end of June see the fund’s portfolio.
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