Morningstar Research Shows ARM is Overvalued

“We are raising our fair value estimate for ARM Holdings ... based on improved long-term revenue assumptions for the firm,” states Colello in his latest ARM research report. “After two strong years of 33% revenue growth in 2010 and 21% in 2011, we expect ARM's top line to continue on this trajectory. We project 23% growth in 2012 ... Longer term, we project ARM will generate average revenue growth of 13% per year from 2013 to 2016, up a percentage point from our prior projections, as ARM should continue to benefit from the robust adoption of smartphones and tablets and also gain share in non-mobile chip markets.”

The Cambridge-based company creates chip designs that are used in more than 95% of mobile phones around the globe. It has been benefitting from booming growth in smartphone sales, and investors have taken notice. Since September 2008, when the global markets took their first Lehman-inspired dive, shares in ARM on the FTSE 100 Index have soared by nearly 500%. ARM develops the blueprints that allow a variety of the world's leading chipmakers to design many of their semiconductors, says Colello. These semiconductors are then used in mobile phones, smartphones, tablets and digital cameras. “In exchange for its [chip designs], ARM collects both an up-front license fee and ongoing royalties, typically 1%-2% of the price of each ARM-based chip sold,” he says.

While Colello and other analysts agree that the company has good future growth prospects, Colello’s report shows the company’s shares have risen too high. “ARM's profitability could come crashing down if the firm fails to live up to ... lofty expectations,” he says.

“ARM still faces some challenges, not the least of which is a collision course with Intel in the mobile market. While ARM and its customers try to pack more processing punch into its low-power chips, Intel is striving to reduce the energy usage of its high-horsepower x86 chips. Intel recently announced lower-power Atom chips geared toward the smartphone and tablet markets, and the firm's agreements to supply these chips to Motorola Mobility (MMI) and Lenovo Group (00992) give some credence to Intel's products.”

It’s also important to note currency risks: “As a British company, ARM reports financial results in British pounds. The company earns virtually all revenue in U.S. dollars, but half of the firm's costs are in dollars, while the rest are in pounds. Thus, ARM becomes more profitable with a strong U.S. dollar,” says Colello. This means that weakness in the U.S. dollar could weigh on the company's profitability in the future.

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