HEARD IN EUROPE: Arm's Earnings Report Suggests Worrisome Trends for Chip Firm
By DAVID REILLY
Staff Reporter of THE WALL STREET JOURNAL
Investors looked at Arm Holdings' second-quarter results, saw a green light and stepped on the gas. But they might be suffering from a case of color-blindness: that signal was yellow.
• ARM Posts 38% Profit Rise But Gives Cautious Outlook1
At first glance, the British chip-design company's results, which came in slightly ahead of expectations, looked quite strong. And it is pretty rare nowadays for anyone, let alone a tech company, to talk about a "record quarter." Despite this, doubts about growth in 2003 continue to nag, a boom in royalty revenue isn't in sight and the stock's still-rich valuation remains a concern.
That means the shares are likely to languish for some time, although they seem to have found a range between 130 pence and 150 pence ($2.06 and $2.37 or €2.04 and €2.35) a share.
The U.K. company, which was relegated from the Financial Times-Stock Exchange 100 Share Index at the end of June, said revenue in the second quarter of £43.2 million ($68.2 million or €67.7 million) rose 20% from a year earlier, but was up just 2.6% from the first quarter. Pretax profit, which rose 33% from a year earlier, was up 3.2% sequentially.
Earnings per share of 1.1 pence in the second quarter and the company's reiteration of expected growth of 25% in the second half from a year earlier reassured many that Arm can meet 2002 consensus estimates of about 4.2 pence a share. Chief Executive Warren East said he is comfortable with this forecast.
Arm's shares rose 9.1% following Tuesday's earnings release to close at 144 pence in London.
Bulls found several reasons to cheer the results. Licensing revenue rose 9% from the first quarter to £25.7 million, while first-half licensing revenue jumped 52% from a year earlier. Arm's operating margin of nearly 35% was better than many had expected, and royalty revenue was flat, which was an achievement in itself considering so few of its partners are shipping products. (Arm's business is based on two main sources of revenue: it licenses chip designs to companies and takes a payment for this; it later receives royalty payments for sales of chips based on its architecture.)
The company also said that its order backlog was flat for the second quarter in a row. In these tough times, that would be a positive as it should have a good amount of business in the pipeline for coming quarters. "People ask us how come you can stay optimistic," Mr. East said in a conference call. "Because we have the backlog, that gives us forward visibility."
But Arm won't give investors a peek into that crystal ball. Both Mr. East and Chief Financial Officer Tim Score stressed that precise information about the backlog would erode its negotiating position when it comes to signing new license deals.
Keeping secrets creates doubts, and this was one area the bears seized on. They questioned the assertion that the backlog was flat, saying that it likely declined quarter-to-quarter if a subscription-license agreement with Samsung for a number of Arm products is excluded. Also, they questioned how the backlog could stay at previous quarters' levels when deferred revenue -- revenue that has been booked but not yet invoiced -- rose by £4 million in the second quarter.
If they are right and the backlog is deteriorating, that calls into question license-revenue growth in coming quarters.
The bears also noshed on the 21% jump to £40.2 million in receivables, or bills that have yet to be collected from customers, in the second quarter. Mr. Score said that this jump occurred because the license business was growing and many contracts were signed toward the end of June. He added that only 9% of the accounts were over 90 days old and that the company had already made provisions for £3.3 million of the receivables.
But the trend is worrisome. Arm's days sales outstanding, a measure of how long it takes a company to collect a bill, has risen in each of the past three quarters: from 54 days, to 71 days, to 84 days in the second quarter. That has occurred against a backdrop of tepid sequential sales, a better measure to look for this purpose than year-to-year revenue growth.
Additionally, average selling prices for licenses continue to decline. A rise in the gross margin to 93% in the second quarter from an average of 90% was due not to a price improvement, but to Arm shifting some costs from its services business to research and development.
This fires up arguments that Arm's business is maturing. A jump in royalty revenue would extinguish that concern. But that will only happen when customers start shipping chips in volume. And nobody's prepared to place a bet on the timing of the tech rebound.
Arm Chairman Robin Saxby said that the company's growth outlook shouldn't be driven by the royalty picture. "We've always said royalties are the icing on the cake," he said.
But investors have taken a much different view. Once they kick in, the royalties should turbocharge Arm's growth in the short term, and in the longer term will support the company when it runs out of new licensing partners. That is why Arm's shares have warranted growth-stock valuations and even earlier this year were trading at 60 times expected earnings.
The stock has come down about 60% since then and is trading at a fraction of its boom-time peak of about £10 a share. But they are still on a multiple of about 34 times consensus 2002 earnings.
Given Arm's licensing/royalty business model, many analysts say the company is more akin to a software company, rather than a semiconductor business. Even on this basis, Arm is pretty fully valued at a 15% premium to average software multiples.
Bulls believe the company warrants a 25% premium because of the strong lock it has on the chip-design market for such a wide variety of products. Even that would only justify a price of about 150 pence to 155 pence a share, which doesn't leave much upside. Bears counter that if growth is as anemic as they believe, the shares are only worth between 70 pence and 120 pence a share.
Arm may be right to say that in the current downturn only the strong will get stronger and it will come out ahead. But investors may want to exercise caution before racing off with the stock.
Write to David Reilly at david.reilly@wsj.com2
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Updated July 24, 2002
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