COMMENTS
from Morgan Stanley
Quick Comment: Investment thesis remains intact.
Underlying business trends are in-line with previous
guidance. Opportunities for both PIPD royalties and
microcontrollers look sizeable.
What's New: The company provided some interesting
data sizing the PIPD royalty opportunity and comparing
PIPD now to the Processor business in 2000. Using
our own assumptions, we believe that both of these
suggest that our own medium-term PIPD assumptions
look reasonable and if anything have upside.
Implications: We continue to believe ARM will be one
of the best performing stocks in our universe this year
and re-iterate our Overweight-V rating. The reductions
to GBP earnings estimates reflect only the translational
impact of the recent decline in the USD/GBP.
KEY MESSAGE FROM THE ANALYSTS DAY: The
company used the opportunity to highlight the
sustainable, long-term nature of the high return business
model that is IP (intellectual property.) Areas of focus
included:
• Whilst up-front investments may be increasing as
successive microprocessors become more complex,
management suggested license ASPs (average
selling prices) would also increase - as we have
seen for initial Coretex A-8 licenses - allowing similar
profits to be generated on these more recent
products.
• New application markets such as microcontrollers
are set to enjoy significant unit and revenue growth.
From a current underlying annualised total shipment
rate of 2.2bn units pa, the company expects to reach
4.5bn by 2010. One of the key volume drivers
within this will be the microcontroller market
(with a 10x increase expected over that timeframe,
from the current level of 70m units pa.) Although
cost, efficiency and reliability will be important
drivers, ease of software development is seen as an
increasingly important driver. Recent product
announcements (Coretex M3) and acquisitions (Keil)
are both focussed on the development of the
microcontroller market.
HOWEVER MOST OF THE DAY WAS SPENT EXAMINING
THE OPPORTUNITY AT PIPD:
• PIPD in 2005 is similar to the Processor biz in
2000. In terms of people, total revenues, licenses
signed, cumulative royalties and partners paying
royalties - PIPD now looks very similar to the
Processor business of ARM back in 2000. We
estimate that in the subsequent five years (00-05)
the Processor business grew 19% CAGR which
compares to our estimate for the growth of the PIPD
business over the next five years (2005-10) of 13%.
Our medium-term estimates appear reasonable -
and as we will see below if anything have upside.
• What market share does PIPD royalties have?
Management suggested that the Total Available
Market (TAM) for PIPD royalties was currently the
proportion of ASIC/ASSP designs that the foundries
manufacture. If we assume the foundries have 45%
of this market currently - and the market
(ASIC/ASSP devices) itself is $78bn (Source:
Gartner, CQ106) this implies a market of $35bn for
the foundries. With an assumed average royalty rate
per chip of 0.6% (equivalent to 1.5% per wafer) then
this implies a TAM of $210m. If we annualise
CQ106 royalties at PIPD, this gives us a market
share currently of about 16%.
• What is the opportunity for PIPD royalties?
Working through a similar calculation, we can derive
our own estimate of where the PIPD royalty stream
could be by 2010. Assuming (1) the royalty rate
stays constant at 0.6%, (2) PIPD by 2010 will be
targeting both the foundry and IDM portion of the
ASIC/ASSP market and again using a Gartner
forecast (ASIC/ASSP market is $120bn in 2010) then
the implied TAM would be $720m. The implied
growth of the overall market is 28% CAGR 2005-
2010. Separately if we assume that PIPD could
transition the success that it has currently in the
foundry business (our estimate 16%) into the whole
market (foundry and IDM) then this would imply
the PIPD royalty revenues by 2010 would be
$115m. We currently forecast $58m in PIPD
royalties in 2010.
Trading Update: The company updated the market on
business trends so far in the quarter: underlying business
remains in-line with guidance given at the time of the first
quarter results. However, the company did remind investors
of the company’s exposure to dollar weakness and suggested
that the effective rate for the quarter was likely to be closer to
$/£1.85 (compared to our own estimate $/£1.78.)
Updating estimates for currency: Although we have left our
USD forecasts unchanged we have revised our GBP
estimates to reflect the recent weakness in the dollar. The
impact varies between 7% and 9% cuts to earnings forecasts.
We have assumed that the estimated effective rate for the
current quarter ($/£ 1.85) is repeated in the forecast periods
as well.
Changing of the Guard: The company also announced that
Chairman, Robin Saxby, would be retiring effective 1st
October to take on the role of President of the IET. We
expect the impact on the day-to-day running of the company
to be limited but note that Robin will remain Chairman
Emeritus of ARM whilst in his role at the IET. Doug Dunn, a
current non-exec director at ARM will succeed Robin. Doug is
well known to investors, has been a non-exec at ARM for
eight years and was previously CEO of ASML Holding. His
3
M O R G A N S T A N L E Y R E S E A R C H
May 24, 2006
ARM Holdings Plc
industry expertise and knowledge of the company we believe
will serve him well in his new role.
Price target methodology and risks
Our long-term residual income model assumes compound
revenue growth of 15.4% from 2006 to 2009, slowing to 8% in
2010-16. We forecast operating margins of 32.9% in 2006-09
and our longer-term operating margin assumptions peak at
34.8% in 2011, then decline to 30.8% in 2016. We use an
average cost of equity of 9.7% and forecast an average RoE
of 20.0% in 2006-16.
Negative risks to our price target and investment thesis
include mis-execution in the alignment of the two
businesses, disappointing revenue synergies from the
combined distribution channels, departure of key personnel
from either company and a major deterioration in the overall
semiconductor environment. In addition, any weakness of the
US dollar relative to sterling is a risk to our revenue and
earnings estimates.
Positive risks to our valuation include the possibility that
ARM generates faster than expected revenue growth via
the PIPD business, experiences more leverage as a result of
this improved growth, is able to cut more costs than originally
forecast, or derives a larger mix of business from the higher
operating margin business of Artisan.
Our view of the European Semiconductor industry is In-
Line
The upside potential implied in the fair values for our stocks is
now in line with our strategists’ forecast for MSCI Europe over
the next 12 months. |
