ARM Holdings A Buy?

The evolution of all connectivity gadgets to the smartphone is one of those megatrends all investors would like to ride in some way. This trend is cleverly depicted at the everylaptopleftbehind.com blog. The header shows an ape-to-man graph with the earliest form of life sitting on a chair punching a big computer which is sitting on a desk. Then the intermediate stage has him stooped over cradling a laptop around with both hands. The final stage has him sauntering freely with a barely noticable smartphone in one hand.

The smartphone is a trend that, according to many experts including Jim Cramer, is being underestimated and presents a prime investment area. Since the first one, the Simon, was introduced in 1992, technological improvement has advanced to the point where the smartphone has now become a "gadget killer". Wired Magazine ran an article on 11/17/08 called Five Gadgets That Were Killed by the Cellphone where they list the PDA, the low end pocket camera, the UMPC, the stand-alone phone, and the MP3 player as a few of the smartphone's victims with the laptop next on the hit list.

Some of the higher profile companies with heavy involvment in smartphones are:

ADCT ADC Telecommunications MRVL Marvell
ADI Analog Devices BRCM Broadcom
SWKS Skyworks Solutions PALM Palm
AAPL Apple QCOM QUALCOMM
RIMM Research In Motion STAR Starent Networks
RFMD RF Micro Devices

What else do these stocks have in common? All of them have out performed the S&P 500 since the broad market rally went flat in late April! Some by a little, most by a lot.

ARM Holdings (ARMH) is a somewhat lower profile, less loved name that nonetheless has a pivotal role in the smartphone revolution. They are a UK based company that licenses chip architecture. Their processors compete with Intel's Atom design for smartphones.

According to Robert Castellano in a 3/10/09 Seeking Alpha article, "ARM processors, not Intel's Atom, will benefit from the current technology-economic cycle. Anyone thinking that ARM will make up only a small percentage of netbooks going forward is not thinking outside the box." Netbooks are sort of between a big clunky, expensive laptop and a smartphone, only you can't talk on it - probably another gadget to be severely wounded if not killed by the smartphones. Castellano explains that the sluggish economy, price point for mobile internet access, and ARM's basic architecture all conspire to change the competitive landscape:

" ... ARM runs under the Linux operating system. Linux is free, whereas Microsoft charges a licensing fee up to $35 on each netbook. To furthur keep costs down near the intended $100 price point, enter cloud computing. Cloud computing is a web-based service that resides on the web, and is much cheaper than software packages that are purchased and stored..."

ARM processors are common in the smartphone market and, with the next generation Cortex-A8 and A9, may replace Intel's current Atom domination of all the other MID (Mobile Internet Device) products like netbooks. Castellano predicts a 55% market share by 2012.

ARMH stock has been battered, down to $5 from $9, but if you look at the last 10 years of their financial results, you see no recession. In fact, cash flow from operations, revenue, and eps have all grown nicely over the course of the debacle. But the valuations of price/sales 5.2, price/cashflow 15.4, and PE 35 repulse me. Still, Morningstar lists these numbers as much cheaper than their industry averages. And historically, the stock has always traded at these valuation levels - no frenzied bubble problem.

Two of the megatrends in technology are likely going to be a smartphone revolution and cloud computing. ARMH has their hands in both pies.