The Weighing of an Investment

08/09/2013 12:00 pm EST

Focus: STOCKS

Royston Wild

Equity Market Sector Correspondent, Shares Magazine

Making the decision to invest in one particular stock can seem daunting, but today, Royston Wild of The Motley Fool UK, weighs the investment options for you.

Today, I am looking at ARM Holdings (LN:ARM) (NASDAQ:ARMH), and considering whether the company knows the passcode to deliver strong returns.

Question marks rumble over future royalties

ARM Holdings announced last month that revenues jumped an impressive 27% in the first six months of 2013, to £341.5m, pushing pre-tax profit 37% higher to £176m. Encouragingly, the company also upped its licensing guidance to $80m from $75m, although it modestly slashed its royalty projections.

However, doubts abound as to whether the firm can maintain the strength which has seen the share price rocket in recent years. Liberum Capital argues that although licensing levels remain high, this may not necessarily translate into juicy royalties for the company.

In particular, dozens of small start-up companies in China have been established recently in the smartphone and tablet PC space. These firms are chasing the same product categories and thus creating market fragmentation, the broker says.

And "while price competition between them could trigger some additional volumes, we do not think the additional volumes so generated would be proportionate to the increased licensing revenues," Liberum notes. High competition and market maturity are also likely to lead to failure amongst many of these companies, and although Asia does not represent the be-all-and-end-all for ARM Holdings, the region represents a big deal to the company in terms of licensing numbers.

Threat of competition also shakes projections

The increasing presence of the likes of Intel in ARM Holdings' space is also casting doubts over future licensing and royalties prospects. Intel—which is ready to launch its 22nm Silvermont architecture in the coming months, and integrated LTE modem solutions in 2014—is steadily growing its customer base by courting both top level and small customers. This is likely to lead to rising doubts over ARM Holdings' ability to guard its market share moving forward.

Still an expensive pick despite recent weakness

Although ARM Holdings' share price has fallen sharply over the past couple of months—the company has fallen almost 21% from May's all-time peak of 1,076p—I believe that the stock still remains vastly overpriced.

The firm currently boasts a prospective P/E rating of 42.3, based on City estimates, vastly above a reading of 22 for the whole technology and hardware sector and the broadly-considered value benchmark of 10. A sharp collapse could be in the offing, should royalties projections come under scrutiny and competition hot up over the next year.

Royston does not own shares in ARM Holdings.

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