At Nearly $55, Is ARM Holdings plc Still a Buy?

The core business is strong and growth prospects goodARM Holdings licenses intellectual property to chip designers, which then take ARM's designs and combine them with other designs to create chips. ARM generally collects an up-front licensing fee and receives subsequent royalty payments that are a percentage of the selling price of the chips that incorporate its designs.

Obviously, ARM benefits from the overall growth in the mobile market -- more smartphones and tablets shipping with ARM designs mean more royalties for the company. Another part of the story, though, is that ARM is increasing the value it delivers into the smartphone market.

As processor cores transition from 32-bit to 64-bit, ARM's royalty rate per core rises. The move to even more cores per device, as well as increased penetration of ARM's graphics IP, should further help the company grow royalty revenue.

ARM is expanding into other marketsARM has also highlighted opportunities in other markets such as networking, servers, embedded, and automotive. All of these markets represent multibillion-dollar chip opportunities. Although ARM would derive just a fraction of that value through royalty payments, in the context of its business (revenue of $1.31 billion last year) this could drive substantial growth if -- via its partners -- ARM can gain share within these markets.

For example, at ARM's analyst day in May 2014, the company talked about its networking-plus-server chip opportunity. Management said this opportunity was worth about $13 billion in 2013 and that the company had approximately 5% share. By 2018, ARM hopes to have 25%-35% share of these combined markets, and it expects $20 billion worth of chips to be sold into this space.

If we assume a royalty rate of 2% for these chips, then ARM's total royalties from these opportunities was about $13 million in 2013. If we keep that royalty rate assumption constant (in reality it will probably rise due to greater core counts, more 64-bit adoption, and so on), then even 25% share of that $20 billion opportunity could mean $100 million in royalty revenue -- much of it falling straight to the bottom line.

ARM is expensive, though, and a pullback may be in orderAfter such a big run to start the year, and as the stock trades at about 65 times trailing 12-month earnings (meaning investors expect significant growth going forward), it might be prudent to hold off on buying into the story until the stock pulls back somewhat.

Furthermore, although ARM's opportunities look attractive, keep in mind that if the companyfails to realize the kind of growth that investors expect, the stock's earnings multiple could significantly contract.

This isn't a stock for the risk-averse, and near its 52-week high I'd say the risk/reward for deploying fresh money isn't particularly attractive. Investors who like the story, and who are willing to take on the risk that comes with an expensive growth stock, will probably be well served by waiting for a pullback.

The article At Nearly $55, Is ARM Holdings plc Still a Buy? originally appeared on Fool.com.

Ashraf Eassa owns shares of ARM Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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