Chip market still tough for Arm Holdings

Arm Holdings scored a coup recently with the revelation that chips based on the company’s designs are running Apple’s iPad tablet, one of the most hyped and desired pieces of computer equipment to hit the market this year.

Although not officially confirmed by either Arm or Apple, the news has helped underline Arm’s position as one of the UK’s technology stars.

The shares have reacted well to the news, rising by more than 30 per cent since the start of the year against a 3 per cent fall in the wider FTSE 100. The company now has a market capitalisation of more than £3.2bn ($4.6bn).

Yet in spite of the company’s involvement with such a high-profile device, analysts have started to put sell recommendations on the stock, or at least moved it from buy to hold.

Concerns have grown about the valuation – a hefty 37 times forecast earnings for this year – and the company’s relatively precarious position in the brutal semiconductor market.

Arm creates the architecture for the low-powered semiconductors found in more than 90 per cent of the mobile phones in the world, as well as in a host of other devices from cameras to power switches.

Yet generating sizeable revenues from such a wide reach is proving to be tough. About 1.2bn mobile phones were sold last year – with smartphones accounting for 172.4m of that – but Arm’s annual revenue was just $489.5m.

“They have saved billions of dollars in research expenses for the mobile industry over the last decade but it’s not the business model that people think it is,” said Lee Simpson, analyst at Jefferies.

“Arm should have been going gangbusters after the big smartphone Christmas we just had, but there is a disconnect there,” Mr Simpson went on.

The problem is that Arm has very little pricing power. It receives a royalty of about 1 per cent from each chip using its intellectual property. Applications processor chips that run smartphones cost somewhere between $15 to $20, meaning about 15 to 20 cents for Arm.

However, many of the less complex Arm-based chips sell for less than $1.

Average royalties per chip were 5 cents for Arm in the first quarter of 2010, down from close to 9 cents six years ago. It has been trying to inch the royalty rate up to 2 per cent but Warren East, chief executive, admits progress is slow.

“We push it as hard as we can, but not too hard. The semiconductor world is littered with companies we no longer hear about, because they tried to charge too much,” Mr East said. “Yes, we help the chipmakers save money on research and development, but there comes a time when they say we are making enough out of them.”

Discussion of the royalty rates will be one of the key themes at Arm’s analyst and investor day on Wednesday.

If Arm put up its royalty rates too much, chipmakers would be likely to start looking at designing their own semiconductors again, as Intel does with the x86 chips that are used in most of the world’s computers.

Qualcomm, the US chipmaker, which currently licenses Arm technology, easily has the resources to do this. Wider competition from Intel is becoming a real risk for Arm.

Intel has recently developed low-powered Atom-branded chips, which could begin to replace Arm-based semiconductors in mobile phones. So far, Intel has only had success in netbooks, or small, low-powered portable computers.

The chips have not been power-efficient enough for mobiles up to now but the latest version of Atom has reduced energy consumption 50 times.

“It is still a little clunky, but the chip is now within an order of magnitude of what Arm can do,” Mr Simpson said.

Arm is fighting back by making its own inroads into Intel’s traditional computing territory.

US chip manufacturer Marvell, for example, recently announced that it would start shipping an Arm-based chip for computer servers later this year.

Arm and Intel will go head-to-head later this year, battling for inclusion in tablet computers like the iPad. While Arm has secured a slot in the Apple device, Intel may be used by many competitors.

Intel and Nokia, for example, have an alliance which may lead to the development of new types of tablets.

Arm’s progress in this category may be hampered by the fact that the Microsoft’s Windows operating system does not work on Arm devices, although Linux and Google’s Chrome systems do.

Pricing power is not likely to improve from here. Even more than before, Arm will have to continue its meek and ungreedy approach.

Arm investors may have to do the same.

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