Tuesday, January 18, 2011

65x Forward Earnings for Arm Holdings (ARMH)? No Problemo Says Goldman Sachs - Buy It!

To say ARM Holdings (ARMH) is stretched on the chart is an understatement.  Last Thursday at it's peak it was more than 25% over its 20 day moving average - to not sell at least part of one's position into that level of extreme is looking a gift horse in the mouth. It is becoming increasingly difficult to justify valuation for many of us... but not Goldman Sachs' British analyst.  After missing the huge run (Goldman was at neutral) NOW the firm changes to buy - thanks for the value add guys!  Where were you the last 50%?   Indeed where you 35% ago (i.e. less than a month ago)

Once more (as in 1999) we are seeing analysts justify valuations today by picking some far off year (rather than the next 12 months) and then reverse engineering a figure that allows for them to say "what a great value".  Many of those assumptions in their reverse engineering are massively aggressive and assume that almost every mid cap tech company on earth is the next Apple, Amazon, or Google.  Thank you Bernanke for bringing back 1999.

Via Barron's

  • Goldman Sachs analyst Simon Schafer this morning raised his rating on the ordinary shares of ARM Holdings (ARMH) to Buy from Neutral, with a price target of 700 pence, about 30% above today’s price in London trading of 539.50.
  • Schafer makes the case that Microsoft’s (MSFT) recent decision to build the next version of Windows both for Intel (INTC) and AMD (AMD) chips as well as ARM-based designs, “opens new doors” for ARM. It could boost ARM’s penetration of computing to 45% by 2015, versus less than 10% today, up from a prior forecast of just 28% or so. That could add an additional $1.2 billion in royalty revenue, he writes.

So aside from the 45% penetration among computer devices versus less than 10% today (which is incredibly aggressive) here is the rest of the reverse engineering.
  • Since royalties are 100% profit for ARM, it should go straight to profit, and Schafer sees ARM’s royalty rate across various products rising from maybe 1% to 2% to 2.5%, on average. That could boost income per device to $1, on average, from a current five cents per piece.
  • Based on average unit growth of 13% over the next 10 years, and a 2% inflation in royalty rates, Schafer sees royalty revenue rising a compounded 16% over the next decade. Schafer models ARM’s royalty revenue rising to 222 million Great British pounds this year, 282 million next year, 365 million in 2013, 485 million in 2014, and 557 million in 2015.
  • While Schafer has the company producing just 11 pence in 2012, which is lower than some estimates (RBC Capital’s Nick Hyslop last week modeled 15 pence on much the same scenario), Schafer sees EPS exploding by 2015, at 30 pence per share. Hence, his 700 pence price target is based on a P/E multiple of 23 times that number.
So let's review... Intel will sit on its hands for the next 5 years.  ARM's royalty rate will go up over time, not down.  And since there is no way to justify valuations today, we'll put a price target on ARMH that is "only 23x, our pie in the sky 2015 EPS guestimate"... that says an ARM chip will be sitting in 1 of ever 2 computing devices produced at the time. The only best case scenario this analyst left out was the "someone may buy ARMH to boot!" 

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