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ARM's dominance in handhelds faces challenge

An employee uses a remote control to demonstrate a Hewlett-Packard Co. Dreamscreen digital photo frame, which contains an ARM microprocessor chip, at the ARM Holdings Plc headquarters in Cambridge, U.K., on Wednesday, March 16, 2011.

Chris Ratcliffe/Bloomberg

ARM Holdings PLC lacks the brand recognition of some companies that use its technology, but when it comes to designing the brains inside handheld devices, the British company dominates the world.

That quiet dominance of the mobile computing market has been a tonic for the microchip maker's shareholders, keeping the stock growing in a difficult environment for the chip sector. But with ARM looking to branch out and huge competitors such as Intel Corp. starting to nip at ARM's heels, the question is whether ARM can go head-to-head with the industry's giants.

ARM designs chips found in the vast majority of tablet computers and more than 95 per cent of the world's smartphones, frequently providing the blueprints for four or five chips in a single device, such as Apple Inc.'s iPhone.

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By some estimates, ARM derives about 10 per cent of its revenue from Apple – and ARM's stock has been enjoying a halo effect from Apple's success, rising 12 per cent over the past year. On Tuesday, ARM posts fourth-quarter results, with the Street expecting profit to rise 40 per cent on revenue growth of nearly 10 per cent.

ARM commands the mobile world the way that Intel has ruled the PC and server markets. Now both players look set to collide, as ARM prepares to push into Intel's domain and Intel targets mobile devices.

The energy efficiency of ARM's chips appeals to businesses and organizations running large data centres and server farms, where power consumption is the biggest operating expense. Intel chips have greater calculating power, but many server farms don't require high-end computing capability.

ARM has received critical support from Microsoft Corp., which is developing its next version of Windows software to run on chips designed by ARM.

But Intel is making its own advances into ARM's territory, inking a partnership with Google Inc. that will let the company's Android mobile operating system run on Intel chips. While many have questioned whether Intel could close the power gap with ARM, this month the Santa Clara, Calif., giant announced deals to provide smartphone chips to both Motorola Mobility Holdings Inc. and Lenovo Group Ltd.

Going head-to-head with Intel and Advanced Micro Devices Inc. in the server market sounds like a tall order for ARM. With a market capitalization of $12.5-billion (U.S.), ARM is still pint-sized in the shadow of Intel, whose market capitalization is $137-billion.

But Ambrish Srivastava, of BMO Nesbitt Burns Inc., says that, while ARM chips won't make it into high-end servers, they could still take up to 20 per cent of the market now served by Intel.

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When ARM's server chips make it to market in late 2013 or early 2014, they could deliver a blow to Intel, reducing its share profit by 12 per cent, Mr. Srivastava calculates. In November, he cut his rating on Intel shares to "market perform" from "outperform," and upgraded ARM shares to "outperform."

Smartphones and tablets comprise less than half of ARM's business. The company's chip designs are employed in everything from eBooks and digital TVs to airbags, smart cards and washing machines.

Semiconductor companies, such as Qualcomm Inc., Texas Instruments Inc., Nvidia Corp. and Broadcom Inc., pay an upfront licence fee for ARM's technology. When they bring a chip to market, they begin paying royalty fees to the company. In the case of high-end smartphones, this amounts to between 1 and 2 per cent of the selling price of the chips, or about 30 cents to 50 cents a device.

ARM tries to cover its costs with the licensing fees, leaving most of the royalties as profit. In the third quarter, gross margins hit 94.9 per cent, as licensing revenue rose 38 per cent, to $72.6-million, and royalty revenue climbed 19 per cent, to $96.8-million.

Analysts are evenly split in their outlooks for ARM, but investor sentiment has been resoundingly bullish. The shares have soared threefold during the past two years, and now trade at a lofty forward price-to-earnings multiple of 54. Revenue grew 26 per cent in the first nine months of 2011.

But Pierre Ferragu, senior analyst with Sanford C. Bernstein & Co. LLC in London, warns in a recent report that Intel's deal with Motorola and Lenovo exposes two negative implications for ARM. First, the deal shows that Intel can be competitive in the market for low-cost, low-power chips. Second, the Street has become increasingly uncomfortable with ARM's high valuation, and this deal might trigger broader negative sentiment. Mr. Ferragu rates ARM's stock "underperform."

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Investors have grown too optimistic about the size of ARM's potential market and misunderstand the company's real potential in the area of laptops, PCs and servers, he cautions.

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