INDEPENDENT RESEARCH ARM Holdings 7th December 2015 Cash me if you can Semiconductors Fair Value 1310p (price 1,122p) BUY Coverage initiated Bloomberg ARM.LN ARM Holdings designs and licences processors used by a large Reuters ARM.L majority of industry players. The group was one of the main winners 12-month High / Low (p) 1,205 / 848.5 of the smartphones wave such that the share price has rocketed from Market capitalisation (GBPm) 15,766 Enterprise Value (BG estimates GBPm) 14,799 75p in 2009 to more than 1100p these days. As we go into 2016, Avg. 6m daily volume ('000 shares) 4,640 questions primarily concern sources of future growth. We have Free Float 79.4% identified in particular, network infrastructure, servers, IoT and the 3y EPS CAGR 17.3% Gearing (12/14) -44% increasing adoption of ARM technologies enabling a rise in the Dividend yields (12/15e) 0.66% royalty rate per chip. In all, we have factored in average EPS growth of 16% for the next three years and value the share at 1310p (upside of YE December 12/14 12/15e 12/16e 12/17e 18%). Revenue (GBPm) 795.20 965.82 1,104 1,226 EBITA GBPm) 400.4 498.1 559.6 634.9 Op.Margin (%) 50.3 51.6 50.7 51.8 Further potential in smartphones! Although we have noted a Diluted EPS (p) 24.12 30.21 33.95 38.89 slowdown in smartphone sales momentum, we believe the group could EV/Sales 18.99x 15.32x 13.08x 11.45x benefit from 1/ moves upscale in processors (from 32-bits to 64-bits), 2/ EV/EBITDA 34.6x 27.3x 23.6x 20.3x EV/EBITA 37.7x 29.7x 25.8x 22.1x the multiplication of cores and 3/ the adoption of ARM's Mali graphics P/E 46.5x 37.1x 33.0x 28.9x technology. In all, we expect average growth potential of 11% between ROCE 36.6 46.7 53.2 62.5 2014 and 2018e in royalty revenues from smartphone processors. Fresh sources of growth at hand! Whereas the market is focusing on 1215.7 momentum in global smartphone sales and is waiting impatiently for the 1165.7 1115.7 emergence of servers based on ARM's processors, we believe that 1065.7 network infrastructure offers more opportunities for the group in the 1015.7 short term. Significant changes are underway in usages and technologies 965.7 915.7 used in this segment and these are clearly beneficial to ARM. In contrast, 865.7 we do not expect the servers segment to be visible before 2018, when we 815.7 expect it to genuinely take off. 765.7 04/06/14 04/09/14 04/12/14 04/03/15 04/06/15 04/09/15 04/12/15 ARM HOLDINGS SXX EUROPE 600 Unrivalled value creation. In historical terms, the group has proven that it has created a sufficiently flexible business model to generate FCF of close to 100% of net profit on a stable basis. With an ROIC/WACC differential of almost 18 points on average over the past five years, ARM's business model clearly generates value for its shareholders. As such, we believe that with a profile such as this and 12m forward P/E of 33.3x, i.e. close to five-year low levels, the share harbours upside potential. Our valuation (DCF and peer comparison) points to upside of more than 18%. Analyst: Sector Analyst Team: Dorian Terral Richard-Maxime Beaudoux 33(0) 1.56.68.75.92 Thomas Coudry [email protected] Gregory Ramirez r r ARM Holdings Simplified Profit & Loss Account (GBPm) 31/12/12 31/12/13 31/12/14 31/12/15e 31/12/16e 31/12/17e 31/12/18e Revenues 577 715 795 966 1,104 1,226 1,364 Change (%) 17.3% 23.9% 11.3% 21.5% 14.3% 11.1% 11.3% Adjusted EBITDA 282 445 437 543 611 692 781 Adjusted EBIT 263 351 400 498 560 635 718 EBIT 208 153 309 405 450 520 589 Change (%) 39.6% -26.3% 101% 30.9% 11.3% 15.4% 13.4% Financial results 13.6 13.2 11.0 12.1 13.2 13.5 13.6 Pre-Tax profits 221 163 317 412 458 527 598 Tax (71.4) (73.4) (68.6) (82.1) (91.7) (97.3) (110) Net profit 161 105 255 340 379 443 503 Adjusted net profit 205 291 343 428 481 551 622 Change (%) 19.7% 41.7% 17.9% 24.9% 12.4% 14.5% 12.8% Cash Flow Statement (GBPm) Depreciation & amortisation 18.8 94.3 36.6 44.9 51.3 57.0 63.4 Change in working capital (80.7) 33.2 (45.5) 7.6 6.1 5.4 6.1 Operating cash flows 157 315 342 476 526 601 681 Capex, net (25.9) (45.3) (30.4) (38.6) (38.6) (42.9) (47.8) Free Cash flow 131 270 311 437 488 558 634 Acquisition, net (7.5) (24.8) (12.8) (3.5) 0.0 0.0 0.0 Financial investments, net 8.8 (3.4) (2.8) (0.69) (5.5) (6.1) (6.8) Dividends (51.8) (68.9) (86.1) (104) (134) (166) (172) Issuance of shares 8.3 5.9 (60.1) (42.2) 0.0 0.0 0.0 Issuance (repayment) of debt (3.3) (4.4) (7.6) (2.7) 0.0 0.0 0.0 Other (50.9) 28.8 (57.1) 10.3 13.2 13.5 13.6 Net debt (381) (584) (668) (967) (1,329) (1,729) (2,197) Balance Sheet (GBPm) Tangible fixed assets 36.1 33.6 43.4 24.1 2.0 (22.5) (49.8) Intangibles assets & goodwill 531 609 644 661 672 684 698 Investments 164 149 221 221 225 229 234 Company description Deferred tax assets 84.0 72.2 64.8 64.9 64.9 64.9 64.9 ARM is a UK group specialised in the Other non-current assets 2.0 1.6 1.7 1.7 1.7 1.7 1.7 Cash & equivalents 386 588 675 969 1,331 1,731 2,199 design of processor architectures and Current assets 264 185 187 227 259 287 319 graphic chips. Virtually all Total assets 1,467 1,638 1,837 2,169 2,555 2,976 3,467 semiconductor players are licencees of Shareholders' equity 1,206 1,311 1,528 1,823 2,172 2,558 3,012 the group and use the designs Provisions 24.2 45.1 45.6 45.6 45.6 45.6 45.6 Deferred tax liabilities 16.6 18.9 32.3 32.3 32.3 32.3 32.3 developed by ARM to help them Current liabilities 214 259 225 265 304 337 376 design their own chips. ARM has L & ST Debt 5.8 4.2 6.5 2.0 2.0 2.0 2.0 benefited massively from the boom in Total Liabilities 1,467 1,638 1,837 2,169 2,555 2,976 3,467 smartphones, 85% of which use Capital employed 826 728 860 857 843 830 815 processors based on an ARM Ratios architecture. To continue expanding, Gross margin 94.83 94.79 95.52 96.10 96.20 96.30 96.60 Adjusted operating margin 45.58 49.10 50.35 51.57 50.70 51.80 52.60 the group now needs to develop new Tax rate 32.32 45.14 21.67 19.92 20.01 18.45 18.36 growth sources including IoT, servers Adjusted Net margin 35.56 40.68 43.10 44.32 43.60 44.97 45.56 and networking infrastructure. ROE (after tax) 13.32 7.98 16.71 18.67 17.43 17.33 16.70 ROCE (after tax) 21.58 26.98 36.58 46.69 53.24 62.55 72.04 Gearing (31.55) (44.51) (43.73) (53.02) (61.18) (67.56) (72.94) Shareholders Pay out ratio 31.78 65.09 33.36 30.45 35.05 37.11 34.02 Number of shares, diluted 1,396 1,412 1,421 1,417 1,417 1,417 1,417 BlackRock Baillie Gifford 5.0% 5.1% Thornburg Data per Share (p) Investment EPS 11.68 7.50 18.16 24.21 26.92 31.52 35.76 5.0% Restated EPS 14.73 20.59 24.12 30.21 33.95 38.89 43.86 % change 18.3% 39.8% 17.1% 25.2% 12.4% 14.5% 12.8% FMR BVPS 0.86 0.93 1.08 1.29 1.53 1.81 2.13 4.9% Operating cash flows 0.11 0.22 0.24 0.34 0.37 0.42 0.48 FCF 0.09 0.19 0.22 0.31 0.34 0.39 0.45 Treasury shares Net dividend 3.71 4.88 6.06 7.37 9.43 11.70 12.17 0.6% Other free float 79.4% Source: Company Data; Bryan, Garnier & Co ests. 2 ARM Holdings Table of contents 1. Investment Case ...........................................................................................................................................4 2. A specific business model ..........................................................................................................................5 2.1. Snapshot: digital architect ...................................................................................................5 2.1. Licence to kill… competition ............................................................................................ 7 2.2. Royal(ties) family: processors for everything! ................................................................. 9 3. What sources of fresh growth for ARM? ............................................................................................. 11 3.1. Enterprise infrastructure: where are the servers? ........................................................ 11 3.2. Network infrastructure: connection underway! ............................................................