Arm's grand designs

Arm designs microchips, licenses the blueprints to companies such as Apple and Samsung, then collects a royalty every time they ship a device containing one of its chips. In the 25 years since it was founded, it has signed more than 1,300 licences and customers have shipped more than 78bn of its chips. Its processors power a vast array of gadgets, from smartphones and tablets to car computers, smart meters and business servers. Moreover, soaring demand for internet-connected devices and high-speed wireless connectivity mean more gadgets than ever require computing power.

The company commands a large share of the smartphone and tablet markets, but has also been branching out into growth markets such as enterprise infrastructure, embedded intelligence - adding 'smarts' to devices such as watches and thermostats - and automotive computing. For instance, it grew its slice of the networking market by half to 15 per cent in 2015 and increased its share of microcontrollers and automotive chip shipments to 25 per cent and 7 per cent, respectively. In the fourth quarter, 55 per cent of shipments were non-mobile.

Arm's strategy helped it sign 173 processor licenses in 2015, 10 more than in 2014. Those included more than 50 for its latest processors, which command higher margins than older chips, and Mali graphics chips, resulting in a 6 per cent rise in processor licensing sales to £327m. Moreover, shipments of Arm-based chips soared more than a fifth to about 14.8bn. And, as customers installed a greater number of chips and more advanced silicon in devices, underlying processor royalty revenues soared 42 per cent to £463m - helped by $9m of catch-up payments from a customer that had previously miscounted its shipments. Combined with higher licensing and royalty revenues from physical technology and rising sales of software, tools and services that drove total operating profits up 31 per cent to £406m.

Other developments that underpin Arm's growth prospects include a recently inked contract with NVIDIA to help build an advanced driver assistance system while Sony, LG and other manufacturers have unveiled new digital televisions that use its chips. It's also collaborating with customers such as Qualcomm to develop microchips that meet their specific needs. Those kinds of deals, together with the group's deepening foothold in multiple growth markets are underpinning growth expectations despite concerns about slowdowns in China and the smartphone market.

The forecasts we've used in our table have already been adjusted some way below consensus to account for the market's fears. But we don't feel all that concerned ourselves. Not only does Arm boast a fantastic long-term track record, it could actually benefit from two trends in China: mounting demand among China's emerging middle class for premium devices such as the iPhone and the rapid growth of large domestic vendors such as Xiaomi that increasingly want to use more sophisticated chips.

Another potential worry for investors might be rising costs. But Arm's underlying operating expenses - up by a fifth last year - reflect increased research, which has historically driven excellent returns. Indeed, over the past five years, return on capital employed has risen from an impressive 15.8 per cent to an even more handsome 23.4 per cent, which gives us confidence that management is spending wisely. And Arm's directors plan to use the large and growing cash pile to finance growth, too, raising the prospect of acquisitions in the near future.