Priced beyond Imagination

Imagination Technologies is best known for developing and licensing video and graphics microchips that help run 126m gadgets, including Apple's iPhone. But it has also branched out into selling a range of intellectual property (IP) for consumer devices, such as microchip performance technology and connectivity applications.

This strategy means its designs can be easily integrated, allowing manufacturers to launch electronic devices more quickly than if they bought chip designs from separate suppliers. Yet the concern is that cash flow from Imagination's proven graphics and video IP is being channelled into areas that may not add value, such as last week's $47m (£29.5m) acquisition of California-based VoIP (voice over internet protocol) and wireless specialist HelloSoft.

Imagination and HelloSoft have been working together for several years, yet Imagination's non-graphics side has yet to make a big impact. And it's difficult to see that this deal will change that, given HelloSoft's most recent trading figures. In 2009, HelloSoft generated $1.85m (£1.15m) of revenue and ran up $2.34m (£1.45m) in pre-tax losses. The acquisition will see Imagination pay approximately $20.2m in cash upfront, and up to $26.9m over the next three years, depending on performance, split roughly one third/two-thirds between shares and cash. The cash part is being funded through a placing of up to 12.2m new shares at 310p.

True, the microchip market has strengthened throughout 2010, thanks to renewed corporate spending on PCs and laptops and, more importantly, huge demand for smartphones and tablet computers. According to Coda Research, 2.5bn smartphones will be sold worldwide between 2010 and 2015, and some analysts expect seven out of 10 Europeans to own a smartphone by the start of the London Olympics in 2012, up from about three out of 10 at the start of the year. As for tablets, forecasts from marker researcher Gartner estimate that global sales will rise by more than 180 per cent next year, mainly thanks to the iPad, but also as rivals' product sales gather momentum. That implies unit sales rising from 19.5m this year to 54.8m in 2011. And tablet sales could break the 200m mark by 2014, says Gartner.

This sounds good for Imagination. But such growth is fostering increasingly aggressive competition, even in Imagination's core video/graphics market, and that could squeeze royalty revenues. These have been growing fast, increasing 75 per cent to £24.4m in 2009-10 and for the first time outstripping licensing revenues, which were £22.9m.

Feeding these worries is evidence that Imagination recently lost out to ARM to supply graphics chips on Samsung's new Orion microprocessor. While the Samsung story has been neither confirmed nor denied by any party, it has been widely reported in Samsung's backyard in southeast Asia. If true, it would be a pretty big blow for the group. Samsung Mobile, the most likely launch customer for the Orion chip, is currently Imagination's leading customer among handset makers that use the Android mobile operating system developed by Google, and Samsung has ambitions to ship 40m smartphones next year.

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Meanwhile, Imagination's share price has motored this year, rising 37 per cent. That means the shares are now priced for perfection, trading on a multiple of underlying earnings forecast for 2010-11 of about 37 times, falling to 34 times 2011-12's forecast. Much of that rise is down to takeover talk, some of it pretty far-fetched. True, US giants Intel and Apple own sizeable stakes in Imagination (14 per cent and 9 per cent respectively), but these look more like passive investments than the prelude to a bid.

Even if we assume Apple might have considered taking Imagination's technology in-house as a way to slow the growth in Android-powered handsets, the recent developments at Samsung show there are other chip designers around anyway.