Time to dis-ARM

ARM is a great company, and one of the UK's leading technology shares. But despite upbeat forecasts and a sound business model, most of the expected growth is already priced in and the market must soon come to its senses over ARM's punchy rating. When it does, the shares are likely to fall.

They currently trade on a 2010 PE ratio of 31-40, based on the 2010 EPS forecast range of between 6.3p and 8.2p a share. Even if you factor in estimated earnings growth of 20-25 per cent into 2011, that's still heroically optimistic. In simple terms, the shares haven’t been this over-egged since the dotcom boom 10 years ago.

Cambridge-based ARM designs microchips for about nine out of 10 of the world’s mobile phones as well as for many of the electronic gizmos we all use today, such as digital cameras, TVs and smart energy meters. By concentrating on chip design and licensing of those blue-prints, it sidesteps the expensive manufacturing process while enjoying long-run royalty income.

That model has worked wonders for the share price. Back in January 2009 you could have picked up the stock for 81.5p as recession bit. Today they cost three times more. Clearly a global economic recovery has helped, but the emergence of smartphones and Apple’s iPad, which come with several expensive ARM-designed chips embedded, is key.

This was underlined in last week’s first-quarter figures showing ARM profits nearly doubling from £13.1m to £25.9m. Chip shipments for funky mobile devices jumped 50 per cent year-on-year, and sales of smartphone chips alone rose 30-40 per cent.

But this space is becoming increasingly crowded and competitive. Intel is looking to bolster its footprint, while Hewlett Packard's swoop for troubled Palm is a clear sign of industry consolidation and a shrinking customer base.

ARM also concedes that visibility is limited, while the economy going pear-shaped again remains a worry. Analysts also believe that technology manufacturers have been double ordering on post-recession stock building, and this will start tapering off into the second half. Deutsche Bank, Citigroup and Jefferies have all cut recommendations on the shares lately, echoing the views expressed in our Bearbull column at the start of March ().

The share price has also been pushed higher on mounting speculation that Apple may be preparing a £3bn bid. The pair go back a long way together and ARM has become a vital technology supplier to Apple, its clever chip designs embedded in iPods, iPhones and, now, iPads. But a deal doesn’t add up for Apple.

For one thing, buying ARM would surely arouse the regulators on competition issues. And even if the California-based firm does fancy taking key intellectual property in-house, continuing to supply design licences to rivals wouldn't make sense. What's more, since Apple knows ARM so well, it surely would have launched a takeover a year ago at a much discounted price. Never say never on takeovers, but ARM isn't likely to fall under Apple's spell anytime soon, if ever.

A final correction catalyst comes from within Arm's boardroom. Directors have been heavy sellers of the shares lately. During a single week in February chief executive Warren East sold over £2m worth of stock, while over £15m of shares were offloaded by directors in February.

Broker Execution Noble estimates pre-tax profits will hit £149m this year, implying EPS of 8.2p, rising to £174m and 9.6p in 2011. That's top-of-the-range stuff, yet the broker has still slapped a sell rating on the shares due to the hefty valuation. It reckons fair value is nearer 215p, over 16 per cent lower.

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