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Can the innovative tech firm survive the slowdown in spending? CFO Tim Score revels in ARM’s strength and royalty harvest

by Russ Mould

For a man who got off a plane from New York early in the morning, and then spent the day fielding questions at an analyst and investor meeting in London, Tim Score looks remarkably well. ARM Holdings’ chief financial officer greets me warmly and shows no sign of the busy day he has had.

Score joined ARM as chief financial officer in March 2002, having previously held the same post at the private-equity funded IT services firm Rebus. In some ways the timing could have hardly been worse for the the tall, affable Oxford graduate. The global semiconductor cycle was firmly in retreat following a burst tech bubble and its first ever profits warning that autumn.

ARM again took a cautious view of the cycle at the start of the year with February’s full-year guidance for sales growth matching at least last year’s 6%, when measured in US dollars. This disappointed analysts and drove the shares down to a three-year low. Score is quick to refute any suggestions 2008 is going to see a re-run of 2000 to 2002’s chip industry collapse.

‘It is nothing as dramatic as that. 2002 was the third year of a downturn, and industry revenues were 40% off their peak but we are in a completely different place in terms of the macro-economy,’ he asserts. ‘Now the argument is about to what extent a financially instigated credit crisis will affect the broader economy and within that whether the semiconductor industry will grow its sales by 1%, 2% or 3% this year.

‘ARM is also in a massively different place from 2002, in terms of visibility and scale. Then [Q3 2002] we had quarterly royalty revenues of around $10 million, and in the last quarter it was $55 million, and one third of unit shipments now come from non-mobile [phone] related areas, against almost nothing then,’ he continues.

Over 70% of ARM’s royalty income comes from the mobile phone industry and profit warnings from Nokia, Sony-Ericsson and others have prompted fears of a slowdown in demand.

Score is not convinced. ‘In the last four quarters, 80% of licenses have been for non-mobile applications as first use. The idea the company is totally at the mercy of Nokia’s handset unit sales is getting a bit passe, really,’ he smiles.

Crunch time

The 47 year old has not missed any of the warning signs witnessed in 2002 either, although he remains realistic. ‘We have not seen anything yet, but anything that depends on consumers spending on things that could be hit by the credit crunch could be impacted. It’s dangerous to assume we’re immune to it,’ he says,

This prudence was the basis for ARM’s February outlook which was received so badly. If Score was rattled by this, he doesn’t show it. ‘You know how it is. One side of the line and all is rosy in the garden, and the other side it’s a disaster. That’s the peril of quarterly reporting,’ he shrugs. ‘Since February most people accept things have got tougher and they accept we got in ahead of this.’

ARM is indeed unusual for a tech firm, as the peer group tends to be cash consumptive due to its rapid rate of growth. ARM’s financial strength stems from the fabless and chipless model which it pioneered.

The company does not get involved in the difficult and expensive process of silicon chip manufacturing. Instead, it licenses out its processor architectures for a fee and then collects a royalty.

A first quarter operating margin of 30.6% and free cash flow of £13.7 million, or 20% of sales, highlight the financial benefits of the ARM model, and most chief financial officers would love to be in Score’s shoes.

He is aware ARM still has issues to address, not least proving 2004’s $913 million cash and stock acquisition of Artisan was not a very costly mistake. Artisan’s sales have barely grown since its purchase and 2007 saw further heavy investment and a shake up of management, which resulted in ARM stalwart Simon Segars being parachuted in to oversee the California-based operation.

‘What we were really seeking to do was to replicate the processor outsourcing model. We saw physical IP as the next potential wave of outsourcing as [chip manufacturing] geometries continue to shrink,’ explains Score. ‘The next question was how to do we get in? We couldn’t build it, as it would have taken more than five years, so we bought the leading physical third party IP provider. It had a good business model and the plan was to take that business and its core technology and move it through three generations of semiconductor technology as soon as possible, so it was just ahead of its target customer base.’

Artisan is at the heart of the PIPD division, where ARM has invested heavily to accelerate product development through successive generations of silicon technology. Progress has not gone as well as hoped though.

Artisan doubts

‘The jury is still out,’ says Score. ‘Most analysts assign Artisan with a valuation little better than neutral, but we view that as an upside opportunity. Showing short-term revenue progress here is key, and the first quarter saw PIPD come in 10% above expectations.’

If fears of a mobile phone slowdown and disappointment at the rate of Artisan’s progress have been two key negatives for sentiment on ARM since last summer, a third is the possible emergence of Intel as a competitive threat. The world’s largest chipmaker is seeking to move into new areas to supplement its dominance of the PC microprocessor arena and as laptops get smaller and mobile phones are get smarter, the bears believe ARM’s hegemony in the wireless handset space could be threatened.

The doom generation

Score persuasively argues the doom merchants have got it wrong. ‘Intel will not have the technology in the foreseeable future. They will buy or win designs, yes, but will they take meaningful share?’ he asks. ‘The mere threat does mean we have to up our own game and it has had a galvanising effect for us and our partners such as Qualcomm and Samsung Electronics, who are not interested in seeing Intel eat their lunch. We are all working together on a product roadmap.’

The stakes here are high and fending off any threat in the lucrative smartphone area is vital, as the royalty stream is potentially very lucrative.

‘ARM is very sensitive to smartphones,’ Score accepts. ‘The royalties from a smartphone can be five to seven times what we would get [from a low end phone shipment] and in the iPhone it’s ten times.’

The current range of iPhone products features the ARM1176, yet Score is quick to point out the Cortex-A9 processor, launched in 2007, offers 16 times the performance of today’s smartphones, and twice the battery life.

‘The iPhone has already come to market so the die is cast there, but we also have second generation products on our developmental roadmap, which take us four or five years along and beyond. So the notion Intel must catch up with us is not a given as ARM and its partners are moving at pace as well,’ he says.

ARM11 processor designs currently generate just 3% of the PD division’s royalty income, against 57% from the ARM7, which was launched as far back as 1993. Nor have any of the 44 Cortex licenses signed in the last two and a half years generated any royalties. When they do so, not only will unit shipments rise, but average royalty per unit should increase too, up from the 6.2 cents seen in the first quarter of this year.

No wonder Score looks forward full of optimism, despite his realistically cautious assessment of short-term trading prospects, when he refers with a broad smile to ‘a royalty harvest from the vineyard of licenses.’

Before that, ARM still has to confound the sceptics and achieve its 2008 sales target and events could still conspire against it. However, the experiences of Score, and chief executive Warren East, of the savage 2000 to 2002 downturn mean their understanding of what the stock market is looking for from the firm, and their realistic assessment of the company’s opportunities and threats, means ARM looks to be in good hands.

30 second ARM Holdings

• Established in 1990 when Advanced RISC Machines was spun out of Acorn Computers.

• Pioneered the fabless and chipless model for semiconductor firms.

• Floated in London and on NASDAQ in April 1998. The deal valued the firm at £264 million.

• ARM has signed 542 licenses for its technology with over 200 silicon partners

• Over ten billion chips have been shipped featuring ARM’s designs

• Acquired America’s Artisan Components in $913 million cash and stock deal in 2004

• Paid its first dividend in 2004 (with respect to the 2003 financial year) and launched a share buyback programme in 2005.