We are maintaining our fair value estimate for ARM Holdings (ARM) after the announcement that Microsoft's next version of Windows will be developed for ARM-based chips. While the deal certainly makes for juicy headlines, since it strays from Microsoft's long, well-publicised partnership with Intel x86 chip architecture over the years in the PC space, we don't see the deal as a shocking game-changer for ARM.
ARM is already poised to benefit from the tablet market via Apple's iPad and a variety of Google Android-based devices. We think Microsoft's deal with ARM will help Microsoft better compete with these two platforms, but ARM will continue to be agnostic if any of these three platforms win. ARM stands to benefit from the deal only if Windows-based tablets help to grow the tablet market at an even faster pace than the exponential growth already expected from these devices. A poll by NPD indicates that most early adopters of tablets have bought these products as additional devices, either in lieu of eReaders or as a third device in the home in addition to PCs and smartphones. Looking ahead, however, we do expect tablets to cannibalise x86-based PCs at an accelerating pace. However, Intel continues to work on lower power chips, and we believe Intel has the size, scale and wherewithal to succeed in these designs down the road. It is certainly possible that any incremental revenue from ARM-based tablets could be offset by ARM losing a portion of its mobile market share to Intel in the coming years.
Finally, ARM's IP is the backbone of low-power chip architectures, but the company's licensees, such as Qualcomm and Nvidia , don't gain much differentiation from ARM's library as they compete against one another. In turn, ARM's pricing power is limited, which is the main reason why we consider ARM to have a narrow, rather than wide, economic moat. We'd also like investors to bear in mind that the company earns royalties as a percentage of the price of each ARM-based chip sold, and although these tablet processors will be sold at higher prices than most other ARM-based chips, ARM's revenue growth from tablets will still likely hinge on higher semiconductor unit sales. Since annual unit sales for tablets (which may reach hundreds of millions down the line) will pale in comparison to handsets (estimated 1.3 billion units sold in 2010), we don't believe that tablets will be ARM's core market any time soon. In short, the recent deal with Microsoft will make for nice headlines and publicity for ARM in the years ahead, but we don't think it will lead to stellar profitability beyond our already-optimistic valuation assumptions for the company.
