This Little Chip Designer Wields Big Clout

Processors based on ARM's blueprints rule high-end gizmos

The two-story, light-filled atrium in the center of ARM Holdings PLC's (ARMHY ) headquarters on the outskirts of Cambridge, England, has a typically professional feel. Amid potted plants and tasteful furnishings, clusters of engineers confer in hushed tones. But one incongruous sight punctures the air of seriousness: Atop a bookcase stand 41 empty bottles of Moet & Chandon and Veuve Clicquot, each commemorating a milestone in the chip company's 12-year history.

ARM might as well add a jeroboam of Dom Perignon to the collection. While the global chip industry suffered its worst year ever in 2001, with sales down 32%--a staggering $65 billion--and profits all but wiped out, ARM handily bucked the trend. The microprocessor designer chalked up a 42% jump in earnings before taxes, to $73 million, on revenues of $213 million. ARM may be dwarfed by European chip giants such as STMicroelectronics (STM ) and Infineon Technologies (IFX ), but investors are impressed by its potential. Since debuting on the London and Nasdaq exchanges in 1998, ARM's stock has outperformed the industry by a three-to-one margin.

Why so much enthusiasm? As intelligent gizmos flood the market, ARM has grown into one of the most influential chip companies in the world. Processors based on its blueprints, which it licenses for up to $5 million a pop plus an average 10 cents-per-chip royalty fee, are now used in everything from Nokia cell phones to Bosch antilock brakes to Nintendo Game Boys. ARM-based chips command three-quarters of the global market for the high-end brains used in electronic products. A staggering 420 million of the chips were sold last year, three times the number of PC chips. "We are the architecture for the digital world," says Chief Executive Warren East, an eight-year ARM veteran who took on the top job last October when co-founder Sir Robin Saxby retired from active management.

The 39-year-old East can't rest easy, though. ARM almost singlehandedly created a new business model: hawking intellectual property instead of selling actual chips. That has earned it the trust of customers such as Texas Instruments, Philips Semiconductor, and even Intel, which uses ARM technology in a line of speedy, power-stingy chips. But ARM's success is attracting stiff competition from the likes of Motorola Inc. (MOT ) and Mountain View (Calif.)'s MIPS Technologies Inc. (MIPS ) "ARM is not a monopoly by any means," cautions analyst Phil Smith at British broker Teather & Greenwood Ltd. It's a dominant supplier in mobile phones, for instance, but has made little progress breaking into segments such as smart cards and automotive chips.

ARM's reliance on the sickly wireless industry also is fueling fears that its stock may be overpriced. The 725-person outfit earns half its royalty income--or about 10% of revenues--from the mobile business. The slump in handset sales is one big reason its stock is down 24% since the start of 2002, even as the chip sector overall has rebounded 7%. The sell-off may be an overreaction, though: Analysts haven't lowered estimates that ARM's revenues will climb 26% this year and profits 36%. But at 85 times trailing earnings, its shares are priced well above the average semiconductor price-earnings ratio of 48.

Is ARM worth that much? Teather & Greenwood's Smith figures the company's revenues will climb at an impressive 20% rate for the next 10 years from growth in existing markets and further penetration into such segments as networking and consumer electronics. But the current share price, Smith says, assumes 30% growth. "We're negative on the valuation, not the company," he concludes. But Merrill Lynch & Co. chip analyst Andrew Griffin disagrees, arguing that ARM is so unusual that normal share-pricing techniques don't work. He thinks ARM will soar 26% this year on strongly higher license fees and royalties.

For his part, East downplays talk of near-term issues such as stock prices. "We're looking at the big prize," he says, aiming to provide the DNA for literally billions of processors every year. If ARM gets there, it could someday rival even Intel Corp. (INTC ) for sheer power and influence. The company's growing collection of Champagne bottles suggests ARM is already well on its way.

By Andy Reinhardt and Kerry Capell in Cambridge, England

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