Business Analysis: ARM Holdings punished for US buy as market fears acquisition will cost it dear

Shares fall nearly a fifth as microchip designer struggles to justify $913m takeover
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The Independent Online

ARM Holdings, the microchip designer, unveiled its biggest acquisition so far when it agreed yesterday to buy the American company Artisan for $913m (£504m).

ARM Holdings, the microchip designer, unveiled its biggest acquisition so far when it agreed yesterday to buy the American company Artisan for $913m (£504m).

The market, however, gave the cash and shares takeover the thumbs down with ARM's shares tumbling 19 per cent to 81.75p on news of the acquisition. The size of the deal and the 42 per cent premium ARM is paying to gain control of Artisan worried investors who are also nervous about the track record of UK companies buying American technology firms.

Warren East, the chief executive of ARM, said the deal would allow the company to move into adjacent product areas and widen its revenue sources. ARM designs the so-called "system-on-chip" which includes the software that animates microprocessors that are contained in a wide range of devices such as mobile phones.

Artisan provides the physical components for manufacturing microchips, including embedded memory components, for instance. However, both the companies' technologies share similar customers and end users and both get paid a royalty each time a device is sold that contains their technology.

Mr East said: "Our strategy has been to design ARM technology into as many digital products as we can. Our fundamental technology is the ARM microprocessor core, which accounts for 75 per cent of our business.

"The deal means that when an ARM-powered device is sold in future we will earn more money. We certainly have had a desire to grow the amount of money we earn from ARM-based products. You can't do that by simply asking customers to pay more. They need more value to do that. We need to extend our product portfolio." The terms of the agreement involve ARM paying Artisan shareholders $9.60 in cash plus 4.41 ARM shares for each Artisan share. The deal valued each Artisan share at $33.89, a 42 per cent premium to the company's closing price on Friday. But the value of ARM shares fell yesterday when the UK stock market opened.

Mr East was optimistic that once the market had digested the deal it would be more enthusiastic. "I think you need to look at the price in a few weeks' time when people have familiarised themselves with the strategic rationale," he said. Defending the price that ARM is paying, the chief executive said: "Artisan is covered by a small number of analysts with share price forecasts ranging from below the price we are paying to above it. So we are paying a price within the range of analysts' expectations.

"This company is cash generative, with a 30 per cent operating margin and it is very profitable and is expected to have 30 per cent top-line growth this year. This is a good business. If you are going to pay for a quality business we think it is reasonable to expect to pay a price in the middle of the range of analysts' forecasts."

According to its last set of annual results for the year to 30 September, Artisan had sales of $68.5m and profits after taxes of $7.3m. Yesterday's announcement also revealed its financial track record for the 12 months to 30 June, which showed the group had increased sales to $82.9m and profits after tax to $17.3m plus $140.4m of cash on its balance sheet.

Both parties have written in substantial break fees should one or other group walk away from the deal. ARM has agreed to pay a break fee to Artisan of $18m if it backs down while Artisan has agreed to pay a break fee of $18m to $31m should it terminate the process. This includes accepting a higher offer from a rival. This would result in it paying the $31m penalty.

One of the reasons why the merger makes sense, according to Mr East, is that the technology the two groups are involved in is getting more complex and shrinking in size. Combining the businesses should help them design more effective products. The official announcement said the deal better positioned the companies to take advantage of opportunities across a range of industries as system design complexity increases in the "sub-micron age". Mr East said: "As the size of the structures in semiconductors get smaller, you run into problems with the laws of physics."

While analysts accepted the industrial rationale for the deal, they are worried it will dilute ARM's earnings this year and next. Michael Blogg, an analyst at Arbuthnot Securities, said: "Its [ARM's] licencees include virtually every electronic device manufacturer and most of the semiconductor companies.

"Its intellectual property [IP] covers only some of the requirements for the completion of the final product. Artisan operates in an adjacent market space, providing IP for the design of physical components, such as memory. Both companies are addressing the pressing need for power efficiency in complex products, since there is a trade-off between functionality [which generates sales] and power drain. We accept that there should be benefits from an ability to address more of the customers' requirements."

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