The Investment Column: Royalty troubles pile pressure on ARM Holdings

Regus; Themutual.net
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The Independent Online

Our view: Avoid

Share price: 134.5p (+2p)

At the height of the dot.com boom ARM Holdings was a FTSE 100 company and its shares traded at a couple of hundred times earnings. These days the semiconductor designer is a FTSE 250 constituent and is valued at 24 times forecast earnings for 2007. Yet even this altogether more modest valuation is too rich.

The 17 per cent rise in first-quarter revenues that ARM reported yesterday looks impressive but failed to meet analysts' forecasts. Only thanks to good cost control did the company manage to hit its earnings targets. It appears that ARM is finding it increasingly difficult to achieve its sales forecasts. In July it cut projected growth to 15-20 per cent from more than 20 per cent. Then in October it again guided down estimates to the lower end of that range.

ARM makes money by licensing its designs to semiconductor companies and by getting a royalty each time one of the consumer devices containing its designs hits the market. Traditionally it has done well from mobile phones, 90 per cent of which contain at least one ARM product, and digital cameras, where the level stands at about 50 per cent. In the future, it aims to have a more diverse range of consumer goods running on its microprocessors coupled with the penetration it enjoys in the mobile phone market.

But that will take some doing. In the meantime, its licensing revenues are disappointing. Analysts say it is because ARM is finding it hard to get semiconductor producers to upgrade to its new designs.

On the royalty side of the equation, the company is seeing the average royalty it makes per product fall because of the increasing influence of low-cost mobile phone handsets and disk drives, both of which use less expensive chips.

Nevertheless, ARM is selling higher volumes at these lower rates, making the net effect a positive one for now.

Until investors see evidence of a pick-up in licensing revenues, the group's shares are unlikely to make much progress. At current levels they are best avoided.

Regus

Our view: Hold

Share price: 110.5p (+3.75p)

The temporary office space group Regus bought back 58 per cent of its UK business from Alchemy yesterday for £88m. It was forced to sell the stake to the private equity house in 2002 for £51m to help remedy severe financial difficulties. When the cash held by the business is added back, the loss Regus suffered from the deal is a lot less than the £37m difference between these two figures. It is probably closer to £20m. And, of course, the business is a lot more profitable that it was four years ago.

The purchase marks the end of Regus' recovery. It has certainly been amazing - many in the City are still baffled how the company escaped collapse in 2002. Back then its shares traded at less than 5p. Yesterday they closed 3.75p higher at 110.5p. Now, the group seems to face a bright future. The market it services is buoyant and will remain so as long as the US and UK economies hold up.

But a word of warning. Regus is a company with very high operational gearing. So when times are good they are really good, and when they are bad, life is truly grim. At current levels, that makes the stock just a hold while at the first sign of an economic downturn it should be ditched.

Themutual.net

Our view: Buy

Share price: 67.75p (+5.25p)

The online advertising sector is booming. It is growing at between 20 and 30 per cent a year and analysts forecast this trend to continue for years to come. Companies now spend more money on getting their message across using the internet than they do through outdoor advertising and radio.

Themutual.net is among a handful of AIM-listed firms cashing in on this explosive growth. Its trading statement yesterday boast that full-year sales would be ahead of City expectations and with profits also strong. The biggest part of its business focuses on direct online advertising - that is ads to people's inboxes as opposed to the more traditional method of sending them through the post.

Themutual also runs an online advertising agency. This buys online ad space for clients such as big credit card companies in return for a fee. The group bought the business in November for £2m and it has significantly outperformed management expectations since.

Things have not always been so rosy. Themutual started life in 1999 as an online community for people to talk about their hobbies. It struggled and nearly went bust in 2000. Then, in January 2001, it cleverly decided to reinvent itself as an online marketing group and has been profitable in every month since November of that year.

Brokers sharply upgraded their forecasts in the wake of yesterday's statement. Investec Securities expects Themutual to deliver a pre-tax profit of about £1.7m for the year ending 30 April 2006, rising to £3.2m in the following year. At 67.75p this leaves the shares trading at just 14 times 2007 forecast earnings. Buy.

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