James Moore: Is paying a heftypremium for chip firm Arm a signof tech madness?

Investment View: The problem is that there is a real dearth of quality technology companies on the London Stock Exchange

Arm holdings

Our view Buy on weakness

Share price 592.5p (-7.5p)

Sometimes it is worth paying a premium because even though the economy stinks, cheapest isn't always the best.

But however good the product is, there does come a time when the numbers just don't add up; when the premium is just not worth paying compared to the competition.

Has Arm Holdings reached that point? The chip designer certainly deserves a top rating. If you have a smartphone (and most people have), there's a good chance that there will be an Arm chip inside it.

And that's not all. Arm has been designing chips for a new generation of toys produced by Lego (fathers will drool) while also boosting the power of tablet computers. Then there's the excitement brewing about (Microsoft) Windows on Arm, a story which analysts expect to really get going next year. Arm chips are, in fact, colonising our lives without our having noticed it.

No surprise then, that the company is something of a moneymaking machine. It gets a royalty from each chip sold (existing designs provide about half of its revenues) in addition to what it makes from the sale of new licences.

Competition is a concern. A certain Intel would like to snatch some of Arm's smartphone market share, and there has been growing interest in the latter's Medfield chip. But analysts argue (while admitting that comparing chips isn't all that easy) that Medfield still doesn't quite match up to the best Arm can do.

With all this being the case, you'd expect Arm shares to carry a premium. That they certainly do. On 6 March the stock hit a six-month low of 535.5p. The shares have been on a tear ever since and now trade on about 43 times this year's forecast earnings, with a prospective dividend yield of 0.7 per cent.

Tech madness? A premium so big it is time to switch into something different? The problem is that there is a real dearth of quality technology companies on the London Stock Exchange. Part of the reason for Arm's premium could simply be its rarity value, although even on a more technology rich market it would still stand out.

It remains shamefully expensive for UK investors to deal in overseas stocks and dollar companies carry currency risk (although there are a number of dollar stocks, notably HSBC and the oil majors, on the London market).

But how about America's technology stars?

Arm's main claim to fame is that its chips are used by Apple. If you have an iPhone, you are a customer. At more than $600 a pop, Apple's shares appear to be expensive, but based on the company's earnings they are not. The company trades on just over 14 times 2012 forecast earnings (its year ends in September) while yielding even less than Arm (although the company has only just commenced dividend payments).

What about that potential threat to Arm's dominance of the smartphone market? Intel trades on 11.5 times full-year earnings, with a forecast yield of just over 3 per cent.

Of course comparing these two behemoths with the much smaller, faster-growing Arm is rather like comparing an apple tree to a small orchard.

All the same it does illustrate just how pricey Arm's shares are.

Arm produces high-quality product and has continually performed better than the City's expectations. Even during the depths of the financial crisis the shares still traded at multiples in excess of 20. As for the August wobble last year? They were trading above 30 times.

That said, there is premium and there is ridiculous.

For the really exciting growth you needed to be in Arm a couple of years ago. The company is still a good one for a portfolio and some analysts think the shares could hit 690p. But I'd be reluctant to get involved at the current level. In my view Arm would be interesting at around 550p and the stock could be due to ease on profit-taking if the forthcoming results are merely very good as opposed to spectacular. Steer clear for now but buy on weakness.

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