Should I Invest in ARM Holdings?

LONDON -- To me, capital growth and dividend income are equally important. Together, they provide the total return from any share investment and, as you might expect, my aim is to invest in companies that can beat the total return delivered by the wider market.

To put that aim into perspective, the FTSE 100 has provided investors with a total return of around 3% per annum since January 2008.

Quality and value
If my investments are to outperform, I need to back companies that score well on several quality indicators and buy at prices that offer decent value.

So this series aims to identify appealing FTSE 100 investment opportunities, and today I'm looking at ARM Holdings (LSE: ARM  ) (NASDAQ: ARMH  ) , which describes itself as a leading semiconductor intellectual property supplier. Many of the world's digital electronic products contain the processors and electronic components the company designs.

With the shares at 922 pence, ARM's market cap is 12,700 million pounds.

This table summarizes the company's recent financial record:

Metric	2008	2009	2010	2011	2012
Revenue (millions of pounds)	299	305	407	492	577
Net cash from operations (millions of pounds)	101	97	176	194	157
Adjusted earnings per share (pence)	5.66	5.45	9.34	12.72	14.93
Dividend per share (pence)	2.2	2.42	2.9	3.48	4.5

Years to December.

The recent full-year results showed cracking business and financial progress at ARM, once again. Investors in ARM are used to this kind of result, thanks to many equipment manufactures adopting the firm's technology designs. Devices such as microcontrollers, medical devices, computers and smart phones all end up with embedded ARM technology, and a mainstream adoption of devices such as tablets and smart phones by consumers has boosted sales and profit margins yet further: ARM's most technical, and therefore most profitable, designs become necessary to make cutting-edge equipment work.

ARM sells intellectual property rather than electronic components. Rather than become encumbered with the costs and challenges of manufacturing, the firm licenses its technology to leading semiconductor and equipment manufacturers, which incorporate ARM's processor and other technology designs in advanced, low-energy chips suitable for modern electronic devices. As well as licensing fees, ARM earns an ongoing royalty as the end-products sell.

It's a successful formula, which has led to ARM's lofty valuation. I remember looking at the shares back in about 2005. They looked expensive to me then and I didn't buy, but they've multibagged since, so a traditional valuation approach caused me to miss out. ARM holds a key position in the markets it serves and, in that respect, appears to have a strong competitive advantage over any potential rivals.

ARM's total-return potential
Let's examine five indicators to help judge the quality of the company's total-return potential:

1. Dividend cover: earnings covered last year's dividend more than three times. 5/5

2. Borrowings: at the last count, there was net cash on the balance sheet. 5/5

3. Growth: revenue, earnings and cash flow (ignoring prepayments) have been growing. 5/5

4. Price to earnings: a forward 39, looks generous given growth and yield forecasts. 2/5

5. Outlook: robust recent trading and a positive outlook. 5/5

Overall, I score ARM 22 out of 25, which encourages me to believe that the firm has potential to outpace the wider market's total return, going forward.

Foolish summary
ARM scores strongly on the business-quality metrics of dividend cover, borrowings, growth and outlook. As usual, this strength has been recognized-and-then-some in the valuation. The shares have had a good run recently, but I'm happy to put the company on my watch list until the share price consolidates.

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