Shares might be too hot to handle

IT is hard to find fault with ARM’s results, which beat expectations on just about every count. Revenues of $180m (£112m) were nine per cent ahead of consensus; ebit margins of 41.1 per cent were higher than the expected 39.4 per cent; and adjusted EPS was 2.9p, 27 per cent ahead of consensus at 2.28p.

The outlook is also looking good. ARM’s order backlog – a key measure of its future prospects – was up 35 per cent quarter-on-quarter in the last three months of the year.

While it is hard to argue with ARM’s performance, the investment case is less clear cut. Several analysts might have nudged up their guidance yesterday, but the stock already trades on around 51.7 times estimated earnings in 2011. That is a stratospheric valuation which is almost impossible to justify on the current facts.

The valuation is based on hugely optimistic assumptions about compound growth over the next decade or so. The bulls’ argument goes like this. The number of devices that carry an ARM chip is growing exponentially; virtually every household appliance from washing machine to clock radio now contains a microchip. And the number of ARM chips in mobile phones is also growing fast, hitting 2.5 in 2010 compared to 1.5 four years earlier.

The bears still wince at the P/E ratio and it’s easy to see why. No one is doubting how hot ARM is, but its stock should be handled with care.