For the first time I can remember indeed, perhaps for the first time ever world-leading chip designer ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US) is cheaper than mobile giant Vodafone (LSE: VOD) (NASDAQ: VOD.US).
Vodafones shares have been buoyant in the last couple of weeks, following comments from John Malone, chairman of cable group Liberty Global. Malone spoke about the attractiveness of Vodafones assets in western Europe. Some kind of deal may or may not happen, but viewed on a standalone basis Vodafone looks much less appealing to me than ARM at their current share prices.
Business models
Vodafone has to spend huge sums on investment, particularly at the moment as it seeks to replace lost earnings from the sale of its stake in US firm Verizon Wireless. As well as exiting the US mobile market, Vodafone is also in the midst of transforming its business in Europe, through heavy organic and acquisition investment, as it seeks to become a quad-play provider, packaging mobile, landline, broadband and TV.
In contrast, ARMs business is capital-light. ARM licenses and receives royalties on the microchips it designs. The company doesnt do the manufacturing, so no heavy investment is required in factories and so on. ARMs biggest investment is in talented engineers. The companys operating costs are covered by licensing revenue, leaving a rising tide of royalties to swell profits as the number of licences increases.
While Vodafone is attempting to transform itself in a competitive market, ARM simply has to go on doing what its always done designing great products and selling them at a great profit margin.
Debt and cash
Vodafone has net debt of 22.3bn, on which the interest paid last year was 1.6bn almost the entire operating profit of the business. Debt is only going to increase in the next couple of years as Vodafone continues heavy capital investment and meets its commitment of paying a rising dividend, currently running at 2.9bn a year.
ARM has no borrowings, and the surplus cash on its balance sheet is increasing at a rate of knots: from 79m in 2008 to 922m today.
Earnings multiples
Vodafone trades on a forecast P/E of 45 for its financial year ending March 2016, falling to 39 for the year to March 2017. ARM has a December year-end, and a current-year forecast P/E of 36, falling to 30 next year.
ARMs multiples are attractively in line with their historical norms, while Vodafones ratings, which clearly have a bid premium baked in, seem to require the companys investment strategy to deliver in spades (if no bid is received), with nothing in the way of a margin of safety for investors at the current share price.
Dividends
Of course, Vodafones dividend has long been a big attraction. The forward yield is 4.6% compared with ARMs 0.8%. However, recently-updated analyst forecasts, show a new consensus that Vodafones management will renege on its commitment to dividend growth. The consensus is for an 11.7p dividend this year (uncovered by earnings of 5.7p), cutto 11.6p next year (and still uncovered by earnings of 6.6p).
To put the dividends of Vodafone and ARM into context, Vodafones debt is equivalent to 7.7 times its current annual dividend. ARMs cash is equivalent to 10.7 times its current annual dividend. The income risk for Vodafone shareholders is all to the downside; for ARM shareholders, all to the upside.
Foolish bottom line
Vodafones massive investment programme could deliver in years to come, or a takeover bid could send the shares higher. But it seems theres little margin of safety for investors today. I believe that cash-machine ARM, on a cheaper earnings multiple and with no reliance on the success of a business reconfiguration (or merger and acquisition activity) is currently the better buy.
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G A Chester has no position in any shares mentioned. The Motley Fool UK has recommended ARM Holdings. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
