Arm Holdings - Earnings Call - Q3 2011

Transcript

Operator (participant)

Thank you for standing by and welcome to the Q3 results conference call. At this time, all participants are in a listen-only mode. There will be a presentation followed by a question and answer session, at which time, if you wish to ask a question, you will need to press star one on your telephone. I would now like to hand the conference over to your speaker today, Ian Thornton. Please go ahead, sir.

Ian Thornton (VP of IR)

Thank you, Nick. Good morning, everybody. This is Ian Thornton, VP of Investor Relations at Arm Holdings. On today's Q3 Results Conference call, we have Warren East, Chief Executive Officer, and Tim Score, Chief Financial Officer. On today's call, Warren and Tim will take us through the highlights and comments from the quarter's results, and then we'll open the call up to a Q&A session. As a reminder, the presentation and press release can be found on the Arm Investor Relations website at www.arm.com/ir. Before I hand over to them, I just have to read out a few words with respect to this conference call and what we're about to discuss. The contents of this conference call are being directed only to those of you who have professional experience in matters relating to investments, and the information communicated on this call is being made available only to investment professionals.

Any persons present on this call who do not have professional experience in matters relating to investments should not act or rely on the contents of this call. The following conference call will contain forward-looking statements, which are other than statements of historical fact. The company's actual results for future periods may differ materially from these statements, as they are based on current expectations and are subject to a number of risks and uncertainties. On this note, I'll hand over to Warren.

Warren East (CEO)

Good morning, everyone, and thank you for joining our call this morning. I'm going to run through the business highlights and then hand over to Tim, who will provide some more detail on the financial implications. As usual, we expect that much of the content will be covered in the question and answers. Quick overview: we reported our first half results three months ago, and when we did that, we highlighted the increased level of design activity with our customers developing even more of their chips based on Arm technology. The good news is that that level of design activity has continued, even though semiconductor sales have been lower over the summer than some industry analysts had expected earlier in the year. We entered the third quarter with a healthy order backlog at historically high levels, and we had ongoing market share gains in long-term structural growth markets.

During the third quarter, we continued to outperform the semiconductor industry with good, strong year-on-year growth in licensing and royalties against an industry that is broadly flat year-on-year. We benefited from the sales of smart consumer products and lots of low-power embedded electronics. The demand for these products is really what's driven licensing, with 28 processor licenses sold in the quarter and royalties with shipments of Arm products growing year-on-year by 25%. That has resulted in revenue growth, and that's enabled us to continue to invest further in R&D at the same time as growing earnings by 47% year-on-year and delivering good levels of cash generation. We're going into the final quarter of 2011 with a strong order backlog. Semiconductor companies are looking to develop more of their products around Arm technology, and this combination points to another strong quarter for license revenue.

Arm Q4 royalty revenues are generated from Q3 shipments from our semiconductor partners, and our data for the third quarter indicates that relevant industry revenues were broadly flat sequentially. Now I'll just discuss the drivers for revenue in the different parts of the business in a bit more detail. We'll start with processors. We signed 28 licenses in the quarter. It was a very broad range of end markets, including deeply embedded designs for powertrain in automotive, sensors, smart cards, and microcontrollers. It also included some consumer electronics products designed wins in things like digital TVs, mobile phones, and mobile computers. 14 of the 28 licenses were bought by new customers, and most of these new customers were actually established semiconductor companies who are now building their first Arm-based chip. This is the highest number of new customers that we've yet seen in a quarter.

As the trend towards smarter products continues and gains pace, semiconductor companies are finding Arm technology quite instrumental in helping them gain a share in increasingly competitive marketplaces. 24 of the licenses were signed for the Cortex family of processors. We sold nine Cortex A licenses, mainly for smartphones, digital TVs, mobile computers, and some embedded computers. 14 licenses for Cortex M processors into microcontrollers and smart cards. This included another lead licensee for the next generation of Arm processors for microcontrollers, and I expect that we'll be announcing that product next year. In total now, 120 Cortex M licenses have been bought by our customers for microcontrollers. If you combine that with recent new product introductions by leading microcontroller companies like Atmel, TI, Samsung, ST, and NXP, this is really an illustration of just how rapidly Arm technology is being adopted and deployed in the microcontroller market.

Two of the processor licenses we sold were for our Mali graphics processor to be used initially in digital TVs and mobile computing. This included another license for our latest T600 series, which will deliver a big performance uplift over the graphics processors that you find in today's high-end smartphones. Switching to the royalty side of our business, Arm royalty, remember, is reported one quarter in arrears. Our royalties for Q3 were generated from chips sold by the semiconductor companies in Q2. Processor royalty was up 20% year-on-year. Total volume was 1.9 billion units, and that's driven by growth in some large markets. Particularly non-mobile devices was interesting, growing at over 50% year-on-year. In our earnings release, we've included a more complete breakdown of the volume shipments, so I won't go into that here.

That breakdown is also included in the presentation that we have put on our website in the Investor Relations section. In mobile, Arm is benefiting from an increase in the Cortex A family chips used in smartphones and tablets. In fact, Cortex A shipments into mobile devices grew 300% year-on-year, and a recent market analyst report said that dual-core Cortex A9 chips can now be found in 14% of smartphones that were shipped in Q2. That's the sort of activity driving the royalty that we're reporting right now. Cortex products collectively are now 22% of total volume, with 14% coming from the Cortex M products and microcontrollers and the like, and 5% from Cortex A processors. Switching to our physical IP division, physical IP revenue was up 17% overall at $26 million, and that was helped by license revenue growing 23% year-on-year.

As with the microprocessor part of our business, we're continuing to see good levels of design activity with both foundry and fabless companies choosing to work with Arm's physical IP at the advanced nodes. For example, during the quarter, we signed a license with UMC to develop physical IP for their new 28 nm process. We've continued to see demand for the processor optimization packages, the PoPs, so-called. As a reminder, these enable our Cortex A9 and Cortex A15 customers to more readily achieve high-performance, low-power processor implementations using specifically optimized physical IP. For every chip implemented using a PoP, remember, Arm receives a royalty both for the processor in the chip and for the physical IP. During the quarter, we signed a further four PoP licenses, including the first one for Cortex A15 on 28 nm.

The underlying physical IP royalties were up 3% sequentially, and that was in line with the foundry industry. Looking within the business at what we've been up to within the business, we've continued to make investments in R&D. We've grown our engineering teams, particularly those working on the advanced processors and the graphics products. We added 53 people in the third quarter. That's a total of 150 since the start of the year, and we do expect to continue that investment into Q4. The result of all this activity can be seen last week when we announced our latest Arm processor, the Cortex A7, which was formerly known as Kingfisher. Cortex A7 is aimed at extremely energy-efficient applications. Along with this, Cortex A7 also enables an innovative technology to reduce dramatically the energy consumption of a system-on-chip device. When we launched this, we're calling it big.LITTLE.

Big.LITTLE processing, where you have a very low-power Cortex A7 tightly integrated with a high-performance Cortex A15 in a multiprocessor configuration. As the user of the product changes application, the performance requirements change and the workload on the microprocessor changes, and the workload is seamlessly migrated between the two processors. The application or the operating system is not even aware of which processor is being used, so all the legacy applications work. This results in a chip that can be both very high-performance and very, very energy-efficient. Over the next few days, actually, Arm engineers, customers, and developers are all meeting at the Arm Technology Conference in Santa Clara. We're expecting close to 4,000 visitors, and there will be more announcements about where Arm and our customers have been investing our R&D.

Keep an eye on the Arm website, and those announcements will be made public over the next couple of days. With that, I'll hand over to Tim, who will provide further detail on the numbers.

Tim Score (CFO)

Thanks, Warren. Morning, everyone. Yeah, just a quick overview of some of the numbers before we move into questions. You've seen the headlines: $192.3 million of total revenue. That's just under $5 million ahead of the consensus expectation, and that's up 22% year-on-year. Particularly strong growth in license revenues with a 41% increase in the processor division and a 23% increase in the physical IP division. PD, processor division license revenue, was just under $60 million, and we've now seen four sequential quarters with licensing over $50 million. We expect license revenues to continue this trend in Q4 as we start the quarter with a high level of backlog and a strong opportunity pipeline. The usual analysis of backlog maturity and composition is included in the slide set that Warren referred to, which is on our website.

That shows that just under 30% of total backlog is expected to be recognizable as revenue over the next two quarters. In Q3, approximately 60% of PD license revenues were generated from backlog, and that's at the upper end of the typical 40%-60% range. Processor royalties also grew strongly in Q3, up 20% year-on-year to just over $84 million. However, as indicated last quarter, Q3 royalty revenue has been impacted to some extent by the slowdown of sales by Japanese semiconductor companies, the earthquake and subsequent tsunami disrupted energy supplies and the semiconductor supply chain in the second quarter. In previous years, normal seasonality has resulted in about a $10 million sequential increase in royalty revenues from Q3 to Q4. Data for the third quarter indicates that relevant industry revenues were broadly flat sequentially.

As noted at our half-year results at the end of July, we may see below-seasonal royalty revenue growth into Q4. Normalized OpEx in Q3 was GBP 60.5 million compared to the guidance given in July of 60-62. As noted in the earnings release, we benefit from net credit due to the impact of a stronger dollar on the accounting of derivative instruments. Normalized OpEx for Q4 is expected to be in the range of GBP 63 million- GBP 65 million, assuming current exchange rates. Sequential increase is partly due to the assumption that the impact of accounting of derivative instruments will be neutral in Q4 and partly due to the effect of hiring in Q3 and Q4 as we invest in the development and deployment of new technology.

Normalized operating margins in Q3 were over 44.5% compared to 38% a year ago, and cash generation continued to be strong, demonstrating that we are continuing to increase profitability and generate good levels of cash whilst increasing investment in future product development and organizational capability. Now to just reiterate outlook. As previously mentioned, both the order backlog and the licensing pipeline are robust, pointing to another quarter of strong licensing. Arm Q4 royalty revenues are generated from third-quarter chip shipments, and as mentioned earlier, relevant data for the third quarter indicates that industry-wide revenues were broadly flat sequentially. Notwithstanding the below-seasonal activity levels in the wider semiconductor industry at the moment, we expect that group dollar revenues for the full year 2011 will be in line with current market expectations, which are around $763 million for the full year. Now over to questions.

Operator (participant)

We will now begin the question and answer session. If you wish to ask a question, please press star one on your telephone and wait for your name to be announced. If you wish to cancel that request, please press the hash key. Your first question comes from the line of Gareth Jenkins of UBS. Please go ahead.

Gareth Jenkins (Head of Research)

Yeah, thanks for taking the question. Just a quick one. The strong order pipeline into Q4. Tim, could you just give a sense of, I know it's probably early days, but how that shapes up for 2012? Is this the kind of new baseline that we should be using for our licensing revenue assumptions into 2012? Just secondly, I wondered if you could just give us a bit more around big.LITTLE and the potential impact on royalty rates going forwards. Thank you.

Tim Score (CFO)

Yeah, hi, Gareth. As I just said, I think Q4 we expect the strong licensing trend to continue. We also say in the earnings release that if you look into the opportunity pipeline for the fourth quarter, the prospects for the exit backlog at the end of the year are promising, which means we expect it to be up. That's going to provide an even more solid base than we currently have for licensing in 2012. With things like Cortex A7 and other still relatively recently introduced products and more to come, we have a pretty rich portfolio of processors for licensing in 2012. Putting macro environments, etc., aside, we believe we are very well placed to continue strong licensing next year.

Warren East (CEO)

I'll answer the big.LITTLE question and the royalty implications. I think it's too complicated to be very detailed about how the royalty agreements work out. The net effect is that, A, big.LITTLE will be used in high-end chips typically, and they're more expensive devices. As you know, our royalties are a percentage of the chip price. Secondly, by definition, these are multiprocessor-capable products. With that higher level of functionality, they continue the trend of higher royalty rates for higher levels of functionality. We would expect to see more royalty from a big.LITTLE configuration than a typical multiprocessor configuration where you just have a Cortex A7 or a Cortex A15. To be very precise about the numbers, it's probably too early to say how these are going to show through in the mix. As you know, high-end Cortex A15 products command a higher royalty rate than Cortex A9s on their own.

Typically, we're at the 2% end of the 1%-2% range, and the big.LITTLE configuration will push things further.

Gareth Jenkins (Head of Research)

Thanks.

Operator (participant)

Your next question comes from the line of Gunnar Plagg of Citi. Please go ahead.

Gunnar Plagg (Analyst)

Yes, hello. Thanks for taking my questions. Two on the ecosystem. The first one on computing. It looks as if Android is starting to become optimized for the Intel architecture. With ports to x86 starting, a lot of work to recompile a native Arm application. I was wondering, to what extent are you following this and to what extent are you factoring in changes in the ecosystem landscape? That's the first one. On graphics, also ecosystem, I see now four main companies in the space: Autodesk, Mentor, Polar Bit, and Gameloft working on Arm. My question would be to how much of the ecosystem is in place now and what do you think would be desirable to have short term to really make further impact? Thank you.

Warren East (CEO)

Okay. Let me talk about Android to start with. I mean, this is an open operating system, and ports are available for multiple architectures. At the moment, the situation is that initial implementations are being rolled out on Arm-based devices. The latest LightScreen sandwich that was released the other day was with an OMAP device. The reality is that it is possible to port this operating system to alternative architectures with effort. Certainly, Intel has the ability to work with Google to create these ports very quickly. The thing about Android is it's a thriving competitive ecosystem with multiple chips supporting Android designs, and that has always been the case and will continue to be so. We certainly factor into our expectations the notion of the progress that Intel is making in the smartphone worlds generally.

We would contend that our architecture is more appropriate and will continue to be more appropriate. Product launches like the big.LITTLE Cortex A7 launch that we did last week continue to demonstrate our leadership in that area. With regard to the graphics ecosystem around Mali architectures, that does continue to develop. As we've said many times before, our ecosystem around the Mali graphics architecture is less mature than some others. 2011 is an important year for that ecosystem maturity to accelerate, and that acceleration is happening as significant volumes of Mali-based devices are starting to ship. We're expecting tens of millions of Mali products shipping in 2011, driving the maturity of that ecosystem. That is indeed the path that we're on for 2011.

Gunnar Plagg (Analyst)

Thanks.

Operator (participant)

Your next question comes from the line of Sandeep Deshpande of JPMorgan. Please go ahead.

Sandeep Deshpande (Analyst)

Yeah, hi. If I may, a quick question on the royalties. I mean, you talk about that your dual-core Cortex are in 15% of the smartphone market now. You've also talked about in the past that the Cortex has a higher royalty per device, but we are not seeing any impact of that yet. Maybe you can talk about also with relation to where, I mean, how much, I mean, how the mobile phone market itself is. Is it because such a huge change in the other market that you're not seeing any impact on the royalty per device in the dual-core Cortexes? Secondly, with regard to the licensing revenue, you've had a lot of new semiconductor companies you've mentioned signing up. I mean, most major semiconductor companies, other than very minor ones, were always Arm licensees.

Can we talk about, I mean, are these all new semiconductor companies who are signing up?

Warren East (CEO)

All right, two questions there. Let's start off with the royalty one. I think you have to remember that we're saying with these results, Cortex A processors are accounting for 5% of the total volume. Yes, they typically go into higher-priced devices, and certainly the dual-core A9s are at the high end of the processor price range. 14% of the volume, that is effectively three times the volume, are Cortex M products. We continue to see very, very strong growth in the microcontroller sector generally. A lot of those microcontrollers that are shipping today are still based on ARM7s and ARM9s, though it isn't just the 14% that is Cortex M.

We're simply seeing, when you do the arithmetic and look at the royalty in dollars and cents that we're earning per chip, the downward pressure on that number from the very high volumes of very low-priced chips is continuing to dominate the arithmetic, even though the Cortex A products, when you look at that effect on its own, the Cortex A products are substantially increasing the royalty that we're earning on chips going into smartphones and mobile computers. It is just those two effects that we have talked about before, and that's continuing to happen. It's still giving us an overall royalty revenue increase. Of course, it's the total royalty revenue, all at near 100% margin. That's what we're interested in. We're interested in growing our share in microcontrollers overall as well.

We can foresee considerable growth yet to come in microcontrollers on the back of all the licensing that's been done for Cortex M products.

Tim Score (CFO)

Yeah, on licensing and licenses, Sandeep. I mean, in recent quarters, most of the new licensees have been in the microcontroller area, taking Cortex M products. These may typically have been companies that weren't necessarily in a position to deploy Arm technology in their previous lives. It is not just that. There is a range. I think generally, we've been talking about the number of licensees and potential saturation and things like that now since I've been here, which is about 10 years ago. I think we had around 80 or 90 licensees, and I was told on arrival that we were saturated. We've now got 275+. I think what's driving it is the broadened applicability of Arm's technology across the breadth of the computing spectrum. I think Ian also wants to add a comment.

Ian Thornton (VP of IR)

Yeah, Sandeep, I have done some analysis on who these companies are and where they've come from, mainly to see were they all startups. The answer is absolutely not. Very few of them are startups, probably unsurprisingly, because there aren't that many, isn't that sort of much seed funding at the moment for those companies to go and gain access to. The majority of them are either microcontroller companies who basically have never needed a 32-bit microprocessor in their chip. They're making very simple chips or they're making just analog or just sensor chips, and now they're putting the microcontroller technology into that chip as well. They are established companies in other markets who maybe have used another architecture, either one they've developed themselves or from one of our competitor companies as well.

Sandeep Deshpande (Analyst)

Thank you.

Operator (participant)

Your next question comes from the line of Didier Scemama of RBS. Please go ahead.

Didier Scemama (Analyst)

Yes, good morning, gentlemen. Thanks for taking my question. Two quick ones, if I may. First of all, on the OpEx guidance for Q4, can you maybe elaborate a little bit on the key areas of investments? Secondly, if you can give us an idea whether that's a base for 2012. That's my first question. Secondly, on the royalty rate, big.LITTLE processing, you know, Warren, you alluded that that number is going to be slightly up or up versus, let's say, current high-end architecture. What I was wondering is if that technology is also applicable to other Arm chips. For instance, can we marry a Cortex A8 with an ARM11 or things like that so that we also benefit in the mid and low-end thing?

Tim Score (CFO)

On the OpEx, Didier, I mean, you know, the vast majority of the investment that you've seen in Arm Holdings in the last couple of years has been into the R&D capability within our processor division, i.e., the processor division and the media processor division. That is where most of the investment has been. I think as we think about 2012 OpEx, I think Q4 will probably be a reasonable base. Sometimes in the fourth quarter, we end the year with a very strong finish on order taking and things like that, which can lead to a slightly artificial high incentive payments, which wouldn't be there going forward. Generally speaking, I think the fourth quarter is a reasonable base. We obviously need to think about the full-year effect in 2012 of the highs in 2011.

Warren East (CEO)

Didier, on the big.LITTLE and wider use of the big.LITTLE, there's nothing stopping you having a big and a little processor combination like a Cortex A8 and something else. However, in that instance, the software has to be knowledgeable about where the application is actually running, on the big processor or on the little processor. What we've done with the big.LITTLE announcement last week was talk about processors that have been specifically designed together to run in big.LITTLE configuration together so that the application, either the application or the operating system even, doesn't need to comprehend the fact that there are two processors down there, and the software doesn't need to know on which processor it's actually running. It's just another lower power state of the processor subsystem.

The answer to your question is effectively no, you can't get the full benefits of big.LITTLE with all the legacy applications with combinations of other processors that we have. However, as we look forward, we will be taking the big.LITTLE concept into newer products from Arm Holdings, and that will become a feature of our roadmap. As we look to things like the Mali graphics processors, which, of course, compared with general purpose processors, graphics processors are taking increasingly large chunks of area on the chip and therefore consuming more power. As we look to improve the efficiency of graphics processors, then we'll be designing those in conjunction with such purpose processors and in conjunction with each other. I'm sure you'll see some big.LITTLE activity there as well.

Didier Scemama (Analyst)

If I may, if I understand correctly, that's a very strong incentive for the Arm-connected community to license Cortex A15 effectively.

Warren East (CEO)

Yes, Cortex-A15 and Cortex-A7 are the first two products designed with this in mind. As I say, you'll see more of it in the future, and you'll see it creeping into our Mali graphics offerings too.

Didier Scemama (Analyst)

Great. Thank you so much.

Operator (participant)

Your next question comes from the line of Nick James of Numis. Please go ahead.

Nick James (Equity Research Analyst)

Yes, good morning. Just a couple of questions. One was on the announcement earlier in the month about the first tape out for 20 nm Arm Cortex-A15. I guess on Intel's conference call, they said they were going into volume on their 22 nm process. I know it's kind of destined for PCs in the initial version, but they are quite hardly focused on getting that into mobile. I just wonder when we can be expecting kind of 20 nm type generations of Arm-based chips for the mobile segment. The second question was just on PIPD. The licensing revenue has been growing nicely. The royalty revenue still seems to be tracking the overall market. When should we be expecting the PIPD royalty revenues to begin to outperform the overall market?

Warren East (CEO)

Two questions are quite similar, really, and it's about the time lag between design and production. Typically, we've always said for Arm processors and the licensing activity, then it's about four years from licensing to when significant volumes of people are going into shops buying products, triggering chip shipments and royalties. That four years is more or less constant. To take your second question, applying that principle to the royalty revenues that we'll see in the more advanced processes for our physical IP, I think we're still a good couple of years away from that. I think we've seen advanced process licensing happening for about the last, certainly quite reliably for the last two years or so. We are starting to see 45 nm shipments happening today. There will be 28 nm shipments happening really very, very soon. In terms of moving the dial, these things have to accumulate.

I wouldn't expect to see significant dial moving from those advanced processes for another 18 months to two years. On the 20 nm and when you'll see production of Arm-based 20 nm, I think that's a couple of years out as well. TSMC, UMC, and GlobalFoundries all have their roadmaps. Devices will go into production as and when they are able to take them into production. The important thing, as far as we are concerned, is that the designs are happening on these advanced processes. That's why we were very keen to support the press release with TSMC and the press release with Cadence that happened on the Cortex-A15. We're keen that people continue to use Arm processors as an essential part of their development of these new technologies. Intel, of course, can control the manufacturing as well as their design.

As and when they choose to introduce 20 nm designs or their 22-nm FinFET design, that's up to them.

Nick James (Equity Research Analyst)

Okay, great. Thank you.

Operator (participant)

Your next question comes from the line of Simon Sagars of Goldman Sachs. Please go ahead.

Simon Segars (Analyst)

Yes, thanks so much. I wanted to go back on this discussion on licensing revenue, if I may. Tim, just on the $60 million, obviously a very high run rate that, as you said, you feel like is sustainable. Perhaps with some of the initial licensing income from the MCU customers tailing off into next year, what is it that you expect this level to keep as high as it is? Is it ARM7 or is it something else? Just to get a little bit more color as to what gives you the confidence that it can be high. It seems like it's been running at an abnormally high level, perhaps. Maybe that's wrong. Maybe you just think it's the new run rate. Thank you.

Tim Score (CFO)

I have now done four quarters over 50. What I said is I see that trend continuing. Clearly, one quarter is still a short reporting period for this type of business model, and we can get lumpiness. We shouldn't be alarmed if we see a lower licensing quarter followed by a higher licensing quarter. Generally speaking, what underpins the comments I made before is the fact that we have a historically high backlog at the end of the third quarter. We are making comments in the release, which give us confidence that we think it's going to be higher at the end of the year.

When we look into the product portfolio that we have for licensing next year and what we think and believe that our customers and potential customers would want to license from us in that period, when we model that out, that gives us a lot of confidence that strong licensing is going to continue. It's not one particular product to a small handful of customers that's going to make the difference. It's the breadth of the portfolio and the breadth of the customer base that's underpinning our confidence.

Simon Segars (Analyst)

Got it. Thank you. My second question would be more as you look into your cost model for next year and your budgeting, what sort of OpEx step-up are we looking at? Is there a lot of investment that you still need to do on an annualized basis as you look into next year to support higher investment for the higher licensing revenue run rate? Just to get a sense as to what you think maybe annualized OpEx growth may be, assuming some sort of normal industry environment. Thank you.

Tim Score (CFO)

I think in a normal industry environment, we would expect to continue investing in our R&D capability next year. As we've seen before with Arm, the pace of that can be moderated according to industry conditions, and we'll see. We have lots of opportunity to, we have ideas to be developing innovative technology, which we'd like to get to market sooner rather than later. That's why we're investing.

Simon Segars (Analyst)

Okay, thanks so much.

Operator (participant)

Your next question comes from the line of Sumant Wahi of Redburn Atlantic. Please go ahead.

Sumant Wahi (Head of Tech Hardware Research)

Hi, thanks for taking my question. My question was, one was on the PIPD. I mean, over the past few halves, if you kindly do give out physical IP division-specific revenue and operating costs, and looking at H1 2011, it did seem that your operating costs were going down a little bit. I was just wondering that currently, looking at the strong licensing and your reducing costs in the PIPD division we expect PIPD division sort of operating profit to kind of break even in the near term? Are we talking about next year or, as Warren said, it's going to be another 18 months to two years before we see a break even in the physical IP division? I have a follow-up.

Tim Score (CFO)

I think Warren was specifically referring to a question about the development of the royalty trajectory, which will obviously be helpful to that. I mean, I think you're right. In the half-year statement and the full-year accounts, we give full segmental analysis where we allocate all of the sort of central Arm cost, if you like. That analysis has indicated that very broadly, once physical IP starts going through $100 million of revenue per year, then on a fully allocated basis, it moves into profitability. That's the position.

Sumant Wahi (Head of Tech Hardware Research)

Okay. I just wanted another further clarification on this patent tax. I think I understood it correctly, but I just want to clarify. When you talk about the patent tax, which may come in over 2012 or 2013, which reduces your tax rate applicable from the 24% to probably 10% or 15%, just wondering whether this is applied retrospectively to patents which were issued before the tax ruling comes into place, or after the ruling, does the tax rate get affected immediately, or do the earnings only get benefited from this new tax rate with a delay of a few years?

Tim Score (CFO)

I think the answer to your question is those are implementation details for this legislation or potential legislation which have not yet been finalized. What we expect is that certain revenues generated by Arm will benefit from the new patent box legislation from 2013 onwards. In terms of exactly how much, in what way, and from when, we'll have to wait and see the legislation and the consultation documents that come along with it.

Sumant Wahi (Head of Tech Hardware Research)

Thank you. Just one final one on Cortex A7. Could you kind of give us an idea of the pricing of it, please? Thanks.

Warren East (CEO)

Yeah. I mean, in terms of license fee, I mean, it's a high-end processor. If you look at it in the context of our overall roadmap, it's an advanced processor with a lot of functionality. It's at the higher end of the price spectrum for license fees. For royalties, we're going to see two use cases for Cortex A7. As we said in the launch, we're going to see it on its own as an applications processor in apps processors that are going to be at the lower price points for lower-end smartphones of the day. By the way, they'll be smarter than the high-end smartphones that we enjoy today. By the time we're enjoying them, they're going to be low-end. You're also going to see it in high-end configurations strapped alongside A15s in the Big.LITTLE configuration.

Those chips will be at the high end of the apps processor price spectrum. The royalty rates there will be higher as well because it's being used in configuration with A15. There's going to be significant upward pressure on the royalty from those sorts of products.

Sumant Wahi (Head of Tech Hardware Research)

We're talking about 4% royalty sort of level at that point?

Warren East (CEO)

I think there's a lot of factors that come together to generate 4%. In our February earnings presentation, we went through some detail there about how things are made up. Those sorts of numbers are not out of the question, but you do have to have a lot of Arm technology on a chip to generate more than 3%. It's certainly not out of the question.

Sumant Wahi (Head of Tech Hardware Research)

Thank you.

Operator (participant)

Your next question comes from the line of Jonardan Menon of Liberum Capital. Please go ahead.

Janardan Menon (Analyst)

Yeah, thanks for taking the question. My first question is just on Windows 8. There's some views that the ecosystem from a software application point of view may not be developed fast enough on the Arm platform, especially for legacy applications when Microsoft launches Windows 8. This could constrain the level of implementation of Arm on that operating system. I'm just wondering whether Arm is doing anything right now to proactively help the development of an ecosystem for its architecture on Windows 8, or is that something that'll have to happen once the operating system is actually launched in the market? Secondly, just a clarification. When you say relevant industry revenue for Q3 was broadly flat sequentially, does that include the Arm market share gain? Is that for Arm-based shipments or is that for industry shipments and you would expect your shipments to be higher because of market share gains?

Tim Score (CFO)

Okay, I'll just take the second one, Tim. That is a comment about industry data. We would expect Arm to outperform in some fashion as is normal.

Warren East (CEO)

Sure. On Windows 8, I think Microsoft revealed a deal of information a few weeks ago. In terms of legacy applications, applications which rely on the fact that there is an x86 processor underneath, i.e., applications that go around the operating system, those will certainly not run on Arm-based platforms. Legacy applications which behave can simply be recompiled to Arm, and the tools will clearly be available for that. Arm's activity is confined to supporting Microsoft in their endeavors to get some of the key applications like the Office applications out and running on the Arm-based platforms and to help Microsoft with the operating system itself and work with the ecosystem in the provision of tools.

As for individual application providers, whether they choose to simply recompile because they've got a very well-behaved application or if they haven't got a well-behaved application, if they choose to port that to Arm-based platforms, that's up to them.

Janardan Menon (Analyst)

Okay. Last question, if I might. Just in terms of when you're saying you had 50% of your new licensees were new established semiconductor companies which are new to the Arm architecture, do you have a feel for how many more of such companies exist, which are established companies? I mean, excluding startups, but relatively established companies which are yet to adopt the Arm architecture. Is that still a significant number or have you pretty much covered the vast majority of that?

Warren East (CEO)

When we say established, we mean a company that's ongoing and is not a startup. That doesn't necessarily mean it's one of the sort of top semiconductor companies that everybody's heard of. When you look into it and look around the world, there are many hundreds of established semiconductor companies. As Tim said a little while ago, we're now at around 275 licensees. There are many hundreds more semiconductor companies that are established semiconductor companies that today don't use Arm technology. Sometimes they don't use microprocessors. Sometimes they use microprocessors, but they're simple 8-bit microprocessors. There's a lot of opportunity out there for established companies that haven't yet used Arm technology to deploy Arm technology.

Janardan Menon (Analyst)

Got it. Thanks, Warren.

Operator (participant)

Your next question comes from the line of Johannes Schaller of Deutsche Bank. Please go ahead.

Johannes Schaller (Director and Equity Research Analyst)

Thank you for taking my question. Just coming back to processor royalties. I mean, obviously, royalty ASPs have declined over the last quarters in general. I think we all understand the drivers probably quite well. I just wanted to see if you can give us a bit of a feeling maybe when you think this trend can stop or slow down or when could we reach trough levels and what could those trough levels potentially be, given that you have also obviously some offsetting factors in there. More specifically on the royalty rate for your quad-core A15 processors, what is kind of the rate you think is realistic for this, say, in 2013? Is that roughly the 3% you have already talked about or should that even be more? Thank you.

Tim Score (CFO)

Yeah, what a lot of questions. I think on the first question, in a sense, Warren has really already addressed it. What you've got here is a number of markets in which Arm is growing its penetration at different rates. We know that one of the very high volume opportunities for Arm is microcontrollers, characterized by lower-priced chips and therefore lower royalties per device. We also know that we're only 5% of Cortex A shipments, and there's been a lot of licensing done in recent years and ongoing, which is going to gradually increase that Cortex A proportion. Exactly how those two factors play out, one being a distinct upward pressure on the average rate and one being a downward pressure on the average rate, only time will tell.

The trend that we have seen over the last couple of years has been absolutely consistent with what we've messaged and what we've expected as Arm has started to make significant progress in 32-bit microcontrollers. I think we'd all have a slightly different model of the relative growth rates of the end markets.

Warren East (CEO)

Okay. The second question about what sort of royalties should we actually expect from things like quad-core A15 devices? I mean, the A15 is itself a very highly functional processor, and the multiprocessor capability is an example of that increased functionality. I think what we've said before is that if you take a range of 1%-2%, then Cortex A15 will be at the higher end of that range. Say it's about 1.75%. Increasingly, we are finding people adopting our physical IP for advanced semiconductor processors, and the greater than 50% attach rate of the processor optimization packages on Cortex A9 is an indicator of that. When a chip is designed with our processor optimization package, we're going to earn a royalty on the processor itself and a physical IP royalty, which will typically be another 0.5% or so.

Those sorts of devices are also devices that typically will include other Arm microprocessors, perhaps for a power management function or some other auxiliary function on the apps processor. Though there is a multi-core discount for the second Arm processor and subsequent Arm processors, typically, you're going to be adding a significant portion of 1% on top of that again. By the time you've added an extra percent for graphics, then you're north of the 3% mark. That's the analysis I went through in February on the conference call. It's there in our presentations on the Investor Relations website. I can't quite remember the slide number right now, but it's starting to be a quite well-known slide. The potential is there for these devices to be commanding well north of 2% up towards 4% as we look forward.

Our customers don't mind that because they are getting increased functionality out of all that Arm technology on the devices, and it's enabling them to produce competitive apps processors. You have to remember that those apps processors themselves, with all that functionality, will be high-priced chips. In absolute dollars and cents terms, we're going to be earning relatively large royalties on those sorts of devices.

Johannes Schaller (Director and Equity Research Analyst)

Very clear. Thank you.

Warren East (CEO)

Thanks.

Operator (participant)

Your next question comes from the line of François Monnier of Morgan Stanley. Please go ahead.

François Monnier (Analyst)

Yeah, thanks for taking my questions. Actually, I've got three, if I may. ASPs are going down for, I think it's the second or third quarter now. Is there any chance actually it could go up in Q1 2012 with iPhone 4S moving into the equation? That would be my first question. Two questions on Windows 8. The first one is on the manufacturers of tablets. I guess you're probably aware of who's going to try to make those. If you could tell us, who do you think are the best placed to launch and manufacture those tablets? Is it the natural PC manufacturers or are those like new entrants or guys coming from maybe the smartphone world? The third question as well is on the application ecosystem to follow up on Jonardan's question.

I'm sure you're talking to the big software companies, whether they will port their software to Arm. Do you know how well advanced they are on this? If you could name maybe the few software you know could be ported at the launch. Thank you.

Tim Score (CFO)

I do the first one, Francois.

François Monnier (Analyst)

Thanks.

Tim Score (CFO)

Yeah, I think if you look at the evolution of the average royalty rate for Arm over time, you can detect an element of seasonality. It is true to say that in Q1 2008, Q1 2009, and Q1 2011, the average rate did go up quarter on quarter. In Q1 2010, it was fairly flat. We'll see. I mean, it'll be a function of the relative growth rates and the relative Arm Holdings penetration in those markets. There certainly is some history which says it's possible.

Warren East (CEO)

All right. With regard to your other two questions, François, I'll take them together if that's all right. The simple answer, can I sort of name people, either people who are going to make tablets or applications providers, then the answer is no. We can't talk publicly about people's plans around Arm technology until they're ready to talk about it. That's always been the case. With regard to the apps porting, which people, I think that's the root of some of these questions, already application or software companies who have apps that are running on PCs are porting those apps to Arm-based platforms that are coming out in tablet form factors. We're seeing that for Android, and we're seeing it for the iOS-type tablets. That's happening today. That trend will probably continue with the Microsoft operating system as well.

It is very much a matter for the individual software companies themselves. They have to weigh up the cost of doing that port and the potential upside in terms of the number of new products that they're going to sell. What we can see is that when we look into the whole mobile computing space over the next few years, we can see traditional form factors continuing to grow, but we can see new form factors growing much, much more strongly, which is why when we look at the overall market and see how that grows over the next few years, we can talk about gaining 40% of that market.

François Monnier (Analyst)

I understand you can't name exactly the companies, but maybe to give us an idea, as I was asking about the manufacturers, do you feel like it's more likely to be the old PC manufacturers or more coming from smartphone-type people?

Warren East (CEO)

I think there's just a whole host of them. When you go and look at things like the Consumer Electronics Show, you'll see loads of manufacturers from both camps with plans out there for tablets and plans out there for supporting Microsoft's new operating system. I mean, we just can't talk about individual companies.

François Monnier (Analyst)

Okay, loads of prototypes in January, basically.

Warren East (CEO)

There's a tremendous amount of activity out there as we speak. I'm just being told that we have only time for one more question, by the way. I'm sorry.

François Monnier (Analyst)

Okay. Sorry. Thank you. Bye.

Warren East (CEO)

All right.

Operator (participant)

Thank you. Your final question comes from Andrew Gardiner of Barclays Capital. Please go ahead.

Andrew Gardiner (Analyst)

Thanks very much. I just had a follow-up on the Mali side of things. You have highlighted again today, and something that you've been saying for the last couple of quarters, that this is a year for the ecosystem to mature or the maturity to accelerate. You've said that again today, yet we've seen the pace of license signings slow over the last few quarters now to just two in the third quarter, even though you have announced a new series of licenses. I was just wondering how you're seeing discussions progress with potential customers in the industry. I suppose more pointedly, are you expecting licensing to ramp again next year?

Warren East (CEO)

I think the number of licenses that are sold in an individual quarter is a number which will fluctuate and go up and down. It is lumpy. We happened to sell two in the last quarter. If you step back from it and look over a period of years, you'll see that we've roughly doubled the number of licenses that have been sold on an annual basis year by year for the last three years or so that we've been selling these licenses. I suspect when the reckoning for 2011 takes place, then we'll be on that sort of trend. To say that licensing of Mali products is slowing is just a fallacy, I'm afraid. Year to date as of the half year, this year, we'd sold 14 licenses. In the whole of 2009, we sold 14 licenses. In 2008, we sold 8. In 2007, we sold 4.

The number is tracking continuously upwards right now. The maturity of the ecosystem comment, that's definitely something which the maturity needs to develop in order to allow that licensing to happen more readily. It is maturing. I said at the beginning of the year, we expected to see tens of millions of Mali products shipped this year, which would help accelerate that trend. We're absolutely in line for that to happen. More and more of these software companies who do need to port to the Mali architecture are indeed doing so.

Andrew Gardiner (Analyst)

All right. Sounds good. Thanks very much.

Warren East (CEO)

Thank you.

Ian Thornton (VP of IR)

Operator, time to hand it back to yourself, I think.

Warren East (CEO)

Thank you all very much for dialing in. We're quite pleased with the results we're announcing this morning. We are going into the fourth quarter with a healthy pipeline, momentum in market share gains, and with an order backlog at near record levels. Things are looking pretty good as we head into the end of the year. We'll be back in February with our full-year results. Thank you very much.

Operator (participant)

Ladies and gentlemen, that does conclude our conference for the day. Thank you for participating. Email disconnect.