Financial review / IFRS

Financial performance in 2007 was pleasing against a backdrop of slower growth in the semiconductor industry, with full-year dollar revenue growth at approximately twice the rate of the industry and strong licensing momentum in our Processor Division. We have also maintained normalised operating margins⁽¹⁾ despite the weakened dollar, grown backlog to a record level and also seen volumes of ARM Powered products increase by 18% to just under three billion units a year.

Performance

The Group’s key financial performance indicators include dollar revenue, operating margin and earnings per share. Non-financial key performance indicators include the number of ARM technology-based chips sold and licenses signed. These are discussed as part of this review.

Revenues

Total revenues for the year ended 31 December 2007 amounted to £259.2 million (2006: £263.3 million). In US dollar terms, revenues grew from $483.6 million in 2006 to $514.3 million in 2007, an increase of 6%. The actual average dollar exchange rate for ARM in 2007 was $1.98 compared to $1.84 in 2006, which had the effect of reducing total reported revenues by approximately £20.7 million based on 2006 rates.

Total licensing revenues in 2007 were £110.7 million, being 43% of total revenues, compared to £110.6 million or 42% of total revenues in 2006. In US dollars, total licensing revenues in 2007 were $217.9 million compared to $202.5 million in 2006, an increase of 8%.

Royalty revenues in 2007 were £104.1 million, representing 40% of total revenues in the year, compared to £107.8 million or 41% of total revenues in 2006. Total royalty revenues in US dollars in 2007 were $208.8 million, up 5% from $199.0 million in 2006.

Sales of development systems in 2007 were £27.9 million, being 11% of total revenues, compared to £28.8 million, or 11% of total revenues in 2006. Development systems revenues in US dollars were up 5% in 2007 to $55.6 million from $53.0 million in 2006. Service revenues, which include consulting services and revenues from support, maintenance and training, were £16.5 million in 2007, representing 6% of total revenues, compared to £16.1 million, or 6% of total revenues in 2006. Service revenues in US dollars were up 10% to $32.0 million from $29.1 million in 2006.

Licensing revenues

Total licensing revenues for 2007 were £110.7 million, comprising £83.4 million from the Processor Division (PD) and £27.3 million from the Physical IP Division (PIPD). In US dollars, PD licensing revenues were $163.5 million (up 18% on $138.3 million in 2006) and PIPD was $54.4 million (down 15% on $64.2 million in 2006).

PD licensing comprised a rich mix from the ARM7, ARM9 and ARM11 families as well as from the newer technologies in the Cortex family and Mali™ graphics processors. 62 new licenses were signed in 2007, with 23 new companies becoming ARM Partners in the year, bringing the total to 210 at the end of the year. These included 14 licenses to the Cortex family (and three lead Partners for the next-generation Cortex-A9 processor) and three licenses to the Mali graphics processors. In addition, 2007 saw four large semiconductor companies underline their long-term commitment to ARM by signing subscription licenses, allowing them access to a broad range of ARM processor technology over a period of between three and five years.

In 2007, ARM maintained progress in achieving the long-term goal of providing ARM’s physical IP to leading IDMs and fabless semiconductor companies. Momentum for PIPD’s 65nm products continued to grow with ten new licenses being signed in 2007, bringing the total to 32 65nm licenses signed with 15 companies cumulatively. In total, 68 licenses to PIPD products were signed in 2007, bringing the total number of licenses signed to 350.

Royalty revenues and unit shipments

Total royalty revenues for 2007 were £104.1 million, comprising £88.0 million from PD and £16.1 million from PIPD. Royalties in PD came from record unit shipments of 2.9 billion compared with £88.7 million and 2.45 billion units in 2006. Dollar royalty revenues earned in PD were $176.5 million, up 8% on 2006 compared with the increase in year-on-year unit shipments of 18%. Average royalty rates (ARR) over the past three years were 6.1 cents in 2007, 6.7 cents in 2006 and 7.9 cents in 2005. The average royalty rate in a given period is based on a number of variables, including the average selling prices of the chips being shipped, the applicable royalty rate payable to ARM and the mix of unit shipments by ARM product family. Unit volume growth more than compensated for the reductions in ARR and, as all royalty revenue is earned effectively at 100% margin, it represents incremental returns on the development cost of the ARM technology on which the royalty is earned.

ARM unit shipments showed significant resilience in a year that was affected by the industry-wide inventory correction which started in the second half of 2006. The proportion of shipments into the mobile and non-mobile segments during 2007 remained broadly consistent with the proportion of mobile shipments edging up slightly to 67%. The ARM content per phone continued to increase, reaching approximately 1.7 processors per phone by year-end. We continue to see strength in the embedded segment, in part due to the continued significant growth in MCU shipments with growth of 2.4x over 2006. MCUs are now the highest volume individual application after wireless handsets. We also reached a significant milestone in 2007 with our Partners shipping the ten billionth ARM microprocessor since ARM’s inception in 1990.

The total number of Partners shipping ARM technology-based product at the end of 2007 was 89 after taking into account corporate activity within the ARM partnership. 15 companies are paying meaningful royalties for physical IP products at the end of the year.

Gross margin

Gross margins in 2007 were 89.2% compared to 88.3% in 2006. Cost of sales in 2007 includes compensation charges in respect of share-based payments and related payroll taxes of £1.1 million (2006: £1.0 million). Excluding compensation charges in respect of share-based payments and related payroll taxes, gross margins in 2007 were 89.6% (2006: 88.7%).

Operating expenses

Over recent years, ARM has acquired a number of companies giving rise to the recognition of intangible assets other than goodwill. These are amortised over their expected useful lives, with the cost recorded against research and development, sales and marketing or general and administrative expenses as appropriate. In order to aid comparability, these costs have been separately identified as “acquisition-related charges” in the narrative below. In addition, the issuance of ARM share-based remuneration to employees of the Group gives rise to non-cash share-based compensation charges. These are also separately identified in the narrative below.

Total net operating expenses in the 12 months to 31 December 2007 were £191.4 million compared to £183.1 million in 2006. Operating expenses in 2007 include acquisition-related charges relating to amortisation of intangibles of £19.2 million (2006: £19.3 million), other acquisition-related charges of £1.7 million (2006: £1.1 million), impairment of an available-for-sale security of £2.1 million (2006: £nil), profit on disposal of an available-for-sale investment of £nil (2006: £5.3 million), restructuring charges of £1.0 million (2006: £nil) and compensation charges in respect of share-based payments and related payroll taxes of £17.3 million (2006: £16.4 million). Excluding these charges and credits, total operating expenses in 2007 were £150.1 million, compared to £151.6 million in 2006.

Research and development expenses in 2007 were £84.0 million, representing 32% of revenues. This compares to £84.9 million or 32% of revenues in 2006. Average headcount in this area increased from 961 in 2006 to 1,163 in 2007. Research and development expenses in 2007 include total acquisition-related charges and credits of £11.4 million (2006: £10.6 million) and compensation charges in respect of share-based payments and related payroll taxes of £10.7 million (2006: £10.1 million). Excluding these charges, research and development expenses in 2007 were £61.9 million and £64.2 million in 2006, representing 24% and 24% of revenues respectively.

Sales and marketing costs in 2007 were £55.3 million or 21% of revenues, compared to £53.3 million or 20% of revenues in 2006. Average headcount in this area increased from 302 in 2006 to 312 in 2007. Sales and marketing costs in 2007 include total acquisition-related charges of £8.6 million (2006: £9.1 million) and compensation charges in respect of share-based payments and related payroll taxes of £3.6 million (2006: £3.5 million). Excluding these charges, sales and marketing costs in 2007 were £43.0 million and £40.7 million in 2006, representing 17% and 15% of revenues respectively.

General and administrative expenses in 2007 were £52.1 million or 20% of revenues, compared to £50.2 million or 19% of revenues in 2006. Average headcount in this area increased from 209 in 2006 to 226 in 2007. General and administrative expenses in 2007 include total acquisition-related charges of £0.9 million (2006: £0.7 million), restructuring charges of £1.0 million (2006: £nil), impairment of an available-for sale security of £2.1 million (2006: £nil) and compensation charges in respect of share-based payments and related payroll taxes of £2.9 million (2006: £2.8 million). Excluding these charges, general and administrative expenses in 2007 were £45.2 million, compared to £46.7 million in 2006 representing 17% and 18% of revenues respectively.

Additionally in 2006, the Group sold its investment in CSR plc, resulting in a profit of £5.3 million.

* Figures for 2003 are shown under UK GAAP and are not comparable to 2004 to 2007 prepared under IFRS.
** Figures for 2004 have been restated from UK GAAP to IFRS.

Operating margin

The operating margin in 2007 was 15.3% compared to 18.7% in 2006. The operating margin in 2007, excluding acquisition-related charges of £20.9 million, restructuring charges of £1.0 million, impairment of an available-for-sale security of £2.1 million and compensation charges in respect of share-based payments and related payroll taxes of £18.4 million was 31.7% (the normalised operating margin) compared to 31.1%, before acquisition-related charges of £20.4 million, compensation charges in respect of share-based payments of £17.4 million and profit on disposal of an available-for-sale investment of £5.3 million in 2006.

Earnings and taxation

Profit before tax in 2007 was £45.1 million compared to £56.0 million in 2006. Profit before tax in 2007, excluding acquisition-related charges of £20.9 million, restructuring charges of £1.0 million, impairment of an available-for sale security of £2.1 million and compensation charges in respect of share-based payments and related payroll taxes of £18.4 million, was £87.5 million or 33.8% of revenues. This compares to £88.5 million, before acquisition- related charges of £20.4 million, compensation charges in respect of share-based payments of £17.4 million and profit on disposal of an available-for-sale investment of £5.3 million, or 33.6% of revenues in 2006.

The Group’s effective taxation rate in 2007 was 21.8%, compared to 14.0% in 2006. This increase was primarily due to a non-recurring tax credit in 2006 arising from a tax-deductible foreign exchange loss.

Fully diluted earnings per share in 2007 were 2.6 pence compared to 3.4 pence in 2006. Earnings per fully diluted share in 2007, before acquisition-related charges of £20.9 million, restructuring charges of £1.0 million, impairment of an available- for-sale security of £2.1 million and compensation charges in respect of share-based payments and related payroll taxes of £18.4 million and related estimated tax adjustments thereon of £9.9 million, were 5.0 pence, compared to 5.2 pence before acquisition-related charges of £20.4 million, compensation charges in respect of share-based payments of £17.4 million, profit on disposal of an available-for-sale investment of £5.3 million and related estimated tax adjustments thereon of £7.6 million, in 2006.

Balance sheet and cash flow

Goodwill at 31 December 2007 was £420.8 million, compared to £427.7 million at 31 December 2006. The decrease in goodwill in 2007 is due primarily to foreign exchange movements, given the weakening of the US dollar against sterling from $1.96 at 31 December 2006 to $1.99 at the end of 2007. Goodwill is not amortised under IFRS but is subject to impairment review on at least an annual basis. The review performed in 2007 concluded that no impairment was required.

Other intangible assets at 31 December 2007 were £44.3 million, compared to £62.9 million at 31 December 2006. The movement in other intangible assets in 2007 primarily reflects the amortisation in the year of the intangible assets arising on acquisitions of £19.2 million. Other intangible assets are amortised through the profit and loss account over their estimated useful lives to the Group.

Accounts receivable at 31 December 2007 were £68.2 million, compared to £69.6 million at 31 December 2006. The allowance against receivables was £1.5 million at 31 December 2007, compared to £2.6 million at 31 December 2006. Deferred revenues were £27.5 million at 31 December 2007, compared to £31.5 million at the end of 2006.

Resources available

The consolidated cash, cash equivalents, short-term investments and marketable securities balance was £51.3 million at 31 December 2007 compared to £128.5 million at 31 December 2006. This reduction is as a result of the continued share buyback programme and payment of dividends (see below) as well as residual payments on prior year acquisitions. Excluding these outflows, the Group generated £76.0 million of cash in the year (2006: £73.7 million).

Interest receivable

Net interest receivable was £5.4 million for 2007 compared to £6.8 million in 2006. The reduction is due to the reduced cash balances held by the Group as a result of the return of cash to shareholders through dividends and share buybacks as detailed below.

Returns to shareholders

Dividend

The directors recommend payment of a final dividend in respect of 2007 of 1.2 pence per share, which taken together with the interim dividend of 0.8 pence per share paid in October 2007, gives a total dividend in respect of 2007 of 2.0 pence per share, an increase of 100% over 1.0 pence per share in 2006. Subject to shareholder approval, the final dividend will be paid on 21 May 2008 to shareholders on the register on 2 May 2008. Total dividends actually paid in 2007 amounted to £18.5 million (2006: £12.4 million).

Share buyback programme

In 2007, the Group continued its rolling share buyback programme to supplement dividends in returning surplus funds to shareholders. During the year, the Company bought back 94.5 million shares (2006: 63.6 million) at a total cost of £128.6 million (2006: £76.5 million).

Since introducing dividend payments in 2004 and commencing the share buyback programme in July 2005, £272 million has been returned to shareholders and 172 million shares, being 12.3% of issued share capital, have been bought back. This has contributed to a net reduction in the fully diluted shares in issue from 1,424 million in 2005 to 1,402 million in 2006 to 1,361 million in 2007. This programme is on-going and is expected to continue during 2008 and beyond.

Capital structure

The authorised share capital of the Company is 2,200,000,000 ordinary shares of 0.05 pence each (2006: 2,200,000,000). The issued share capital at 31 December 2007 was 1,344,055,696 ordinary shares of 0.05 pence each (2006: 1,389,907,834). As a result of the buyback programme, the Company owns 65,201,176 of its own shares at 31 December 2007 (2006: 49,500,000).

Treasury policies and objectives and liquidity

The Group has established treasury policies aimed both at mitigating the impact of foreign exchange fluctuations on reported profits and cash flows and at ensuring appropriate returns are earned on the Group’s cash resources.

With more than 95% of Group revenues earned in US dollars and approximately 40% of Group costs being incurred in US dollars, the Group has a significant exposure to movements in the exchange rate between the US dollar and sterling. This exposure is partially mitigated by an ongoing hedging programme, involving forward contracts and low-risk option contracts where appropriate.

Principal risks and uncertainties

In line with the guidance for the preparation of an operating and financial review, certain risk factors faced by the Group are identified below. A more detailed description is included in the Group’s annual report on Form 20-F. Details of the Group’s internal control and risk management procedures are included in the corporate governance report on pages 25 to 29.

ARM’s quarterly results may fluctuate significantly and be unpredictable which could adversely affect the market price of ARM ordinary shares ARM has experienced, and may in the future experience, significant quarterly fluctuations in its results of operations. Quarterly results may fluctuate because of a variety of factors. Such factors include:

• The timing of entering into agreements with new licensees;
• The mixture of licence fees, royalties, revenues from the sale of development systems and fees from services;
• The introduction of new technology by us, our licensees or our competition;
• The timing of orders from, and shipments to, systems companies of ARM technology-based microprocessors from our semiconductor Partners;
• Sudden technological or other changes in the microprocessor industry; and
• New litigation or developments in current litigation.

In future periods, ARM’s operating results may not meet the expectations of public market analysts or investors. In such an event the market price of our shares could be materially adversely affected.

General economic conditions may reduce ARM’s revenues and harm its business

ARM is subject to risks arising from adverse changes in global economic conditions. Because of economic uncertainties in many of our key markets, many industries may delay or reduce technology purchases and investments. The impact of this on ARM is difficult to predict, but if businesses defer licensing our technology, require fewer services or development tools, or if consumers defer purchases of new products which incorporate ARM’s technology, revenue could decline. A decline in revenue would have an adverse effect on the results of operations and could have an adverse effect on ARM’s financial condition.

ARM competes in the intensely competitive semiconductor market

The semiconductor market is intensely competitive and characterised by rapid technological change. ARM cannot give assurance that it will have the financial resources, technical expertise, or marketing or support capabilities to compete successfully in the future.

Competition is based on a variety of factors including price, performance, product quality, software availability, marketing and distribution capability, customer support, name recognition and financial strength. Further, given ARM’s reliance on our semiconductor Partners, its competitive position is dependent on their competitive position. In addition, ARM’s semiconductor Partners do not license ARM’s architecture exclusively, and several of them also design, develop, manufacture and market microprocessors based on their own architectures or on other non-ARM architectures.

ARM may not operate systems which comply fully with the requirements of the Sarbanes-Oxley Act

Attestation under section 404 of the Sarbanes-Oxley Act as at 31 December 2007 has been successfully completed. Full details appear in the Group’s annual report on Form 20-F. There can be no guarantee, however, that in future the detailed testing of internal controls required as part of the attestation process will not identify significant control deficiencies or material weaknesses that impact on the auditors’ opinion on internal controls over financial reporting and/or require disclosure on Form 20-F for future years.

Other risks include ARM’s inability to manage the significant changes in the number of its employees and the size of its operations in the United States; dependence on semiconductor Partners and systems companies; availability of development tools; systems software and operating systems compatible with ARM’s architecture; dependence on a small number of customers and products; ARM’s inability to develop new products on a timely basis; unanticipated costs due to products that could have technical difficulties or undetected design errors; the ARM architecture not being continued to be accepted by the market; risks associated with any strategic investments or acquisitions; dependence on senior management personnel and on hiring and retaining qualified engineers; exposure from international operations; litigation and threats of litigation and protection of ARM’s intellectual property; unavailability of debt financing or additional equity funding to satisfy future capital needs, adverse effects resulting from changes in share option accounting rules adversely impacting ARM’s reported operating results and its competitiveness in the marketplace.

Tim Score
Chief Financial Officer

Nearly one billion ARM technology-based chips were shipped in non-mobile applications in 2007.

ARM Powered stability control systems reduce single car accident rates by 40%.

Today’s smartphone has more computing power than the first Cray Super computer.

Mobile phones outsell laptops five to one.

⁽¹⁾ See operating margin section on page 19.