Thank you for standing by, welcome to the Arm Q3 analyst results conference call. At this time, all participants analyst-only mode. There will be a presentation followed by a question and answer session. At that time, if you'd like to ask a question, please press star and one on your telephone. I must advise you that this conference is being recorded today on Tuesday, the 21st of October, 2014. I would now like to hand your conference over to your first speaker, Mr. Ian Thornton. Please go ahead, sir.
Thanks, Vivian. Good morning, everybody. This is Ian Thornton, VP of Investor Relations at Arm. On today's Q3 results conference call, we have Simon Segars, Chief Executive Officer, and Tim Score, Chief Financial Officer. On today's call, Simon and Tim will take us through the highlights and comments from the quarter's results, then we'll open up to a Q&A session. As a reminder, the presentation release can be found. This conference call is being directed only to those of you who have professional experience in matters relating to investment, the information communicated on this call is being made available only to investment professionals. Any person present on this call who does not have professional experience in matters relating to investment should not act or rely on the contents of this call. The following conference call will contain forward-looking statements other than statements of historical facts.
The company's actual results for future periods may differ materially from those statements and are based on current expectations and are subject to a number of risks and uncertainties. On this note, I'll hand over to Simon.
Thanks, Ian, good morning, everyone. Thank you for joining our Q3 2014 results conference call. This morning, I'll run through the business highlights, then hand over to Tim to provide some more detail on the numbers. Following Tim, there'll be some time for Q&A. Throughout 2014, we've seen very strong demand for Arm's technology, with leading semiconductor companies licensing our latest products and increasingly deploying their Arm-based solutions into a wide range of end markets. We've seen this continue through Q3, the ongoing demand for Arm's products underpins our confidence in the long-term growth of the business. The third quarter of 2014 saw particularly strong licensing for Arm's most advanced technology.
We signed three licenses for Maya, our next generation Armv8 processor, two licenses for the next generation Mali graphics processor, and another license for Cortex-M7, our recently introduced processor for embedded applications, including the Internet of Things. This takes the number of licenses signed for Cortex-M7 to five. In addition, a major technology company signed two subscription licenses, which grants them access to future products on Arm's processor and graphics technology roadmaps. Processor royalty revenues grew 11% year-on-year in the third quarter, in line with the expectations discussed in previous earnings results earlier this year. This compares to growth of 3% year-on-year in the first half. We expect the acceleration in royalty growth to continue in Q4.
During the quarter, we saw many announcements from our customers about their new Arm-based product developments in smartphones and mobile computers, enterprise networking and servers, microcontrollers, and the Internet of Things. I'll go through some of those in more detail later. I'll now discuss the revenue drivers in the different parts of the business in more detail, starting with technology licensing. We signed 43 processor licenses in the quarter. These licenses were signed for a broad range of end applications from smartphones and smart meters to base stations and bank cards. We signed two subscription licenses with a major technology company. One subscription license was for a broad range of future Armv8 processors, and the other was for a family of Mali graphics processors that are still under development.
Although they were an existing customer, this is a demonstration of their continued commitment to using Arm technology across a wide range of their products. 11 of the licenses signed were for Arm's Cortex-A series technology. This included seven licenses for Arm's Arm Version 8 processors, three of which were for one of our next generation processors, codenamed Maya. We have also continued to see strong demand for our Cortex-M processors, which are used extensively in microcontrollers, embedded connectivity chips, smart sensors, and can be found in most of the Internet of Things and wearable devices that have been announced to date. 22 Cortex-M processors were licensed in the quarter, and 10 of these licensees were companies taking their first ever Arm processor license. Finally, we signed four more Mali licenses, three for advanced graphics processors and one for our recently announced display processor.
We signed five more POP IP licenses during Q3. POP IP is physical IP that's been optimized to enhance the performance of Arm processors. Four of these licenses will be used in the implementation of Cortex-A53 processors on TSMC's 28 nanometer HPC and HBM manufacturing processes. Now I'll switch to the royalty side of the business. Arm's royalty revenues are reported one quarter in arrears. So our royalty for Q3 was generated from chips sold by our customers in Q2. Processor royalty revenue was up 11% year-on-year, demonstrating the acceleration that we expected when we reported last quarter. Making a comparison with the overall industry is complicated this quarter by the strong growth in PC and server markets. These are still future markets for Arm, and so we didn't benefit from their growth. Excluding PCs and servers, the remaining market segment grew between 5% and 9%.
We expect the level of outperformance to increase in Q4 and into 2015. Our customers reported that they had shipped 3 billion Arm processor-based chips in the second quarter. This 19% year-on-year increase represents an additional 500 million chips. Many of these additional chips went into embedded sensors, smart cards, and microcontrollers. Some of these chips are making the Internet of Things real today by enabling the world around us to become smarter and more capable, from wireless payment in payment cards to wearables such as smartwatches and pedometers, and into more advanced manufacturing and logistics systems. With Arm-based microcontrollers growing over 55% year-on-year, we expect that the embedded segment will soon become a larger proportion of chip shipments than the mobile segment. As we only introduced the first Cortex-M processor about 10 years ago, this is a remarkable achievement.
Arm continues to benefit from the sales of smart consumer devices such as smartphones, tablets, and digital TVs. During the quarter, we saw the introduction of a sub-GBP 35 smartphone. Phones like this are bringing smart mobile technology to the next billion consumers. This particular phone has both a multi-core Cortex A-class processor and a Mali graphics processor. There are, of course, other Arm cores in these types of phones, making this a fantastic opportunity for both consumers in developing markets to get connected for the first time and for Arm's future royalty revenues from the expanding market segment. Early in Q4, we hosted our annual technology conference, TechCon. This is a premium event not just for Arm but for the whole Arm ecosystem, as it attracts developers, engineers, and thought leaders from all across the industry. This year, TechCon was in early October, and we hosted about 4,000 people.
I had the pleasure of meeting some of you there. Many new technology and product announcements were made at the event, demonstrating the continued innovation within the Arm partnership. With strong demand for Arm technology from microcontrollers in the Internet of Things, we introduced the Cortex-M7 processor. This is the highest performance processor in the energy-efficient Cortex-M family and is suitable for a wide range of end applications. We have now licensed this technology five times, including to Atmel, Freescale, and STMicroelectronics. As part of our Internet of Things strategy, we also introduced the Arm mbed IoT device platform, which includes two parts. Firstly, mbed OS. This is a free operating system for IoT devices.
This provides companies building and deploying smart sensors and controllers into their products with a lightweight operating system that includes connectivity standard support such as Bluetooth, Wi-Fi, and LTE, as well as web protocols such as HTTP and CoAP. The other part is mbed Device Server. This is software that resides on the customer's server and creates the connection to the IoT device and allows them to manage their IoT network. It enables high functionality services to be run across IoT networks, including data aggregation for analytics, enabling firmware updates across all nodes, and so on. We also saw many announcements around servers and networking infrastructure. HP announced two new Arm-based servers as part of their HP Moonshot portfolio, including the first enterprise-class 64-bit Arm-based server based on the Applied Micro X-Gene chip and another based on TI's Keystone two chip.
TI's chip is interesting because it integrates DSP technology alongside a multi-core Arm processor to create an SoC for application acceleration. PayPal demonstrated how they were using TI's Keystone 2 in an HP server to detect fraud across their payment system. We also saw the commercial availability of server software on Armv8-based servers from Canonical with their Ubuntu, Juju, and Metal as a Service products, and also from IBM with their Informix database software. There was a lot more announced, the last one I'll talk about today is HiSilicon and TSMC announcing that they have built the first multi-core Armv8-based chip using TSMC's 16-nanometer FinFET process. The chip contains 32 Arm Cortex-A57 processors running at up to 2.6 gigahertz and will be deployed in next generation wireless communication and routers.
You will find many more announcements on our website and on our partners. I could talk more about them here, in the interest of time, I'll hand over to Tim, who will provide further details on the numbers.
Thanks, Simon. Good morning, everyone. Hopefully, many of you will have had a chance to have a look at the Arm Q3 earnings release. As Ian said, the quarterly slide set is available on the website as usual. I'll just add a few more comments on the numbers and on the guidance before we move to Q&A. Overall, Q3 dollar revenues at just over $320 million were up 12% year-on-year, with 13% growth in processor licensing in the quarter and 11% growth in processor royalties. As Simon says, reflecting the acceleration that we discussed at the half year. A processor license revenue of $120 million included about a 60% contribution from backlog, which is at the upper end of the normal range, consistent with recent quarters.
Backlog at the end of Q3 was slightly lower sequentially, with 43 licenses signed, including a number of backlog building deals. Looking at the expected conversion of backlog to revenue in Q4 and the licensing opportunity pipeline for Q4, we expect backlog to be up sequentially at the end of the year and to be at a similar level as backlog was at the half. The usual backlog analysis can be found in the slides on the website. Looking at costs, headline normalized OpEX in Q3 was a shade under GBP 87 million. Taking account of the credit of GBP 5 million arising from the revaluation of monetary items due to changes in FX rates and the impact of a stronger dollar on the accounting for derivative instruments offset by charges that do not occur regularly. Underlying OpEx in Q3 was approximately GBP 89 million compared with consensus of around GBP 91 million.
We continue to invest in our R&D teams and in our business infrastructure, with our employee base increasing by just over 400 since the start of the year. Normalized OPEX in Q4, assuming effective exchange rates similar to current levels, are expected to be in the range of GBP 92 million-GBP 94 million, in line with current consensus. The group's normalized tax rate in Q3 was 17%, and the full-year normalized effective tax rate is still expected to be around 18% as we continue to benefit from the reduction in U.K. corporation tax rates and the phased introduction of the Patent Box tax regime. Moving on to outlook. We enter the final quarter of the year with a robust opportunity pipeline that points to both strong license revenue in Q4 and a sequential increase in order backlog.
With market data underpinning the short-term outlook for royalty revenues, we expect group dollar revenues for the fourth quarter to be in line with market expectations of about $350 million.
Thanks, Tim. Now let's go to Q&A.
Thank you. Just as a reminder, if you'd like to ask a question, please press star and one on your telephone and wait for your name to be announced. If you'd like to cancel your request, please press the hash key. Star one to ask the question. The first question comes from the line of Gareth Jenkins. Please ask your question.
Yeah, thanks. A couple if I could. One technologically related and one maybe financial. Just technologically, we've seen the introduction of Google Android Runtime. I just wondered whether you feel this is a potential risk to the ecosystem going forwards or whether it doesn't really move the needle so much for you. Does it open up the barriers to entry a little bit more for your competition to try and re-penetrate? Then secondly, just in terms of financials, I think you said historically that Q4 would set the tone for 2015. I know it's very early obviously, but can you give us some sense of how you see the year progressing into next year? Thank you.
All right. On the question of the Google Android Runtime, that is a technology that enables applications to be written independent of the underlying hardware just like Dalvik did in previous versions of Android. ART definitely does a better job of that than Dalvik did. At the end of the day, there are many applications written to run natively on Arm. Anything that requires really high performance is written using native development, so an Arm binary is created. That may change over time with the advent of ART. Given how many devices there are out there that are running on Arm processors today, and just given the overall traction that we have in the market, I can't see that dynamic changing that much. Right now any application that is running on a device that doesn't have an Arm processor is using emulation.
That lowers performance and makes the user experience worse. As long as we keep innovating and our partners keep innovating around what we do, then I don't see really that dynamic changing very much in the end market. Yeah, Gareth, on 2015, as you know, we sort of typically will guide on 2015 in February. I think probably for us the two key metrics that we're looking at as we go towards 2015 would be the Q4 royalties which will form the base obviously for 2015 royalties and 2015 royalty growth. Following the acceleration to 11% in Q3, we are expecting mid-teens year-over-year growth in Q4 which we think will set us up nicely as a platform for 2015 royalties. I think the 2014 royalty number will be achieved largely without any meaningful contribution from Armv8 shipments which come with higher royalty rates.
We do expect that the ramp of devices including that technology to really start at the end of this year and start to have a real impact on 2015 royalties. We think royalties are in good shape across the multiple markets. Again, just reflecting on the backlog commentary, we expect to exit 2014 with a backlog that supports the license revenue targets that are out there in the market now for next year. Early days, but it looks encouraging.
Thanks.
Next question from the line of Andrew Gardiner, please ask your question.
Thanks very much. Good morning. I just had a question on the royalty side of things. You highlighted in the quarter that comparisons are a bit tricky given the strength in PC and server demand that we saw in the second quarter for the industry. I was just wondering if you can put any sort of further numbers around it perhaps to sort of more your current addressable market, if you will, as to how that would compare to the 11% royalty growth that you've seen.
Mobile grew about 5%, consumer devices about 6%, MCUs were about flat. Overall, when you look at the key strategic markets for Arm, the outperformance was quite strong.
Okay. That's helpful. Also, just specifically within the quarter, you mentioned the strength in enterprise infrastructure, chips going into that vertical. I understand it's early days and you were looking at about 5% market share or so last year. Just any additional detail in terms of the specific verticals where those are heading and perhaps what's driving the uptick and therefore an outlook over the coming quarters, coming years for how that business should progress. Thank you.
In the 3 billion chips shipped in Q2, and obviously that we've just reported for the royalty. In that, there was about a 35% year-on-year growth of enterprise infrastructure chips. We reported at the end of last year about a 5% market share. We're expecting that to continue to grow. It's really about the rollout of next generation wireless technologies. Many of our products are being used in base stations, and as they get replaced, that's good for the uptake. Then just generally, the growth of mobile devices, the coming growth of the Internet of Things, puts pressure for an upgrade of network infrastructure. People want flexibility in the silicon designs that they're putting into those products. Arm's model is highly applicable for anyone designing products in that space.
Thank you.
Your next question is from the line of Pierre Ferragu. Please ask your question.
Hi, good morning, thanks for taking my question. This is Justin Funess on behalf of Pierre Ferragu from Bernstein. I had two very quick questions, one on licensing and one on royalties. On licensing, it seems fair now to expect that the level of backlog probably does not get back to the 2013 peak levels. Would you expect over 2015 for it to start to come down, or it maybe remain flat at the H2 2014 levels? Then could you possibly share a bit more color around if you still expect 10% licensing revenues growth, and what drives it? Then I have a follow-up on royalties.
On the licensing side, as you say, we've seen really quite exceptional backlog growth and license revenue growth in recent years. I think we've been very consistent in painting a picture of license revenue growth sort of moderating into its more historic range in the sort of high single-digit, 10% level.
I think as that happens, you will see backlog be flatter. In some quarters it will go up and some quarters it will go down. We certainly would expect backlog to underpin that type of level of license revenue growth. I think in terms of what is driving that, as you know, Arm now has a very large installed license base of over 350 companies. Many of whom have the ability to use Arm technology more widely than they're already using it. Most of whom will want to keep upgrading their use of Arm technology to the next generation, the latest processors. We expect the combination of that plus some continued new entrants into the Arm family to drive the licensing.
Very quickly on royalties, could you please give a bit more color on how inventory evolved in mobile over the quarter? What you expect for the next quarter, fourth quarter, and if there is a risk of maybe another inventory correction based on MediaTek's outlook.
It's a bit hard to call for us. We're looking at our customers' outlook statements as much as anyone else. We have only limited visibility in that. It was quite encouraging to see TSMC's comments overnight about inventory at normal levels and right in the middle of the range that they would expect. We're seeing a royalty acceleration as we anticipated through this year. From the various data points that we've seen so far and from talking to our customers, it gives us the confidence in underpinning our outlook for Q4 and continued acceleration of royalty. Beyond that, we are always subject to supply and demand fluctuations which can lead to inventory blockages in the pipe. We'll obviously take that as it comes and manage through that as it comes.
The long term with the growth in the end markets, with the further adoption of v8 and with the shipment of v8 going into next year, it gives us confidence for growth in royalty.
Okay. Thank you.
Your next question is from the line of Kai Korschelt. Please ask a question.
Hi. Thanks for taking the question. The first one was really, Tim, I wanted to connect on what you said that the Q4 royalty growth rate kind of sets the tone for next year, I think you've been commenting that you expect something like 15% or mid-teens growth in Q4. My question then I guess is, you've come off high 20s, low 30s growth. Obviously, it is slowing from that sort of level. I guess my question is, at which point? What would be the drivers? Could we see an acceleration of royalty growth to maybe sort of 20-ish%? Is it just v8 adoption? Is it networking really coming in? What should we look for to potentially see the royalty growth re-accelerate closer to levels that you have seen or shown in the past? The second question is just on the tax rate.
I think you were alluding to a sort of 18 or slightly below. Longer term, what sort of target tax rate should we look at? Thank you.
Well, I think in terms of medium to longer term royalty growth rate, as Simon said, I think in 2015, we're starting to benefit from the impact of the version eight shipping for the first time. I think we've spent quite a lot of time talking over the last 12 months about how we see the development of Arm royalties in smartphones. Assuming that smartphone device tag of about 10% over the next five years, we see Arm's royalty revenues in smartphones growing at approximately double the rate of the devices because of the mix of Arm technology that's being designed into these products and the royalty rates that we will be earning on those products. I think smartphones themselves, we continue to see as a major contributor going forward. Then, of course, there are a number of other markets where our share is currently fairly nascent.
We touched on enterprise networking earlier. The licensing there has been very strong. The volumes we expect to continue to grow in embedded. I think all of this is strongly underpinned by the fact that our license revenue has been growing at 30% per annum for the last four years, which I think, again, is very supportive of the medium-term royalty outlook. I think there are multiple factors, multiple layers of growth, but no real change in our expectation of royalty growth rates going forward. On the tax side, there's still a notch or two down in the U.K. corporation tax rate from earlier budgets. We're also only partway through the implementation of the Patent Box regime. I would expect, all other things being equal and no change in legislation, for Arm's tax rate to be in the mid-teens in a couple of years' time.
Okay. Thank you.
Your next question comes from the line of Andrew Humphrey. Please ask your question.
Hi. Thanks for taking my questions. Just a couple if I may. Firstly, I wanted to ask a bit about microcontrollers and the market there. We've obviously seen some weakness from some players reporting into that market at the moment. I wanted to ask, what is your exposure in microcontrollers, autos, industrials, those sorts of markets? How far do you expect we could see some kind of impact from inventory correction over Q4 and Q1? My second question is on royalty growth in Q4. You're guiding for 15%. That's in a quarter with what we're expecting to be a pretty strong Apple ramp. Could you maybe talk a bit about the other factors that could be holding that back from being a higher growth rate in Q4?
Okay. In terms of our exposure to the microcontroller market, yeah. That's quite significant growth for the Arm community. When we look at what our partners are saying, there are some mixed results out there for sure. But those, it would seem, with a greater exposure to the Arm side of the microcontroller market seem to be doing a bit better than those who aren't. There may be some share gains moving around. There may be some supply chain issues. But again, just going back to the point that TI made overnight, they're a big shipper in this market as well, they're seeing what they describe as a normal market. We'll see as more people report how that changes. We are quite positive in our outlook for future penetration of Arm technology into microcontrollers. There are many customers that have licensed Cortex-M.
We've seen a strong uptake of Cortex-M7, which we only announced a couple of weeks ago, five licensees of that. At our TechCon event a couple of weeks ago, ST demonstrated silicon based on Cortex-M7. That, in conjunction with the other family members, are leading to quite strong growth and market share gain for Arm in MCUs.
Yeah. I think in terms of Q4 royalty, Andrew, I think there are multiple factors. If you look back over time, there's quite a lot of what you might define as normal seasonality in the trajectory of Arm's royalties. If you look at Q4 uptick on Q3, it's fairly routinely in the sort of up to GBP 20 million on lower absolute numbers. I think these new product launches are helpful and will have some impact, and will probably have more impact in Q1 2015. Obviously, we're also looking at the guidance of some of our major shippers as to what happened in their guiding for their third quarter. Yeah, we've got quite good data points on the Q4 outlook.
Okay. That's very helpful. Thank you very much.
Your next question comes from the line of Brett Simpson. Please ask your question.
Yeah. Thanks very much. For Simon, how should we think about v8 penetrating smartphones over the course of 2015? Most of the new low-end LTE chips ramping this core in China are already supporting 64-bit. I'm just wondering whether that's changed your thinking on the penetration curve of v8 for smartphones over the course of next year.
As we said, about 1% of our processor shipments are based on v8. Again, this is going back to chips that were shipped in Q2. We do expect that to change. We've seen many announcements of mobile-oriented chips from customers based on Cortex-A57, Cortex-A53, either alone or together in various combos. There are obviously a lot of devices based on v8, which are ready to come to market. I would expect many of the new devices sold next year to be based on v8 chips. We're going to see an increase in the smartphone share moving towards v8. Exactly how far that goes next year, a bit hard to say. What we said at the Analyst Day earlier in the year was over a five-year period, we'd expect pretty much all smartphones top to bottom in the range to be based on v8.
I think next year will make good progress towards that.
Okay. Maybe just following up, Microsoft has announced Windows 10, and they talk about unifying apps. It seems to be CPU agnostic, so I'm just wondering whether you expect full support for Arm on Windows 10, not what we saw with Windows 8, with the RT version. How should we think about Arm on Windows, as this starts to roll out at some point next year?
From what they've said, that they appear to want a unified application environment, whether you're experiencing Microsoft on a game station or on a phone to have a very similar experience. That would suggest an architecture-agnostic way of developing applications. As far as I'm aware, they haven't disclosed a huge amount of detail about that. If that is indeed the case, that would create additional opportunity for us.
Maybe if I just asked that a slightly different way, Simon. Next year, we're going to see a lot of 64-bit apps processors, and FinFET is coming maybe towards the second half of next year. How do you think this positions Arm for mainstream computing? Or is there something on the hardware side that you think your partners are missing to really compete with Intel and its new Broadwell platform?
I think there is nothing to stop the creation of chips that deliver enough performance to exist in a more conventional computing environment. You look at the chip that HiSilicon announced with TSMC on 16 FinFET, 2.6 gigahertz, multi-core. That is a very high performance chip, and there are others being built by other licensees. We've said all along that I don't see that there's an issue about performance. We've seen some mobile computing. The Chromebooks, for example, have provided great user experience based on Arm. Performance is not an issue there. It's not an issue in any tablet. I don't know any tablet user who complains about the performance of their tablet, and there being some lag in the user interface. Performance is not an issue.
I think the question in conventional clamshell style computing is whether that's a market that's big enough with the growth prospects for our semiconductor licensees to warrant spending their time on it. If you look at the projected growth rates in the industry for laptops, the next three or four years, it looks like they will grow back to where they were in about 2011. It's not the most dynamic market in the world. Most of our licensees are focusing on other areas where they can leverage their ability to innovate.
Thanks very much.
Your next question comes from the line of Sandeep Deshpande. Please ask your question.
Yeah. Hi. Thanks for letting me on. My question is following on to some of the earlier questions. You're highlighting that your growth next year will be depending on, of course, where the smartphone market grows, smartphone market plus based on the v8 architecture. What we're seeing overall in the handset market is this rush towards the bottom in terms of ASPs coming down very rapidly outside the Apple ecosystem on the handset market. Are you actually saying that in this environment, that even though the customers shift to v8 architectures on the handset, that they are going to start charging higher ASPs? How does that work economically in an industry where the ASPs of the handsets keep coming down? I have one follow-up.
Yeah, the way we look at this is, with lowering ASPs of handsets, we can increase the number of people in the world. There's an opportunity for multiple royalties for Arm due to the technologies that are in there. v8 with a higher royalty rate, multi-core products, the addition of Mali graphics, the addition of physical IP, creates an opportunity for multiple royalties for Arm. When we look at those dynamics, as we've modeled out and shared the analysis in the past, we see that that's supporting our projections for growth rate in mobile royalties overall. That progression is pretty much going as we expected it to. We think the opportunity for growth in volume is a great thing.
Following on, just again, Simon, respond something you've already highlighted or rather responded to, there seems you're just coming out of this inventory correction associated with potentially Samsung's loss of share in the high-end handset market. At the same time, we are seeing clearly some signs of whatever. Somebody talked about the microcontroller market, there are signs of softness overall in the semiconductor market. Are you saying at this point you're not taking a stand on that and you'll see how it progresses rather than saying that, "Well, I think it's not going to impact 2015?
I think for now we will wait and see how things progress, really. Looking at the overall trends and market share gains for Arm, all very positive. Back to the microcontroller thing, the industry was flat year-on-year in microcontrollers, but the shipments of Arm-based chips in microcontrollers went up 55%. There's a market share gain there that we are enjoying. Those trends appear to be in our favor.
Okay, thank you.
Your next question comes from the line of Matthew Ramsay. Please ask your question.
Thank you very much. Good morning. I guess the first one on royalties in Q4 and the Q1 in particular. Maybe, Simon, you could talk a little bit about, it seems to me there are some share shift dynamics obviously at the high end of the smartphone market between OEMs that typically use merchant silicon and OEMs that use their own silicon, and the royalty recognition dynamics might be a little bit different for those. Maybe you could talk about how that maybe weighs on the growth rate for Q4 and Q1 for royalties. Thanks.
In terms of our business model in serving people, well, the merchant silicon players and people who are more vertically integrated, there aren't any meaningful differences there. If there is share shifts around these players, that wouldn't make too much difference to Arm's royalty. What we are more focused on is the end market trends and overall growth of handset shipments.
All right. Thanks. Maybe we can get into the subtleties of that one offline. I guess I just wanted to follow up, in addition to the v8 dynamics that people have asked about into next year, maybe you could give a bit of an update on big.LITTLE as a trend, both from a software support point of view, but also from a traction within your end market licensees. It'd be nice to hear an update on that, as we've not heard about it in a quarter or so. Thanks.
Yeah, in terms of big.LITTLE adoption, many of the new devices that you're seeing launched by our licensees into the mobile segment are combo A57, A53 chips. That's become a very common configuration in big.LITTLE configuration, and utilizing the software that we've created over the last couple of years, which very efficiently allows tasks to switch from one to the other. One reason why we haven't spent a lot of time talking about it is because it's kind of becoming a norm. Not something to particularly underscore.
All right. Thanks very much.
The next question from the line of Jordan Menon. Please ask your question.
Hi, good morning. Thanks for taking the question. I have a question on royalty mix, then a short follow-up on licensing. I was just looking at the mix by processor series, comparing that, say, with a year ago or so. In the current quarter, you reported that Cortex-A is 18% of unit shipments. It was actually 18% of unit shipments a year ago as well. In the meantime, you have the Arm7, which was, say, 27% and has dropped very slightly to 26%, on a year-on-year basis. You also still have material shipments on Arm9, et cetera. I presume this mix has also an impact on your average royalty rate. I was just wondering, what is the timeframe for some of the Arm7 shipments to drop off? I presume most of that goes into the baseband.
Is there anything in the market as a conversion to LTE or further on that will necessitate baseband companies from moving some of that out into Cortex-A? Also, I'm not sure what is driving the 16%, sorry, 14% of Arm9, but is that likely to move to Cortex-A as well? What would be the timeframe for some of that to happen?
Well, in terms of the longevity of those designs, some of the products that Arm7 and Arm9 are designed into are going to keep shipping for many years. As long as they do, that's a good thing because that is just a pure profit royalty for us. On a quarter-by-quarter basis, I don't look at these numbers and think, "Oh, good. Arm7's dropping off at last." That isn't something that we're necessarily rooting for because there are some designs there which can go on and ship for a very long time to come. Arm7 is used all over the place. It is used in some modems. I think actually less so these days. Maybe it's some low-end modems. With the shift to 3G, 4G, all the different flavors of 4G, it does typically require higher processing.
some of those designs are moving on to Cortex-A and Cortex-R, in fact. More of the modem space does move on to more advanced technologies, you would expect greater volumes of those designs. Now, in terms of the overall mix, that is less of an issue. We worry more about the volume than we would the absolute mix effect. The mix does impact the average, but I'd say that average is moved around more by the continued very strong growth of Cortex-M. Again, that's a great thing because it's enabling Arm to be used in areas of technology where we hadn't been historically strong. That mix shift isn't massively important to us. The other thing to note about Arm7 is that it's used in a lot of smart card applications. They ship in very high volumes. They're very inexpensive chips.
Again, that's a good thing for us. It reflects the fact that we've got the right technology for that particular application. If that shifts for another decade, then frankly, that's happy days for us.
Understood. That's very clear. Just a brief follow-up on licensing. Your licensing growth fell to 13%, and this is the lowest in about four years. After doing 30%, 40%, et cetera, for a long time, you're down to about 13%. On the other hand, you sound quite bullish about the outlook for licensing into Q4 as well. I'm just clarifying an earlier question. Is 2015 likely to be a year of normalized licensing growth, which is, say, in the nine, 10% range, or does a strong Q4 lift you up?
We have consistently painted a picture of it trending back to the levels you talk about. I think the exact rate of transition between the 30% and the 10%, we will see what happens. Clearly we're now moving into a world of much tougher comparisons because it was in the second half of last year where licensed revenue sort of took a jump in from the eighties per quarter to over 100. We'll see. As I said earlier in the call, I think the backlog position at the end of this year is likely to underpin the currently expected licensed revenue growth for 2015.
Got it. Okay. Thank you.
The next question is from the line of Achal Sultania. Please ask your question.
Thanks for taking my question. First on the outperformance, I think, Simon, you've consistently delivered about 15%-20% royalty outperformance versus industry growth in the last 3-4 years. Now in this quarter it was only about 5%-6% based on the industry growth, if you just look at mobile and consumer devices. I think long term, you're still saying 15%-20% is doable. Is that all going to be just mainly driven by the transition towards v8 architecture or is there something else which can also help you get to that 15%-20% outperformance?
I think it's a number of things. It's adoption of v8 and it's growth of market share outside our conventionally strong markets. With more microcontrollers, for example, being Arm-based, that would point to an outperformance in the microcontroller segment. With growth of market share in enterprise networking, you'd see a similar effect with the growth of the use of Arm in servers. Again, that would point to an outperformance. If we gain share, and we believe our product portfolio, and the way we engage with our licensees points to us gaining share in these other markets, then that would help support further outperformance of the industry.
Thanks. Maybe a follow-up on the Mali traction. We've already seen strong share gains for Mali outside one of the biggest chipset vendor, which obviously is using their own in-house graphics. I think on the mobile side, do you expect that there is still some more room for share expansion or are we already getting close to a ceiling on that side of things?
Well, I think there is scope for further share gain in graphics. There were another, I think, four licenses of Mali in the quarter. One of our significant partners took a subscription license to feature Mali technology. I think the trends are there to suggest further market share gains for us in graphics.
Great. Thanks a lot.
Your next question comes from the line of Amit Harchandani. Please ask your question.
Good morning, gentlemen. That's Amit Harchandani from Citigroup.
Good morning, Amit.
Just maybe a couple of clarifications and a quick question, if I may. Firstly, earlier in the call, I believe you mentioned that if the device CAGR grows at, say, 10% or whatever rate, you hope to have royalties growing at twice of that rate. Is my understanding correct? That's what you said?
That's what we said. That was commentary on a five-year view.
That devices, when you talk about devices in that bracket, you are including smartphones and tablets?
That was a comment about smartphones.
Perfect.
By the way, you may have seen it. There's a slide in the deck that we've been talking to for, I don't know, three or four quarters now. Which really summarizes that. In a sense, it's no new news, but we're reiterating the fact that if we're entering a five-year growth phase of about a 10% device growth in smartphones, we think our royalties from smartphones will grow at approximately double the device rate.
Perfect. Yeah. That's what I just wanted to clarify. Secondly, I think also in response to another question, in talking about Arm moving to conventional computing, your view is that it's really a function of the growth rate that you see in the conventional computing market, but in terms of hardware, software compatibility, for example, Arm on Windows or even say Arm on Mac OS, there is nothing in terms of technological advancements that still needs to be carried out, for say, for me to see an Arm-based chip in a conventional laptop. It's really a function of the growth rate of the market.
Well, no, what I was trying to say was that from a performance perspective, there is nothing to stop an Arm licensee creating a chip that would deliver enough performance to be used in a conventional laptop style computer. Whether that happens or not is then a function of whether that market represents enough opportunity in terms of growth rates for one of our licensees to attack that. Obviously software compatibility, which is a completely different issue. The question I was being asked was, I think about performance. I was just trying to answer it from that perspective.
Thanks, Simon. Maybe just on software compatibility, how much more work needs to be done on that front in your view? You think we are pretty much there, or are there a few more hurdles to come?
You mean in a-
In a software world, for example, if I want, say, the Mac OS to run on Arm or say Windows 10 to run on Arm, is there a substantial amount of technological work that needs to be done for that? Is it something that is manageable relatively quickly if the manufacturer decides to do so?
I think that's more a question you need to ask either Microsoft or Apple. Based on the earlier ports of Windows to Arm, it shows that it's a tractable problem and one that can be done. It's down to whether those companies see an opportunity there to create differentiation or customer benefit around a different architecture platform. That is entirely up to them.
Fantastic, Simon. Just very quickly, could you give us an update on physical IP, please? Where does the traction over there stand with the large fabless chip makers, particularly as we continue this whole march down to the advanced node? Thank you.
With the progression to advanced nodes, designing chips, manufacturing them becomes much more complex, our partners are looking to us to provide assistance in helping achieve the best performance and lowest power in their implementations of Arm technology, which is why our POP IP has preferred for some time now. You can see that kind of coming through in the licensing performance of the physical IP business, which has been growing quite strongly, the business as a whole has had double-digit growth for about the last four or five years quicker with a better technology solution.
Thank you very much.
Your next question was from the line of Lee Simpson. Please ask your question.
Great. Thanks so much. I just wonder if we could maybe try and do a quick sum up question, just along the various strings that you've laid down in this call. It looks to me as though you've said mid-single digit % rise in royalties Q and Q to Q4. That as we go into next year, pre the V8 architecture, you're looking at a normal growth profile again of about mid, say if we go back to a base rail of high single digit % growth. Is that the sort of complexion that you're happy to talk to right now with the delta being just how successful can V8 architectures be in the second half next year?
Well, what we said, Lee, was that we expect mid-teens year-on-year growth in Q4, which will then obviously form the platform for 2015 royalties. We expect the introduction of version eight to start to make a meaningful contribution. I think Simon and I both answered questions about the sort of multiple markets that we see contributing to that royalty growth rate. I think your summary was yeah, it was a fair summary by Lee Simpson.
Thank you very much. Second to that, just wanted to ask, could you remind us what is the tech focus per se or the end market focus again from Maya and Artemis? Maybe second to that, it looks as though you've got three lead licensees in Maya, if I'm reading this correct. We haven't called out anyone in Artemis as yet. Thirdly, do we expect the usual two-year lead time to silicon? In other words, is this the real entry point for high-end compute for Arm?
Well, you are joining the dots there. In terms of Maya and Artemis licensing, at the early stages of a product like this I wouldn't read much, actually I would read nothing into whether one of them was licensed in a quarter and the other one wasn't. The next quarter, it might be the other way around. We do engage with a small number of licensees. We have talked about working with lead partners on Artemis in previous calls. I'm very happy with the lead partner engagement that we have on those products. In terms of what they're for, when they're going to come to market, what they're going to look like, I'm afraid you're going to have to wait and see on that one.
The usual two-year lead time to silicon?
Well, let's wait and see on that one.
Okay, great. Thanks, guys.
Thanks.
Next question comes from the line of Johannes Schaller. Please ask your question.
Yeah. Hi there. Thanks for taking my question. Really one in connection to some of the questions that have already been asked. There seems to be certainly an expectation that we should be looking at a stronger increase in the mobile percentage royalty rate next year than we've probably seen in some of the previous years, maybe mostly on the back of v8. If I look at some of the shipment schedules, to me it appears that for you, the positive v8 impact outside of Apple will be largely in the second half. Then on Mali, you will still gain market share, but maybe at a slightly slower pace than the very good pace we've seen over the last few years.
If you could just help us maybe a little bit, if we should be really thinking about a stronger increase in the percentage rate in mobile from your perspective, or how you are thinking about that. I have a quick follow-up on OPEX as well.
Yeah. I think you are not a million miles away from probably how the uptake of v8 will go through next year. It's 1% of our royalties right now. There's a handful of our customers starting to ship v8 products right now. We would expect that to increase over the coming year with a ramp of more v8 based chips shipping. That is one of the things that leads us to believe that the royalty dollars will grow next year. I think you're reasonably there on that.
On OpEx, a bit of a maybe surprise, I would say, has obviously been on the currency rate, which had a positive impact. If you could just give us a bit of color what your OpEx guidance for the fourth quarter implies on the FX side. Is it kind of the 162 exit rate for the quarter or something along those lines, or maybe a bit different than that?
Yeah. The way we express it is that if it's assuming effective rates similar to current levels, and as you know, currently it's sort of 161, 162. Obviously that can move it around both in terms of the translation rate and probably more meaningfully, the mark-to-market adjustment at the end of the quarter, which obviously depends on the rate prevailing at the end of the quarter, not during the quarter. There are some variables. Q3 was unusual. Usually, the mark-to-market is ± GBP 1 million. This quarter it was more significant because the U.S. dollar strengthened considerably between Q2 and Q3. It was 172 at the end of June and 162 at the end of September. That's unusual.
Basically, if we are back to 162 at the end of this quarter, there shouldn't be much of an impact.
No. I think for the purposes of modeling the rest of the year, GBP 92 million-GBP 94 million is reasonable, ±. Obviously, FX is a variable on that, there'll be other variables as well.
Understood. Perfect. Thank you.
Just to clarify one thing I said a moment ago, the 1% of v8 was actually in our unit shipments, not I think I said in the dollars. I actually meant the units.
The volumes. Yeah.
With that, let's just have one last question, please.
Your last question comes from the line of Andrew Dunn. Please ask the question.
Thank you. Unfortunately, all my questions have been answered, so I will leave it there. Thank you.
Thank you, Andrew. Great. Thanks, Andrew. Okay. Well, thank you very much, everyone, for joining us on the call today. We will see you for full year results in February.
Thank you very much.
Thank you. That does conclude our conference for today. Thank you all for participating. You may now disconnect.