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Could the Chip Battle for Tablets Get Graphic?

Which chipmakers could win or lose the motherboard grab for tablet space?

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Ever since the release of  Apple's (AAPL) iPad in April 2010, gadget lovers have been buzzing about tablets. This new category of electronic devices is composed essentially of hybrids between a PC and a smartphone. At this month's Consumer Electronics Show (CES), a host of upcoming tablets stole the spotlight, and the kings and queens of the dance were the semiconductor firms that make the processors which will power these devices. Here's a quick look at the chipmakers at the center of the burgeoning tablet hype.

Tablets: The Latest Battleground in Tech
There's no question that firms in both the PC and handset supply chains are on a collision course in the tablet space. These devices hope to combine the processing power and productivity functions of a low-end PC with the all-day battery lives and touch screen interfaces seen in today's most popular smartphones. In the chip space, the battle comes down to  Intel (INTC) and its x86 processors versus  ARM Holdings (ARMH) and its line of Cortex architectures used in the mobile space. There has traditionally been a clear line of demarcation between these two firms. Intel rules the PC processor business because of its manufacturing expertise, massive research-and-development staff, and well-publicized "Wintel" alliance with  Microsoft (MSFT), the predominant PC operating system. Meanwhile, ARM-based processors are prevalent in the handset industry because these chips are ultra-low power, allowing cell phones to run for days, rather than the 2-to-4 hour battery lives within laptops. ARM essentially develops the architecture for these low power chips, while today's leading chipmakers, like  Qualcomm (QCOM),  Texas Instruments (TXN) and  Nvidia  (NV)DA, expand upon these blueprints to develop their proprietary handset processors. The tablet market is a one-horse race at the moment, with the iPad in the lead, and ARM as the jockey along for the ride, as the iPad uses an ARM-based A4 processor developed by Apple, and manufactured by Samsung. Yet, a host of PC and handset competitors are working on the latest iPad killer, and most of the processors in these tablets are ARM-based as well.

ARM: Muscle More for Show Than for Dough
ARM has been one of the highest-flying chip stocks in recent months. The company is constantly considered to be a takeover target, but we're skeptical of this scenario, given ARM's strategic importance to chipmakers and the antitrust scrutiny that may come if another chipmaker were to acquire the firm. Additionally, ARM's run-up likely came on the heels of the company's well-publicized deal with Microsoft, where the software titan will make its next full version of Windows compatible with ARM-based chips. The Windows-on-ARM deal certainly makes for juicy headlines, since it strays from the well-publicized Wintel partnership. We see the deal as a necessity for Microsoft, but from ARM's standpoint, we don't see the alliance as a game-changer.

As discussed, ARM's chip architecture powers the iPad, in addition to the first wave of tablet challengers running  Google's (GOOG) Android operating system. If Windows-based tablets gain share from Apple or Android, ARM would only maintain, rather than gain, its market share lead. ARM stands to benefit from the deal only if Windows-based tablets help to grow the tablet market at an even faster pace than the exponential growth already expected from these devices. A poll by NPD indicates that the majority of tablet sales thus far have been additional devices for customers, either in lieu of eReaders, or as a third device in the home in addition to PCs and smartphones. Incremental growth could happen if Windows-based tablets cannibalize Intel x86-based PCs, which is a segment where ARM currently has no presence. Little cannibalization appears to be happening today, and although we expect this trend to accelerate as tablets become more powerful in the years ahead, the rate of this change remains highly uncertain. We still see plenty of room for both classes of devices, especially when thinking about the role that tablets will someday play in the enterprise space.

The other factor to consider is ARM's revenue model. The firm provides the blueprint for low-power chip architectures, and in turn collects royalties based on a percentage of the price of each ARM-based chip sold. However, ARM's customers, such as Nvidia, perform extensive research and development on top of ARM's designs. We believe this will limit ARM's ability to raise its licensing and royalty fees on its customers. If ARM was to significantly raise its royalty rates, then customers would likely switch to a different architecture (MIPS (MIPS) is a viable competitor) or develop a new architecture internally. ARM's revenue windfall from tablets probably won't come from a monopoly position, but rather from the fact that ARM-based tablet processors will carry above-average selling prices, as well as from an increase in ARM-based chip unit sales, again as customers buy tablets as third devices, or in lieu of Intel-based PCs. Although tablet-related chip sales should spike in the years ahead, we still think the tablet market will continue to pale in comparison to ARM's foothold in the much larger handset industry. We already have optimistic growth prospects for ARM, but we're not quite certain that tablets will give ARM enough of a cash flow boost to justify the stock's recent runup.

Ultimately, the bigger tablet winners in the chip space will likely emerge from ARM's stable of customers, which include Qualcomm, TI, and Nvidia. All will benefit from incremental sales of higher-priced tablet processors, but we think only a handful will end up victorious. Picking out these winners may be difficult, as we expect this market to be highly competitive in the years ahead, especially as other chipmakers eye up the tablet space, such as  Broadcom (BRCM) and  Marvell (MRVL). Reports have surfaced that  Advanced Micro Devices (AMD) fired its CEO this month precisely because it lacked an adequate mobile processor strategy. We also wouldn't overlook Intel, the world's largest chipmaker, in the tablet space either. We view the Windows-ARM news as a slight negative for Intel, again to the extent that tablets cannibalize x86 PCs in the years ahead. However, while ARM-based chips try to move upstream with more processing power, Intel is trying to extend its presence downstream with lower-power Atom chips better suited for mobile devices. Intel already supports Android-based tablets today, and we expect the firm to become much more competitive on the power efficiency front over the next several years.

We can certainly see a scenario where any share gains made by ARM and its customers against Intel as tablets cannibalize PCs could just as easily be ceded by these firms, as Intel earns more design wins in tablets and smartphones in the years ahead. Finally, we think an overlooked point is that the rise of tablets is part of the larger shift toward cloud computing, where computing tasks are offloaded onto "clouds" of servers and users access the cloud via cheap, low-powered devices, such as tablets. Mass adoption of tablets will likely require substantial server buildouts to create the supporting clouds, which in turn will drive significant demand growth for server processors, which is Intel's most lucrative segment.

At the end of the day, we think the tablet processor space will shape up like the handset chip market, where it will be difficult for a single firm to dominate, rather than the PC processor space, where Intel maintains a foothold.

Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.