Total dollar royalty revenues in Q1 2007 grew by 8% to $53.4 million, representing 41% of group revenues, compared to $49.3 million in Q1 2006. Royalty revenues comprised $45.0 million from PD and $8.4 million from PIPD. Against the backdrop of an overall semiconductor industry inventory correction, underlying PD royalties grew 5% sequentially and 16% compared to Q1 2006. Total PIPD royalties of $8.4 million included $1.5 million of catch-up royalties.
Development Systems and Service revenues
Sales of development systems in Q1 2007 were $13.5 million, representing 11% of group revenues, compared to $13.9 million in Q1 2006. Service revenues in Q1 2007 were $8.0 million, representing 6% of group revenues, compared to $6.0 million in Q1 2006.
Gross margins in Q1 2007, excluding the FAS123(R) charge of GBP0.2 million (see below), were 89.5% compared to 89.0% in Q4 2006 and 89.0% in Q1 2006.
Operating expenses and operating margin
Total operating expenses in Q1 2007 were GBP48.0 million (GBP42.8 million in Q1 2006) including amortisation of intangible assets and other acquisition-related charges of GBP5.1 million (Q1 2006: GBP4.6 million) and GBP3.7 million (Q1 2006: GBP3.8 million) in relation to the fair value of share-based remuneration in accordance with FAS123(R) - "Share-Based Payment". The total FAS123(R) charge of GBP3.9 million in Q1 2007 is included within cost of revenues (GBP0.2 million), research and development (GBP2.3 million), sales and marketing (GBP0.8 million) and general and administrative (GBP0.6 million). Normalised income statements for Q1 2007 and Q1 2006 are included in notes 6.20 and 6.21 below which reconcile US GAAP to the normalised non-GAAP measures referred to in this earnings release.
Operating expenses (excluding acquisition-related and share-based remuneration charges) in Q1 2007 were GBP39.3 million compared to GBP40.8 million in Q4 2006 and GBP34.5 million in Q1 2006. The sequential decline in operating expenses arises because the impact of pay increases effective from the start of the year and the inclusion of the operating expenses of businesses acquired post Q1 2006 were more than offset by a favourable net foreign exchange impact and the absence in Q1 2007 of certain one-off costs that were identified in the Q4 earnings release. Further, following a year of significant investment in headcount in 2006, headcount remained broadly flat in Q1 (see People below).
Normalised research and development expenses were GBP16.6 million in Q1 2007, representing 25% of revenues, compared to GBP18.2 million in Q4 2006 and GBP15.1 million in Q1 2006. Normalised sales and marketing costs in Q1 2007 were GBP11.1 million, being 17% of revenues, compared to GBP11.4 million in Q4 2006 and GBP9.4 million in Q1 2006. Normalised general and administrative expenses in Q1 2007 were GBP11.6 million, representing 17% of revenues, compared to GBP11.2 million in Q4 2006 and GBP10.0 million in Q1 2006.
Normalised operating margin in Q1 2007 was 30.3% (6.1) compared to 29.0% (6.2) in Q4 2006 and 35.6% (6.3) in Q1 2006.Operating margins in Q1 2007 were lower than Q1 2006 due to the 11% weakening of the US dollar against sterling and the effect of the investment in headcount made in 2006. At constant currencies, applying the Q1 2006 effective rate of $1.75/GBP1, the operating margin for Q1 2007 would have been approximately 34%.
Earnings and taxation
Income before income tax in Q1 2007 was GBP12.7 million compared to GBP16.1 million in Q1 2006. After adjusting for acquisition-related and share-based remuneration charges, normalised income before income tax in Q1 2007 was GBP21.6 million (6.5) compared to GBP24.7 million (6.7) in Q1 2006. The group's effective tax rate under US GAAP in Q1 2007 was 25% reflecting the availability of research and development tax credits and taking into account the benefits arising from the structuring of the Artisan(R) acquisition.
In Q1 2007, fully diluted earnings per share prepared under US GAAP were 0.7 pence (4.1 cents per ADS****) compared to earnings per share of 0.8 pence (4.4 cents per ADS****) in Q1 2006. Normalised fully diluted earnings per share in Q1 2007 were 1.14 pence (6.16) per share (6.7 cents per ADS****) compared to 1.27 pence (6.18) (6.6 cents per ADS****) in Q1 2006.
Intangible assets at 31 March 2007 were GBP399.6 million, comprising goodwill of GBP348.4 million and other intangible assets of GBP51.2 million, compared to GBP349.2 million and GBP56.0 million respectively at 31 December 2006.
Total accounts receivable were GBP67.0 million at 31 March 2007, comprising GBP39.1 million of trade receivables and GBP27.9 million of amounts recoverable on contracts, compared to GBP69.6 million at 31 December 2006, comprising GBP45.8 million of trade receivables and GBP23.8 million of amounts recoverable on contracts. Days sales outstanding (DSOs) were 41 at 31 March 2007 compared to 43 at 31 December 2006 and 45 at 31 March 2006.
Cash flow, share buyback program and capital structure update
Net cash at 31 March 2007 was GBP126.8(6.9) million compared to GBP128.5(6.10) million at 31 December 2006. Free cash flow in Q1 2007 was GBP15.6 million before a total cash outlay of GBP20.2 million on the share buyback program in Q1.
Since introducing dividend payments in 2004 and commencing the Company's share buyback program in July 2005, GBP31.8 million has been paid to shareholders by way of dividend and GBP112.9 million has been spent on buying back 92.9 million shares, being 6.7% of the issued share capital. This has contributed to a net reduction in the fully diluted shares in issue from 1,431 million in Q4 2005 to 1,378 million in Q1 2007.
As part of the Board's regular review of the Company's capital structure and cash distributions to shareholders, the directors have determined that, given ARM's cash generative business model, a net cash balance of approximately GBP50 million is currently sufficient to enable the Company to continue to invest in the business as opportunities arise whilst delivering the benefits of a more efficient capital structure.
It is planned that the net cash balance of GBP126.8 million at 31 March 2007 will be reduced to approximately GBP50 million by the end of 2007 via both a step-up in the annual dividend paid to shareholders and an acceleration of the Company's ongoing share buyback program. Given the Company's market leadership position and the visibility of strong cash flows as the benefits of the licensing and royalty business model bear fruit, it is expected that a step-up in the full year 2007 dividend will be proposed to 2p per share, a 100% increase on the combined interim and final 2006 dividend of 1p per share. Thereafter, it is expected that dividends will grow broadly in line with earnings from this new base.
The rate at which the Company buys back its own shares (an average of GBP22.4 million per quarter over the last four quarters) as part of its ongoing share buyback program will be also be accelerated in the last three quarters of 2007. It is anticipated that the share buyback program will resume following the announcement of these results.
In addition, in order to ensure capital structure flexibility going forward, the Board has proposed a capital reorganisation to shareholders, for approval at the Company's Annual General Meeting on 15 May 2007, which will make certain reserves, which are currently undistributable, available for distribution to shareholders in order to fund dividends and the ongoing share buyback program in future years.
Group order backlog at the end of Q1 2007 was marginally up compared to the end of Q4 2006 and approximately 20% up on the level at the end of Q1 2006. Following a strong licensing quarter for newer PD and PIPD technology in Q4 2006, the majority of licences signed in Q1 2007 were for more mature technology. The order backlog was positively impacted in Q1 by the renewal of a subscription license with one of our partners for a further term.