Giving Intel and AMD a run for their money

San Francisco (Fortune) -- You've likely never heard of ARM, a small U.K. company that doesn't advertise or put its name on any products. But chances are that as you read this, you're within sight of an "electronic brain" that ARM designed -- its handiwork lives in items as diverse as GPS navigators, camcorders and the Nintendo DS.

While those gadgets are nice, ARM's real claim to fame -- if it were famous, that is -- would be cell phones. Its low-power circuitry is at the core of practically every phone on the planet.

ARM may be obscure, but it's everywhere.

This new year, you'll also find ARM-based chips in netbooks, that emerging breed of mini-laptops that proved a hit with cash-strapped shoppers this holiday season. This netbook explosion, driven in equal parts by a bad economy and consumer lust for all things mobile, is sure to thrust the reclusive company into the spotlight and bring it into closer combat with giant Silicon Valley competitors Intel and Advanced Micro Devices.

Oh, and the real surprise? ARM might just give those big dogs a run for their money.

At first blush, it's hard to imagine ARM as much of a threat to anyone. It's a pretty small operation -- certainly not as big as you'd expect considering its customer list. ARM's 1,700 employees make it about one-fiftieth the size of Intel and a tenth the size of AMD (AMD, Fortune 500). Its annual sales are $397 million -- less than Intel makes in a bad week.

But these details obscure a few important factors: ARM's no-frills business model, its lead in power-efficient technology, and its ability to help customers make unique gadgets.

Unlike Intel (INTC, Fortune 500), which designs and manufactures its chips and sells them to customers, ARM just sells chip blueprints, and lets customers like Qualcomm and Samsung build the actual chips on their own. ARM makes less money than Intel by selling ideas instead of products, but it also carries lower costs.

Because it sells only designs, ARM doesn't have to worry about building its own multi-billion-dollar factories or deploying an army of marketing specialists to keep those factories busy. So even though its annual sales are so much lower than Intel's, ARM still retains a healthy 32% profit margin -- and the flexibility that comes from its lean structure.

ARM also has some of the best low-power designs at a time when efficiency is the name of the game. Because it originally designed its chips for battery-powered gadgets instead of for computers, it is well positioned to compete as all kinds of technology (including PCs) become more mobile. It makes sense, then, that in 2009, Qualcomm and Nvidia both plan to introduce ARM-based chips that could go into netbooks, potentially stealing business from Intel's Atom chip.

It's not that ARM is spoiling for a fight; in fact, ARM has long insisted it's not particularly interested in tangling with powerful foes like Intel and AMD. But these days the smartphone trend has phones acting more like PCs, the netbook trend has PCs acting more like phones, and Intel has made no secret of its desire to dominate both markets.

This fight, in other words, came to ARM.

The best weapon in ARM's arsenal, though, might be customization. While its competitors sell chips the way restaurants sell food -- you order from the menu, with minimal changes -- ARM instead sells recipes. The structure leaves its customers with more decision-making power, since after paying a licensing fee for ARM's designs, they're free to do what they want with them, including modify them.

In a world where every gadget manufacturer is trying to stand out from the crowd, that's a valuable edge. Intel's chips may be the most powerful on the market, but they're also available for anyone to buy. Come up with a unique, low-power ARM-based design, though, and you'll have something competitors can't easily copy.

That seems to be what Apple has in mind. Rather than rely on an outside company to supply chips for future iPhones and iPods, it recently bought a firm that is rumored to be designing ARM-based chips specifically for that purpose. Apple could eventually take the designs to a manufacturer, controlling the process from beginning to end.

For companies like Intel and AMD, whose business is based on offering the most advanced chips at the lowest price, this is a nightmare scenario. To fight back, Intel executives are already saying they plan to let large customers request more custom features in their chips, though nothing as extensive as ARM allows.

So who will come out ahead, an old-school player like Intel or upstart ARM? In the long run, it will come down to who offers the right combination of horsepower, efficiency and flexibility at the right price. This year, it's anybody's game.