It has been just over a year since British semiconductor company Arm Holdings(NASDAQ: ARM) went public, and those who invested in its initial public offering (IPO) are now sitting on gains of 121%.
Arm's impressive stock market surge can be attributed to the company's robust growth and solid prospects. The secular growth of the semiconductor market and the emergence of new catalysts such as artificial intelligence (AI) have been tailwinds for the company, which licenses its chip architecture to semiconductor producers, consumer electronics companies, automotive businesses, and cloud and networking providers.
Let's look at Arm's growth drivers and check why it could turn out to be a solid investment for the next five years.
Arm's addressable market suggests robust growth is here to stay
Arm's recent results suggest there is strong demand for the company's intellectual property (IP). Revenue of $939 million in the first quarter of fiscal 2025 (which ended on June 30) increased by 39% from the same period last year. Revenue from sales of licenses increased 72% year over year to $472 million as the company struck what it calls "multiple high-value license agreements" thanks to catalysts such as AI. The huge installed base of Arm-based chips led to a healthy year-over-year jump of 17% in its royalty revenue to $467 million. Adjusted earnings increased 67% year over year to $0.40 per share.
The full-year outlook is solid as well. Arm management forecast revenue of $3.8 billion to $4.1 billion in the current quarter along with earnings in the range of $1.45 to $1.65 per share. At the midpoint, its revenue would increase by 22% from the previous fiscal year, along with an identical increase in its earnings. But don't be surprised to see revenue and earnings landing at the higher end of its forecast range because of a couple of simple reasons.
First, the growing need for the company's chip architecture is driving demand for its licenses and helping create a healthy revenue pipeline. This is evident from its remaining performance obligations (RPO) of $2.17 billion at the end of the previous quarter, a jump of 29% from the same quarter last year.
RPO refers to the total value of contracts that will be fulfilled in the future. So, the strong increase in this metric is an indication of healthy revenue growth to come. At the same time, an increase in the number of licenses points toward an improvement in royalty revenue in the future. Arm gets a royalty from each chip manufactured using its IP, so as more customers purchase its licenses to design chips, its royalty streams should increase.
Second, the company's latest architecture commands a higher royalty per chip as compared to earlier versions. Customers have been adopting the Armv9 architecture to make more-advanced processors with higher computing power and lower electricity consumption. The new architecture was developed with an eye on the AI market as well, which explains the strong adoption of it.
Royalty revenue from smartphones increased by more than 50% in the fiscal first quarter while the number of smartphones sold increased only in the mid-single digit percentages. So the new architecture should allow improvement in margins and robust bottom-line growth.
Arm estimates that its total addressable market stands at $214 billion across multiple end markets such as automaking, the Internet of Things, the cloud, and networking, among others. The company enjoys a healthy market share in almost all of these markets. For instance, it has a share of more than 99% in mobile applications, 30% in consumer electronics, 41% in automaking, 15% in cloud computing, and 28% in networking equipment.
How much upside can investors expect?
Given all of the above, consensus estimates project earnings to increase at an annual rate of 31% for the next five years. Based on the fiscal 2024 earnings of $1.27 per share, its bottom line could hit $4.90 per share after five years if it grows at that rate. And Arm seems capable of such performance.
Assuming the stock trades at 46 times earnings after five years -- which would be in line with the U.S. technology sector's multiple and a discount to Arm's forward earnings multiple of 94 -- it could jump to $225 a share.
That would be 60% above the current price. And if the market decides to reward Arm with a higher earnings multiple thanks to its healthy growth, it could deliver even stronger gains over the next five years.
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Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
