While there haven't been a lot of tech IPOs over the past year, there is one that clearly stands out: Arm Holdings(NASDAQ: ARM). The company debuted in September, returning to the public markets after going private in 2016.
The stock has been strong since its IPO, up over 85% from its IPO price. However, the stock has pulled back recently, creating a more attractive entry point.
What makes Arm special?
Arm's architecture forms the basis of how central processor units (CPUs) work. CPUs act as the control center or brain for computers and perform functions such as arithmetic and determining which data to process and how to process it. These chips are the backbone of computing and are found in all sorts of devices, including computers, smartphones, consumer electronics, automobiles, and data centers.
The company generates revenue in two primary ways. It gets an upfront fee when it licenses its designs to customers so they can create Arm-based chips. The company also receives per-unit royalties based on the number of chips shipped based on its designs. The great thing about license and royalty revenue is that they are very high margin and tend to fall directly to the bottom line as profits.
Arm's technology is found in nearly all smartphones, which creates a steady royalty revenue source for the company. In fact, nearly half its royalty income comes from Arm products released between 1990 and 2012.
An AI opportunity
When you think of semiconductors and generative AI (artificial intelligence), the first name that comes to mind is Nvidia, which provides the graphic processing units (GPUs) that are helping power the AI revolution in the data center. However, Nvidia isn't the only semiconductor company benefiting from AI, and ARM is seeing tailwinds from AI as well.
In fact, Nvidia saw the value of Arm back in 2020 when it tried to acquire the the company. The deal was rejected by regulators, though, and had to be terminated. However, Nvidia still highly values Arm and made an investment in the company at the time of its IPO. Nvidia said that Arm's architecture was important to its products and ecosystem and that it was supporting the company by investing in its IPO.
Nvidia uses Arm architecture for its CPUs used in high-performance computing. Its Grace Hopper superchip, meanwhile, combines an Arm-based CPU with a GPU to help lower energy costs while providing faster performance for AI workloads.
For its part, Arm has said that it is seeing more AI running on end devices, such as the Gemini Nano Pixel 6 from Alphabet or the Samsung Galaxy S24, which is creating more licensing growth. However, it says that current technology has not yet caught up and that new designs using Arm technology are needed.
Arm also said that it is seeing shorter sales cycles and selling additional licenses that were not in prior plans. This speaks to the breakneck speed at which AI is being adopted and the importance of Arm architecture as the AI landscape evolves.
Image source: Getty Images.
A great stock for the long term
Arm has a great business model that generates a lot of high-margin royalty revenue over many, many years once its architecture is incorporated into a chip. The company greatly benefited from the smartphone boom, and continues to reap the benefits of the proliferation on those devices even today. Meanwhile, the company is just starting to benefit from AI, which should propel future growth.
With a forward P/E of just over 64, Arm's stock isn't in the bargain bin, but it is now trading at a much more attractive valuation than it was just a few months ago following a pullback in the stock.
ARM PE Ratio (Forward) data by YCharts
Given the long-tail nature of its royalty revenue stream combined with its long-term growth prospects, this could be a good time to take advantage of the pullback and buy this semiconductor stock.
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