Arm Holdings (NASDAQ: ARM) has been one of the biggest winners in the artificial intelligence (AI) boom. The company was late to the party, going public in September 2023, nearly a year after ChatGPT launched, but the stock has tripled from its initial public offering (IPO) price.
Arm is a semiconductor company, and it makes money by licensing chip designs, typically for CPUs, to companies like Nvidia, and collects royalties once those chips are sold. Because of its exposure to the AI boom, it's thought of as an AI stock and carries a valuation deserving of one, like a lot of its artificial intelligence peers. After its fiscal second-quarter earnings report, the stock trades at a price-to-sales ratio of 45 and a price-to-earnings ratio of 109.
That valuation has given investors pause, and there seems to be some confusion about its business model. The stock sold off in after-hours trading following the earnings report before gaining in the regular session.
Arm's revenue rose just 5% in the quarter to $844 million as it lapped a large licensing deal from the quarter a year ago. While licensing revenue fell 15%, royalty revenue was up 23%, but Arm's business model means that much of its future growth is baked in as it collects royalty revenue on technology it's already licensed.
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Don't underestimate Arm stock
Arm's biggest market is smartphones and it dominates CPU market share in that category. Its chips are in more than 99% of phones, and its architecture is much better at conserving power than the competing X86 technology offered by Intel and Advanced Micro Devices.
Roughly 40% of its revenue comes from the smartphone market, and the smartphone industry has mostly matured as Apple's results show. Even as the smartphone market grew just 4% in the quarter, according to IDC data, Arm reported 40% growth in royalty revenue from smartphones, showing how it's able to grow its business in an industry that looks mature.
It was able to do that because its newer Armv9 technology earns a royalty rate that is twice that of the previous generation, Armv8. Arm CFO Jason Child also explained in an interview with The Motley Fool that the price of the chips on which Arm earns royalties has gone up as well, saying, "Now, the other thing that happens in smartphones is it used to be that a flagship chip, 10 years ago it was $75 today, a Snapdragon [made by Qualcomm] is $200, right?"
If both the royalty rate and the price of chips are going, it's easy to see how Arm can grow revenue even in a relatively flat smartphone market. For example, a 3% royalty on a $75 chip would give it $2.25, while a 5% royalty on a $200 chip would be $10, more than 300% growth.
There's more coming down the pipeline
Arm has a lot of potential growth in the data center market, but Child expects the smartphone market to be its biggest segment for the foreseeable future.
Nonetheless, its growth rate should accelerate in the second half of its fiscal year as Microsoft Arm-based Cobalt data center chips just went live on its cloud infrastructure platform, and Alphabet just released its new Arm-based Axion data center chip.
Those two chips should power stronger growth for the company in the second half of the fiscal year as should the adoption of its compute subsystems (CSS), which provide packaging in addition to the CPU design and come with an even higher royalty rate than the v9.
With a significant competitive advantage in its power-efficient CPU architecture, Arm should be able to maintain wide operating margins, and it can continue to grow even in slow-growth markets thanks to higher royalty rates from newer technology and rising chip prices.
While the stock may look expensive, it still remains well-positioned to be a winner over the long run.
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