Why Arm Holdings Is the Next Must-Have AI Stock

The artificial intelligence (AI) rally just keeps getting bigger. The latest stock to get caught up in the AI mania is Arm Holdings PLC (ARM), which listed on the Nasdaq in September.

On Feb. 8, ARM shares surged 47.8% after AI spending boosted the chip designer’s forecast. CEO Rene Haas said the opportunity presented by AI is still in its early stages, telling Bloomberg TV, “AI is not in any way, shape or form a hype cycle. We believe that AI is the most profound opportunity in our lifetimes, and we’re only at the beginning.”

Notably, his remarks pretty much echoed what Nvidia (NVDA) said after the blowout quarter it reported after the close last night.

In its blockbuster earnings report, Arm projected revenue of $850 million to $900 million for the March quarter, which far exceeded analysts’ forecasts of $778 million. Adjusted earnings per share were projected to be roughly 30 cents, well ahead of Wall Street’s 21-cent estimate. Arm also raised its sales forecast for fiscal 2024 to a range between $3.16 billion and $3.21 billion.

For those of you unfamiliar with Arm, it is 90%-owned by Japan’s Softbank Group (SFTBY). Its technology is going into an ever-widening array of products, from smartphones to cars to appliances.

The company sells chip design licenses to manufacturers for the fundamental set of instructions that software uses to communicate with chips. These companies, in turn, pay royalties to Arm on each unit shipped. Its unique role in the semiconductor industry also involves providing so-called design blocks that companies such as Qualcomm (QCOM), Amazon (AMZN), and Apple (AAPL) use to build their processors.

The key characteristic of Arm’s chip designs is that they use less energy per unit of performance than their rivals, which has helped them to become the industry standard for mobile processors - where Arm's market share is 99%. Power efficiency has also helped the company take significant share in data center chips, where energy use is an increasingly important consideration.

Arm and AI

Arm does have major tailwinds at its back, as its customers shift to a new version of its technology called V9, which carries twice the royalty rate of its predecessors. And they’re using more Arm computing cores per device — over 100 in Microsoft’s (MSFT) new server chips, for example — which boosts royalties. Arm is also gaining market share from rival technology in the aforementioned data centers market, as well as the automotive market.

Nvidia’s Grace Hopper, Microsoft’s Cobalt and Amazon’s Graviton - used to run large language models - are all based on Arm’s newest V9 chip design. The V9 now makes up 15% of the company’s overall royalty revenues, up from 10% during the last quarter. I expect this number to continue expanding quite rapidly as Arm’s management continues to move its business away from the smartphone market, which is showing little growth, and toward AI-related sectors.

The recently mauled Arm bears would argue that Arm is mainly a CPU (central processing unit) company, while AI computing is driven primarily by GPUs (graphics processing units), which are Nvidia's bread and butter.

They have a point, but they are misreading the story. Arm is a data center story. Yes, the core AI jobs will be done by GPUs. But there are lots of ancillary computing tasks that need to be done, such as serving web pages, gathering data, and formatting it for AI.

So, Arm is part of the AI story. If you look at the overall computing infrastructure, there is going to be a lot of change, with data centers being rebuilt. Arm will be a major player in that rebuild, which is perhaps why Nvidia itself recently disclosed an investment worth $147.3 million in the company it once tried to acquire.

Why Buy Arm Stock?

There are several reasons to buy Arm stock.

First, the company has a huge amount of room to increase the royalty rates it charges customers that use its chip designs, especially now that its designs are becoming an integral part of the new data center/AI computing infrastructure. Keep in mind that it only charges phone makers $0.50 per phone sold for its mobile CPU designs.

And even if we ignore Arm’s improving fundamentals, there is another reason its stock could be in store for more fireworks after the massive post-earnings rally. SoftBank sold less than 10% of Arm during the IPO, holding on to most of its shares so that it would be able to borrow money against the stock. This will obviously restrict the supply of stock out there over the longer term, which should help increase the stock’s value.

I also believe Arm will keep gaining market share in the cloud computing and automotive sectors. Energy consumption is one of data center’s main expenses, so energy efficiency is paramount. In automotive, the transition to electric vehicles (EVs) creates demand for more efficient chips, as well.

Arm chips will continue to see growth from AI, as they are used in conjunction with GPUs in data centers and to enable on-device AI features in smartphones.

And Arm is in a financially healthy position, with $1.6 billion of cash on hand and no debt.

Buy Arm stock under $150 a share.