For nearly every smartphone that ships, Arm Holdings (ARM 5.19%) gets a small piece of the sale. The same is true for a big chunk of the consumer electronics market. ARM estimates that the value of chips containing its technology was nearly $100 billion in 2022. The company generated about $2.7 billion in revenue during fiscal 2023 through licenses and royalties.
In the smartphone market, Arm's market share exceeds 99% and has done so for many years. The company's chips are also prolific in the consumer electronics market, although not quite as dominant. It would be an ordeal for a customer to switch chip architectures. Apple reportedly began testing custom Arm processors for its Mac computers in 2014, but it wasn't until 2020 that the company officially announced the switch.
While Arm is largely untouchable in the smartphone and consumer electronics markets, neither is likely to be a significant source of growth in the long run.
Mature markets
Because Arm's market share is so high in these markets, its revenue can only be driven higher by an increase in device shipments containing its chips or an increase in the revenue it derives from each chip. There is essentially no market share to gain.
The smartphone market is currently going through a downturn, which has led to a decline in global shipments. International Data Corporation (IDC) expects shipments to slump by 4.7% this year to 1.15 billion units, the lowest volume in a decade. This follows an 11.3% decline in 2022, which was capped by an 18.3% decline in the fourth quarter of that year.
Consumers are keeping their devices for longer as inflation puts pressure on household budgets. While this situation will eventually improve, it's possible that the smartphone market is going to start looking like the PC market did prior to the pandemic. In other words, unit growth may be a thing of the past, for the most part. Although some people upgrade their phones frequently, no one needs a new iPhone every year, just like no one needs a new laptop every year. Annual improvements have become incremental, giving consumers little reason to upgrade.
A similar story is playing out in the market for smart home devices like TVs. Global shipments of smart home devices slumped 2.6% in 2022, with shipments of smart TVs declining by a steeper 4.3%. This slump could extend into 2024 as consumers pull back on discretionary spending. Once the downturn is over, growth is unlikely to be robust. Products like TVs and smart thermostats can last for many years, and everyone who upgraded during the pandemic won't be upgrading again anytime soon.
Royalties from smartphones and consumer electronics combined to account for more than 50% of Arm's royalty revenue in fiscal 2023. There's some room for Arm's processors to become more complex in these markets and thus generate additional royalty revenue. In particular, built-in AI functionality could drive royalty revenue per chip higher in the coming years. But with unit shipments stagnating, that may not be enough to move the needle.
A tough stock to justify
More than half of Arm's royalties are essentially locked in. The smartphone market won't be switching architectures any time soon, and Apple has an agreement with Arm that extends past 2040. In the markets where Arm is already dominant, it's close to untouchable.
That doesn't look like enough to justify the stock's post-IPO valuation. With a market capitalization of around $60 billion, Arm stock trades for well over 20 times sales and 100 times earnings. Total revenue declined in fiscal 2023, dragged down by slumping demand for smartphones and other devices.
With the long-term growth story for more than half of Arm's royalty business looking weak, investors should be careful paying such a high premium for the stock.
