On Thursday, shares of leading chip designer Arm Holdings (ARM 4.11%) skyrocketed 48% following the company's release on the prior afternoon of a strong report for the third quarter of fiscal 2024. For the period ended Dec. 31, 2023, growth was driven by the robust adoption of artificial intelligence (AI) across end markets along with a rebound in the smartphone market.
As background, the U.K.-based company held its initial public offering in September 2023. Its primary business is licensing its intellectual property (IP) related to the design of central processing unit (CPU) chips along with associated software and tools.
For fiscal Q3, Arm's revenue grew 14% year over year to $824 million, crushing Wall Street's expectation of 5% growth. Adjusted earnings per share surged 32% to $0.29, speeding by the analyst consensus estimate of 14% growth. Moreover, management guided for fiscal Q4 top-line growth of 34% to 42% year over year, and adjusted bottom-line growth of 1,300% to 1,500%. Both outlooks easily exceeded the Street's projections.
Earnings releases tell only part of the story. Below are two key things from Arm's fiscal Q3 call that you should know.
Image source: Getty Images.
1. Benefiting from a virtuous circle
From CEO Rene Haas' remarks:
Arm is the most fundamental, foundational, pervasive compute platform really in the history of digital design. Over 280 billion units [based on Arm IP] in the 30-plus years [the company was founded in 1990] that Arm has been a company have been built. And that has underpinned a software ecosystem and hardware ecosystem like no other. And given the fact that a CPU design is really driven by the hardware and the software, it creates a flywheel for continuous development.
Arm has a great business model for several reasons. A main one is that the company benefits from a virtuous circle. The more hardware built using Arm IP, the more software that's written for Arm. And the more software that's written for Arm, the more popular hardware based on its IP becomes because that hardware has more or better applications and features. And so on and so on.
This virtuous circle is a big factor in Arm's hardware and software ecosystem becoming the world's largest open computing system.
2. Profiting mightily as its customers transition from its v8 to v9 architecture
First, a note about royalties: Arm licenses its IP, and some of these licenses generate royalties for the company. So, the company's revenue comes from both licenses and royalties.
From CFO Jason Child's remarks:
Royalty revenue sequential growth is mainly coming from increasing penetration of Armv9, where royalty rates are, on average, at least double the rates on equivalent Armv8 products. Additionally, we are seeing an increasing amount of Arm technology in chips being deployed. And as the amount of Arm technology in chips increases, so does the royalty rate. [Emphasis mine]
Let's forget about the second part of Child's comment for a moment, and just focus on the first part in boldface. On average, Arm's royalty rates for products that use its newest chip architecture, Armv9, are at least double the rates for equivalent products using its prior architecture. That's at least a 100% increase in just one generation! The main reason for this huge leap is AI, which is driving the need for chips to have significantly beefed-up compute capabilities, be those chips in cloud servers or smartphones or autos or what have you.
Arm's v9 architecture, introduced in early 2021, accounted for 15% of the company's total royalty in fiscal Q3, up from 10% in the prior quarter, according to CEO Haas, who said on the call that he sees this growth "accelerating" as customers continue to transition to licensing v9.
Where is the company in this upgrade cycle? It depends on the end market. Nearly all to all of the premium smartphones have moved to v9-based CPUs, with Arm expecting the entire market to upgrade within the next three to four years. Its other markets have been slower to transition because those markets don't refresh their products as frequently as does the smartphone market. So, overall, Arm still has a nice runway for growth from this upgrade cycle.
The second part of Child's comment seems self-explanatory. Beyond Arm benefiting from higher royalty rates as customers transition to its newest architecture, it also benefits from higher rates when customers use more of its technology in their products.
