Arm Holdings (ARM 4.11%) is a fantastic business. The company develops the Arm architecture, which clients license in various ways to develop their own chips. Some clients license Arm's CPU cores, while others license the architecture itself to develop highly customized processors. Apple, for example, licenses the Arm architecture for the custom chips that power its iPhones, iPads, Macs, and other devices.
Arm collects licensing fees as well as royalty fees based on the number of devices shipped with Arm technology and the complexity of the chips. While licensing revenue grew faster than royalty revenue in the third quarter of fiscal 2024, which ended on Dec. 31, Arm expects royalty revenue to be the main driver of growth going forward as demand for Arm-based chips expands.
Shares of Arm rocketed higher after the company's third-quarter report last week, with the stock more than doubling at one point. Some of those gains have since eroded, but Arm stock is still up about 75% as I write this. While Arm's results were solid, a guidance bump and optimistic talk about how artificial intelligence would drive demand for Arm chips were likely behind the epic rally.
A supremely expensive stock
Arm has traditionally dominated markets outside of PCs and the data center. Essentially all smartphones are powered by Arm-based chips, for example. The company is making inroads in both the PC and data center markets, although progress has been slow. The data center CPU market is dominated by Intel (INTC -9.20%) and AMD, and multiple attempts over the years to bring Arm to the data center have mostly fallen flat.
AI may be enough to change the situation. Nvidia, already a leader in the AI accelerator market, will ship its GH200 Grace Hopper Superchip this year as part of systems from partners. In a server featuring two of these chips, customers would have access to 144 Arm-based CPU cores as well as 8 petaflops of AI performance driven by Nvidia's GPU technology.
As Arm's IP finds its way into higher-value products that target AI workloads, the company's growth could certainly accelerate. However, the stock's valuation already bakes in an incredible amount of optimism.
Arm expects to deliver $1.22 of adjusted earnings per share in fiscal 2024, based on the midpoint of the company's guidance. At the stock price as of midday Tuesday, Arm's price-to-earnings ratio stands at 100. That's even pricier than Nvidia stock, which trades for around 60 times the average analyst estimate for fiscal 2024 earnings.
Because expectations are now so high, shares of Arm could underperform even if the company grows revenue and earnings at a solid pace over the next few years. A sky-high valuation introduces a ton of risk.
A lower-risk way to bet on Arm and AI
There's another way to bet on Arm's success and the AI revolution without taking on a high level of risk. Intel offers exposure to both, and the stock trades at a beaten-down level.
The core of Intel's turnaround plan is leveraging its semiconductor manufacturing expertise to build a foundry business to compete with market leader TSMC. Even though Intel's own chips don't use Arm technology, Arm chips are going to play a leading role in the company's foundry business.
Intel and Arm inked a deal last year to co-optimize Intel's upcoming Intel 18A manufacturing process and the Arm architecture. When Intel 18A is ready for volume production early next year, Intel expects the process to be the best in the industry.
For Arm-based chip designers, particularly those focused on cutting-edge chips designed for flagship smartphones and AI servers, Intel will become a viable manufacturing partner next year. Intel has locked in $10 billion of eventual revenue for its manufacturing and advanced packaging services, and a recent deal with ASIC designer Faraday Technologies to use Intel 18A for that company's 64-core Arm-based server chip adds further momentum to Intel's foundry efforts.
If demand for Arm-based chips surges, Intel will likely benefit because it manufactures a growing share of those Arm-based chips. Outside of Arm-based chips, Intel will also be a viable manufacturing partner for those designing AI accelerators and other advanced chips.
Shares of Intel are down about 36% from their multiyear high. The stock doesn't look all that cheap based on earnings, but the company's bottom line is being depressed by multiple factors, including a weak PC market and market share losses to AMD in the data center. Those headwinds will eventually fade as the PC market recovers and Intel launches new products this year.
Intel has a massive long-term opportunity in the foundry business. Arm's optimistic outlook is ultimately good news for Intel and its manufacturing ambitions as the company gears up to become a major player in the foundry business.
