Arm Holdings (ARM 0.68%) might not get as much attention as chip designer stocks like Nvidia, but it's one of the most important companies in the semiconductor industry. Its designs are found in more than 99% of smartphones. In fact, the company says it has the world's most pervasive CPU architecture, ahead of classic rivals like Intel and AMD.
Arm also has a unique business model in the semiconductor industry. Rather than selling chips directly to its customers, the company licenses its designs, primarily for CPU architectures, and then collects royalty revenue when those products are sold. Typically, 60% to 70% of its revenue in a given quarter comes from royalties, with the remainder from technology licenses.
The key to understanding Arm stock
Arm trades at a lofty valuation, but its unusual business model helps explain why it trades at a rich premium. Arm makes money in two ways: first from license contracts, then from royalties. It usually takes 2-3 years after a contract is signed before the product reaches the market and royalty payments begin.
That means that Arm's current royalty revenue doesn't yet fully reflect the AI boom, though management has said it is seeing strong AI-related demand.
To understand how Arm is performing, it's useful to track numbers like revenue growth in both license and royalties as well as operating margin and earnings per share, but one key metric that gives you added insight into how its technology adoption curve is progressing is its royalty revenue by architecture. You can see this in the chart below.
Image source: Arm Holdings.
V9, short for Version9, is the key part of this graph, as that is the company's most recent CPU design. This latest and greatest architecture commands a royalty rate double that of v8. While it might seem like a bad thing that v9's share of revenue is essentially flat over the last three quarters at about 25%, it shows that demand for the broad range of Arm-based products is growing rapidly, with royalty revenue up 23% in the fiscal third quarter.
Keep an eye on the share of v9 revenue and overall revenue growth. It should eventually gain share from earlier CPU versions, but overall growth from v8 and earlier versions is a good sign for Arm's long-term growth.
