Like a lot of high-priced tech stocks, Arm Holdings (ARM -0.52%) has been volatile over the last year. Its shares have whipsawed as investors assess the central processing unit (CPU) architecture specialist's future, and that was on display in its latest earnings report.
The stock tumbled about 10% after-hours on May 7 after the company's fiscal fourth-quarter earnings report came out. Its results edged out expectations with revenue rising 34% to $1.24 billion and adjusted earnings per share jumping from $0.36 to $0.55.
However, the stock fell as Q1 guidance was below expectations, and management did not offer full-year guidance due to a lack of clarity from its customers and uncertainty around trade and the economy. So what's an investor to conclude? Let's find out.
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A valuation question
Arm trades at a premium valuation due to its growth rate, wide profit margins, and competitive advantages, which put additional pressure on guidance as it's priced based on future earnings. The stock currently sits at a price-to-earnings (P/E) ratio of 166, but investors may be overreacting to the lack of full-year guidance.
In an interview with The Motley Fool, CFO Jason Child said that the company had given full-year guidance before but decided not to do so now due to uncertainty around tariffs, saying, "There could be some supply chain impacts that happen later in the year, and we already normally have a pretty wide range just for our license business." He concluded, "It would mean that we'd have to give such a big range that it just annoys people."
Investors should understand that the lack of guidance isn't due to a weakness. It's due to a lack of visibility because of the uncertainty in the economy and the lack of full-year guidance from customers like Apple. While investors might want more clarity, especially given the stock's premium, it's also worth remembering that Arm is more resilient than it looks.
What we do know about next year's results
The company has two revenue streams. It makes money from licensing its semiconductor technology to its customers, and then it makes money through royalties when those products sell. It can take two or three years for a product to go from being licensed to being in production, at which point Arm begins to earn royalties.
So Arm's royalty revenue is mostly pre-determined because the products it earns royalties on have already been licensed. What isn't known is the timing of production on some of them and how many will be sold. The royalty rates have already been negotiated.
Licensing revenue is harder to predict and can swing significantly from one quarter to the next. In fiscal Q4, for example, the company signed a major deal with the Malaysian government for around $250 million.
Why Arm deserves a premium valuation
Arm has a unique business model in the semiconductor industry based on licenses and royalties. Child explained on the earnings call that the stock also has one hidden advantage: "Arm's revenues today come from technology developed years or even decades ago, and our costs today are investments for future revenue streams."
That's a key point and shows why the stock is a buy. Hardware companies, like semiconductor companies, naturally sell products they've already made, but the costs associated with Arm's current revenue are minimal.
Since it sells designs rather than products, it has almost no cost of goods sold (COGS). In fiscal 2025, for example, its COGS were $121 million on $4.01 billion in revenue, or just 3%. Its other expenses were $984 million in selling, general, and administrative expenses, and $2.07 billion in research and development (R&D).
In other words, there's $1.1 billion of direct costs related to Arm's existing revenue since R&D is an investment in the future. That means the business's operating margin excluding R&D would be 72%. Very few, if any, publicly traded companies can claim to be that profitable.
Arm's business is exceptionally profitable, and about half of its royalty revenue comes from products launched 10 or more years ago. That should reassure investors that the business can continue to thrive despite this year's uncertainty.
Regardless of what happens with the trade war and the global economy, Arm still looks well-positioned for long-term growth as demand for semiconductors will continue to grow and it gains market share.
