Arm Holdings (ARM -0.01%) has been a clear winner since its 2023 initial public offering as the stock has tripled in less than two years. However, investors have greeted its last two earnings reports less warmly. For the second time in a row on Thursday, Arm stock dove following its earnings report after offering disappointing guidance.
Back in May, shares fell 6.2% after management declined to give full-year guidance due to uncertainty in the macro environment and the semiconductor sector. This time around, the stock fell 13.4% after first-quarter results only matched estimates and guidance for the second quarter was underwhelming.
The company's first-quarter results were in line with guidance, since revenue rose 12% to $1.05 billion as it lapped a large licensing deal from the quarter a year ago. Adjusted earnings per share fell from $0.40 to $0.35 as the company stepped up its investments in R&D, which rose 48% to $440 million on an adjusted basis.
Some investors seemed to balk at those expenses given the double-digit sell-off in the stock, but Arm could be setting itself up for some big wins down the road.
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Arm makes a big bet on the future
Arm didn't make any product announcements on the earnings call despite questions from analysts, but media reports have been trickling out about its plans for new chip components after finding success with Compute Subsystems (CSS), a more advanced starting point to build chips, which moves its design strategy beyond Arm v9 CPUs. On the earnings call, CEO Rene Haas said that CSS has "been successful beyond our expectations."
In an interview with The Motley Fool, Arm CFO Jason Child explained the evolution of the company's strategy from licensing its CPU architecture to now possibly designing its own chips. Child described the status of the product development as being far enough along that it's time to increase investment for things like lab testing, more complete design, and growing head count around those products. He called the investment "offensive spending," and said the company has a track record of turning this kind of investment into high-leverage revenue, as it did with CSS.
With this investment cycle, Arm is also responding to what its customers want. Haas said on the earnings call that newer customers and even traditional customers have "asked for a better starting point as they develop their systems on chips." By doing more of the design work, Arm can both charge more money for its product and save its customers valuable time bringing products to market, especially at a time when many of its customers are racing to develop artificial intelligence (AI) models.
Is Arm a buy?
On the one hand, the post-earnings sell-off in the stock is understandable. A 12% revenue increase, even with difficult comparisons, isn't particularly exciting, and a decline in profits tends to be anathema for growth stocks. Arm also trades at a lofty price-to-sales valuation of 42, showing high expectations are baked into the stock.
However, it makes sense for the company to advance its product strategy right now, when AI demand is soaring from all end users. Arm already has a unique competitive advantage in the industry with its battery-efficient CPU design, which gives it a clear edge in markets like smartphones and, increasingly, data centers. Building chiplets or even complete chips with that technology inside seems like a winning strategy, especially as Arm continues to take market share from the X86 design employed by Intel and Advanced Micro Devices.
Investors will have to be patient with the current investment cycle, but it seems likely to pay off for Arm, given the strong performance of CSS and customer interest in more advanced products. Arm may not even have to take a product to market to reward investors. A simple announcement may be enough for that.
It's unclear when we'll get an update, but viewed in that context, it's much easier to look at the increase in R&D spending as an investment in future growth and a potentially transformative product, rather than just a headwind on profits.
Arm has the competitive advantage and strength of its core business to take such a risk, and the success with CSS should lead to other wins. For long-term investors, taking advantage of the post-earnings sell-off looks like a smart move.
