Arm Holdings (ARM 1.41%) has only been public for about two years but is already established as one of the leading artificial intelligence (AI) stocks on the market. Its share price has more than tripled since its debut, and it's forged partnerships with Nvidia and the major hyperscalers, like Alphabet, Amazon, Microsoft, and Meta Platforms.
Arm has a unique business model in the semiconductor industry. It licenses its central processing unit (CPU) technology to partners like those above and then collects royalties once those products ship. Arm's CPUs are known for their power efficiency. Because of that, the company has more than 99% market share in smartphones and is gaining market share in areas like the data center, where energy efficiency is key.
Coming into the company's fiscal second-quarter earnings report, investors were hoping to see more evidence that Arm was capitalizing on the tailwinds in AI, and Arm delivered just that.
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Arm heats up
Arm blew past its own guidance and estimates in the quarter as it reported strong growth in both licensing and royalties. Overall revenue was up 34% to $1.14 billion, which topped $1.06 billion. Royalty revenue increased 21% to $620 million, with growth across the board coming from smartphones, data centers, automotive, and Internet of Things (IoT).
Arm is uniquely positioned in the market as it's the only chip company that serves all of those end markets, and everywhere from the cloud to the edge, meaning in devices owned by end users.
Licensing revenue jumped 56% to $515 million. Licensing revenue can be lumpy for Arm, depending on the deals it signs each quarter, and CFO Jason Child said that a Chinese customer signed a significant new deal for the company in the quarter. Its relationship with Softbank also drove licensing growth.
On the bottom line, adjusted operating income jumped 43% to $467 million and adjusted earnings per share (EPS) improved by 30% to $0.39, topping the consensus at $0.33. Both revenue and EPS numbers topped the high end of Arm's guidance, as well.
The emergence of Compute Subsystems
There are a number of tailwinds driving Arm's growth, but the most important one may be the growth of Compute Subsystems (CSS), the most advanced iteration of Arm's technology. It goes beyond a CPU, which includes other key components like memory and GPUs, to speed up the time to market for its licensees.
Demand for CSS remains strong as the company signed three CSS licenses in the quarter, bringing the total to 19 across 11 companies. CSS isn't just a tailwind for the company because it's a bigger product that customers are demanding, but the company also charges a higher royalty rate on it, at 10%, compared to 5%, for v9, its newest CPU version.
Arm Holdings also achieved a milestone with the launch of its Lumex CSS platform, the most advanced smartphone platform the company has made, with five times AI performance on the CPU and three times greater efficiency. The company issued strong guidance, as well, calling for revenue of $1.175 billion-$1.275 billion in the third quarter, up 27% at the midpoint, and adjusted EPS of $0.37-$0.45, which compares to $0.39 in the quarter a year ago.
NASDAQ: ARM
Key Data Points
Why Arm Holdings still fell on the news
Despite beating guidance and delivering what Child called the "strongest beat and raise we've ever had," the stock fell 1.3% last Thursday and continued to trend lower on Friday. Valuation has been a concern for investors, following Arm's surge as investors recognized the AI opportunity in front of it. Today, the company trades at close to 40 times sales and around 100 times adjusted earnings.
Last week, concerns about a possible bubble in AI also weighed on tech stocks after Michael Burry of The Big Short fame revealed short bets against Nvidia and Palantir Technologies. Because of its business model and stable profits, Arm Holdings should be more resilient to a bubble than, say pre-revenue or pre-profit AI start-ups. However, the valuation does add risk for investors.
Over the long term, Arm Holdings still looks like a winner, and the company is making the right moves for growth, including its upcoming acquisition of AI networking chipmaker DreamBig. Investors will have to be patient as the volatility in the market plays out, but any significant drawdown in Arm stock should be seen as a buying opportunity for long-term investors.
