Arm Holdings (NASDAQ: ARM) has been one of the top artificial intelligence (AI) stocks on the market since its initial public offering nearly a year ago, but shares of the chipmaker ran into a wall on Thursday. The stock fell despite beating estimates on the top and bottom lines.
Investors sold the stock, which was priced for perfection coming into the report, on concerns that its guidance was weaker the expected. The company failed to raise its full-year guidance and is targeting a sequential decline in revenue to between $780 million to $830 million and adjusted earnings per share of $0.23 to $0.27 for the second quarter, which compares to the consensus at $0.27. For a stock trading at a price-to-sales ratio near 50, that seemed to be enough of a reason for the decline, and shares fell 15.7% on the day.
Let's break down the earnings report to understand what investors should make of the sell-off.
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1. Future revenue just got a major boost
Arm makes revenue in two ways. First, it sells licenses for its technology, which its customers use for a wide variety of applications. Then, the company records royalty revenue each time a product is sold with one of its designs.
In this two-step revenue process, licenses precede royalties typically by two to three years because it takes time for companies to develop new smartphones, computers, and other devices.
In the fiscal first quarter, license revenue jumped 72% to $472 million as demand seemed to be driven by big tech companies like Amazon , which is using Arm's technology for its new Graviton4 chips, and Alphabet , which just launched its new Axion line.
A 72% jump in license revenue is a win for Arm in and of itself, but it's especially promising since it will flow through to revenue in a few years. Typically, royalty revenue makes up 60% to 70% of total revenue, so the impact from the recent license sales is likely to be even greater on the royalty side.
2. There's still a huge opportunity in cloud
Arm's stock and its business have been soaring with the AI boom, but the company isn't yet capitalizing on data center demand in the way most of the industry is.
Smartphones still drive the biggest component of Arm's royalty revenue, making up 40% of royalty revenue in fiscal 2024. Arm has long had a dominant position in smartphones with more than 99% market share, but in the cloud segment, its designs are only in 15% of components, leaving a significant growth opportunity.
In an interview with The Motley Fool, Arm CFO Jason Child said that the company is targeting 50% market share in data center by 2030. Child also talked up a number of upcoming data center chip releases that will benefit Arm, including Amazon's Graviton4, Microsoft Cobalt, Google Axion, and Nvidia's Grace Hopper and Grace Blackwell.
Arm has already done the hard work of landing these major hyperscalers as customers, and it should be able to grow along with them now.
3. Royalty rates are going up
In addition to penetrating new markets like data centers, Arm is also benefiting from higher royalty rates from new technology. For example, its Armv9 architecture, which was launched in 2021, is starting to pay off in royalties. The v9 is now generating approximately 25% of royalty revenue, and its shares are growing quickly.
Arm will benefit from that because it charges about double the royalty rate for the v9 as it does for the v8, the next-oldest model.
The company has also been investing in compute subsystems (CSS,) which are more complete systems than the CPUs it is best known for and help customers speed up time to market. CSS components also carry roughly double the royalty rate of the v9, and they're expected to be a major royalty revenue driver as they come online.
Is Arm Holdings stock a buy?
Arm's competitive advantages are clear -- its energy-conserving architecture has made it a mainstay in smartphones and is rapidly earning adoption in data centers because AI applications demand lots of power.
The biggest risk with the stock today is valuation because it trades at a price-to-sales ratio of close to 40. Over the long term, the stock should be a winner as AI gains adoption, but the stock could fall further in the near term, especially given the recent pressure on semiconductor stocks.
Investors may be best off taking a dollar-cost-averaging approach and capitalizing if the stock continues to fall.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Jeremy Bowman has positions in Amazon. The Motley Fool has positions in and recommends Alphabet and Amazon. The Motley Fool has a disclosure policy .
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