Aggressive AI And CSS Expansion Will Deliver Mixed Outcomes

Key Takeaways

• Aggressive expansion in AI and compute could stall due to overreliance on new tech and unmet revenue expectations.
  
• Heavy R&D spending threatens future net margins if results don't match investments or if returns delay.
  
• Arm's innovations in AI and market expansion suggest robust revenue growth, with strategic partnerships enhancing long-term earnings potential amid increased technology adoption.

Catalysts

Arm Holdings plc architects, develops, and licenses central processing unit products and related technologies for semiconductor companies and original equipment manufacturers rely on to develop products.

• Arm Holdings may be overextending itself in pursuing aggressive growth in AI and compute subsystems, which could lead to the company failing to meet lofty revenue expectations. Increased reliance on new technologies like v9 and CSS might not translate to the expected adoption rates and revenue generation.
  
• The high rate of research and development spending, which reached $522 million in the third quarter, highlights a potential risk of reduced net margins in the future, especially if these investments don't lead to proportionate revenue increases or if the payback period is longer than anticipated.
  
• Arm's assumption that it will continue to capture a significant portion of the data center market with its CSS offerings could be optimistic, particularly if customers like AWS and Microsoft eventually shift or diversify to other architecture providers. This reliance on a few major companies for data center growth could adversely impact projected earnings.
  
• The potential for licensing deal timing slipping into future fiscal years, as noted by management, suggests that projected licensing revenue growth may not be as robust or timely as expected. If key deals are delayed, it could result in significant earnings volatility or lower-than-expected revenue guidance.
  
• Arm's high expectations that its solutions will drive long-term growth for decades to come might be overestimating the sustainability of current trends. The dynamic and competitive nature of the tech industry could introduce unforeseen challenges or disruptors, potentially affecting Arm's longer-term earning forecasts.

Arm Holdings Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Arm Holdings compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Arm Holdings's revenue will grow by 21.4% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 21.8% today to 28.0% in 3 years time.
• The bearish analysts expect earnings to reach $1.8 billion (and earnings per share of $1.72) by about April 2028, up from $806.0 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 87.4x on those 2028 earnings, down from 132.1x today. This future PE is greater than the current PE for the US Semiconductor industry at 23.2x.
• Analysts expect the number of shares outstanding to grow by 1.31% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.99%, as per the Simply Wall St company report.

Arm Holdings Future Earnings Per Share Growth

Risks

• Arm has reported record total revenue and an all-time record royalty revenue, driven by strong demand for its v9 technology and CSS, suggesting continued strength in revenue growth in the near term.
  
• The company is seeing increased adoption of its technologies across a variety of markets, including smartphones, data centers, and automotive, which could lead to an improvement in both revenue and net margins due to economies of scale and increased market penetration.
  
• Arm's investment in AI infrastructure projects like Stargate and partnerships with companies such as NVIDIA for advanced AI supercomputers indicate potential long-term growth in earnings as these initiatives mature and drive further demand.
  
• The solid momentum of Arm's licensing revenue, which grew 14% year-on-year, along with the expectation of continued licensing deals related to AI and CSS, could maintain or increase Arm's income from these streams, positively impacting earnings.
  
• Arm's strategic position in AI ecosystems and partnerships with major tech companies like SoftBank and OpenAI for projects such as Cristal intelligence highlight a forward-looking opportunity set, suggesting potential revenue and earnings growth over time.

Valuation

• The assumed bearish price target for Arm Holdings is $110.82, which represents one standard deviation below the consensus price target of $152.72. This valuation is based on what can be assumed as the expectations of Arm Holdings's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $225.0, and the most bearish reporting a price target of just $73.0.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $6.6 billion, earnings will come to $1.8 billion, and it would be trading on a PE ratio of 87.4x, assuming you use a discount rate of 10.0%.
  
• Given the current share price of $101.0, the bearish analyst price target of $110.82 is 8.9% higher. The relatively low difference between the current share price and the analyst bearish price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.