Power-Efficient Technologies And AI Capabilities Spark Revenue Surge And Market Expansion

Key Takeaways

• Arm's focus on power-efficient computing and AI technology shows promising growth in licensing revenue from partnerships with major cloud providers.
  
• Expansion into new markets with advanced technologies like Arm Ethos-U85 and a significant increase in smartphone royalty revenue indicate higher per-unit earnings and market share.
  
• Arm Holdings faces volatility in royalty and licensing revenues, execution risks with new architectures, and pressure on net margins from rising R&D expenses.

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.

• The recent announcements of Google's Axion processor for the cloud and AWS Graviton show an increasing demand for Arm's power-efficient compute platforms, potentially leading to increased license revenue from these high-value partnerships—impacting revenue and future earnings.
  
• Arm's licensing revenue rose 72% year-over-year, with a significant increase in license revenue by 70% for AI technologies, indicating a growing market demand for AI capabilities that Arm is well-positioned to capture—likely to affect overall revenue positively.
  
• The introduction of Arm Ethos-U85 for edge AI and the engagement in compute subsystems (CSS) across major markets like mobile, laptop, cloud, and automotive suggest an expansion into new markets and increased adoption, enhancing both royalty and license revenue—potentially increasing market share and revenue streams.
  
• A 50% year-on-year increase in smartphone royalty revenue amidst a single-digit increase in unit sales highlights Arm's growing royalty-per-unit and deeper penetration in the smartphone market through advanced technology adoptions (v9), foreshadowing higher per-unit earnings.
  
• Continued high investment in research and development, as evidenced by the release of new CPU and GPU technology and the expectation of licensing revenue to pick up significantly in Q4 FY25, points towards sustained growth in licensing revenue, which is a precursor to future royalty revenue as these licenses materialize into products—indicating an impact on long-term revenue and net margins.

Assumptions

• Analysts are assuming Arm Holdings's revenue will grow by 21.7% annually over the next 3 years.
• Analysts assume that profit margins will increase from 12.1% today to 34.9% in 3 years time.
• Analysts expect earnings to reach $2.2 billion (and earnings per share of $2.0) by about October 2027, up from $424.0 million today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting $2.7 billion in earnings, and the most bearish expecting $1.7 billion.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 87.3x on those 2027 earnings, down from 372.4x today. This future PE is greater than the current PE for the US Semiconductor industry at 28.5x.
• Analysts expect the number of shares outstanding to grow by 1.6% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 8.87%, as per the Simply Wall St company report.

Risks

• The ongoing inventory correction in the broader industrial market, including IoT and networking equipment, might persist longer than anticipated, affecting Arm's royalty revenue growth in these segments.
  
• Licensing revenue, while currently strong, is described as lumpy, indicating potential volatility in future revenue streams, which could impact overall financial stability.
  
• The transition from v8 to v9 architectures, and the initial ramp of chips based on compute subsystems in the second half of the year, present execution risk that could affect royalty revenue growth expectations.
  
• Investments in R&D and future growth initiatives are leading to a 19% year-over-year increase in non-GAAP operating expenses. If these investments do not yield the expected revenue growth, it could impact net margins.
  
• The company’s projection of smartphone royalty revenue outpacing unit growth significantly relies on successful v9 adoption and market share gains. Any slowdown or competition in smartphone markets could undermine these revenue forecasts.

Valuation

• The analysts have a consensus price target of $135.66 for Arm Holdings based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $200.0, and the most bearish reporting a price target of just $66.0.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $6.3 billion, earnings will come to $2.2 billion, and it would be trading on a PE ratio of 87.3x, assuming you use a discount rate of 8.9%.
• Given the current share price of $150.67, the analyst's price target of $135.66 is 11.1% lower. The relatively low difference between the current share price and the analyst consensus 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.