In-house Chip Design And RISC-V Will Undermine Licensing Revenue

Key Takeaways

• Rising in-house chip design by key clients and open-source adoption threaten Arm's traditional licensing and royalty-based revenue streams.
  
• Increased R&D spending and changing market dynamics could squeeze margins, while geopolitical tensions risk limiting access to critical growth markets.
  
• Arm's expanding presence in AI and cloud, rising royalty rates, and robust software ecosystem are driving stronger revenue growth, profit margins, and long-term market leadership.

Catalysts

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

• The rising internal chip design capabilities at major customers, such as Apple, Google, and Amazon, threaten to reduce their dependence on Arm's IP, which could significantly erode Arm's future revenue and market share as these large-scale clients shift to in-house solutions or alternative architectures.
  
• The accelerating global move toward open-source hardware and the widespread adoption of RISC-V architecture present a credible risk to Arm's existing licensing model, potentially leading to steep declines in royalty fees and limiting long-term recurring revenue streams.
  
• Escalating R&D investments are necessary just to maintain competitiveness against emerging and existing rivals, especially as alternative architectures and vertical-specific solutions gain traction, which may cause operating expenses to rise at a rate that outpaces revenue and compresses future net margins.
  
• Geopolitical and technology decoupling, especially between the US and China, could soon restrict Arm's access to critical growth markets or subject it to tighter regulatory scrutiny, placing renewed pressure on top-line growth and increasing operating or legal costs.
  
• As semiconductor customers and OEMs seek to diversify away from broad-based, general-purpose solutions toward more specialized, custom chips, the addressable market for Arm's standardized IP risks shrinking, threatening both future revenue growth and the sustainability of Arm's premium royalty rates.

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 15.8% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 17.0% today to 26.7% in 3 years time.
• The bearish analysts expect earnings to reach $1.7 billion (and earnings per share of $1.55) by about August 2028, up from $699.0 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 71.1x on those 2028 earnings, down from 209.8x today. This future PE is greater than the current PE for the US Semiconductor industry at 29.1x.
• Analysts expect the number of shares outstanding to grow by 1.05% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 10.85%, as per the Simply Wall St company report.

Arm Holdings Future Earnings Per Share Growth

Risks

• The rapidly accelerating demand for AI compute across hyperscale data centers, cloud, enterprise, automotive, and edge devices positions Arm as the foundational platform for scalable, energy-efficient processing, which is already resulting in strong double-digit royalty revenue growth and likely to drive continued revenue expansion in the long term.
  
• Arm is realizing substantial, above-forecast increases in licensing annual contract value and backlog, driven by successful next-generation compute subsystem (CSS) launches and multi-generational GPU deals, indicating rising customer adoption and higher, more predictable future licensing revenues.
  
• The strategic shift to higher royalty rates, with latest CSS platforms commanding royalties over 10% of device ASP compared to historical norms of 2.5% to 5%, is directly expanding Arm's net margins and boosting long-term earnings potential as higher-value deals proliferate across premium mobile, data center, and automotive segments.
  
• Arm's unmatched global software ecosystem, with over 22 million developers and increasing investment in tools and partnerships, strengthens customer stickiness, reduces churn risk, and underpins long-term licensing and royalty revenue stability.
  
• The company's penetration into new verticals-including automotive (with Zena CSS for ADAS and autonomous driving) and custom silicon for AI workloads-alongside expanding customer relationships and a growing share in cloud data centers (from under 20% to nearly 50% in just a year) dramatically increases Arm's addressable market and supports sustained multi-year revenue and profit growth.

Valuation

• The assumed bearish price target for Arm Holdings is $81.68, which represents two standard deviations below the consensus price target of $150.45. 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 $210.0, and the most bearish reporting a price target of just $80.0.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $6.4 billion, earnings will come to $1.7 billion, and it would be trading on a PE ratio of 71.1x, assuming you use a discount rate of 10.8%.
  
• Given the current share price of $138.5, the bearish analyst price target of $81.68 is 69.6% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
  
• 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.