After Earnings and a Massive Rally, Is Arm Stock a Buy, a Sell, or Fairly Valued?

Arm Holdings ARM reported its fiscal third-quarter earnings on Feb. 7. With the stock up almost 60% in 2024, here’s Morningstar’s take on Arm’s earnings and outlook.

Key Morningstar Metrics for Arm Holdings

• Fair Value Estimate: $45.00
• Star Rating: 1 star
• Economic Moat Rating: Wide
• Uncertainty Rating: High

What We Thought of Arm Holdings’ Fiscal Q3 Earnings

• Results came ahead of expectations, and management raised guidance for the year, which finishes in March.
• Arm is gaining market share across many verticals, and this is helping the company diversify outside the mobile market, which has moved from two-thirds of revenue a few years ago to one-third today. The main growth drivers are the cloud and automotive.
• Arm is raising its royalty rates. It was already known that the firm would do this, but management confirmed the royalty rates for its newest architecture, v9, are double that of v8, which was a surprise. The company will be able to capture more value thanks to this, which together with more chips and more content per chip will be positive. This raise will let Arm grab a larger piece of the value chain. It has historically taken very little compared to the value it provides to chip designers.
• But we don’t think the positive news justifies a 50%-60% increase in Arm’s stock price. We have raised our fair value estimate by 32% to $45, mainly to incorporate higher royalty rates in the medium and long term, but shares remain highly overvalued. We believe there is little to win and a lot to lose by buying shares now, as expectations are exorbitant.

Fair Value Estimate for Arm Holdings

With its 1-star rating, we believe Arm’s stock is significantly overvalued compared with our long-term fair value estimate. Our increased fair value estimate comes from higher licensing revenue and royalty rates over the longer term. We estimate royalty rates for v9 could be 3%-4%, compared with the 1.7% blended rate the firm reported in its IPO filing for 2022. Adoption of v9 keeps increasing mainly thanks to adoption in smartphones and the data center, and management sees it increasing in the following year. Our fair value estimate represents an EBIT multiple of 42 times for fiscal 2024 and 38 times for fiscal 2025.

Overall, we model Arm’s revenue seeing a 13% compound annual growth rate over the next 10 years. We expect royalty revenue will grow in the high-single-digit or double-digit range, while licensing revenue will grow by the mid-single-digits. Arm’s average royalty rate in 2022 was 1.7%, and we expect that to expand to more than 3% in 2030 after the introduction of v9 and future architecture improvements. After our 10-year explicit period, we model double-digit returns on new invested capital and mid-single-digit growth in profits for another 10 years, in line with the modeling for a wide-moat firm.

Read more about Arm’s fair value estimate.

Economic Moat Rating

We assign Arm a wide moat based on intangible assets and switching costs. Arm is the IP owner and developer of the ARM (Acorn RISC Machine) architecture, which is used in 99% of the world’s smartphone CPU cores. The firm also has a high market share in other battery-powered devices, like wearables, tablets, and sensors.

In a chip, the instruction set architecture, or ISA, is a set of instructions that act as the middleman between the hardware and the software, dictating how the hardware behaves when it receives software instructions. Examples of architecture instructions include 1) arithmetic instructions (addition, subtraction, multiplication), 2) memory instructions, which facilitate the transfer of data between the CPU registers and the memory, and 3) data pathway instructions, which define the speed at which data moves between the CPU and the registers (temporary storage locations). Software written for a certain architecture won’t work straightforwardly in a different architecture, creating switching costs.

Read more about Arm’s moat rating.

Risk and Uncertainty

We give Arm a High Uncertainty Rating, with key risks coming from China and the slow but steady adoption of RISC-V architecture.

More than 20% of Arm’s business comes from China. Arm China is the only entity allowed to sell its IP in the country, but Arm China is not controlled by the company. Rather, Arm licenses IP to Arm China, which then sublicenses it to Chinese customers like Xiaomi or Huawei. Arm’s revenue recognition from the country depends on the information Arm China provides, and financial reporting controls there have historically been weak. SoftBank, Arm’s main shareholder, still has significant influence over Arm China. There could be attempts to steal intellectual property from Arm China, given the geopolitical tensions between the United States and China. Previous Arm China CEO Allen Wu was accused of behaving unethically and ejected in 2022 after months of corporate fighting, but he still has a stake in the company.

Read more about Arm’s risk and uncertainty.

ARM Bulls Say

• We expect Arm will keep gaining market share in the data center business from x86 architecture, as its chips consume less power and data centers need to minimize their energy consumption. We also expect share gains in the automotive segment, thanks to the transition to electric vehicles.
• The overall trend toward the Internet of Things and battery-powered devices is a long-term tailwind for Arm, as it has the most energy-efficient architecture.
• If Arm manages to change its business model and charge royalties on a per-device basis, this would provide huge revenue and margin upside.

ARM Bears Say

• If Arm manages to charge royalties on a per-device basis, or if it were to meaningfully increase its royalty rates per chip, it could become a double-edged sword. Too much royalty revenue may encourage customers to adopt open-source RISC-V instead.
• Arm China is one of Arm’s largest clients, representing more than 20% of revenue. Its financial reporting has historically been opaque, and there could be attempts to steal Arm’s intellectual property.
• Arm’s revenue concentration is very high, with its top five customers representing close to 60% of sales.

This article was compiled by Tom Lauricella.