When analyzing a business that is going public, it is crucial for analysts and financial writers to thoroughly examine regulatory filings and understand the company’s position in the market. However, even the most diligent research can lead to incorrect assumptions. Such was the case for Arm Holdings (NASDAQ: ARM), a company that provides central processing units (CPUs) to the smartphone industry.
Upon my initial review of Arm’s regulatory filings, I grasped the company’s dominance in the smartphone CPU market but failed to see the connection between Arm and the growing demand for generative artificial intelligence (AI). In an article I wrote last year, I dismissed Arm’s potential in the AI field, comparing it to Nvidia and stating that wishing to be like Nvidia does not make it so.
However, I was proven wrong when CEO Rene Haas highlighted the tremendous opportunity that AI presents for Arm in a recent interview. The proliferation of AI technology has created a surge in demand for Arm’s higher-end processor designs. For instance, Nvidia’s GH200 Grace Hopper Superchip, which combines accelerated CPU and GPU technology, utilizes 144 Arm version 9 (V9) CPU cores. Moreover, Microsoft’s new AI server chips incorporate over 100 V9 processors. These examples illustrate the widespread adoption of Arm’s latest processor designs.
Furthermore, many of Arm’s existing customers are transitioning to the V9, which offers enhanced computing power and a higher royalty rate. As AI processing becomes more prevalent in devices such as smartphones, connected TVs, smart appliances, and automobiles, the demand for higher-end CPUs will only continue to grow.
My misunderstanding of Arm’s potential was a result of overlooking the pervasive nature of the company’s intellectual property (IP), which is used by 70% of the world’s population. Arm’s revenue primarily comes from licensing and royalties obtained through the use of its designs by various companies. This licensing model allows Arm to benefit from economies of scale and offer its designs at a lower cost compared to companies developing the technology internally.
Arm’s recent financial results further demonstrate its success. In the third quarter of fiscal year 2024, Arm achieved record revenue of $824 million, a 14% year-over-year increase. License revenue grew by 18%, and royalty revenue reached a record high with an 11% increase. Adjusted earnings per share (EPS) rose by 32% to $0.29.
Arm’s remaining performance obligation (RPO), which includes contractually obligated revenue yet to be recognized, increased by 38% year over year to $2.43 billion in the third quarter. Management expects this growth trend to continue, as Arm forecasts a revenue range of $850 million to $900 million for the fourth quarter, representing a 38% increase at the midpoint.
Although Arm’s valuation may appear high based on certain measures (1,677 times earnings and 44 times sales), a closer look at its projected growth reveals a different perspective. When assessed using the forward price/earnings-to-growth (PEG) ratio, Arm’s valuation indicates an undervalued stock.
Reflecting on my misconceptions, I now have a better understanding of Arm’s potential and plan to invest in the company as soon as trading rules allow. Arm’s impressive financial performance, extensive customer base, and significant growth opportunities in the AI field make it an attractive investment. It is a reminder that even experienced analysts can make mistakes, but it is important to learn from them and adapt one’s strategy accordingly.
