Smartphone and AI Advancements Boost Arm's Share Price, Leaving Investors Pondering if Purchase is Warranted.
The shares of ARM Holdings (ARM 0.04%) saw an increase post its Q2 financial report, surpassing expectations for the quarter. The stock has nearly doubled since the beginning of the year, despite being below its summer highs.
Let's delve into the latest earnings and valuation of this microchip company to determine if it's the right time to invest.
Stellar royalty income growth
With ARM's technology being a staple in almost every top-of-the-line smartphone worldwide, it's only now beginning to reap the benefits of the smartphone resurgence and upgrade phase. Additionally, the increased use of its Armv9 technology, which comes with a substantially higher royalty rate than its v8 counterpart, is also contributing to its growth. For instances like Compute Subsystems (CSS), which aids AI tasks on edge devices and in data centers, the royalty rate can be as high as double.
This contributed to a 23% year-over-year increase in Q2 revenue to $844 million. ARM stated that approximately 25% of its royalty income now stemmed from its v9 technology, up from 10% the previous year.
License income, however, decreased by 15% to $330 million. ARM attributed this to the usual variations in the timing and size of significant license contracts during the quarter. During the quarter, it signed six additional Arm Total Access agreements, bringing the total to 39. It also reported 269 customers for its Arm Flexible Access program by the end of the quarter.
Overall revenue increased by 5% year over year to $844 million, exceeding its revenue forecast of $780 million to $830 million. Adjusted earnings per share (EPS) dropped by 17% to $0.30, but was higher than its previous projected range of $0.23 to $0.27.
Remaining performance obligations (RPO), a combination of deferred revenue and backlog and an indicator of future revenue, climbed 10% sequentially to $2.39 billion. ARM stated that it was witnessing strong demand for Compute Subsystems, which was boosting both licensing and royalty income. It also mentioned that its technology was now being used in data centers by the leading three cloud computing companies, as well as in smartphone chips.
ARM maintained its full-year guidance of an adjusted EPS of $1.45 to $1.65 on revenue of $3.8 billion to $4.1 billion. Analysts predicted an adjusted EPS of $1.56 on revenue of $3.97 billion, according to FactSet. However, for the second quarter in a row, it lowered its royalty revenue forecast, predicting a high-teens growth rate. Last quarter, it had mentioned low 20% royalty revenue growth, while at the start of its fiscal year, it had projected mid-20% growth.
For Q3, ARM projected an adjusted EPS of between $0.32 and $0.36 and revenue of $920 million to $970 million. Analysts had anticipated EPS of $0.33 and revenue of $939 million.
Should you buy Arm Holdings?
This quarter presented a contrasting picture for ARM. It's seeing success with its new high-royalty Armv9 technology in smartphones, while also making headways in both the data center and automotive industries.
However, the IoT sector's persistent weakness led to a further reduction in its royalty revenue projections. Additionally, the proportion of v9 technology in its royalty income remained flat sequentially, as there appeared to be a shift toward mid-tier smartphones using older tech during the quarter.
Nevertheless, I expect the v9 penetration to rise in the coming quarters. The company has several notable projects using this newer tech that are just starting to pick up momentum, including Microsoft's Cobalt chip for the data center, MediaTek's Dimensity 9400, the first Arm-based CCS chip in the mobile space, and Nvidia's Grace Blackwell chip, which combines its GPUs with an Arm-based CPU.
ARM shares currently trade at a forward P/E ratio of over 74 based on fiscal 2026 analyst estimates.
Although the stock's valuation is undeniably high, its royalty and license-based business model warrants a premium. Once its technology is integrated into a device, it can often create a royalty revenue stream that lasts for a decade or more. Moreover, it stands to benefit from AI's progression, supported by a hardware upgrade cycle and its increasing presence in data centers.
Over the long term, I believe that ARM's stock will remain a strong investment choice.
Considering ARM's impressive royalty income growth due to the success of its Armv9 technology and increasing use in data centers and smartphones, now might be an opportune time for investing in this microchip company. With analysts predicting a strong performance for the year, ARM's royalty- and license-based business model, which can generate revenue for a decade or more, could potentially make it a long-term investment worth considering.
