ARM Stock Trading: Should I Buy Now?

Just six months ago, the financial world buzzed with anticipation over Arm Holdings' (ARM 3.10%) return to public marskets. Now, the debate shifts to whether it's too late to invest. Since its IPO in late September, Arm has notched a 176% return, outpacing the S&P 500 by over 13 times, driven largely by the rapid adoption of artificial intelligence (AI). Arm's CPUs, integral to everything from consumer electronics to hyper scale computing and cloud services, underscore a significant growth area.

This poses a dilemma for investors who missed the initial surge: should I buy into Arm Holdings now, hoping for continued growth, or is the company's high valuation a deterrent? Let's explore the data to inform this decision.

ARM's Business Model and Revenue Composition

ARM's business model stands out as a unique global monopoly in chip design IP, based on robust patent technology barriers. Instead of manufacturing chips, ARM charges every mobile chip maker patent fees, plus an initial authorization fee for using its chip design IP. This strategy secures ARM's dominant position in key areas of the chip design IP market. Notably, ARM commands a 99% market share in smartphone IP, with its design patents integral to the A-series chips in popular devices like Apple's iPhone and iPad.

ARM Holdings thrives on two primary revenue streams: licensing fees and royalties.

Licensing Fees

ARM generates licensing fees by allowing companies to utilize its intellectual property (IP) in chip design. These one-time fees grant companies the rights to develop products with ARM's technology under a licensing agreement. Although licensing fees constitute roughly 40% of ARM's revenue, this segment has faced stability challenges, largely because the market is already saturated with ARM's clients. Yet, the rise of artificial intelligence (AI) has spurred demand for next-generation AI chips, leading ARM to introduce AI-focused chip design IP, namely Arm Total Access (ATA). This innovation has significantly boosted ARM's licensing revenue in FY24.

Royalties

Royalty revenue, contributing to about 60% of ARM's total income, comes from the production of chips that use ARM's designs, spanning sectors like mobile, data centers, automotive, and IoT. Despite ARM's market dominance, this revenue stream was nearing saturation. To counter this, ARM has innovated by transitioning from Armv8 to Armv9 technology, nearly doubling the unit price for newer chip designs. This strategic move has markedly increased ARM's royalty income over recent quarters.

What is AI Logics of ARM?

ARM faced a potential revenue plateau, challenged by its vast market share and slowing demand in sectors like mobile phones, PCs, and wearables. This situation threatened both of ARM's main revenue paths: licenses, which grow with new clients or IP types, and royalties, reliant on increasing sales.

However, ARM's management adeptly capitalized on the AI boom, introducing innovative growth strategies that rejuvenated both licensing and royalty revenues. This strategic pivot, driven by robust customer demand and impressive performance, underlines ARM's successful adaptation to AI-driven market dynamics.

Logic 1 - Licensing Part: Guide clients' licensing schemes from AFT to ATA to increase income

• Arm Flexible Access (AFA) Licenses: Offers an affordable entry point for smaller companies into consumer electronics and embedded computing markets, through an annual fee model covering a range of popular products.
• Arm Total Access (ATA) Licenses: Grants comprehensive access to ARM's entire product suite across various sectors, again via an annual fee. This includes the latest product launches within the license period. This approach has successfully secured long-term partnerships with leading CSPs and chip manufacturers, extending for a decade or more.

Logic 2 - Royalty Enhancement: Doubling Royalties with AI-Driven Armv9 Upgrade

• Elevated Security: The Armv9 architecture introduces a major enhancement in security features, significantly bolstering its defensive capabilities.
• Advanced AI and DSP Performance: Armv9 significantly elevates its artificial intelligence and digital signal processing capabilities, integrating new instructions and features for optimal support of these complex workloads.
• SVE2 Vector Extension: Armv9 introduces SVE2, an advancement over NEON, offering a scalable SIMD instruction set for diverse DSP workloads. With vector sizes adjustable from 128 to 2048 bits, SVE2 enables efficient code optimization across various CPU architectures.
• Boosted Performance and Revenue with Armv9: Shifting to Armv9 has doubled royalty rates over Armv8, marking a notable performance upgrade. This transition contributed to a quick rise in Armv9's share of total royalty revenue, from 10% to 15% in a single quarter, driving significant revenue growth for ARM in fiscal years 24 and 25.

Logic 3 - Consumer Electronics Rebound

Centered on volume, the consumer electronics sector is recovering from post-pandemic downturns, now at a pivotal growth inflection driven by demand for AI-enhanced devices. Expectations are set for moderate shipment growth in the 2024-2025 period. However, for ARM, the primary growth catalyst lies in value rather than volume, with future performance gains predominantly price-driven.

ARM's Stock Value: Is Now the Time to Invest?

ARM earns royalty revenue from around 8 billion chips quarterly at $0.06 each. This figure is projected to climb over $0.1 by 2025 with the V9 upgrade, potentially surpassing expectations if adoption accelerates. By 2025, ARM expects to hit $5 billion in revenue ($1.6 billion from licensing and $3.4 billion from royalties), with a net profit margin over 55%, possibly close to 60%, thanks to a 96% gross margin and R&D investments. This positions ARM for profits between $2.75 billion and $3 billion. With its dominant market position, ARM's PE ratio could easily stay above 40, spiking to 50 in high-performance periods, valuing the company between $120 billion and $150 billion. Presently at $130 billion, the fundamentals suggest stability with a chance to outperform, particularly with AI advancements driving demand. Any market value below $120 billion is seen as a strong buy, with the prospect of reaching $200 billion if next quarter exceeds forecasts.

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