Is Arm Stock an Earnings Buy?

• Arm revenue was $939 million, compared to management’s guidance of $875 million – $925 million for the quarter, while adjusted earnings per share were $0.40, compared to indications of $0.32 and $0.36. However, that wasn’t enough to satisfy investor demand, and the stock fell 12 percent in stock market trading to around $126 a share. The revenue growth is driven by the adoption of the company’s v9 architecture.

• Although management already expected the next quarter to be the weakest of the year because of the timing of license revenue, its sales guidance of $780-830 million was weaker than anticipated. Management also slightly moderated its annual targets and expects royalty revenue to grow in the low 20% range, compared to mid-20% previously. As with other tech stocks, we assume investors expected a beat and raised guidance to justify Arm’s high valuation.

• Nothing has changed our opinion that Arm is overvalued and has no margin of safety.

Morningstar Key Values ​​for Arm

• Estimated fair value: $66
• Morningstar rating: ★
• Morningstar Economic Moat Rating: Lat
• Morningstar Uncertainty Rating: High

Estimated fair value for Arm

Our forecasts are unchanged and we maintain our estimated fair value of $66 per share. We estimate that Arm will achieve a combined royalty rate of approximately 5% in 2030 and 6% in our terminal year, 2034. The company’s newest architecture, v9, has double the royalty rates of its predecessor, v8.

We estimate v9 royalty rates to be 4%-5%, compared to the 1.7% compounded rate reported by the firm in its 2022 IPO filing. V9 adoption continues to grow, primarily from adoption in high-end smartphones and in the data center and management. sees increased adoption over the next few years. Our fair value estimate represents an adjusted price/earnings ratio of 44 times in fiscal 2025 and 35 times in fiscal 2026.

Assessment of Arm’s Economic Moat

We give Arm a wide berth based on intangibles 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 large market share in other battery-powered devices such as wearables, tablets and sensors.

The ARM architecture is known for its optimal design for battery-powered devices, which is simpler and consumes less power compared to the Intel x86 architecture. x86 has traditionally been associated with higher computing performance at the expense of increased power consumption, making it ideal for PCs or data centers. In contrast, the Arm architecture consumes less power but tends to provide less computing power, making it ideal for battery-powered devices. For years, the two architectures have been trying to meet in the middle.

Financial strength

We believe Arm is financially sound, with $1.6 billion of cash on hand and no debt. According to its IPO filing, the firm does not plan to pay any dividends on its common stock. We also don’t expect any significant M&A, as Arm would likely face antitrust scrutiny in any mid- or large-sized deal given its large market share. Over the past five years, the firm has made several small equity investments in semiconductor startups that it could sell if it needs cash.

Risk and uncertainty

We give Arm a high uncertainty rating, with key risks coming from China and the slow but steady adoption of the RISC-V architecture.

More than 20% of Arm’s business comes from China. Arm China is the only entity authorized to sell its IP in the country, but the company does not control Arm China. Rather, Arm licenses the IP to Arm China, which sublicenses it to Chinese customers such as Xiaomi or Huawei. Arm’s in-country revenue recognition is dependent on information provided by Arm China, and financial reporting controls 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.

Although RISC-V chips currently can’t match Arm in terms of performance, power efficiency, and ecosystem support, the architecture is slowly but steadily gaining adoption. RISC-V is open source, saving startups costs and adding design flexibility. On the other hand, Arm offers a faster time-to-market (since it sells standard models) and better customer support, given that it is backed by a single company. We don’t see the Arm architecture being challenged by RISC-V in the next 10 years, but beyond that, RISC-V could gain market share.

Arm Bulls Say

• We expect Arm to continue to gain market share in the x86 architecture data center business as its chips consume less power and data centers need to minimize their power consumption. We also expect share gains in the automotive segment due to the shift to electric vehicles.
• The general trend towards the Internet of Things and battery-powered devices is a long-term tailwind for Arm because it has the most energy-efficient architecture.
• If Arm changes its business model to charge royalties per device, this would provide huge revenue and room for growth.

Arm Bears Say

• If Arm succeeds in charging royalties on the device, or if it were to significantly increase royalty rates on the 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 customers, accounting for over 20% of revenues. Financial reporting has historically been opaque and there may be attempts to steal Arm’s intellectual property.
• Arm’s revenue concentration is very high, with its top five customers accounting for nearly 60% of sales.