Think Arm Is Too Expensive? 1 Thing You Need To Understand About the Chip Stock

Arm Holdings, a leading provider of power-efficient CPU architectures, experienced a significant drop in its stock price following its fiscal second-quarter earnings report. Although the company met estimates on both revenue and earnings per share, investors were concerned about weak growth in royalty revenue, which rose modestly by 8% to $670 million.

This decline in royalty revenue was primarily attributed to a stagnant smartphone market, as Arm remains the dominant player in the smartphone CPU market with nearly 100% market share.

Despite the challenges in the smartphone segment, Arm's growth markets, including data center and physical AI royalty revenue, outperformed expectations. Data center royalty revenue doubled year-over-year, accounting for roughly a quarter of the company's total royalty revenue. Physical AI royalty revenue surged by 50%, driven by advancements in the automotive sector.

Guidance for royalty revenue growth in the third quarter was disappointingly low, as the company expected only single-digit growth due to weaker smartphone sales and unfavorable comparisons with the previous year.

License revenue, up 50% to $773 million, was boosted by an increase in long-term agreements. Total revenue for Arm reached $1.44 billion, surpassing analysts' expectations of $1.38 billion. Adjusted earnings per share also exceeded estimates at $0.52, compared to the anticipated $0.48. The company's stock witnessed an uptick in March when it announced its entry into the silicon business, following a broader rally in chip stocks.

Arm's foray into designing its own chips, such as the Arm AGI CPU, led by Meta Platforms, has generated significant excitement. The data center CPU boasts superior performance per watt compared to competitors and is expected to enter production in fiscal 2024. Arm has already secured more demand than it can handle and has raised its revenue guidance for the chip through fiscal 2028 from $1 billion to $2 billion. The company anticipates reaching $15 billion in annual revenue from the Arm AGI CPU by fiscal 2031.

Arm CFO Jason Child highlighted the potential impact of the Arm AGI CPU on the expanding AI market. With every Muse user requiring a single CPU core, the core pricing between $10 and $20 could translate into $35 billion to $70 billion in revenue if Meta converts its vast user base into Muse adopters. While not every user will adopt the product, the example illustrates Arm's potential growth with the new CPU.

The addressable CPU market may be larger than previously estimated, considering various personal AI agents and agentic AI products that will likely expand in the future. Despite Arm's high valuation, with a price-to-earnings ratio of around 80, the company's prospects in agentic AI warrant consideration for investors seeking exposure to this burgeoning market.