Arm Holdings: Super Growth But Fairly Valued

In this analysis, we covered Arm Holdings plc (NASDAQ:ARM), a semiconductor company based in the UK that specializes in the development of intellectual property for processors. The company has a high revenue CAGR of 18% and thus, we examine whether its growth outlook could be sustainable. First, we examined the company’s business model by analyzing its revenue breakdown and analyzed its growth performance in terms of shipments and royalty fees per shipment as well as its number of licensees and revenue per licensee. We then examined the company’s revenue by end markets to determine which are the key markets driving its revenue growth. Finally, we examined the company’s competitive positioning and determined whether its chip architecture has any competitive advantages over its competitors.

Growth Supported by Strong License and Royalty Revenue Growth

We first looked into the company’s business model and analyzed its revenue segment breakdown by License and Royalty revenues to determine its growth drivers.

We compiled the revenue segment breakdown based on its available data in the past 4 years and calculated its average revenue per chip shipment to determine whether its growth driver was caused by shipment growth, average revenue per chip shipment growth or any other factor. We then compiled its number of chip licensees and customer chip shipments and derived its average license revenue per licensee and average royalty revenue per shipment.

Source: Company Data, Khaveen Investments

In terms of Arm’s business model, license revenues are recognized as contractual payments to use Arm’s IP, whereas royalty revenue is charged % per chip ASP and only occurs when its customers sell the chip based on Arm-related technology according to its annual report.

Based on the table above, Arm’s royalty revenues have been consistently increasing by 11% on average for the past 4 years, with a significant 19% YoY increase in 2022. In its latest transcript, management highlighted that the increase in royalty revenue has been due to the increasing adoption of its Armv9 from Armv8 by its customers for AI-related applications such as high-performance computing. During its Q3 FY2024 earnings transcript, management also highlighted customers such as Nvidia (NVDA) (Grace Hopper), Google (GOOG) (Pixel 6), and Microsoft (MSFT) (Cobalt). Additionally, Arm’s chip shipments have averaged 4% growth for the past 3 years and its revenue per shipment has increased moderately by 7%.

Furthermore, license revenue has increased significantly by an average of 30% for the past 4 years, with substantial increases of 60% in FY2022 and 43% in FY2024. Its growth had been supported by the rising number of licensees which grew every year in the period with an average of 25%, indicating an increasing adoption of Arm chip architecture. During its latest Q1 FY2025 earnings transcript, management highlighted that they have been “seeing AI everywhere, which is driving demand for Arm's performance and power-efficient compute platform”. Management highlighted previous partnerships with AWS, Google, and Microsoft. Microsoft has also recently introduced its Copilot+ PCs that are run on Arm, whereby on Windows 10 and 11, “87% of the total app minutes people spend in apps today have native Arm versions”, excluding gaming hours. Google has also recently introduced its Axiom Processors, which run on Arm-based CPUs for its Cloud data centers. Furthermore, Amazon’s (AMZN) Graviton 4 runs on the latest Armv9 for its AWS data centers while Nvidia has introduced its Arm-based Grace Hopper CPU enables generative AI applications. Moreover, the company’s revenue per licensee had grown by an average of 4% over the period, supporting its license revenue growth.

Overall, we believe the company’s revenue growth remains positive in both segments due to license and royalty revenue growth. We expect license revenue growth to continue supporting its strong growth, higher than its royalty revenues, as we see its growth to remain supported by the growth of the number of licenses as the adoption of Arm chips increases. We further examined its competitive advantages in the next section, which could bode well for its licensee growth. For example, major companies such as Microsoft, Google, Amazon and Nvidia licenses Arm’s technologies for their chip development. Thus, we based our forecasts for its Licensee Revenue according to the 3-year average number of licensees (25%) and revenue per licensee growth (4%). Additionally, we expect its royalty revenue growth to continue being supported by the rise in Arm chip shipments growth as their customers develop more Arm-based chips, as well as a growing revenue per shipment due to the continuous advancements of Arm architecture such as with v9 which still only accounts for 20% of its revenues with the remainder still on older (v8 and v7 architectures). We projected its Royalty revenue growth based on average shipment growth (11%) and revenue per shipment growth (7%). In total, we forecasted the company’s forward total revenue growth at 22%.

Rising Market Share of Arm Chips

In our second point, we analyzed whether Arm chip architecture has any specific advantages over other competitors and whether the market share trend of Arm chips could benefit the company.

Thus, we compiled the company’s chip value market share and analyzed the performance of Arm architecture compared to other competitors to determine whether it has any advantages and if it could gain future market share.

Based on the table above, the Arm-based chip market share has been steadily increasing over the last 10 years, increasing from 39% in 2014 to 51% in 2023, with large increases in 2021 (3% YoY), 2022 (4% YoY) and in 2023 (2% YoY). Additionally, the Arm-based chip market share currently represents the largest market share in 2023 at 51%, which is the combined x86 (26%) and others market share (23%). Additionally, both x86 and others-based architecture have seen significant market share declines compared to Arm-based architecture. To explain the trend, we examine Arm-based architecture's competitive advantages which include:

• Cost Efficiency: Arm has better cost efficiency (performance per cost) compared to its competitors for both cloud and smartphones, as mentioned previously Cortex-A725 CPU (released May 2024) delivers 35% greater performance efficiency. Based on InfoQ’s benchmark results for AWS Graviton 2 (Armv8 architecture) and Intel’s x86 CPU, AWS Graviton 2 is overall substantially higher than Intel x86 when running software benchmarks like Docker + Native, where Graviton 2 is 30-40% more cost-effective than Intel x86. For example, when running software such as “cat-sync*50”, Graviton 2 performance per cost is 12.4 and Intel x86 is 21.7, or when running “binary-trees”, Graviton 2 is 12.3 and Intel x86 is 19.3. The significant improvement in Arm’s architecture cost efficiency is important for cloud computing environments, as cloud computing requires high resource efficiency and faster “lightweight runtimes” to optimize performance.
• Energy Efficiency: Arm has better energy efficiency compared to its competitors, which allows for more energy-efficient data centers and smartphones. For example, Arm-based CPU architecture has been implemented in Google Cloud Axion, where there was a “60 percent better energy efficiency compared to legacy competition architectures” to power AI training, or in Oracle Cloud Ampere Altra Max, where its servers use 2.8 times less power compared to traditional competition architectures. To add on, Arm’s latest Armv9 architecture in smartphone CPU provides 25% greater power efficiency compared to its previous-gen, Cortex-A720, which helps with heavy 3D gaming graphics that require better energy efficiency, and the added energy efficiency also helps with day-to-day apps.
• Partnerships: We believe Arm has better architectural licensing and a wide range of partnerships with top customers compared to its competitors, due to better cost and energy efficiency. For example, Arm has partnerships with Google for its Google Cloud Axion, Amazon for its AWS Graviton 4, Microsoft for its Azure Cobalt, Oracle for its Cloud Arm-based Ampere Altra Max as well as Nvidia for its Grace CPU Superchip.

In summary, we believe Arm could continue gaining shares in the CPU market against x86 and other chip architectures supported by the company’s competitive advantages. These include its high-cost efficiency, with the latest Cortex-A725 CPU (Armv9) delivering 35% greater performance efficiency compared to Armv8, and its Arm architecture (e.g., AWS Graviton 2) being 30 to 40% more cost-effective than x86. Additionally, another advantage of the Arm architecture is that it is highly energy-efficient, offering a 60% improvement in energy efficiency over the legacy competition, as noted by Google Axion (Arm), and a 25% increase in energy efficiency with the Cortex-A725 CPU compared to the previous generation. Furthermore, Arm's architecture has been widely adopted by leading companies such as Amazon for its Graviton 4 (which holds a 31% cloud market share), Microsoft (with a 25% cloud market share in Cloud) and Nvidia (the market leader in servers GPUs). Therefore, we believe Arm’s competitive positioning in the CPU could continue to strengthen against x86 and other competition chip architectures.

End Markets Growth Drivers

In our third point, we analyzed the company’s royalty revenues growth outlook based on its end market exposure and determined its key end market growth drivers.

Thus, we compiled the company’s royalty revenue breakdown by end market and analyzed its key end market growth drivers. For FY2023, we estimated the royalty revenue breakdown from the company’s pie chart in the Q2 FY2024 investor presentation. For 2025F, we utilized both our projections and other research sources such as Grand View Research to estimate the forecasted market CAGR.

Source: Grand View Research, Company Data, Khaveen Investments

Based on the table and pie chart above, smartphone end market royalty revenue % increased significantly by 7% from 40% in FY2023 to 47% in FY2024, due to the increasing adoption of its Armv9 architecture from Armv8, within the premium handset segment. In contrast, other end markets such as IoT and Embedded and Consumer Electronics declined by 5% YoY each. Additionally, the smartphone end market represents Arm’s largest end market in both FY2023 and FY2024 as the smartphone semicon market also represents the world's largest semicon market at $104 bln in 2023, followed by personal computing ($89 bln), automotive ($79 bln), and servers and data storage ($78 bln). Moreover, Arm’s Smartphone AP end market is also significantly greater by 27% than the second closest end market, IoT and Embedded in FY2024.

Furthermore, we compiled Arm’s market share based on the end market from its investor presentations below to identify its trend.

Source: Company Data, Khaveen Investments

Based on the above, mobile applications represent Arm’s largest chip value market share, which is significantly higher than the second closest end market, IoT and Embedded consistently averaging 99% for the past 5 years. Other than that, IoT, and Embedded represented Arm’s second-largest chip value market, averaging around 55% for the last 5 years whereas Cloud Compute has doubled over the last 5 years, increasing from 7% in FY2020 to 15% in FY2024 and the other infrastructure segments have seen close to a double increase chip value share, from 9% in FY2020 to 16% in FY2024. Moreover, the company’s market share has been rising in Consumer Electronics, Cloud, Networking, Other Infrastructure, and Automotive. For Consumer Electronics processors, there are also competing architectures such as RISC-V (Reduced Instruction Set Computing 5) and MIPS (Microprocessor without Interlocked Pipeline Stages), whereas for Cloud, there is x86 (AMD’s EPYC) and RISC-V (Scaleway’s Elastic Metal RV1). For Networking, there is MIPS and Power Architecture. For Other Infrastructure, there is Power Architecture and RISC-V (SiFive’s U8-Series). For Mobile Applications and Other Mobile, there are mainly x86, Armv8 and Armv9.

Overall, we believe the company’s end market outlook is positive and derived a weighted average CAGR of 12% based on its revenue exposure of all of its end markets. In particular, we believe the company’s key end markets with a positive outlook include markets in which it has a dominant position such as Mobile (99% market share), Other Mobile (67%), and IoT (54%) and its market share has been fairly stable in these end markets as well, indicating its technology is ingrained in these markets. Moreover, we believe its strong market positioning in these end markets could be supported by its competitive advantages in the second point due to its cost and energy efficiency advantages. For example, IoT devices have high energy efficiency requirements which makes Arm chips suitable due to their energy efficiency. Moreover, we believe the Cloud end market could also be a key growing end market for the company due to the high market growth of 21% as well as its rising market share in the cloud market which we believe could continue rising due to the custom chip developments of major cloud companies such as Amazon, Google, Microsoft and Nvidia.

Risks: Geopolitical Risks on China Business

We believe one of the risks for Arm is its revenue concentration in China amidst current and potential export control imposed on Arm by the US and UK, which might reduce Arm’s revenue if more potential export controls are implemented. For example, based on its FY2024 annual report, Arm highlighted that its “highest performance processor in its Neoverse series meets and exceeds performance thresholds under U.S. and U.K. export control regimes and thereby triggers U.S. and U.K. export license requirements prior to export and delivery to customers in the PRC”. To add on, in 2022, Arm “determined that the US and UK would not approve licenses to export the technology to China” such as its latest Neoverse, as its processor performance was too high, with China accounting for 14% of Arm’s revenue in FY2024.

Verdict

Overall, the company has experienced strong positive revenue growth in both license and royalty segments, which we expect to continue with the rising adoption of Arm could spur further growth in the number of licensees whereas the growth in its customers’ chip shipments and adoption of the v9 Arm architecture could bode well for royalty revenue growth. We believe the company’s competitive advantages could also bolster its market positioning due to factors including cost and energy efficiency and its strong partnership network. We believe these advantages support its dominance in several key end markets such as mobile and IoT where it accounts for the majority of market share and also highlighted its growing presence in high-growth end markets such as cloud and network equipment.

However, in terms of valuation, we chose a comparable valuation based on P/S as we forecasted the company’s growth to be robust with a forward 5-year average of 20.6%. For the P/S ratio, we compiled the average of 16.03x based on semicon companies with a 20%+ CAGR including Nvidia, AMD and Monolithic Power Systems.

Source: Khaveen Investments

Based on the table above, we derived a price target of $126 from an average P/S ratio of 16.09x based on semicon companies with a 20% CAGR (5-year) based on our forecasted revenues in FY2029. Based on our prorated price target, we derived a price target of $133.6 in FY2025 with an upside of -1.46%. Therefore, despite the company’s competitive advantages that we had highlighted and our strong growth outlook for the company at a 5-year forward average of 20.6%, we believe its main drawback is its high market valuation due to its high P/S ratio currently of 38.29x, which is 1.4x higher than the average P/S ratio of 16.03x based on high-growth semicon companies. Therefore, we believe the company’s robust growth outlook is fairly priced based on our valuation model and rate the company as a Hold.