At this point, it might be a stretch to call Arm Holdings (NASDAQ: ARM ) an overlooked AI stock.
After all, the chip design company’s shares are trading at a lofty price-to-earnings multiple of 50, which isn’t the best way to value a stock.
Arm is highly profitable, with adjusted operating margins of 43.6% in the March quarter, which means that while its shares are still expensive on a traditional price-to-earnings basis, they’re more reasonably priced, especially given the company’s accelerating growth rate and the long-term potential of its AI chips.
Less than a year after its IPO last September, Arm shares have tripled, and there are several reasons why the company will continue to rise. Let’s take a look at some of them.
Image source: Getty Images.
1. Arm’s unique business model is expected to drive revenue growth
Arm operates differently from other semiconductor companies: Rather than selling chips to end users, Arm designs architectures and licenses them to chip partners such as Nvidia, Apple and Alphabet.
Additionally, the company’s monetization model is unique: the company makes money in two ways. First, it earns licensing revenue when it signs new license agreements with partners. However, the majority of its revenue comes from royalties it earns when its partners actually sell products built on Arm technology.
Royalty revenues typically lag new license deals by one to two years, so Arm should see a surge in royalty revenues over the next few years as new license deals surge. In the most recent quarter, license revenues increased 60% due to increased demand for AI and Arm’s new v9 technology, which also has higher royalty rates, which should also lead to wider margins.
2. Competitive advantage is growing
Arm has risen to prominence due to its power-efficient architectures that are prized in devices like smartphones where battery efficiency is paramount, which is why Arm designs are found in 99% of premium smartphones around the world.
But its efficiency benefits are also proving valuable for AI, as large language models and other AI programs consume huge amounts of power, making Arm’s architecture especially valuable for data centers.
To meet the growing demand for AI components, Arm has also released Compute Subsystems (CSSs), packaged configurations of its technologies designed for specific end markets and use cases, opening up valuable new revenue streams to help meet the massively growing demand for AI hardware as the business world races to deploy its own generative AI models.
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3. Guidance is conservative
Technology companies tend to be conservative with their guidance, choosing to set goals they know are achievable, and Arm appears to be operating with a similar strategy.
For example, the company expects revenue growth of 22% in fiscal 2025, down significantly from 47% in the fourth quarter. Arm should be able to beat that figure easily, judging by its recent momentum. The company should benefit from continued growth in AI, its close relationship with NVIDIA, which is leading the AI revolution, and a shift from licensing revenue to royalties, which now accounts for the majority of Arm’s revenue.
Wall Street analysts are expecting similar growth, predicting sales will rise 24.5% this year.
Revenue growth seems likely to outpace this as Arm benefits from surging royalty revenue, demand for its new v9 architecture, and growth in AI data centers. As Arm raises its guidance, the stock price should rise as well.
In the long term, Arm looks well-positioned as the AI revolution progresses.
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Suzanne Frey, an executive at Alphabet, serves on The Motley Fool’s board of directors. Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet, Apple, and Nvidia. The Motley Fool has a disclosure policy.
Opinion: These are the most overlooked artificial intelligence (AI) stocks to buy right now. This was originally published by The Motley Fool.
