Arm stock might look expensive, but it still has a lot of room for growth.
It might be hard to call Arm Holdings (ARM -5.07%) an overlooked AI stock at this point.
After all, the chip designer trades at a lofty price-to-sales ratio of 50, but that’s not the best way to evaluate the stock.
Arm is highly profitable, generating a 43.6% adjusted operating margin in its fiscal year ended in March. That means that on the more conventional price-to-earnings basis, the stock is still expensive, but more reasonably priced, especially considering its accelerating growth rate and its long-term potential in AI chips.
Less than a year from its IPO last September, Arm stock has tripled, but there are still several reasons for it to keep gaining. Let’s take a look at a few of them.
Image source: Getty Images.
1. Arm’s unique business model means revenue is set to surge
Arm operates differently from most of its semiconductor peers. Rather than selling its chips to end users, Arm designs architecture that it then licenses to chip partners like Nvidia, Apple, and Alphabet.
Additionally, its monetization model is also unique. The company brings in revenue in two ways. First, it generates licensing revenue when it signs new licensing agreements with its partners. However, the bulk of its revenue comes from royalties when its partners actually sell the products built on Arm technology.
Royalty revenue generally lags behind new license agreements by one or two years, which means that Arm should see a boom in royalty revenue over the next couple of years as it’s seen a spike in new license agreements. License revenue jumped 60% in its most recent quarter, driven by surging demand for AI and Arm’s new v9 technology. Its v9 technology also commands a higher royalty rate, which should help drive expanding margins as well.
2. Its competitive advantages are getting stronger
Arm rose to prominence thanks to its power-efficient architecture, which is prized in devices like smartphones where battery efficiency is superlative. That’s why Arm’s designs can be found in 99% of premium smartphones around the world.
However, that efficiency advantage is also proving to be valuable in AI as large language models and other AI programs use enormous amounts of power, making Arm’s architecture especially valuable for data centers.
To meet growing demand for AI components, Arm has also launched compute subsystems (CSS), which are pre-packaged configurations of the company’s technology designed for specific end markets and use cases, opening up another valuable revenue stream that should help it meet the large and growing demand for AI hardware as the business world is racing to deploy its own generative AI models.
3. Guidance looks conservative
Tech companies tend to be conservative with guidance, choosing to give targets that they know are within reach, and Arm seems to be operating with the same playbook.
For example, the company called for revenue growth of 22% in fiscal 2025, which is down from 47% in the fourth quarter, a significant step lower. Based on its recent momentum, Arm should easily be able to beat that — the company looks set to benefit from continued growth in AI and its close relationship with Nvidia, which is leading the AI revolution, as well as the shift from licensing revenue to royalty revenue, which makes up the majority of its revenue.
Wall Street analysts are calling for similar growth, forecasting 24.5% top-line growth this year.
As Arm benefits from the jump in royalty revenue, demand for its new v9 architecture, and the growth of the AI data center, its revenue growth seems likely to top that. As Arm raises its guidance, the stock should move higher as well.
Over the long term, Arm looks well positioned to take advantage as the AI revolution marches on.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Apple, and Nvidia. The Motley Fool has a disclosure policy.