Shares of the leading chip designer on Thursday Arm holds (ARM 1.16%) soared 48% after the company released a strong third-quarter fiscal 2024 report the previous afternoon. For the period ended December 31, 2023, growth was driven by adoption robust use of artificial intelligence (AI) in end markets. with a rebound in the smartphone market.
As a reminder, the UK-based company completed its IPO in September 2023. Its main business involves licensing its intellectual property (IP) related to the design of central processing unit (CPU) chips as well as on associated software and tools.
For the fiscal third quarter, Arm's revenue rose 14% year over year to $824 million, crushing Wall Street expectations of 5% growth. Adjusted earnings per share jumped 32% to $0.29, beating analysts' consensus estimate of 14% growth. Additionally, management forecast fourth-quarter revenue growth of 34% to 42% year-over-year and adjusted net income growth of 1,300% to 1,500%. Both prospects far exceeded street projections.
Results publications only tell part of the story. Below are two key takeaways from Arm's third-quarter tax appeal that you should know about.
1. Benefit from a virtuous circle
According to remarks from CEO René Haas:
Arm is the most fundamental, foundational, and ubiquitous computing platform in the history of digital design. More than 280 billion units [based on Arm IP] aged 30 and over [the company was founded in 1990] that Arm was a company that was built. And that supported a software ecosystem and a hardware ecosystem like no other. And because a processor's design is truly driven by hardware and software, it creates a flywheel for continued development.
Arm has a great business model for several reasons. One of the main ones is that the company benefits from a virtuous circle. The more hardware that is built using Arm IP, the more software is written for Arm. And the more software that is written for Arm, the more popular hardware based on its IP becomes, because that hardware has more or better applications and features. And so on.
This virtuous cycle is an important factor in Arm's hardware and software ecosystem becoming the world's largest open computing system.
2. Benefit greatly from the transition of its customers from its v8 to v9 architecture
First, a note on royalties: Arm licenses its intellectual property, and a few of these licenses generate royalties for the company. Thus, the company's revenue comes from both licenses and royalties.
Excerpt from CFO Jason Child's remarks:
The sequential growth in royalty revenues mainly comes from the increasing penetration of Armv9, where royalty rates are, on average, at least double the rates of equivalent Armv8 products. Additionally, we're seeing an increasing amount of Arm technology deployed in chips. And as the amount of Arm technology in chips increases, so does the royalty rate. [Emphasis mine]
Let's forget the second part of Child's comment for a moment and just focus on the bolded first part. On average, Arm's royalty rates for products that use its latest chip architecture, Armv9, are at least double those of equivalent products using its earlier architecture. This represents an increase of at least 100% in a single generation! The main reason for this huge leap forward is AI, which requires chips with significantly enhanced computing capabilities, whether they are chips installed in cloud servers, smartphones, automobiles or elsewhere.
Arm's v9 architecture, introduced in early 2021, accounted for 15% of the company's total royalties in the fiscal third quarter, up from 10% in the previous quarter, according to CEO Haas, who said on the call that he saw this growth “accelerate” as customers continue to upgrade to the v9 license.
Where is the company in this upgrade cycle? It depends on the end market. Almost all high-end smartphones have moved to version 9-based processors, with Arm expecting the entire market to upgrade over the next three to four years. Its other markets have been slower to evolve because they don't update their products as often as the smartphone market. So overall, Arm still has a nice runway for growth from this upgrade cycle.
The second part of Child's comment seems self-explanatory. Beyond the fact that Arm benefits from higher royalty rates as customers move to its new architecture, it also benefits from higher rates when customers use more of its technology in their products.
Beth McKenna has no position in any of the stocks mentioned. The Motley Fool has no position in any of the securities mentioned. The Motley Fool has a disclosure policy.