ARM Crushes Earnings, But Investors Wanted More: Here is Why

Short Summary:

ARM crushed earnings expectations for its fiscal Q1 2024, but the British chip giant's stock slipped after the results as some investors had hoped for even bigger beats amid accelerating AI demand.

While ARM's 21% year-over-year revenue growth to $928 million surpassed expectations, the market reaction highlights the lofty expectations surrounding the company's prospects in artificial intelligence (AI) and data center computing applications. ARM's Q2 and full-year guidance also appeared to disappoint some bulls looking for more aggressive targets.

The mixed market response underscores the challenges ARM faces in meeting heightened investor enthusiasm, despite the company's strong market position and growth drivers. Let's take a closer look at the key takeaways from ARM's latest report:

Royalties and Licensing Drive Upside

ARM reported royalty revenue of $514 million for the quarter, up an impressive 37% from the prior year. This reflected continued demand for ARM's power-efficient chip designs across smartphones, PCs, data centers, and other computing devices.

Licensing revenue was even stronger at $414 million, increasing 60% year-over-year. ARM noted this jump was driven by "a number of valuable licensing agreements" for AI applications. As AI workloads proliferate across the tech ecosystem, ARM's energy-efficient architectures are increasingly being tapped by chip developers.

Guidance Tempers Expectations

For Q2 2024, ARM forecasts revenue between $875 million and $925 million, with adjusted EPS of $0.32 to $0.36. While representing continued growth, this outlook was slightly below the $866 million in revenue and $0.31 EPS that analysts were modeling.

ARM's full-year guidance of $3.8 billion to $4.1 billion in revenue and adjusted EPS of $1.45 to $1.65 was also marginally under consensus estimates of $3.97 billion and $1.54, respectively.

The somewhat muted guidance likely sparked the selloff in ARM shares after the report. Investors may have been hoping for more aggressive targets to reflect accelerating AI-driven demand tailwinds.

Bright Outlook Driven by Multiple Growth Drivers

Despite the Q1 stock reaction, most analysts remain bullish on ARM's prospects given the company's key role in enabling advanced AI, data center, and computing workloads:

AI Inflection: ARM highlighted design wins for AI chips during the quarter, benefitting from increasingly AI-optimized architectures. Bank of America sees ARM as a prime beneficiary of AI adoption, projecting a revenue opportunity of $2.5 billion to $3 billion by 2026 just from AI alone.

Royalty Growth: As ARM's latest chip architectures gain traction, the company should realize significantly higher royalty rates per chip shipped. BofA estimates around 20% of current royalties are from the AI-enhanced ARMv9 architecture, up from just 5% last quarter.

Expanding Addressable Market: ARM is pursuing an aggressive roadmap to extend its low-power architectures into new markets like data center CPUs, automotive, and networking chips. This should drive higher unit shipments and revenue for ARM's IP.

Compelling Valuation: Bank of America reiterated its $150 price target on ARM shares, implying 41% upside from current levels. With the post-earnings selloff, ARM trades at around 36x forward earnings, an attractive multiple given projected 20%+ annual EPS growth.

Investment Risks

While the bull case on ARM is compelling, investors should also weigh some key risks: China Exposure: ARM notes over 15% of its revenue comes from China engagements. Geopolitical tensions or export restrictions could potentially impact this key region for growth.

Competitive Landscape: While ARM is dominant in mobile chips, it faces stronger competition in areas like data center CPUs from incumbents like AMD and Intel's x86 architectures. An protracted fight for market share could pressure growth and margins.

Limited Trading Float: With SoftBank still holding over 90% of outstanding ARM shares, the limited float could periodically result in higher volatility around events like earnings releases.

Well-Positioned for Powerful Secular Trends

ARM's Q1 demonstrated continued momentum, but the market reaction showed high expectations already baked into the share price. However, most analysts view the company as a premier growth play on transformative technology trends like AI, edge computing, IoT, and data center acceleration.

With a robust royalty model, expanding total addressable market, and strong free cash flow generation, ARM looks well-positioned to continue compounding growth for years to come. Investors may want to take advantage of any excessive weakness in ARM to build a position in this secular chip winner.

ARM Stock Analysis

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