da-kuk/E+ via Getty Images Expensive stock keeps rising Arm Holdings (NASDAQ:ARM) had a great Q4 quarter and fiscal 2024. The company’s revenue reached $928 million, a 47% YoY increase, driven by strong v9 chip adoption and semiconductor recovery. Gross margin for the quarter was 97% and non-GAAP operating margin stood at 42%, in line with company guidance and market expectations. The stock was already up 100% from its IPO price before earnings. After the earnings, the stock continued to rise, and appreciated another 50%. It has now returned 200% since its IPO, making it one of the best performing stocks in the market (see below). ARM price performance (Seeking Alpha) As the stock continues to rise, many SA analysts have turned bearish, rating it a ‘Sell’ due to overvaluation concerns. However, the market remains bullish, driving the stock price even higher. This situation has caught our attention, so we decided to take a closer look. We wanted to see what the market was pricing in and check if expectations were aligned with reality or not. We examined ARM’s long-term growth prospects to understand if its high valuation could be justified. The result of our analysis is that Arm’s growth drivers and market position are among the strongest in the industry. The company dominates the mobile and IoT markets and is rapidly gaining market share in datacenters, PCs, and automotive sectors. With limited competition on the horizon, we think that ARM is positioned to become the dominant global computing platform in a few years. The company is on an accelerated growth path, and this is likely what the market is pricing in today. The Semi Market Recovery Will Fuel Royalty Fees The reason we want to look at the semi market is that ARM has more than 50% share of the global chip market. The semi sales trends give us a good indication of ARM’s royalty revenue. After an 8% decline in 2023, the global semiconductor industry has started to recover. According to the SIA, in Q4 2023, semi sales turned positive with 12% YoY growth, and achieved 15% YoY growth in Q1 2024 (see below chart). ARM’s royalty revenue has closely tracked global semi sales, with both declining in FY23 and recovering in the last quarter of 2023. In Q1, semi growth was 15%, while ARM revenue increased 37%. Due to its multiplier effect (more CPUs per chip and higher v9 royalty fees), the company is able to grow much faster than the semi industry. Semi revenue YoY% vs ARM Royalty revenue (Author) SIA expects the strong trend to continue throughout 2024 and 2025. It is sizing the market at $611 billion and projecting 16% growth in 2024 and 12.5% in 2025 (see below). Global semiconductor forecast (SIA) Due to the favorable semi market conditions, the company anticipates royalty revenue to grow by approximately 20% this year. However, we see significant upside potential for royalty revenue due to its compounding effect. ARM Taking Over The Cloud Datacenter ARM’s CPUs are rapidly gaining traction in the datacenter segment. Lower power consumption and high-core density features of Arm CPUs are appealing to cloud service providers. As of 2022, the company had a 10% share of the cloud computing market, and it is expected to grow its share to 22% in 2025. The main driver for this growth is the demand for custom silicon. ARM has a special custom silicon program which is called Compute Subsystem (CSS) and enables companies like Microsoft, Amazon and Google to design and manufacture custom Arm-based chips. This program allows the company to capture more of the value chain and increases its revenue per unit (bypassing chip manufacturers as well) In terms of CSS program progress, Amazon’s Graviton 4 Arm chip was announced last year and Nvidia announced that its Arm-based CPU Grace will be part of the Blackwell superchip. Google announced Axion, their first Arm-based chips for GCP workloads and Microsoft has recently announced its Azure VM series running on its own Cobalt 100 Arm-based processor. This custom silicon trend is expected to continue, as the company increases its market share in the datacenter. From the Q4 earnings call: Rene Haas (CEO): I think now with NVIDIA’s most recent announcement, Grace Blackwell, you are going to see an acceleration of ARM of the data center in these AI applications. One of the benefits that you get in terms of designing a chip such as Grace Blackwell is by integrating the ARM CPU with the NVIDIA GPU, you’re able to get an interconnect between the CPU and the GPU that allows for a much higher access to memory, which is one of the limiting factors is for training and inference applications. In a conventional system where you might connect to an X86 externally, you have to do that over a PCI bus, which is much slower. So by using a custom bus in the NVIDIA example like NVLink, you get much higher memory bandwidth. The Windows On ARM Opportunity The AI PC is going to revolutionize the PC market, and Arm seems to be the ideal platform for it. The company has key advantages due to its low-power usage, lightweight design and speed. The company already powers all Mac PCs, which has 15% PC market share. Arm is now pushing for Windows on Arm together with Microsoft and several OEMs. Microsoft recently launched its Arm-based Copilot PCs in partnership with Acer, ASUS, Dell, HP, Lenovo and Samsung (all powered by Qualcomm’s Snapdragon X processor). Arm CEO Rene Haas is predicting that the company can capture over 50% of the Windows PC market within five years. According to IDC, PC shipments are projected to reach 420 million units by 2028, with Windows holding a 74% market share. This presents a significant TAM opportunity for ARM, equivalent to approximately 310 million devices (see below). IDC PC market growth (IDC) Historically, ARM received relatively low royalty fees for its Armv8 and older chips on Mac devices. However, with the introduction of Armv9, it is now charging higher royalty rates. As Windows Copilot PCs will be based on Arm v9, we anticipate Windows on ARM to become a significant growth driver for the company in the coming years. Note: There is currently a lawsuit between ARM and Qualcomm (QCOM), where ARM is suing Qualcomm for breach of licensing agreement related to Qualcomm’s acquisition of chip design company Nuvia. This ongoing legal issue has led Arm to request all the Snapdragon-based Windows PC shipments to be halted. Currently, Qualcomm is the exclusive provider of Arm CPU’s for Windows PCs, but this exclusivity will expire in 2025. At that point, other chip companies will be able to manufacture Arm chips for Windows PCs. The Automotive Opportunity ARM has a diverse growth strategy. The company is not only expanding its offerings with higher-value services such as ATA (Arm Total Access) and CSS programs (compute sub system), but also broadening its portfolio with verticalized offerings in order to target high-growth markets like automotive and industrial IoT. The Automotive segment is one of ARM’s fastest-growing areas, driven by the increasing demand for autonomous and connected vehicles. The company has launched many new products, which will drive accelerated demand in the next several years. The automotive segment also has higher royalty fees compared to smartphones and IoT devices, resulting in a higher growth multiplier for the company. In FY 2023, revenue from the automotive segment was approximately $200 million, and we expect this figure to grow significantly as the autonomous car industry accelerates. By FY 2029, we anticipate auto revenue to reach $3 billion (see below). Automotive revenue mode (Author) Valuation ARM is one of the most expensive stocks in the market, trading at very high valuations, with a sales multiple of 41 and an earnings multiple of 101. Management is guiding for 17% – 27% growth in FY2025, and 20%+ growth in the longer term, which still doesn’t justify the high multiples (see below). ARM Valuation metrics (Author) Interestingly, the market is also ignoring analysts’ forecasts, which are quite modest, as shown below. ARM analysts’ consensus (Seeking Alpha) We think that the market is pricing ARM at such a high premium due to its unique and dominant position. With limited competition and multiple growth levers, it has a very significant upside potential, which the market is already factoring. To understand the upside potential, we have modeled Arm’s potential revenue for the next five years. Our model projects a 37% CAGR until FY2029. We project 30% growth in FY2025 due to the semi recovery and accelerated Armv9 transition. Beyond FY2026, we anticipate multiple growth levers to kick in, including Windows on Arm, cloud, AI and automotive, creating an accelerated growth path for the company (see below). ARM Revenue model FY 2029 (Author) Our model projects Arm’s mobile segment to grow at 9% CAGR over the next five years, outpacing the 2.4% CAGR forecasted by IDC for the mobile market. The primary driver of this growth is the ongoing ARMv9 transition, which has double the royalty fees of v8 and still has approximately 50% adoption to go (see below). Additionally, the Apple phone refresh cycle is expected to accelerate, driven by the Apple’s AI announcements at WDC last week. Some analysts anticipate a 10% increase in iPhone sales in 2025, which could also boost the company’s royalty fees. Arm v9 transition (ARM) ARM’s cloud segment is its fastest-growing, driven by strong demand from hyperscalers and chipmakers. The hyper-scaler compute market is growing at 23% CAGR, and the company is winning share in this rapidly growing market. In FY 2023, ARM’s cloud revenue was approximately $300 million, equivalent to 10% market share (see below). Analysts predict that ARM’s market share will reach 22% by 2025. Our estimation is that ARM will achieve 30% cloud market share by FY 2029, generating $5.4 billion revenue. ARM Market share (ARM) Driven by the Windows on ARM push, we expect Arm’s PC market share to reach 60%, with Windows accounting for 45% and macOS 15%, respectively. We project a 75% CAGR over the next 5 years, resulting in $3 billion PC Arm revenue by FY 2029. In the automotive sector, we estimate ARM’s market share will increase from 42% in FY 2023 to at least 60% by FY 2029, equivalent to $3 billion revenue. For IoT we estimate a 15% CAGR, aligned with the global IoT market growth. In conclusion, we believe the company has the potential to reach $15 billion revenue by FY 2029. We want to do a forward sales multiple valuation based on the $15 billion projected revenue for FY 2029. We are assuming a 37% CAGR and assigning a forward sales multiple of 15 due to high growth. Based on a discount rate of 8%, our price target is $154, which suggests that the stock is currently fairly valued considering its high growth potential. ARM Valuation model (Author) Risks The main risk for ARM is the RISC-V platform. RISC-V is an open-source competitor to Arm and is supported by major technology companies like Google, Nvidia, and Qualcomm. RISC-V is gaining popularity in the industry, but we don’t think it can be a significant threat to Arm. Arm has an overwhelming dominance in the market due to its diversified portfolio, its broad ecosystem and advanced R&D capabilities. For more than 30 years, the company has built a vast ecosystem of partners and customers. This ecosystem is critical to Arm’s success, and it would be very difficult for RISC-V to replicate it. Conclusion We believe that Arm is a special company and has key attributes that no other company has. The company brings innovation to the industry, is benefiting from all the major secular trends, has multiple growth levers and is gaining rapid market share across major end-markets. Due to its unique market position, the company is ready to capitalize on large AI opportunities. Our analysis shows that ARM has the potential to reach $15 billion revenue by FY 2029, which is twice the current consensus. However, our valuation model suggests the market has already priced in this growth potential, as the stock is currently trading close to our target price. But we also recognize that companies like ARM are not easy to valuate, as they have multiple secular growth drivers and are at the center of an ongoing AI-driven paradigm shift. This complexity makes it difficult to accurately assess the company’s future performance. Therefore, we recommend taking advantage of any price weakness or market correction to invest in the stock, as its potential upside outweighs the valuation uncertainty.
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