Arm Holdings (NASDAQ: ARM) often seems misunderstood by the stock market. The company has a unique business model as it licenses its CPU designs and then earns royalty revenue when the products with those designs are sold.
That misunderstanding has manifested itself in the response to its earnings reports. For instance, the stock initially fell on Wednesday after it reported earnings, but then climbed in regular trading on Thursday. There were some valid reasons for the initial sell-off. Investors are spooked about declining production in the smartphone sector, which makes up Arm’s biggest source of royalty revenue, due to the memory shortage.
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However, Arm has less exposure to weakness in the smartphone sector than it might seem since partners like Mediatek are cutting production of lower-end chips, which provide much less royalty revenue to Arm than its newer designs do.
Additionally, the stock is expensive, trading at a price-to-earnings ratio of roughly 60 based on adjusted earnings per share, meaning high expectations are baked in.
Arm is delivering solid growth with revenue up 26% in the third quarter, but it doesn’t have the explosive numbers that other AI stocks like Nvidia do. Still, despite a methodical business model tied to licensing and royalty revenue, Arm could have more growth potential than you think.
Arm’s business model produces gross margins near 100% so its biggest line item is often research and development. Spending on research and development jumped 46% on a non-GAAP basis to $512 million, and that ramp seems to reflect the increasing opportunity in front of the company.
In an interview with The Motley Fool, Arm CFO Jason Child said, “We’re spending a lot of time and money on continuing to build out new solutions” in areas like edge AI, putting AI into consumer devices like smartphones, and physical AI, designing products for applications like robotics and self-driving cars.
Arm expects its research and development spending to outpace revenue growth for at least the next few quarters, but that investment is likely to pay off as the company currently earns much higher royalty rates from its newer products than it does from older ones. Presumably, the products it’s working on now will generate even higher royalty rates and license fees.
The company is now seeing growth take off in the data center, where revenue more than doubled on a year-over-year basis, which also reflects its growth potential. The company expects to have 50% of the CPU market share among the top hyperscalers by the end of the year, showing its growing market share in a massive market, and it expects it to keep growing.