Arm FQ2 24 – Pretty plain sailing

The next 2-3 years look pretty good.

• Arm reported good results but the variation in the timing of deals closing being recognised as revenue meant that guidance for the next quarter was a little bit lower than had been forecast.
• FQ3 revenues / Adj-EPS were $806m / $0.36 which was nicely ahead of expectations of $740m / $0.26 as licensing and other revenues more than offset softness in royalties.
• Licensing revenues grew by 106% YoY to $388m which was attributed to the increase in investments being made by clients who are designing chips to run AI algorithms on devices and in the cloud.
• This was offset by a 5% YoY decline in royalty revenues as a result of the ongoing softness in the smartphone market giving 28% YoY growth in revenues overall.
• Although Arm’s visibility over a 12-month period is pretty good, it is more difficult to work out when specific deals will close which makes forecasting on a 3-month basis more difficult.
• This is why FQ3 revenues missed expectations coming in at $720m – $800m ($760m) 1.6% below forecasts of $773m.
• However, FQ4 will be stronger meaning that the forecast for FY2024 revenues is ahead of expectations coming in at $2.96bn – $3.08bn ($3.02bn) compared to estimates of $2.96bn.
• It is also worth noting that the forecasted range for FY2024 is 4% from low to high while FQ3 24 is 11% reflecting that this is more about timing than any weakness in the market or market share loss.
• However, the fickle market doesn’t care as all it sees is a miss against expectations of a highly-priced stock and sends the shares down accordingly.
• The outlook for FY2025 is also fairly good as revenues are expected to grow by 22% to $3.69m where 20% of those revenues are already in the order book and where there are other factors in play.
• One of these is the migration of the customer base from v8 to v9 which is ongoing and should continue for a while where v9 carries higher royalty rates resulting in both higher prices and higher margins.
• Here the company is comfortable that it can leverage scale to get back to 60% non-GAAP operating margins over the course of the next few years.
• This effect was demonstrated in FQ2 24 where non-GAAP operating margins expanded to 47.1% up from 31.4% in FQ2 23 and Arm thinks it can keep that going in FY2024 and FY2025.
• While RISC-V remains a risk to Arm in the long-term with Google and Qualcomm looking to develop more advanced chips, this remains at a very early stage meaning that there is very unlikely to be a RISC-V smartphone chip anytime in the next 2-3 years.
• RISC-V doesn’t necessarily mean that Arm will lose share, but it would certainly add weight to a customer’s argument that it should have a lower royalty rate at contract negotiation time.
• This combined with any move by China to become self-sufficient in processor designs remains quite far away giving a pretty good medium-term outlook.
• This is what supports the valuation which does remain high at 13.7x FY2025 EV/Sales and FY2025 PER of 38.2x but becomes more reasonable as one looks forward.
• Arm is trading not far off the multiples as Nvidia which is on 14.2x 2024 EV/Sales with a 2024 PER of 27.3x but if the AI bubble bursts in 2024, there is risk to Nvidia’s 2024 EPS estimate of $17.00.
• This risk is lower for Arm given its greater diversity.
• The main challenge for Arm here is to grow into the valuation that it has achieved at IPO, and it looks like it has a couple of good years ahead where it will be largely untroubled by competitive threats.
• The best-case scenario would be a settlement of its contract dispute with Qualcomm which remains one of its biggest customers as then it would be free to talk much more about Windows on Arm.
• Qualcomm’s X Elite CPU has put up some really good performance numbers compared to both Intel and Apple and as long as Microsoft gets the software transition right, there is a very good chance that Qualcomm will gain share in laptops from Intel taking Arm with it properly into that segment for the first time.
• Although the unit shipment numbers are much smaller than smartphones, the chip prices are much higher meaning that revenues for both Qualcomm and Arm will be meaningful.
• None of this is factored into the forecasts or valuation of Qualcomm (or Arm) which even after the recent rally is trading at 12.9x FY2024 PER.
• This multiple tells me that the market thinks that Qualcomm is simply a smartphone chip company and is giving it no credit for any of the other segments that it has signalled its intention to address.
• Given that Qualcomm is trading at less than half the multiple of Arm, the risk-reward balance of Qualcomm shares looks particularly attractive to me.
• Arm has a lot of work to do to justify where it is trading but the next two years look good enough to give the shares a chance to do well.
• I continue to have a position in Qualcomm.