Arm Holdings' (ARM -0.17%) earnings report last week was a bit of a mixed bag. While Arm beat analyst expectations for both revenue and earnings, the chip company's outlook for fiscal 2025 fell a bit short of the consensus estimate. Arm expects to generate revenue of $3.95 billion for the full year, plus or minus $150 million, a hair below the $3.99 billion analysts anticipated.
Arm stock initially tumbled following the earnings report, but it rebounded in the following days. While the company's outlook didn't blow investors away, there was a lot to like about Arm's results. Revenue surged 47% year over year thanks to strong royalty and licensing growth. Free cash flow increased nearly as fast.
Arm's growth in fiscal 2025 will slow compared to the latest quarter. The midpoint of Arm's revenue-guidance range calls for growth of 22% from fiscal 2024. The timing and unpredictability of licensing deals is a wildcard that can swing revenue up or down. In the long run, Arm expects royalty revenue from devices shipping with Arm-based chips to drive the lion's share of its growth.
Is Arm stock a buy after a mostly solid earnings report? There's one good reason to invest in the stock and one equally good reason to stay away.
Reason to buy: Just getting started in the data center
Arm-based chips are prolific in the smartphone, IoT, and embedded markets. In the data center, attempts to chip away at the dominance of Intel, AMD, and the x86 architecture have largely come up short in the past. This situation is finally starting to change.
Major cloud-computing companies have long designed their own chips. Amazon Web Services and Alphabet's Google, for example, have been using custom AI chips in their data centers for years. What's new is the cloud giants' willingness to design custom server central processing units (CPUs).
Amazon is already on the fourth generation of its Graviton Arm-based server CPU, and other cloud giants are now following suit. Microsoft is designing custom AI chips and server CPUs based on Arm technology; Google is installing its new Arm-based Axion server CPUs into its data centers for cloud customers; and Apple is reportedly aiming to add custom chips similar to those used in its Mac computers to its data centers to power AI workloads. Beyond the cloud giants, chip start-up Ampere is pushing Arm-based server CPUs for the masses.
Data-center chips won't be as high-volume as smartphone chips for Arm, but royalty rates are based on the value of the chip, and server CPUs can be orders of magnitude pricier. Royalty rates vary per customer and chip type, but if Arm-based server chips take off, Arm should be generating a significant amount of revenue from a market where it's been largely absent for most of its history.
Reason to stay away: Priced for perfection
While the data-center opportunity can drive solid revenue growth for Arm for years to come, the stock price already reflects the expectation of incredible growth.
Arm is valued at roughly $114 billion. The company generated a free cash flow of $907 million in fiscal 2024. That puts the price-to-free-cash-flow (P/FCF) ratio at a princely 125.
Profit and free cash flow could grow much faster than revenue as high-value data-center chips become a larger part of Arm's business. However, the free-cash-flow margin is already quite high at 28%. That percentage could certainly increase over time, but a sky-high valuation already bakes in substantial earnings and free-cash-flow growth.
Is Arm stock a buy?
Arm is in an enviable position in the chip industry. Its technology and intellectual property have a monopoly in the smartphone market, and all of the custom chip activity occurring at the cloud giants use the Arm architecture. Annual revenue growth exceeding 20% for the foreseeable future is realistic.
While Arm's long-term growth prospects are compelling, the valuation leaves little room for error. If Arm-based server CPUs don't take off quite as quickly as expected, the stock could be in for a major correction.
For long-term investors comfortable with volatility, Arm stock could be a solid bet. But for those unwilling to pay a huge premium, there are better options.
