ARM: AI faith, can it support a hundredfold valuation?

ARM (ARM.O) released its fiscal year 2025 second quarter report (ending September 2024) after U.S. stock market hours on November 7, 2024, Beijing time. The key points are as follows:

1. Overall Performance: Revenue & Profit both meet market expectations. ARM achieved revenue of $844 million in the second quarter of fiscal year 2025 (i.e., 24Q3), a year-on-year increase of 4.7%, slightly better than market expectations ($810 million). The growth in revenue this quarter was mainly driven by the rapid growth of the royalty business; the company's gross margin this quarter was 96.2%, an increase of 1.9 percentage points year-on-year, in line with market expectations (96.3%), maintaining above 96%.

2. Business Segmentation: Royalty business hits a new high. Although the company's licensing revenue declined this quarter, the total number of customers for $Arm(ARM.US) continues to increase, with annual and unfulfilled contracts still growing. The royalty licensing business was the main contributor this quarter, primarily due to a 40% year-on-year increase in revenue from mobile customers, far better than the single-digit growth in global mobile market shipments. In addition, the company's share in the automotive and cloud services sectors continued to rise this quarter.

3. ARM's Performance Guidance: For the third quarter of fiscal year 2025 (i.e., 24Q4), expected revenue is $920 million to $970 million (market expectation $951 million) and adjusted profit is expected to be $0.32 to $0.36 per share (market expectation $0.34).

Overall View of Dolphin: ARM's financial report this time is quite good.

The company's revenue and profit both met market expectations this quarter. The growth in revenue this quarter mainly came from the increase in the company's royalty business revenue, with royalty revenue from mobile devices increasing by 40% year-on-year. Although licensing revenue declined this quarter, annual and unfulfilled contracts continue to grow, influenced by the timing of revenue recognition this quarter.

Combining the company's guidance for the next quarter, both revenue and profit performance are in line with market expectations. Revenue is expected to rebound significantly quarter-on-quarter, consistent with annual contract data, and revenue recognition will occur later. In addition, through collaborations with major companies like NVIDIA, Microsoft, and Google, the company's share in the AI and cloud services market continues to grow.

Regarding the company's performance, due to its extremely high gross margin of 96%, there is limited room for improvement in gross margin. Currently, the company's R&D expense ratio and sales and management expense ratio combined have long maintained above 70%, which directly squeezes the company's profits. The company itself is relatively asset-light, so the key to improving performance lies in expanding revenue scale and reducing operating expenses.

Due to the high-tech nature of the company, it continues to expand the scale of its related R&D personnel. The number of engineers in the company has increased from less than 5,000 before going public to 6,429 today, which also makes the current R&D expenses relatively rigid. The company's main focus remains on expanding revenue and forming economies of scale to absorb the growth in expenses. From this financial report, it can be seen that the company is on the right path of expansion. The number of licensed customers and related orders has been growing this quarter, and the market share in the royalty business continues to increase. Considering the company's full-year revenue expectations, although the revenue data for this quarter is somewhat weak, Dolphin expects that the next two quarters will see a sequential increase (USD 950 million / USD 1.22 billion), with the revenue for the last quarter of this fiscal year reaching a new high of USD 1.2 billion.

Although the company's business outlook continues to improve, with revenue expected to achieve over 20% growth, the current market corresponds to the company's profit for this fiscal year at over 100 times. This high valuation already incorporates the market's optimistic expectations for AI and the company's business. As long as the company's performance, the AI industry chain, and the funding situation continue to improve, it can still support market confidence. However, if there is a deterioration in related business areas, the company's high valuation will also face corresponding pressure.

Here is Dolphin's specific analysis of ARM:

1. Overall Performance: Revenue & Profit both meet market expectations

1.1 Revenue

ARM achieved revenue of USD 844 million in the second quarter of fiscal year 2025 (i.e., 24Q3), an increase of 4.7% year-on-year, slightly better than market expectations (USD 810 million). The company's revenue continued to increase this quarter, although the licensing business saw a decline, the company still benefited from the rapid growth of its royalty business.

1.2 Gross Profit

ARM achieved a gross profit of USD 812 million in the second quarter of fiscal year 2025 (i.e., 24Q3), a year-on-year increase of 6.8%. The year-on-year growth rate of gross profit slightly exceeded that of revenue.

ARM's gross margin for this quarter was 96.2%, an increase of 1.9 percentage points year-on-year, better than market expectations (95.9%). Driven by the continuous growth of royalty income and economies of scale, the company's gross margin continues to improve, reaching over 96% for two consecutive quarters. In addition, the revenue share of Armv9 in this quarter has increased to 25%.

1.3 Operating Expenses

ARM's operating expenses in the second quarter of fiscal year 2025 (i.e., 24Q3) were USD 724 million, a year-on-year increase of 35.8%. The company maintains high investment and continues to expand the scale of its R&D personnel.

Specific cost situation, broken down as follows:

1) R&D expenses: The company's R&D expenses for this quarter were $507 million, a year-on-year decline of 19%. The year-on-year decline is mainly due to stock compensation and other expenses for relevant personnel in the same period last year. The number of engineers in the company continued to grow to 6,429 this quarter, and R&D investment slightly increased quarter-on-quarter.

2) Sales and management expenses: The company's sales and management expenses for this quarter were $241 million, a year-on-year decline of 17%. Sales and related expenses remained stable quarter-on-quarter.

1.4 Net profit

ARM achieved a net profit of $107 million in the second quarter of fiscal year 2025 (i.e., 24Q3), turning a profit year-on-year, in line with market expectations ($107 million). The net profit margin for this quarter was 12.7%.

If we look solely at the operating situation, the company's operating profit increased to $64 million quarter-on-quarter, turning positive year-on-year. Although ARM has a very high gross margin, most of the company's expenses are directed towards R&D and other costs. Even with a 96% gross margin, nearly 60% of the R&D expense ratio directly squeezes the company's final profit.

Currently, the company's gross margin does not have much room for improvement; the company mainly aims to expand revenue scale, generate economies of scale, thereby reducing the proportion of operating expenses, and ultimately achieve profit growth.

2. Business Segmentation: Royalty Income Hits New Highs

From ARM's segmented business situation, the licensing and royalty businesses for this quarter are nearly 55-45. The company's business is currently mainly benefiting from the demand driven by AI, and with the continuous growth of royalty income, the current revenue proportion has increased to 60.9%, while the licensing business accounts for 39.1%.

2.1 Licensing Business

ARM's licensing business achieved revenue of $330 million in the second quarter of fiscal year 2025 (i.e., 24Q3), a year-on-year decline of 14.9%. In this financial report, both the annual contract value and the unfulfilled portion increased quarter-on-quarter, indicating that the company's licensing business is still on the rise. The decline this quarter was mainly affected by quarterly revenue recognition.

The number of full license customers and flexible license customers both increased this quarter. The number of full license customers increased to 39, while the number of flexible license customers grew to 269, indicating a continuous rise in the overall number of customers

2.2 Royalty Business

ARM's royalty licensing business achieved revenue of $514 million in the second quarter of fiscal year 2025 (i.e., 24Q3), a year-on-year increase of 23%. The growth in royalty licensing business is mainly attributed to contributions from smartphones.

In this quarter, smartphone royalty revenue grew approximately 40% year-on-year, significantly exceeding the single-digit growth in smartphone shipments, primarily due to the increased share of Armv9-based processors and higher royalty rates. The company's market share in the automotive and cloud service provider sectors is also continuously increasing. The current revenue share from the Armv9 architecture has risen to 25%, significantly higher than 10% in the same period last year.

Dolphin Investment Research on ARM and related companies

August 1, 2024 Conference Call: ARM: Downgraded Full-Year Royalty Revenue Expectations (FY25Q1 Conference Call Summary)

August 1, 2024 Earnings Report Commentary: ARM: Guidance Cooling, AI Faith Encountering Chill

May 9, 2024 Earnings Report Commentary: ARM: After the Carnival, is AI Slowing Down?

February 8, 2024 Earnings Report Commentary: ARM: How Long Can AI's Wings Still Fly?

September 13, 2023 ARM Deep Dive: ARM: After Selling Alibaba, is SoftBank's Next Lifeline Worth 50 Billion?

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