Arm Holdings plc

Moat: 4/5

Understandability: 3/5

Balance Sheet Health: 5/5

A global leader in semiconductor design, particularly known for its low-power ARM architecture used in a wide variety of devices, from smartphones to servers.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

ARM possesses a strong and wide moat (4/5) primarily due to its intellectual property (IP) dominance and the network effects associated with its ubiquitous architecture.

Moat Justification:

  • Intangible Assets (Patents & IP): ARM’s core strength lies in its ARM architecture, which is essentially a set of instructions (and related technology) for how to build computing chips that have optimized power consumption and perform well. This core architecture is protected by patents and intellectual property rights, which create a significant barrier for competitors to replicate or work around their technology. Also, even if someone wanted to replicate it, they would have to pay for licenses.
  • Network Effects: ARM’s ubiquity has created a strong indirect network effect. Because so many chips are based on the ARM architecture, developers and tool-makers build tools, libraries and other systems around the ARM architecture creating a system that is incredibly difficult for competitors to compete with. These tools and systems attract more developers and designers to the ARM platform which in turn makes the chip more powerful, more popular, and more in demand.

The network effect is such that having more users on a platform makes the platform more attractive, making it harder to compete with since newer platforms will take time to build those user bases.

  • High Switching Costs: Although end consumers never feel it, switching costs for ARM’s direct customers (chip designers and makers) are extremely high. Switching to an alternative architecture would require a complete redesign and adaptation of the whole chip ecosystem, including its hardware, drivers, and software, which represents significant cost and risk to clients. So, companies will generally stick with the ARM architecture they have been using for years.
  • Market share: The pervasiveness of ARM’s technology in mobile devices (smartphones), which have a huge market, also provides a level of incumbency and market share that is hard to match. Though the server and automotive markets are now becoming important to the company, smartphones still dominate. This position in a huge established and growing market gives ARM an upper hand.
  • Performance: ARM’s architecture is designed to be low power and high performance which are the needs for most of its core customers. Competitors would need to match ARM’s power and performance capabilities, which can be very difficult, as their designs are protected by patents and intellectual property rights.

Risks That Can Harm The Moat and Resilience:

  • Technological Disruption/Innovation: A major risk to ARM’s moat would be a breakthrough in alternative chip architectures that outperform its design. If a completely new method of computation was created that has a massive advantage over current architectures, ARM could have its position challenged.
  • Open Source Risk: The RISC-V architecture is becoming increasingly popular. The open-source nature of RISC-V means that companies have more flexibility, and that makes it easy for competitors to innovate and make their own customized chip architectures, reducing the barriers to entry in the chip design market. This is very long term, but it is worth watching.
  • Dependence on Few Key Customers: While ARM’s architecture is prevalent across many devices, some segments, like smartphones, are dominated by a few big companies like Apple and Samsung. The loss of a big client would have a great impact on the company.
  • Geopolitical Risk: ARM’s customers and supply chains are geographically diverse. Geopolitical tensions, such as those in China, could impact ARM’s sales if trade restrictions are imposed or if customers refuse to use ARM technologies over geopolitical risk.
  • Dependence on Key Partnerships: ARM relies heavily on key partners like foundries (TSMC), software vendors, and other hardware partners to have their ecosystem function. Should those partnerships break down or be restricted by any third party, ARM could suffer.

Business Overview:

  • Business Model: ARM operates on a licensing model, selling licenses to companies that manufacture and design semiconductor chips based on its architecture. ARM provides the basic design (Intellectual Property or IP) but is not involved in manufacturing them. This approach generates high margins as it does not involve a big cost of fabrication.
  • Revenue Distribution: As per the recent earnings call, almost 70% of ARM’s revenue comes from licensing its IP, and around 30% from royalties on units sold by customers. While the mobile/smartphone segment still comprises a majority of revenues for the time being, ARM has been focused on diversification towards data center/cloud, automotive, and industrial applications.
  • In the long run, ARM expects the server and automotive business will become the largest contributors to their revenue.
  • Trends in the Industry: ARM is benefiting from the increasing demand for computing power across various devices (like smartphones, servers, industrial equipment), with a growing focus on power-efficient computing as the size of the chipsets become increasingly smaller and the performance is expected to be greater and greater. ARM’s architecture is well-positioned to handle all these things. More and more devices are also adopting AI which also benefits the demand of companies like ARM. Also, due to geopolitical factors, the market is trending towards supply chain diversification and companies wanting more reliable sources of production (as we are witnessing with Intel and their attempt to manufacture more in the US).
  • Margins: ARM has high operating margins (62% in the recent quarter), which shows its strong profitability. However, its sales are not particularly high when compared to its market cap, because it uses licensing and royalties as its primary revenue drivers, leading to a scalable business.
  • Competitive Landscape: ARM faces competition from proprietary chip architectures like Intel’s x86 and also RISC-V open source architectures. While Intel primarily focused on x86, which now has competition in desktop and mobile markets, ARM’s focus is on the architecture, which reduces its risk as they don’t sell their own chips. However, there is a risk of companies switching to new architectures like RISC-V for their low cost and flexibility benefits.
  • What Makes ARM Different: ARM doesn’t compete with their clients, making it very favorable for companies to work with them since their architecture enables them to build custom chips and solutions as per their requirements, without the fear of being pushed out of the market by ARM. They also provide a diverse ecosystem for developers that is very attractive. Lastly, the low-power optimized designs of ARM allows it to have a foothold in a large number of devices. The company does not need to produce products physically, and this increases its margins.

Financial Analysis:

  • Strong Cash Position: ARM has a healthy cash position, with over $4.3 Billion in cash and short-term investments, and no debt, providing financial flexibility and stability. It has a 1.9X current ratio and a solid 107% current asset-to-liability ratio, indicating an excellent ability to meet short-term liabilities.
  • Revenue Growth: ARM is experiencing a high rate of revenue growth from a low of $274 M in 2019 to $2679 M in the last twelve months. In the recent quarter, Q3, revenues grew by 14%, and royalty revenues grew by 18% year-over-year and the outlook for future growth is also strong, with management expecting growth from the automotive and server business and also further expansion into other markets and use cases.
  • For the FY 2025, they expect total revenues to be between 3.87 and 4.13 Billion, an increase of 14-21% YoY.
  • Profitability: As noted previously, ARM has extremely high gross and operating margins which allows it to turn a large part of its revenues into profits. For the last quarter, its GAAP operating margin was at 61.7% and its Non-GAAP operating margin at 62.3% which are extremely high.
  • Financial Stability: ARM’s financial statements are very clean, simple, and easy to understand, with few complexities in their presentation. It has no debt at all and a good cash balance. Also, its business model is inherently less volatile, due to the nature of their IP focused business.

Understandability Rating: 3 / 5

  • While the basic idea of ARM is easy to understand, the intricacies of its architecture, business model, and the complex market dynamics can be complex for investors not well versed in the semiconductor industry. Thus, it does take some effort to get to the bottom of how the company’s business works.

Balance Sheet Health Rating: 5 / 5

  • ARM has a pristine balance sheet with no debt and massive cash holdings. All of its key financial ratios and solvency levels are extremely strong and there are no worrying signs. The balance sheet is simple and easily understandable. This financial stability is a testament to the business model and makes the company a safe bet, both financially and operationally.

Recent Concerns, Controversies and Problems:

  • Chinese Regulations: The Chinese market is a major segment for ARM, with Arm China being its subsidiary. Increasing tensions with China pose a risk. In the latest earnings call, management noted that while they are monitoring the China situation closely, they do not see any issues impacting revenue projections for FY 2025.
  • They believe that by managing through the legal and economic complexities of the chinese markets, they should be able to keep revenues from china safe.
  • Lawsuit against Qualcomm: ARM filed a suit against Qualcomm due to them going beyond the license that Qualcomm had obtained. These types of licensing problems can create complications in revenues and operations.
  • Slowdown in Smartphone Market: The smartphone market has slowed down in recent years. As ARM has most of its business tied to this area, any further decline in its revenues could have some negative effects on ARM, even though management has stated that the trend towards servers and automotive markets will make up for this.

In the most recent earnings call, management stated that there was a bit of softening of demand in the smartphone market. However, overall financial projections remain unaffected, and with increasing adoption in other segments, the company will be able to maintain strong growth.

  • Other Long-Term Risks:
    • The competition from RISC-V is a very serious, long-term issue that management must be aware of.
    • A change in customer preferences towards x86 could affect ARM, however it is not something that is likely to happen, at least immediately.

In summary, ARM is a structurally great company with significant competitive advantage over its peers with the right tailwinds behind its business. Although risks are present in any business, the positives here greatly outweigh the negatives, and ARM will likely be able to provide significant returns for investors who can understand its complex ecosystem.