Arm Stock Rises on Accelerating AI Revenue, But a Big Risk Remains

Arm Holdings (NASDAQ: ARM) shares rose after the company -- which sells critical design architecture for making semiconductors -- saw artificial intelligence (AI) demand boost its revenue. The stock, however, has still lost about a third of its value over the past year and it faces a big potential risk next fiscal year. Let's see what that is -- and what investors should do.

AI powers results, but smartphone risk emerges

After an initial dip following its results, Arm shares rallied as investors turned their focus more toward its AI opportunities than worries about smartphones. Arm said it sees its data center business becoming its largest segment in the coming year, and that it will reach a 50% market share among top hyperscalers. This growth is being led by the shift toward inference and AI agents, which it says makes central processing units (CPUs) more important within the data center.

However, the company did admit that increasing memory supply constraints could put a dent in smartphone sales, with talk of a potential 15% reduction in volumes over the next year. That said, it noted that even a 20% reduction would only equate to a 2% to 4% effect on its smartphone royalties. However, this company is trading at a growth multiple, so that is a big potential risk.

Overall, Arm's fiscal third-quarter revenue jumped 26% year over year to $1.24 billion. License revenue rose by 25% year over year to $505 million. Its agreement with Softbank contributed $200 million to that total. It increased its number of Arm Total Access licenses in the quarter by two, to 50. Over half of its top 30 customers use this license. It also added six Arm Flexible Access customers, bringing the total to 318.

Royalty revenue, meanwhile, rose 27% year over year to $737 million. The growth was driven by increased adoption of newer ARM technology, including Armv9 architecture and Arm CSS (compute subsystems), which carry higher royalty rates. It said five customers are now shipping devices with CSS chips, including the top four Android phone makers.

Annualized contract value (ACV), which smooths out license revenue, soared 28% to $1.62 billion. Looking ahead, Arm guided for fiscal fourth-quarter revenue to come in around $1.47 billion, representing year-over-year growth of 18%. Royalty growth is projected to be up by the low teens and licensing by the high teens. It forecasts that adjusted earnings per share will be between $0.54 and 0.62.

Is ARM's stock a buy?

Arm's licensing and royalty business model is attractive given its high gross margin and recurring nature, and the company has an opportunity to continue to grow nicely in the data center space. Meanwhile, its ties to Softbank provide a steady stream of growth.

At a forward price-to-earnings (P/E) ratio of around 49 based on analysts' fiscal 2027 consensus, and a forward price/earnings-to-growth (PEG) ratio of under 0.7 (with below 1 considered undervalued), ARM looks reasonably priced. However, the likely weakness in the smartphone market next year isn't necessarily embedded in those estimates, and as such, this would keep me on the sidelines for now.

Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.