Arm Earnings: The High Cost of Innovation and the Wait for an AI Takeover

Global semiconductor IP leader $Arm Holdings(ARM)$   released its FY26 Q3 earnings after hours, but the stock tumbled more than 7% in the aftermath, dragged down by weak guidance from mobile chip giant $Qualcomm(QCOM)$   , which reported earnings simultaneously. Let's peel back the layers of this report to see the true quality of the results and identify exactly what has the market worried.

Three Things to Watch

Data Center Royalties Continue to Double, but Mobile Growth Faces Pressure

$Arm Holdings (ARM.US)$ reported Royalty revenue of $737 million for the quarter, up 27% year-over-year, accounting for 59% of total revenue. Notably, the data center business has achieved doubling growth for multiple consecutive quarters. Management went as far as predicting that the data center segment will surpass mobile to become Arm's largest business unit within a few years. They emphasized that Agentic AI is stimulating robust demand for server CPUs, with a specific focus on power efficiency, which plays directly into Arm's strengths.

The ecosystem is expanding rapidly. $Amazon (AMZN.US)$ AWS released its fifth-generation 192-core Graviton Arm CPU, $NVIDIA (NVDA.US)$ released the 88-core Vera Arm CPU, $Microsoft (MSFT.US)$ launched the 132-core Cobalt 200 Arm CPU, and $Alphabet-C (GOOG.US)$ introduced the second-generation Axion Arm CPU. Furthermore, the company is benefiting from increased network chip deployment driven by new AI data center construction, particularly regarding DPUs and SmartNICs, where Arm holds significant market share.

However, data centers currently account for only about 15%-20% of Royalty revenue, while the mobile business still commands a massive 45% share. Although mobile Royalty revenue continued to outpace overall mobile market shipment growth this quarter, this was primarily driven by the high royalty rates of CSS (Compute Subsystems). Management revealed that five customers are currently shipping CSS-based chips, with two already on the second-generation CSS platform. All four top Android manufacturers are now shipping devices powered by CSS.

Despite this, the weak guidance for 2026 global mobile shipments from MediaTek and $Qualcomm (QCOM.US)$ has triggered market anxiety regarding Arm's growth in this sector. Management responded by acknowledging that rising memory prices will significantly drag down global mobile shipments, but they noted this forces OEMs to focus on the high-end market where Arm v9 and CSS exposure is most concentrated. Management estimated that even a hypothetical 20% drop in mobile shipments in 2026 would only impact Arm's mobile Royalty revenue by roughly 2% to 4%, resulting in a mere 1% to 2% negative impact on the company's overall performance.

Stubbornly High R&D Costs Limit Operating Margin Expansion

Thanks to its high-margin IP business model and monopolistic position, Arm has long enjoyed gross margins far exceeding most global enterprises. This quarter, GAAP gross margin stood at 97.6%. However, a closer look reveals a GAAP operating margin of only 15%. This discrepancy is largely due to R&D expenses, which accounted for 59% of revenue. These expenses grew 38% year-over-year, far outstripping revenue growth, and remain significantly higher than many semiconductor peers.

With sales and administrative expense ratios stable at around 25%, the ability to reduce the R&D expense ratio is the deciding factor for operating margin expansion. However, management signaled that Arm will continue to ramp up R&D investment in next-generation architecture innovation, CSS, and the exploration of chiplets and complete SoCs. Consequently, guidance for next quarter's operating expenses suggests continued sequential growth.

Soft FQ4 Guidance with Profit Growth Slowing to Single Digits

Arm expects FY26 Q4 revenue of $1.47 billion, an increase of 18% year-over-year. Non-GAAP operating profit is projected at $700 million, up 7% year-over-year, with Non-GAAP net income at $620 million, up 6% year-over-year. It is evident that as revenue growth slows, profit growth is decelerating further into single-digit territory.

Breaking it down by segment, the company expects Q4 Royalty revenue to grow in the low double-digits and license revenue to grow in the high double-digits year-over-year.

FQ3 Key Financial Highlights

– Revenue: $1.24 billion, up 26% year-over-year, slightly beating the consensus estimate of $1.23 billion. Previous guidance was $1.23 billion.

– GAAP Gross Margin: 97.6%, an increase of 0.4 percentage points year-over-year, slightly below the consensus of 97.7%, though still leading most companies globally.

– GAAP Operating Profit: $185 million, up 6% year-over-year, missing the consensus estimate of $246 million.

– Non-GAAP Operating Profit: $488 million, up 10% year-over-year, in line with consensus. Previous guidance was $474 million.

– GAAP Net Income: $223 million, down 12% year-over-year, missing the consensus estimate of $232 million.

– Non-GAAP Net Income: $457 million, up 10% year-over-year, beating the consensus estimate of $438 million. Previous guidance was $438 million. 

Summary

In conclusion, the long-term certainty of Arm's business remains intact. However, in the short term, while the data center segment continues its doubling growth trajectory, the mobile business, which still accounts for a larger portion of revenue, is under pressure. This, superimposed with persistently soaring R&D investments, is further suppressing profit growth. 

Finally, the potential selling pressure from SoftBank remains a Sword of Damocles hanging over the stock, despite management's assurances that SoftBank has no current intention to reduce its holdings.

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