Morgan Stanley: Arm licensing revenue props up results, while CPU ramp-up faces cost and delivery tests

Why did royalties disappoint despite the earnings beat?

Arm’s 2027 fiscal second-quarter revenue and earnings per share were respectively 4% and 8% above market consensus, mainly driven by the licensing business. Licensing revenue reached a record $773 million, up 50% year over year and about $100 million above expectations.
The company attributed the licensing beat to new AI business. During the quarter, it signed 3 Arm Total Access agreements and 4 CSS agreements, and received milestone payments on licensing projects. Morgan Stanley believes this reflects customers continuing to invest in custom chips for specific workloads.
Royalty revenue was $670 million, up 8% year over year, below market consensus of about $710 million. Data center royalties doubled year over year, while mobile and edge AI royalties faced pressure from rising memory prices.

Management said purchase orders for AGI CPUs from several customers extend through calendar year 2027. With supply agreements for wafers, substrates, test equipment and memory in place, the company is more confident in generating up to $2 billion in CPU revenue combined over fiscal years 2027–2028, compared with previous revenue visibility of more than $1 billion.
Supply costs are higher than expected when the project was first announced in March 2026, particularly for wafers and memory. The company now expects a gross margin of 30%–40% for the first-generation CPU, versus the previously cited level of 40%; management hopes margins for the second through fourth generations will gradually rise above 50%.
Initial commercial deliveries are still planned for the fourth quarter of fiscal year 2027, with a small contribution expected in the third quarter. Management said the current priority is moving from pilot production to customer volume deliveries, including ensuring yields, coordinating supply, managing inventory and collecting receivables.

The midpoint of the company’s third fiscal-quarter revenue guidance is about $1.54 billion, up about 24% year over year; its earnings-per-share guidance is $0.56, compared with market consensus of $1.52 billion and $0.55, respectively. Revenue remains weighted toward licensing, which is expected to grow about 50% year over year.
The company expects third fiscal-quarter royalties to rise by a low-double-digit percentage sequentially, but by only a low-single-digit percentage year over year: growth in cloud and AI will be partly offset by continued weakness in smartphones and a higher year-ago comparison.
Management expects fourth fiscal-quarter revenue growth to be potentially similar to the third quarter year over year, but with a more balanced mix of licensing and royalties. Based on this, Morgan Stanley estimates fourth-quarter licensing revenue of about $850 million and full-year fiscal 2027 revenue above $3 billion.

Morgan Stanley maintains its Equal-weight rating and $212 price target. The firm believes that, after the share price retreated from its June peak, the valuation better reflects fundamentals; there is limited new near-term catalyst information this quarter.
The firm would need to see two things to turn more optimistic: Arm maintaining operating leverage after entering the chip business, and demand for CPUs through 2030 materializing.