Arm Stock Is Down More Than 40%. Here's Why I'm Staying on the Sidelines.

Shares of chip designer Arm Holdings (NASDAQ:ARM) fell nearly 10% on Monday as a sell-off swept across artificial intelligence (AI) stocks. The slide followed a weekend essay from Anthropic CEO Dario Amodei arguing that the industry should slow the pace at which it improves AI model capabilities. And other tech leaders, including OpenAI CEO Sam Altman, quickly backed the idea.

The drop leaves Arm shares around $239 as of this writing, more than 40% below their 52-week high of $452.70. Clearly, a lot of the stock's value rides on AI enthusiasm.

But an argument about how fast frontier models should improve says little, at least directly, about how Arm makes money. The company collects licensing fees when chipmakers sign up to use its designs, and it collects a royalty on nearly every chip that ships with its technology inside.

Image source: The Motley Fool.

Royalties follow shipments

Showing what that model produces, Arm's revenue rose 22% year over year to $1.29 billion in the fiscal first quarter of 2027 (the period ended June 30, 2026) -- a first-quarter record. Royalty revenue grew 22% to $715 million, and licensing revenue grew 23% to $574 million. Non-GAAP (adjusted) earnings per share rose 29% year over year to $0.45, above the top end of management's guidance range.

Arm licenses its chip designs and architecture to semiconductor companies, which build processors around them and pay Arm a per-unit royalty on substantially all chips shipped. Those royalties are booked in the quarter customers ship the chips. More than 350 billion Arm-based chips had shipped cumulatively as of the end of March.

In other words, none of that money is tied to whether a new model gets trained on schedule. If a frontier lab paces its next release, no royalty on a chip that already shipped goes away.

The royalty pressure is coming from phones

Smartphones are still the biggest end market: Royalty revenue from mobile applications processors (the chips at the heart of smartphones) was about 43% of Arm's total royalty revenue in fiscal 2026, which ended March 31.

Data centers are the fastest-growing slice. Data center royalties more than doubled year over year in fiscal Q1, at least the third straight quarter of that pace. But even there, the growth is coming from Arm's Neoverse server processors, the general-purpose chips that sit alongside graphics processing units (GPUs) and other AI accelerators in the data center, not the accelerators themselves.

And the pressure on royalties this year has nothing to do with model timelines. Royalty revenue grew 27% year over year in the December quarter, 11% in the March quarter, and 22% in fiscal Q1 -- and it grew 21% across fiscal 2026 as a whole.

On the July earnings call, chief financial officer Jason Child said Arm has "seen some incremental slowdown versus what was expected at the beginning of the year" as higher memory prices dent smartphone sales. Royalty growth for the full fiscal year, he said, is now "probably somewhere closer to the high teens," down from the roughly 20% the company had expected coming into the year.

The royalty line's real swing factor, I'd argue, is phones.

Is the dip a buying opportunity?

What moved on Monday is the price investors will pay for all of this. Even after the decline, Arm stock trades at about 79 times next fiscal year's expected earnings.

A price-to-earnings multiple like that assumes data center royalties keep compounding at extraordinary rates for years to come. It also assumes newer bets pay off, like the company's first in-house chip, where management says customer demand now tops $2 billion across this fiscal year and next.

Of course, a slower frontier could eventually reach Arm too. If AI infrastructure spending cools because the labs pace themselves, licensing renewals and data center royalty growth could cool with it. The revenue already booked wouldn't change, but the growth the valuation depends on could.

Does the training-pace debate touch Arm's revenue model, then? Not much, and not soon. Royalties follow chips out the door, and the biggest slice still comes from smartphones. The business just posted a record first quarter with 29% earnings growth.

Ultimately, the stock is a different matter. At about 79 times next fiscal year's expected earnings, shares need years of AI-driven growth to justify the price. And AI enthusiasm is arguably the main thing holding that price up. I'd stay on the sidelines for now.

Daniel Sparks and his clients do not have positions in any of the stocks mentioned. The Motley Fool has positions in and recommends Arm Holdings. The Motley Fool has a disclosure policy.