Every Arm Holdings Investor Should Keep an Eye on This Number

Arm Holdings (NASDAQ: ARM) is one of the best-performing artificial intelligence (AI) stocks of the last year, trading up 119%.

However, Arm doesn't make money the way most semiconductor stocks do. Instead of selling its products directly to customers, the company licenses its technology, primarily its CPU (central processing unit) architecture to partners like Nvidia and Apple. Then it collects royalties when the products containing those designs are sold, so licenses and royalties make up its two sources of revenue.

Royalties are typically the larger source of revenue, but license revenue precedes royalty revenue by two years or so, as it takes time to develop the product that's based on Arm's technology.

License revenue is important because it gives an upstream indication of where the business is headed, but license revenue is lumpy from quarter to quarter. License revenue fell 15% to $330 million in the company's fiscal second quarter, its most recent period, as it lapped a large license agreement. However, Arm also reports license revenue as annualized contract value (ACV) to help smooth that out. In the second quarter, ACV rose 13% to $1.25 billion.

Why you should keep your eye on royalty revenue

While license revenue gives a good indication of the long-term direction of the business, royalty revenue is a better representation of how the business is doing currently. Royalty revenue also better reflects the impact of new technology like the Armv9 CPU architecture, which carries roughly double the royalty rate of the previous generation, Armv8.

In the second quarter, royalty revenue rose 23% to $514 million, which was much stronger than total revenue growth; that was only 5%, due to lower license revenue.

Royalty revenue is determined by the royalty rate Arm charges for the technology that's been licensed and the number of products sold, so it shows how fast Arm's products are being adopted and the impact they're having in the market.

While overall revenue will continue to be volatile in the coming quarter, watch royalty for a clearer indication of the strength of the business.

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Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple and Nvidia. The Motley Fool has a disclosure policy.