British chip designer Arm Holdings (NASDAQ: ARM) went public again on Sept. 14, 2023, seven years after it was acquired by the Japanese conglomerate SoftBank(OTC: SFTB.Y). Arm priced its IPO at $51, and its shares started trading at $56.10 and closed at $63.59 on the first day. But as of this writing, Arm stock sits around $55 a share.
The market's muted response reflects the uncertainties regarding Arm's growth rates, growth potential, and valuation. Let's review those issues and see if Arm's stock is still worth buying as a long-term play on the semiconductor market.
Image source: Getty Images.
How fast is Arm growing?
Arm doesn't produce any chips of its own. It only designs chips and licenses its architecture to third-party chipmakers like Qualcomm(NASDAQ: QCOM), Nvidia, and Apple. Generally speaking, the Arm architecture is more power efficient but less powerful than the x86 architecture used in Intel's (NASDAQ: INTC) and Advanced Micro Devices' (NASDAQ: AMD) high-end CPUs.
That advantage makes Arm chips better suited for mobile devices, Internet of Things (IoT) devices, connected vehicles, and other products that benefit more from power efficiency versus raw horsepower. That's why over 95% of the world's smartphones currently use Arm chips -- and why Intel repeatedly failed to crack the mobile market with its x86 chips.
Arm's market dominance, broad diversification, and high-margin royalty and licensing fees all seem to make it a solid long-term investment. But in fiscal 2022 (which ended on March 31, 2023), its revenue and net income declined as its operating margin shrank. That slowdown worsened in the first quarter of fiscal 2023.
Metric | FY 2021 | FY 2022 | Q1 2023 |
|---|---|---|---|
Revenue growth (YOY) | 33% | (1%) | (2%) |
Gross margin | 95% | 96% | 95% |
Operating margin | 25% | 23% | 16% |
Net income growth (YOY) | 41% | (5%) | (53%) |
Data source: Arm Holdings. YOY = year over year.
That decline was caused by soft sales of smartphones as the 5G upgrade cycle ended and macro headwinds curbed consumer spending. According to IDC, global smartphone shipments dropped 11.3% in calendar 2022 and are on track to dip another 1.1% in calendar 2023. As the market's demand for new smartphones dried up, Arm's operating expenses rose as it ramped up its development of new chips. That's why its operating margin contracted and its net income tumbled.
How does Arm plan to keep growing?
The bears argue that Arm has already saturated the mobile market, doesn't have much room to grow, and will simply follow the ebb and flow of the broader semiconductor space. But in its IPO filing, Arm argues that its total addressable market (TAM) can still expand at a stable compound annual growth rate (CAGR) of 6.8% between calendar 2022 and 2025.
Arm expects that growth to be driven by the increased "cost and complexity" of future chips, and it plans to grow its royalties as a "greater proportion of each chip's total value" as it contributes a "greater proportion of the technology included in each chip." That higher revenue per chip could offset the market's slower sales of individual chips.
Furthermore, Arm believes the expansion of artificial intelligence (AI), automotive, cloud infrastructure, IoT, networking equipment, and mixed reality markets will drive that growth and reduce its dependence on the saturated smartphone market.
But mind the near-term and long-term challenges
That plan sounds promising, but Arm still faces stiff competition from other chip architectures. Intel and AMD have both been developing more power-efficient x86 chips, while the open-source RISC-V architecture has been gaining steam as a power-efficient alternative to Arm-based processors.
Arm also doesn't control the development of its chips in China, which is overseen by a separate company called Arm China that was established in 2018 after SoftBank sold 51% of Arm's Chinese unit to Chinese investors. Arm only owns about 5% of Arm China, but it generated 24% of its revenue from the royalties and licensing fees it received from that stand-alone company. That complicated relationship could expose it to the intensifying trade and tech war between the U.S. and China.
Arm's stock also looks pricey relative to its growth. With an enterprise value of $55 billion -- which is higher than Nvidia's failed takeover bid of $40 billion back in 2020 -- Arm trades at 20 times last year's sales. Qualcomm, the mobile chip leader that has also been struggling with slow smartphone sales over the past year, trades at 3 times last year's sales.
Is it the right time to buy Arm?
Arm will likely generate stable growth again as the macroeconomic environment improves, but its stock looks overvalued and its business model hasn't changed that much since the last time it was publicly traded. Therefore, I'll keep a close eye on Arm's stock, but I certainly won't buy it when so many other high-quality tech stocks are still on sale.
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Leo Sun has positions in Apple and Qualcomm. The Motley Fool has positions in and recommends Advanced Micro Devices, Apple, Nvidia, and Qualcomm. The Motley Fool recommends Intel and recommends the following options: long January 2023 $57.50 calls on Intel and long January 2025 $45 calls on Intel. The Motley Fool has a disclosure policy.
