Arm Holdings(NASDAQ: ARM) returned as a publicly traded company last September. The U.K. chip designer was previously acquired by the Japanese conglomerate SoftBank(OTC: SFTB.Y) in 2016, nearly sold to Nvidia(NASDAQ: NVDA) before antitrust regulators scuttled the $40 billion deal in 2022, and finally spun out as an independent company again.
When Arm listed its shares at $51, investors initially scoffed as its slowing growth and frothy valuations. But today the stock trades at about $125. Let's see why Arm's stock soared over the past six months -- and if it's too late to chase that rally.
Image source: Getty Images.
What happened to Arm over the past three years?
Arm develops CPUs and licenses its designs to other chipmakers like Apple, Qualcomm, and MediaTek. It only collects fees and royalties and doesn't manufacture any chips on its own.
Arm-based CPUs aren't as powerful as the x86 CPUs from Intel and Advanced Micro Devices, but they're more power-efficient and better suited for mobile devices, vehicles, and Internet of Things (IoT) gadgets. Arm-based chipmakers are also expanding into PCs and servers, though it's still mainly dependent on the cyclical smartphone market.
More than 280 billion Arm-based chips have been shipped across the world so far, and its chip designs are used in more than 95% of all smartphones. From 2014 to 2023, Arm's total share of the global chip market expanded from 39% to 51%.
Arm's revenue rose 33% in fiscal 2022 (which ended in March 2022) as smartphone makers sold more 5G devices, but dipped 1% in fiscal 2023 as the 5G upgrade cycle ended and the macro headwinds intensified. But in the first nine months of fiscal 2024, its revenue increased 13% year over year as the smartphone market stabilized, its new chip designs gained ground in the cloud server and automotive markets, and it charged higher royalties for its newest AI-enabled Armv9 chip designs. All of those strengths offset the slower demand for its IoT, embedded, and automotive microcontroller chip designs.
Can Arm grow into its premium valuations?
For the full year, Arm expects its revenue to rise 18%-20% and its adjusted operating margin to expand about 10 percentage points to a midpoint of 53%, and it expects to generate an adjusted EPS of $1.20-$1.24.
For fiscal 2025, analysts expect Arm's revenue and adjusted EPS to grow 25% and 28%, respectively. Those growth rates look healthy, but its stock looks expensive at 89 times forward earnings and 32 times next year's sales.
Arm's valuations seem to have been inflated by the buying frenzy in AI stocks. Arm's designs aren't used in Nvidia and AMD's high-end GPUs for processing AI tasks, but they'll likely be used to power new AI features in a wide range of markets.
During Arm's latest conference call, CEO Rene Haas said that between its "strong growth in royalties" from its higher-end chip designs and "all things AI needing energy-efficient compute, and compute subsystems," it was "very, very strongly positioned for growth." Haas noted that Arm was "seeing demand for incorporating CPUs with anything that helps with AI acceleration," that it was benefiting from a "great tailwind" in the data center market as servers installed more power-efficient chips to process AI applications, and more AI workloads were "being pushed" to smartphones.
Those comments impressed the bulls, but investors shouldn't casually toss Arm into the same basket as Nvidia, which is actually growing at a faster rate but trades at just 37 times forward earnings and 22 times this year's sales. Arm and Nvidia operate different business models, but the former probably shouldn't be trading at such a high premium to the latter.
Is it too late to invest in Arm?
Arm still has plenty of room to grow as it rolls out higher-royalty designs and benefits from the secular expansion of the AI market. However, I believe its valuations have gotten ahead of its business, and it's too late to buy the stock if you missed its rally over the past six months. Investors who are interested in Arm should keep an eye on the stock and pick up some shares after its valuations cool off to more reasonable levels.
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Leo Sun has positions in Apple. 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, long January 2025 $45 calls on Intel, and short May 2024 $47 calls on Intel. The Motley Fool has a disclosure policy.
