Like many businesses involved in semiconductor design and manufacturing, Arm Holdings (NASDAQ:ARM), a British semiconductor designer, could be looking at a period of very high performance ahead as a result of ongoing AI development.
Is Arm Holdings stock a buy now, or are there better options available to investors in today’s market?
Arm’s Plan to Grab Market Share from Intel and AMD
At the moment, the most interesting aspect of ARM is almost certainly its plan to seize off a massive portion of the data center CPU market.
Starting from a market share of just 15 percent last year, the business hopes to capture 50 percent of the market by the end of this year alone. In order to pull this off, Arm will have to displace Intel and AMD, the other two large players when it comes to CPUs in data centers.
Although much of the market’s focus over the last few years has been on GPUs, CPUs remain an important component of the data center hardware mix. As with GPUs, the rise of AI has increased demand for high-performance CPUs, presenting significant opportunities for the businesses that stake out leads in this field.
To its credit, Arm has already made some decent progress in this area. Of particular note is the fact that NVIDIA’s Blackwell GPU is integrated with Arm’s Grace CPU.
Amazon, Microsoft and Alphabet have also turned to Arm’s platform for building their own custom chips, a fact that could support further use by these major tech firms. The goal of going from 15 to 50 percent market share in a single year, however, remains an extremely difficult task that Arm may or may not actually be able to deliver on.
Arm Holdings’ Ironclad Smartphone CPU Moat
While the stock has been driven upward by on Arm’s play on the data center market, it’s also worth recognizing that the business is absolutely dominant in the smartphone CPU space.
About 99 percent of smartphone CPUs use Arm’s architecture, giving Arm Holdings what amounts to an unassailable moat where mobile processors are concerned.
As such, the business enjoys a high degree of stability and a durable economic advantage that will likely last for the foreseeable future.
Arm Up 34% YoY and Royalties Up
Although there are very real questions about whether Arm Holdings will be able to achieve its goal of seizing off 50 percent of the data center CPU market this year, it’s difficult to dispute the results the company has delivered recently.
In its fiscal Q4 report released in early May, for example, Arm reported year-over-year revenue growth of 34 percent to a quarterly total of $1.24 billion. This record-high quarterly revenue coincided with the first time in Arm’s history that it reported over $4 billion in annual revenues.
Crucially, Arm’s royalty revenues rose 18 percent year-over-year to a quarterly total of $607 million. Royalties are paid to Arm on an ongoing basis for its IP and are estimated to average 1-2 percent of the selling price of chips. These royalties are an important component of Arm’s overall revenues, and the rapid increase of royalties bodes well for both the business and its shareholders.
Turning to profitability, Arm has generated EPS of $0.75 over the last 12 reported months. Net income has been reasonably high at 19.8 percent, while returns on both invested capital and equity came in at 13.1 percent. Looking forward, Arm’s earnings per share are expected to grow at a compounded rate of over 26 percent annually.
ARM’s High Valuation
The downside of ARM for many investors will likely be its valuation, which is high even for a growth business with exposure to the AI field.
ARM shares trade at nearly 218x earnings, over 43x sales, 25.3x book value and almost 1,100x operating cash flow. These metrics make Arm Holdings expensive by practically any standards.
Analysts do believe that ARM can support very high valuation metrics, but the stock has even gone beyond what analyst price forecasts project for it.
The average price target for ARM at the moment is $140.87, while the stock’s most recent price was $163.17. This implies a downside of more than 13 percent if the average price forecast proves accurate over the coming 12 months. Analysts are also divided on how attractive ARM looks, with 16 rating it a buy, 14 rating it a hold and 3 issuing sell ratings.
ARM’s extremely high valuation may also go some way toward explaining pronounced changes in institutional investment activity.
Until late last year, institutional investors were buying far more shares of ARM than they were selling. In the last six months, though, institutions have sold $32.9 billion worth of ARM while only buying $23.8 billion. Institutional ownership is also fairly low at only 10.8 percent of the business, a fact that may reflect the stock’s uncomfortably high price tag.
Is Now the Time to Buy ARM?
Arm Holdings appears to be a high-quality business with solid profitability, good growth prospects and a strong moat. By these standards, ARM has many of the characteristics most investors typically look for in long-term holdings.
Arm Holdings appears to be in an especially strong position to benefit from the rise of AI, a trend that will likely keep both its revenues and earnings growing at attractive rates for several years to come.
The problem, however, is ARM’s valuation. Even for a business with as many positive qualities as Arm Holdings has, the price multiples the market is assigning to the stock at the moment are fairly difficult to justify.
Though strong competitive advantages and solid growth prospects support some degree of premium pricing, ARM’s triple-digit P/E ratio and quadruple-digit cash flow ratio both seem to demand exceptional performance over long periods of time with little to no margin for error.
So, while Arm Holdings is quite appealing as a business, the price investors must pay to acquire it today is likely too high. This conclusion is somewhat supported by the drop in institutional activity in the stock. Though ARM may be worth watching for better entry points in the future and to see how its bid to grab off CPU market share develops, the stock likely isn’t a buy right now.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.