Move over, Nvidia! The semiconductor industry has a new name in the headlines. After being taken private by SoftBank Group in 2016, along with an abandoned acquisition by Nvidia last year, Arm Holdings is set to go public again.
Here's a look at how investors can participate in an initial public offering (IPO) and whether Arm looks like a good deal, given what we know about the company.
How does IPO investing work?
A company typically hires an investment bank to underwrite the deal when it goes public. One of the bank's duties is to solicit shares to willing buyers. Typically, access to shares in IPOs is limited to high-net-worth individuals or sophisticated investors.
With that said, you may be eligible to participate in an IPO. You may have access to IPO investing depending on your broker and a number of different parameters, including your account value and how actively you buy and sell securities. Of course, even if you meet these requirements, there is no guarantee your brokerage firm will have access to the IPO in question.
Given all the hype surrounding artificial intelligence (AI), I suspect there is an inflow of retail interest in Arm's IPO. However, astute investors should question whether the semiconductor company is worth investing in or if it is simply looking to cash-in on the hype.
How is Arm's business performing?
When a company files its paperwork with the Securities and Exchange Commission (SEC) to go public, part of the prospectus is dedicated toward historical financial results. The table below is a recreation of Arm's financial data from its F-1 filing.
| Line Item | Year Ended March 31, 2021 | Year Ended March 31, 2022 | Year Ended March 31, 2023 |
|---|---|---|---|
| Revenue | $2,027 | $2,703 | $2,679 |
| Gross profit ($) | $1,882 | $2,572 | $2,573 |
| Gross margin (%) | 93% | 95% | 96% |
| Operating income | $239 | $633 | $671 |
| Net income | $388 | $549 | $524 |
Source: Arm Holdings F-1 Filing.
The data above shows a pretty clear picture. While revenue increased by an impressive 33% between 2021 and 2022, it actually shrunk for the fiscal year ended March 31 by about 1%. Unsurprisingly, the company witnessed slowing growth in its operating income as well.
To be fair, the semiconductor industry has been no stranger to challenges -- including supply chain disruptions, inflation and its impact on costs, and geographic constraints in regions such as China -- due to the lingering effects of the COVID-19 pandemic.
Even so, Arm's most recent financial profile may shed some light on bigger problems. For the fiscal quarter ended June 30, the company reported revenue of $675 million, a 2.5% decline year over year. To make matters worse, operating income for the period ended June 30 was 62% lower year over year.
While reviewing the footnotes in the F-1, I did find that the company's operating expenses have increased significantly throughout 2023 due to substantial investments in research and development. Of note, some of the more pronounced spend is captured through stock-based compensation, considered a non-cash expense.
While some of Arm's results can be attributed to cyclical trends in the chips sector, I think it's appropriate to have a level of skepticism regarding the company's long-term potential.
Should you buy?
Given that Arm is still private, it's hard to know the company's exact valuation. However, several public reports suggest that SoftBank is seeking a valuation between $60 billion and $70 billion for its portfolio company.
Using Arm's revenue of $2.7 billion and its net income of $524 million for the fiscal year ended March 31, a midpoint valuation of $65 billion would imply a price-to-sales (P/S) multiple of 24, or a price-to-earnings (P/E) ratio of 124. To put this into perspective, Nvidia trades at a P/S of 37.6 and a trailing P/E of 119 trailing. However0, investors should keep in mind that Nvidia is growing at record levels, which, at least in part, plays a factor in its premium valuation. By contrast, Arm's revenue and profits appear to be shrinking.
In my opinion, Arm is looking to take advantage of some broader market themes. AI, generative AI, and machine learning are hot buzzwords right now. Moreover, the companies investing the most in these areas are experiencing higher market activity. And virtually no other company has witnessed such a pronounced uptick in valuation than Arm's cohort Nvidia, which is up nearly 230% year to date and joined the ranks of Apple, Amazon, Microsoft, and Alphabet in the prestigious $1 trillion market cap club.
While there is likely a good chance that Arm stock will pop on the day of the IPO, I would strongly suggest sitting on the sidelines and observing the company for a while. In due time, Arm will be hosting earnings calls like other public companies, and investors will be able to assess the company's performance in a more holistic way.
Although buying into a hot stock can be tempting, I feel that retail participation in this particular IPO will lead to more bag holders than profit takers. A long-term approach to investing, coupled with exercised and disciplined patience, should help in forming your investment thesis when it comes to Arm's IPO and beyond.
