Will Arm Holding Stock Be a Buy After the IPO?

After a long freeze during the bear market of 2022, it looks like IPO (initial public offering) activity is beginning to unthaw. A big test for privately held tech companies wanting to raise cash (or shareholders that want to sell on public markets and raise cash for themselves) will be Arm Holding, which is expected to undergo its IPO in mid-September. 

Or maybe we should say "re-IPO," since Arm owner SoftBank Group (SFTB.Y 1.75%) -- Japan's large investment holding company, including its venture capital unit Vision Fund -- will be selling shares from its holdings to investors. It acquired Arm back in 2016 for about $32 billion.

Arm is the chip patent holder powering all sorts of mobile tech, like Apple's iPhones and MacBooks, as well as lots of wearable gadgets. It also has a growing presence in data centers (Nvidia is a top customer and tried to acquire Arm from Softbank a couple of years ago).

Suffice it to say there is some excitement surrounding Arm. But should investors really buy following the September 2023 IPO?

Maybe not exactly a growth business

Arm Holdings is an important cog in the global chip industry. It generates revenue in two ways: licensing fees and royalties. Licensing fees are paid by customers for access to Arm's patented central processing unit (CPU) architectures and other related computing technology. Royalties are paid when those chips, often a customized design based on Arm's architecture, head for production. Arm then receives an agreed-upon payment (either a percentage of the chip's value or a fixed fee per chip) for every unit manufactured and sold.

Given the high profile of Arm's customers -- a who's who in tech ranging from Apple to Alphabet's Google to Amazon and more than 260 other companies -- Arm sure sounds like a growth business. Indeed, the company estimates its total addressable market (or TAM, which can help indicate the direction of revenue) will grow at nearly a 7% average annual clip through 2025.

However, bear in mind that nearly 7% average annual growth is about the pace the overall semiconductor industry is expected to grow through the end of the 2020s. On this metric alone, it makes Arm an "industry perform" candidate, not an "outperform" stock, compared to other semiconductor businesses. That's especially so when considering that other areas of the chip world -- like graphics processing units (GPUs), which are a type of computing accelerator, and chip-supporting electrification (e.g., for electric vehicles) -- are expected to grow even faster.

It's also important to remember that though Arm gets steady fees from licensing chip designs, the royalty revenue can be highly variable as it's tied to the cyclicality of manufacturing. For 2023, that means declining sales, especially from the smartphone market, which makes up a big bulk of Arm's revenue (e.g., Apple, Qualcomm, and China smartphone makers). After flat revenue in fiscal years 2022 and 2023, first-quarter sales for this current fiscal year fell 2.5% year over year to $675 million, and the resulting operating profit was more than halved from $294 million in Q1 last year to just $111 million this year.

Data source: Arm Holdings.

Data source: Arm Holdings.

In other words, after a pandemic-era growth spurt, Arm looks like it will be a more sluggish business going forward.

A dubious valuation

Now, a slower-growth business doesn't mean a bad investment, especially not if said business can boost profit margins over time. However, for a slower-growth business, valuation is critical. And this looks like the biggest issue for Arm stock. As of this writing, SoftBank is apparently seeking a market cap valuation on Arm of upwards of $55 billion.

Suffice it to say that's a very hefty price tag for a company that only hauled in $671 million in operating profit last year (over 112 times trailing 12-month operating income) and is on track for a significant dip in profitability this year.

SoftBank appears to be trying to cash in with this IPO, but investors won't be getting a great deal if they buy at this valuation. I'm sitting this one out and will see how things at Arm develop over the first six months after the IPO.