Outside of PCs and servers, nearly everything with a CPU runs on Arm's (ARM +5.22%) architecture. Some customers license Arm's CPU cores, while others license the architecture and design their own custom chips. Either way, Arm receives a royalty.
Nearly every smartphone uses Arm chips, as do most tablets and smart TVs. A big chunk of all embedded processors are Arm-based as well, and the company is slowly making headway in the PC and server CPU market. Apple now uses custom Arm chips for its Mac computers, and start-up Ampere is pushing Arm-based server chips as an alternative to Intel and AMD.
While investors are excited about Arm following its IPO this week, there are a few reasons to be wary of the stock.
1. Revenue is flatlining
Because Arm's revenue depends on the number of devices containing Arm chips that are shipped, the company is sensitive to slowdowns in its end markets. The smartphone market is hobbling along this year, with IDC expecting a 4.7% decline in global shipments. In the fiscal year ending on March 31, Arm suffered a slight revenue decline partly due to weak smartphone demand.
Arm's strategy to grow revenue in the long run involves increasing the value of its processors. Arm receives higher royalty payments depending on the number of CPU cores and the complexity of the chip. Even if device shipments don't grow much, Arm can still grow revenue per device. The company is also developing additional licensable products, including full system-on-a-chip solutions.
Still, Arm's growth is unlikely to be anything other than sluggish in the years ahead. From fiscal 2015 through 2023, revenue grew at a compounded annual rate of just 8%. The company's business is stable, predictable, and unlikely to be disrupted, but growth has been unimpressive.
2. Profits haven't budged
In fiscal 2015, Arm generated an operating margin of 42% and an operating profit of $772 million, using today's exchange rate. In fiscal 2023, operating margin had fallen to 25%, and operating profit totaled $671 million. The company has ramped up its spending on research and development, but the total lack of profit growth over the past eight years is something investors need to keep in mind.
Arm's elevated R&D spending could pay off in the long run as the company infiltrates new high-value markets, but right now it's depressing the bottom line. Major opportunities include server CPUs, which historically have been dominated by x86 chips from Intel and AMD, as well as the rising semiconductor content in automobiles. But Arm won't be as dominant in markets where it's coming from behind.
3. A sky-high valuation
After Arm's strong debut, the company was valued at approximately $65 billion. While the stock deserves to trade at a premium given how entrenched and untouchable Arm is in its core markets, that valuation is quite a stretch.
Based on fiscal 2023 revenue and net income, Arm stock trades at a price-to-sales ratio of 24 and a price-to-earnings ratio of 124. Given that Arm's revenue growth is unlikely to blow investors away and its track record for profit growth is lacking, those valuation ratios are tough to swallow.
Arm is a great company that holds a critical position in the global semiconductor market. There's essentially zero chance that smartphones will be powered by anything other than Arm chips in the foreseeable future. But Arm will need to figure out a way to greatly accelerate revenue growth and push profits dramatically higher to even begin to justify its lofty valuation. I'm not holding my breath.
