Arm Holdings (ARM +2.31%) went public last week and it may be this year's hottest initial public offering (IPO). The company generates revenue from licensing and royalty deals that it arranges with customers who want to use its designs when making semiconductor chips.
And with chips soaring in demand and tech being a great place to invest these days, the timing couldn't have been better for the stock -- it can benefit from an uptick in demand due to the growing popularity of artificial intelligence (AI).
Investors who missed the boat on Nvidia's (NVDA +3.75%) mammoth 200% gains this year might be wondering if Arm is a good alternative right now. Could it be the next big AI stock, or should investors hold off on investing in this hyped-up IPO?
A big opportunity for Arm
Although investors have become bearish on Arm in recent days, there's no denying the company's strong brand presence and the long-term growth potential it possesses. Its central processing units are in nearly all smartphones. The company estimates that it has a 49% share of the total semiconductor design market, up from just over 42% at the end of 2020.
Arm's total addressable market is a whopping $202.5 billion, and it is expanding at a compound annual growth rate (CAGR) of 6.8%. And with AI potentially accelerating the demand for chips, the market may soon prove to be a lot bigger than those already high projections.
NASDAQ: ARM
Key Data Points
The company's growth has been underwhelming
Historically, Arm hasn't been a fast-growing business despite the increase in tech spending. For the fiscal year ending March 31, 2023, Arm's revenue totaled just under $2.7 billion and was flat from the previous year. Over a two-year streak, the top line has risen by 32%.
Royalties account for a significant part of the company's revenue and can provide the business with some great stability. But that's not the type of thing that might excite growth investors who may otherwise expect a big influx of sales due to soaring demand for AI-powered chips.
Arm's net profit margin of 20% is also lower than Nvidia's, which has averaged more than 30% over the trailing 12 months.
It could take a while for Arm to generate significant growth from AI
Arm is definitely an AI play, but it may not be the one that investors are hoping for. While Nvidia's revenue has been doubling, it may not be as quick of a payoff for Arm.
One analyst, Richard Windsor from Radio Free Mobile, says that it could take up to five years for Arm to benefit from an increase in AI-related demand. That's because right now, the AI craze relates to applications that are in the cloud.
The bigger payoff for Arm is in edge computing, where processes take place on an individualized device. But demand for AI on the "edge," as it's called, may take longer given how nascent AI development still is. As concerns about privacy and security grow related to AI, the demand for AI processes to work locally rather than in the cloud could increase significantly. That's when Arm could see a big jump in revenue.
But given that its sales have gone up only 32% in two years, it's debatable just how much growth investors will see from Arm -- remember, its total addressable market is only growing at a CAGR of less than 7%.
The valuation isn't cheap
Even out of the gate, Arm isn't a cheaper option than Nvidia. At a valuation of more than $60 billion, it is trading at 23 times revenue and over 110 times its trailing earnings.
Nvidia trades at a comparable multiple of earnings while its revenue multiple is higher at 33. But with Nvidia growing at a much faster rate than Arm, there's little reason to pay a greater premium for shares of Arm.
NASDAQ: NVDA
Key Data Points
Is Arm's stock worth buying right now?
Arm started out hot out of the gate but things have since cooled down -- drastically, as investors may be thinking twice about how strong of an AI stock it really is. It's not the next Nvidia. Even if it were to have promising growth prospects, its high valuation doesn't give investors any incentive to buy it instead of Nvidia. While it did well in its first day, shares of Arm have already begun falling as the hype appears to be wearing off.
Investors should wait to see how the company does after a couple of earnings reports. But as of now, there isn't much of a reason to add this stock to your portfolio. And at its high price tag, you're better off simply buying shares of Nvidia.
