The long-awaited initial public offering (IPO) of semiconductor maker Arm Holdings (ARM 4.11%) finally happened, and it's a doozy. The licensor of chip architecture made its publicly traded debut in mid-September with a hefty market capitalization of over $60 billion, before falling closer to $50 billion in the days following.
Arm is a powerful company. Its chip designs have been an integral part of the rise of mobile computing over the last two decades, tapped by a diverse ecosystem of big customers including Apple (NASDAQ: AAPL), Qualcomm (NASDAQ: QCOM), and Nvidia (NASDAQ: NVDA). But valuation is a serious concern. There are two chip stocks more reasonably valued that investors might like to know about instead.
Why Arm looks overvalued
The first hint that Arm isn't a buy for most retail investors is the very nature of the IPO. Typically, a business sells shares to investors to raise cash to fund expansion. But that's not what happened to Arm. Back in 2016, Japanese investment conglomerate SoftBank Group acquired Arm. SoftBank is the company that just sold Arm shares, raising nearly $4.9 billion in cash for itself -- not for Arm. SoftBank still owns about 90% of Arm, so it could continue to sell shares in the years to come to raise more cash.
And then there's the valuation. Arm stock was valued high out of the gate due to supply and demand dynamics on stock available for purchase. SoftBank only sold about a 10% stake in Arm, and a long list of Arm customers lined up as buyers (likely to secure future access to Arm chip architecture, should another big buyer like SoftBank try to assert control over Arm). That's one likely reason the valuation soared.
As of this writing, Arm stock trades for an incredible premium of 130 times trailing-12-month net income. Of course, the company has been deeply impacted by the decline in smartphone sales over the last year (remember, mobile chips are a key pillar of this company's sales). If the smartphone market rebounds, Arm profits will follow suit.
However, through 2025, Arm expects its total addressable market to increase at an average of 6.8% per year -- a bit lower than expected average growth rates of 7% to 8% for the semiconductor industry overall. My conclusion: Arm looks like a wildly overpriced investment option right now.
Two companies Arm customers can't do without
There's another way to play the chip design and licensing game, though. Design software is a must -- known as electronic design automation (EDA). This specialty software niche is dominated by Synopsys (SNPS 2.56%) and Cadence Design Systems (CDNS 1.92%), as well as German industrial conglomerate Siemens EDA, via its acquisition of an EDA company called Mentor back in 2017.
Let's focus on the two EDA pure-plays, Synopsys and Cadence.
These two companies are indispensable to the semiconductor industry. Regardless of architecture from Arm, Intel, the AMD x86 chip, or some other proprietary design, it all runs through EDA software. And once a design is complete, Synopsys and Cadence are used to check for any errors. Their software suites are then used by chip manufacturers themselves, including Taiwan Semiconductor Manufacturing.
The mind-boggling complexity of making semiconductors, managing the global supply chain, and spending endless dollars on their continuous improvement has created a fast-and-steady expansion story for Synopsys and Cadence. Given their oligopoly of EDA, the expectation is these two will continue to grow annual revenue at an average low-teens percentage for the foreseeable future.
Data by YCharts.
Owing to the critical nature of their businesses, steady growth projections, and cash returned to shareholders via stock buybacks, neither Synopsys nor Cadence are cheap stocks. As of this writing, Synopsys trades for 67 times trailing-12-month earnings per share, or 35 times next year's expected earnings. Cadence trades for 70 times trailing-12-month earnings, or 39 times next year's expectations.
By contrast, Wall Street analysts seem to think Arm trades for at least 50 times next year's earnings per share -- though the company has yet to officially provide guidance.
Suffice to say that given their current growth projections and lower valuations, Synopsys and Cadence are relatively better buys than Arm right now. Investors should be mindful of the premium valuation and tread lightly, if deciding to buy at all. Nevertheless, if you're interested in investing in the future of chip design, Synopsys and Cadence should rank near the top of your watch list for the decade ahead.
