With its September market debut, British chip designer Arm Holdings (ARM 5.90%) has been one of 2023's hottest initial public offerings, arriving just in time to capitalize on the AI hype cycle. But while the company managed to generate a buzz, concerns about lackluster growth and an undiversified business model weigh on its lofty valuation. Let's explore what the next five years could look like for this hot new stock.
What is Arm Holdings?
Founded in 1990, Arm Holdings is a technology company that focuses on designing central processing unit (CPU) cores with its proprietary architecture. The company's designs are low-cost and energy-efficient, making them popular in consumer products such as smartphones, where it has a market share of 99% in the premium category.
Arm was taken private by the Japanese investment company SoftBank, which acquired it in 2016 before relisting it on public markets this year, presumably looking to take advantage of the AI hype to obtain an inflated valuation. But to be fair, Arm actually does stand to potentially benefit from AI growth, even though it doesn't participate in the consumer side of the industry.
Management believes the company has a total addressable market of $202.5 billion that will have a compound annual growth rate of 6.8% to reach $246.6 billion by 2025. It thinks the cost and complexity of chip design will continue to increase while Arm contributes a greater proportion of the technology used in each one.
The company expects particularly rapid growth in cloud computing, where companies like Nvidia use its architecture to make data processing units (DPUs).
What does this mean for investors?
Nvidia describes DPUs as "a new class of programmable processor" that can improve applications' performance for AI and machine learning. And it cites Arm's architecture as being a key component. The semiconductor giant has developed its Arm-based BlueField-3 DPUs for data center clients, including Oracle, Cisco, and others.
So it makes sense that sales of this and other Arm-based products could soar as more companies pivot to computationally intensive AI-related applications.
That said, over 50% of Arm's CPU licensing revenue currently comes from smartphones and consumer electronics. This is a problem because the smartphone industry peaked in 2016 and saw global shipments fall by 11.3% in 2022. Investors can expect continued declines over the long term, which means less demand for Arm's CPUs.
It is unclear whether the new data center demand will be able to counteract what looks to be a secular decline in Arm's core operations.
Image source: Getty Images.
The company's recent performance isn't encouraging. Fiscal third-quarter revenue fell from $692 million to $675 million year over year, while net income collapsed by over half to $105 million as Arm's core clients grapple with challenges like inflation.
Is Arm Holdings stock a long-term buy?
AI adoption will probably help diversify Arm's business away from its declining consumer electronics revenue. But the growth might not be enough to justify the stock's sky-high valuation. With a trailing price-to-earnings (P/E) multiple of 132, Arm's shares are significantly more expensive than the S&P 500 average of 25 and dwarf even Nvidia, with a trailing P/E of 99, despite much higher growth (Nvidia's net income jumped by over 200% in the second quarter).
Over the next five years, investors can expect Arm's valuation to fall as AI-related hype dies down. Despite enjoying a potentially lucrative niche, the company's stock doesn't look like a buy at current prices.
