Where Will Arm Holdings Stock Be in 1 Year?

Arm Holdings (ARM -3.43%) went public on Sept. 14, 2023, seven years after it was acquired by the Japanese conglomerate SoftBank Group. The British chip designer listed its shares at $51, but they still trade at only $54 as of this writing.

Arm's high valuations, the cyclical slowdown of the smartphone market, and questions about its long-term growth potential all prevented the bulls from rushing in. But could this bellwether of the semiconductor sector rally over the next 12 months?

Image source: Getty Images.

Is Arm's cyclical slowdown nearly over?

Arm doesn't manufacture any chips. Instead, it designs chips based on its own Arm architecture, then licenses those designs to fabless chipmakers like Qualcomm, Nvidia, and Apple. As a result, it generates most of its revenue from royalties and licensing fees.

The Arm architecture is generally more power-efficient than the x86 architecture that dominates PCs and servers through Intel and Advanced Micro Devices. That's why over 95% of the world's smartphones currently use Arm-based chips. They are also used in cars, Internet of Things (IoT) devices, and other platforms that prioritize power efficiency over processing power.

Arm generated robust growth in fiscal 2022 (which ended in March 2022) as more consumers upgraded to 5G devices in a post-pandemic market. Its near-monopolization in smartphone chip designs also enabled it to keep its gross margins in the mid-90s, while economies of scale boosted its operating margins even as it developed new chips.

Data source: Arm Holdings. YOY = year over year.

But in fiscal 2023, Arm's revenue declined as the 5G upgrade cycle ended and the macro headwinds curbed the market's appetite for new phones. IDC estimates that global smartphone shipments tumbled 11% in calendar 2022, and will likely drop another 5% in calendar 2023 before finally rising about 4.5% in 2024.

Arm's revenue declined again in the first quarter of fiscal 2024, but rose again in the second quarter as the market's fresh demand for new AI, cloud, and auto designs offset the slower growth of its smartphone designs.

For the full year, Arm expects its revenue to rise 10% to 15%. That acceleration lines up with the latest results from Qualcomm, Micron Technology, and other chipmakers that are heavily dependent on the smartphone market. It expects to generate adjusted earnings of $1 to $1.10 per share for the full year. Analysts had only expected Arm to grow its revenue by 10% and generate $1 per share in adjusted earnings.

That outlook seems stable, but Arm warned that there was still "uncertainty regarding the exact timing of some deals," and the trajectory of the semiconductor industry's recovery was "not clear" in the current macro environment.

But is its stock too expensive relative to those growth rates?

At $54, Arm trades at about 54 times this year's earnings and 17 times this year's sales. Those valuations are a bit frothy relative to its growth potential and its industry peers.

For reference, Qualcomm and Nvidia trade at just 14 and 30 times forward earnings, respectively. Taiwan Semiconductor Manufacturing, which manufactures most of Qualcomm's and Nvidia's top-tier chips, has a forward multiple of 17. That high valuation makes Arm a less compelling turnaround play on the chip market than many of its peers.

Arm could also face longer-term challenges as the open-source RISC-V architecture, which shares the same roots as Arm, gains ground as a cheaper alternative to Arm's proprietary designs. Its Chinese business, which it indirectly owns 5% of, could also face unpredictable headwinds as the tech war heats up between the U.S. and China. All those issues could make Arm an even less attractive investment in this tough market.

Based on these facts, I believe Arm will underperform many other semiconductor stocks and the broader market over the next 12 months. Its stock might head higher once the smartphone market stabilizes and the macro environment improves, but it will remain out of favor as long as it trades at a steep premium to its industry peers.