The technology-heavy Nasdaq Index has risen an impressive 43% year to date. Much of that came from investor optimism in artificial intelligence (AI), which is already boosting growth for many companies. But even though a rising tide can lift all boats, some of these stocks don't deserve their inflated valuations. Let's discuss why C3.ai (AI 3.02%) and Arm Holdings (ARM 4.11%) might underperform in 2024.
1. C3.ai
With shares up by a whopping 183% year to date, C3.ai was a fantastic investment for those who got in at the start of 2023. But this doesn't overshadow the company's weak fundamentals. Despite its name, C3.ai remains a poor way to bet on the AI opportunity because of its relentless cash burn and lackluster growth.
Founded in 2009, software company C3.ai offers enterprise software in a variety of industries. According to the company website, its turnkey systems have been for tasks ranging from predicting system failure in military aircraft to optimizing industrial plant management. But while the business has a slew of big-name clients (including Shell and the U.S. Air Force), operational results leave much to be desired.
Revenue increased by just 17% year over year to $73.2 million, with the vast majority coming from recurring client subscriptions. However, C3.ai's cost of revenue and overhead expenses remain high, leading to an operating loss of $79.4 million -- up 10% from the prior year period. With such modest top-line growth, the company doesn't look likely to scale into profitability any time soon. Even though, with $762 million in cash and marketable securities on its balance sheet, it is in no immediate threat of running out of the liquidity needed to maintain operations.
Based solely on its income statement and balance sheet, C3.ai doesn't look like a horrible company. But its valuation is simply too high. With a price-to-sales (P/S) multiple of 12.6, the stock is roughly 5 times pricier than the S&P 500 average. And that's just too much for what's on offer.
2. Arm Holdings
With an initial public offering (IPO) in September of this year, Arm Holdings was at the right place at the right time to ride the wave of AI hype, which helped it earn a market cap of $73 billion at the time of writing. But while the chip designer can benefit from rising AI-related demand, it will struggle to justify its astronomical valuation.
On the surface, Arm Holdings is an attractive business with a deep economic moat. Founded in 1990, the U.K.-based semiconductor company is a leader in designing and licensing the intellectual property needed to make central processing units (CPUs) -- a technology with applications in a wide range of consumer and enterprise hardware. Management expects new demand from data centers and cloud computing providers to help offset its more mature revenue streams, such as smartphones and PCs.
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But like C3.ai, Arm's biggest problem is valuation. With a price-to-sales ratio of 26, it makes even C3.ai look cheap.
In fact, the stock's valuation is similar to the industry-leading semiconductor company, Nvidia, which trades for 27 times sales. The problem is that Nvidia grew its top line by 206% year over year in its most recently reported quarter, while Arm grew its top line by only 28% (to $806 million). Investors who want to bet on the "picks and shovels" side of the AI opportunity have better options.
Focus on fundamentals
Following the launch of ChatGPT in late 2022, AI has arguably become a hype cycle -- a situation where investor excitement can begin to overshadow fundamentals. Companies that seem associated with the technology have enjoyed substantial share price growth despite minimal improvement in their operations. C3.AI and Arm Holdings seem to fit into this category. Investors should be careful about holding these stocks into 2024 as the hype begins to fade and pressure mounts for AI-related companies to justify their sky-high valuations.
