It was only six months ago that investors were talking about the reintroduction of Arm Holdings (ARM 4.11%) to the public markets. Now, just months later, market watchers are debating whether it's too late to buy the stock. Indeed, Arm Holdings has delivered 176% returns (as of market close on Thursday) since its late September initial public offering (IPO), more than 13 times the returns of the S&P 500.
Make no mistake -- it's the accelerating adoption of artificial intelligence (AI) that has sparked those gains. Arm's central processing units (CPUs) are found in a wide variety of electronic devices, including personal computers, tablets, smartphones, thermostats, drones, and smart TVs. However, its CPUs are also the gold standard, helping to run hyperscale computers, data centers, and cloud infrastructure services. It's this last group that represents the most compelling opportunity.
What does all this mean for investors who sat out Arm's recent run? Should they buy the stock now in the hope of additional upside or simply look elsewhere due to the company's frothy valuation? Let's dig in to see what the evidence reveals.
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A (not too) brief history of Arm
While Arm conducted its (most recent) IPO just five months ago, the company has a long and distinguished history in the tech world. The British semiconductor company was founded in 1990. Just a few years later, management revised Arm's business model. Rather than make processors, the company focused on licensing the intellectual property (IP) it developed.
That move was prescient. By offering licenses to all comers, Arm reached the scale necessary to make its licenses more cost-effective for customers than their own in-house development. Arm's chip designs quickly became the go-to processors powering mobile phones, eventually capturing an eye-catching 99% of the market.
The company went public on both the London and Nasdaq stock exchanges in 1998 before being taken private by SoftBank in late 2016. By then, the company was a household name in tech circles. Fast forward to late 2020, and chipmaker Nvidia made an offer to buy Arm for $40 billion before the deal was quashed by regulators. Late last year, SoftBank decided to spin off Arm while retaining a roughly 91% stake in the company.
And the rest, as they say, is history.
The current opportunity for Arm
Lest there be any doubt, it's the rapid adoption of generative AI that represents Arm's biggest opportunity. While graphics processing units (GPUs) from Nvidia do much of the heavy lifting, they're not alone. For example, Nvidia's GH200 Grace Hopper Superchip, which combines the capabilities of CPUs and GPUs working in unison, contains 144 of Arm's latest version 9 (V9) CPU cores. Nvidia isn't the only one: Microsoft designed a new AI server chip that incorporates more than 100 Arm cores.
The use of AI is spreading like wildfire as companies scramble to leverage the productivity gains these advanced algorithms offer. The strong demand helped boost Arm's recent financial results. For its fiscal 2024 third quarter, Arm generated record revenue that grew 14% year over year to $824 million, while record royalty revenue climbed 11%. This resulted in adjusted earnings per share (EPS) that jumped 32% to $0.29.
Yet that only tells part of the story. Arm's remaining performance obligation -- a forward-looking sales indicator -- grew 38% year over year, suggesting Arm's growth spurt will accelerate. As the adoption of AI grows, so too will Arm's fortunes.
Rosenblatt Securities analyst Hans Mosesmann argues that the "shift to accelerated computing ... for generative AI models" will spark an upgrade cycle in the data center space. With an installed base of roughly $1 trillion, that's a lot of CPU cores, with Arm a primary beneficiary.
There's no clear consensus about the economic impact of AI, but everyone agrees the potential is massive. A report by Goldman Sachs suggests AI will boost labor productivity, driving a 7% or $7 trillion increase in global GDP. Morgan Stanley came in a close second at $6 trillion.
Whatever the total market ends up being, Arm's IP will be at the heart of this shift in the technological landscape, making the company a major player in the space.
What about Arm's valuation?
There's no question that Arm's price tag is steep -- that is, when using the most popular valuation metrics. For example, the stock is selling for 1,874 times earnings (not a typo) and 50 times sales. Unfortunately, those metrics don't take into account Arm's current growth spurt. However, when measured using the more appropriate forward price/earnings-to-growth ratio (PEG ratio) -- which factors in its growth trajectory -- it sells for less than 1, the standard for an undervalued stock.
Given the magnitude of the opportunity and its place in the industry, it's not too late to buy Arm stock.
