Could Arm Holdings Become the Next Nvidia?

Back in 2020, Nvidia (NVDA 6.18%) declared it would buy U.K. chip designer Arm Holdings (ARM 4.11%) from SoftBank for $40 billion. That acquisition would have added Arm's chip designs, which are already used in more than 95% of the world's mobile devices, to Nvidia's massive chipmaking business.

However, that deal was terminated in 2022, after antitrust regulators claimed it would give Nvidia an unfair advantage against its industry peers. Nvidia would no longer have paid Arm licensing fees for its own Arm-based Tegra chips, but other chipmakers -- including Qualcomm, MediaTek, and Apple -- would still have paid Nvidia licensing fees for those designs.

Image source: Getty Images.

Last September, SoftBank spun off Arm in an IPO at $51 per share. Investors initially shrugged at that offering, since its growth was cooling off and its valuations were high. However, the stabilization of the smartphone market and expansion of the AI market brought back the bulls -- and its stock soared to its current price of about $127.

So could Arm follow Nvidia's footsteps and become the next hot AI chip stock? Or will it struggle to justify its soaring valuations?

Arm's growth stabilized over the past year

Arm doesn't manufacture any chips of its own. It only designs CPUs and licenses those designs to other chipmakers. Arm-based CPUs generally aren't as powerful as the x86 CPUs produced by Intel and AMD, but they're more compact and power-efficient, which makes them well-suited for mobile devices.

However, Arm's heavy exposure to the smartphone market is a double-edged sword. Its licensing fees and royalties soared in fiscal 2022, which ended in March 2022 as smartphone makers sold more 5G devices, but they declined in fiscal 2023 as the 5G upgrade cycle ended and the macro headwinds rattled the market.

On the bright side, Arm's pricing power in mobile chip designs kept its gross margin in the mid-90s even as its revenue growth cooled off, and its adjusted operating margins rose even as it ramped up its spending on new chip designs. In the first nine months of fiscal 2024, Arm's revenue rose year over year again, its gross margin held steady, and its adjusted operating margins expanded.

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

The company attributed that recovery to the stabilization of the smartphone market, robust demand for its AI-enabled Armv9 handset chip designs that have higher royalty rates, market share gains for its Armv9 chips in the cloud server market, and strong sales of Arm-based chips for advanced driver assistance systems in new vehicles. All of those tailwinds offset its headwinds across the Internet of Things, embedded, and automotive microcontroller markets.

The stock looks richly valued relative to Arm's growth

For the full year, Arm expects its revenue to grow 18%-20%, its adjusted operating margin to expand to a midpoint of 53%, and its adjusted earnings per share (EPS) to come in between $1.20 and $1.24. That outlook seems healthy, but Arm's stock already trades at 40 times this year's sales and 105 times this year's earnings.

For fiscal 2025, analysts expect Arm's revenue and adjusted EPS to rise 25% and 28%, respectively, as its core markets expand. But based on those estimates, its stock still looks pricey at 82 times forward earnings and 34 times next year's sales.

By comparison, analysts expect Nvidia's revenue and adjusted EPS to grow 81% and 90%, respectively, in fiscal 2025, which ends next January. However, Nvidia trades at only 36 times forward earnings and 20 times this year's sales.

Arm seems to be fetching a premium valuation as more chipmakers license its higher-end chip designs for new AI applications. But investors shouldn't confuse Arm's CPU designs with Nvidia's GPUs, which play a much more important role in processing machine learning and AI tasks. Arm also still generates most of its revenue from the cyclical smartphone market instead of cloud servers or connected vehicles.

Arm isn't the next Nvidia

Arm's business still has room to grow as it rolls out its pricier chip designs, but the AI hype is inflating its valuations to unsustainable levels. Investors shouldn't confuse Arm with Nvidia, which is a much simpler "pick and shovel" play on the booming AI market, and realize that its stock has rallied a bit too far ahead of its actual business.