Last year, chip design company Arm Holdings (ARM 5.19%) was one of Wall Street's hottest initial public offerings. Shares have corrected recently after soaring out of the gates on hype over its artificial intelligence (AI)-related tailwinds. Today, the stock trades nearly 30% off its high.
The company designs products that serve as the foundation of modern semiconductors; roughly half of the world's chips use designs owned by Arm. An increasingly digital world warrants more chip demand, meaning more Arm royalties. But is the stock already priced too high despite its recent stumble?
Here is what you need to know.
Market share momentum points to a competitive edge
Arm develops semiconductor architecture, the foundational design for chips. Whenever companies build a chip based on an Arm design, it gets a small fee or royalty. This is a high-margin business model with gross profit margins in the high 90% range.
Management expects the business to generate about $3.1 billion in revenue this year and be profitable. Analysts estimate the company will earn roughly $1.20 per share this year, pricing the stock at approximately 69 times its expected fiscal year 2024 earnings.
That's the price. Is it a good value for investors? That requires a look into Arm's growth prospects.
The company reported its market-share trends for various end markets while going public. This is important because investors could expect future revenue growth if Arm gets a bigger slice of the chip pie, especially if that pie (the chip market) grows.
Market share trends from 2020 to 2022 include:
| End market | 2020 Market Share | 2022 Market Share | 2022 Market Size | Est. market growth rate through 2025 |
|---|---|---|---|---|
| Mobile applications processors | 99% | 99% | $29.9 billion | 6.4% |
| Consumer electronics | N/A | N/A | $46.9 billion | 4.3% |
| Industrial IoT and embedded | 58.4% | 64.5% | $41.5 billion | 6.7% |
| Networking equipment | 18.8% | 25.5% | $17.2 billion | 1.8% |
| Cloud computing | 7.2% | 10.1% | $17.9 billion | 16.6% |
| Automotive | 33% | 40.8% | $18.8 billion | 15.7% |
| Other infrastructure | 9.1% | 16.2% | $12.7 billion | 2.7% |
Chart by author. Data sourced from Arm Holdings F-1 filing. IoT = Internet of Things.
Investors looking for Arm's competitive advantage should look no further than its massive gains in market share over such a short time frame. For long-term growth, the picture is less certain. Consistent double-digit revenue growth will likely require continued gains in market share because most of Arm's primary markets are growing by the low to mid-single digits.
Arm has proved capable of that, but market share gains are not guaranteed to last forever. As Arm gains ground, competitors might become more aggressive in protecting their share.
The good news is that chip companies can't move away from Arm once they design a chip on its architecture. It would be like tearing a house down to its foundation; designing a new chip is easier. That means revenue is very sticky.
Is there a margin of safety in the price?
A great business can be a lousy investment if you pay the wrong price. Ideally, investors buy with a margin of safety, a cushion in the price if things don't go as well as expected. Keep this in mind when evaluating Arm or any other stock.
Arm PE ratio (forward) data by YCharts; LT = long term.
The price/earnings-to-growth (PEG) ratio is one of my favorite tools for valuing a stock. A Peter Lynch favorite, it shows you how much you're paying for a company's expected earnings growth. Arm Holdings trades at a price-to-earnings ratio (P/E) of 69 using its estimated fiscal year 2024 earnings. Analysts believe Arm can grow earnings by an average of almost 40% annually over the next three to five years.
The resulting PEG ratio is 1.7, which is higher than I would like to pay (1.5 or less is ideal). It's not so much higher that the stock price is prohibitive, but paying "full price" for a stock doesn't leave much margin of safety.
What if Arm doesn't grow its earnings as analysts expect? Investing sometimes boils down to making educated guesses, so you should always leave some wiggle room in case things go awry.
Is Arm Holdings a buy?
It's difficult to justify aggressive buying at these prices because the margin of safety that investors should be looking for appears absent. Staying patient and waiting for a better buying opportunity might be wiser.
If you want to buy, consider dollar-cost averaging, which means buying a little at a time so you'll face a win-win situation. You'll be happy you bought if shares go up and positioned to buy the dip if Arm Holdings continues to fall.
