Could Arm Holdings Be a Prospect for Millionaire Investments?
Every financially ambitious individual yearns for the jackpot from a well-timed investment in a fast-growing company in a sizzling sector. Those who snatched up Arm Holdings (ARM -0.38%) shares shortly after its public debut in autumn 2023 have already reaped the rewards of jaw-dropping gains. The stock has skyrocketed approximately 75% this year, fueled by anticipation that its technology licensing business could benefit from a surge in demand due to the artificial intelligence (AI) craze.
However, it's essential to ponder whether the firm's fundamentals support the hype. Let's delve into it.
A commanding niche in the tech realm
Launched in 1990, U.K.-based Arm Holdings has carved a niche for itself as a prominent player in the global technology scene. It excels in intellectual property, granting licenses for central processing unit (CPU) architectures to other companies that integrate its designs into a variety of hardware. Arm processors are widely used in consumer tech, accounting for an estimated 99% of smartphones.
However, it's crucial to note that Arm concentrates on CPUs, not graphics processing units (GPUs) utilized by advanced AI models such as ChatGPT. While Arm will indirectly gain exposure to the AI sector by licensing designs like its Armv9 CPUs, tailored for increased performance for more demanding smartphone tasks as companies incorporate chatbots and additional features into their mobile devices.
Companies built around licensing revenue can be alluring due to their dependable, recurring income and substantial profit margins. However, Arm faces a plethora of challenges that could potentially hinder its long-term success. Firstly, the company faces the ramifications of its own prosperity.
Is this still an accessible growth avenue?
Arm-powered processors enjoy a vast market share in smartphones and other consumer devices, limiting future growth prospects. The company estimates that approximately 70% of the global population utilizes Arm-based products. Additionally, many of its core industries, like smartphones, are considered mature. For instance, smartphone sales allegedly peaked in 2016, making it challenging to envision how AI-related opportunities can significantly impact a company predominantly targeting large yet stagnant industries.
Arm's second-quarter fiscal 2025 earnings unveiled this dynamic. For the quarter, which concluded on September 30, its royalty revenue saw a 23% year-over-year increase to $514 million, mostly due to the success of its armv9 architecture in smartphones. Nevertheless, this impressive growth was overshadowed by weaknesses in other segments, resulting in a mere 5% consolidated revenue growth to $844 million.
Arm's financial performance for the quarter was underwhelming as well. With a meager $64 million in operating income, its operating margin was only 8%, largely attributable to its substantial research and development expenses as it endeavors to remain competitive.
Arm doesn't have an easy remedy for its predicaments. Despite its significant market share, its CPU architectures face competition from other manufacturers like Intel and its x86 architectures, as well as a free, open-source alternative known as RISC-V, developed by computer scientists at the University of California, Berkeley. These competitors could erode its pricing power and growth potential.
Arm's valuation strays from reality
In conclusion, Arm Holdings represents a mature, sluggish-growth company with limited involvement in the AI sector. Ironically, its valuation seems distorted from this fundamental reality. With a forward price-to-earnings (P/E) multiple of 67, its shares are significantly more expensive than the Nasdaq-100's average forward P/E of 27, along with chipmakers like Nvidia and Intel, which boast ratios of 33 and 22, respectively.
For investors, the risks flowing from purchasing Arm Holdings could outweigh the potential profits. Shares appear significantly overvalued and may recoup a considerable portion of 2024's gains in 2025 and beyond. This stock is advised for sell-off or avoidance.
Investors considering additional finance opportunities in the tech sector might want to reconsider investing in Arm Holdings, given its high forward price-to-earnings (P/E) multiple of 67, significantly higher than the Nasdaq-100's average of 27.
Despite Arm Holdings' dominant position in the smartphone market, its growth prospects are limited due to the mature nature of its core industries and a saturated market share, making it challenging to capitalize on AI-related opportunities.
