Arm Holdings (NASDAQ:ARM) stock surged following the firm’s Q3 results in February. The stock soared 48% after beating earnings and issuing a more bullish outlook for Fiscal Year 2024. However, despite the overwhelmingly positive sentiment surrounding the boom in artificial intelligence (AI), it seems hard to justify Arm’s current valuation. The stock is trading around 106x forward earnings and has less exposure to AI than I believe many would have thought.
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While I’m bullish on AI stocks, I find it hard to get behind this semiconductor and software design company. Thus, I am neutral on ARM stock.
Guidance Raised
In February, Arm said that it had earned an adjusted operating income of $338 million during the third quarter, with sales coming in at $824 million, marking a 14% increase year-over-year. $470 million of this related to revenues from royalties, as 7.7 billion Arm-based chips were shipped during the quarter. It was a strong earnings beat, but investors were more interested in the forecast.
Looking ahead, Arm raised its sales and earnings forecast for Q4 and Fiscal Year 2024. The company said it expects to earn between $0.28 and $0.32 per share on an adjusted basis for Q4, with sales increasing sequentially to between $850 million and $900 million.
That’s some distance ahead of analysts’ expectations, which had been for adjusted earnings of $0.21 per share on $778.5 million of sales. For Fiscal Year 2024, Arm raised its guidance to between $1.20 and $1.24 per share on an adjusted basis. That was up from a prior guidance of of $1 to $1.10 per share and above the estimated $1.05 per share.
The firm’s earnings beat and upbeat guidance are not just a reflection of its positive financials but Arm’s strategic positioning within the AI and smartphone industries. Premium brands within the smartphone industry have elected to adopt Arm’s v9 architecture, further cementing the company’s integral role within the segment.
The smartphone industry also returned to growth during the quarter, providing a useful boost. In its Q3 letter to shareholders, the company highlighted that royalties from the v9 were typically at least double the royalty rates for equivalent Armv8 products. Arm suggested that this tailwind would continue as multiple end markets transitioned to the v9.
Moreover, Arm noted the impact of positive trends within AI. The company said that it was seeing the demand for Arm technology to enable AI everywhere and that many of the most demanding AI applications are already running on Arm-designed chips. Royalties from the sector are expected to expand further in the coming years as the growth of generative AI and large-language models (LLMs) continues.
The Valuation Is Hard to Justify
Arm is currently trading at 106x forward earnings (for Fiscal 2024, which ends this month). That figure is expected to fall to 83.8x in forward year two, 64.47x in forward year three, and 53.5x in forward year four.
There’s clearly plenty of growth here over the medium term, however it’s not enough considering the current multiples at which the company is trading. In fact, we can observe a forward price-to-earnings-to-growth (PEG) ratio of 2.47x, which infers that the stock is significantly overvalued, at least according to its growth prospects in the medium term.
One of the issues with this valuation is that Arm suggests its own addressable market is only growing by 6.8%. That’s until 2025, when the addressable market size is expected to be worth $246.6 billion. Of course, it could grow faster after this forecasting period, but for a stock trading at 106x forward earnings, it’s not a positive sign.
Arm has a 99% share of the mobile applications processor market — expected to be worth $36 billion by 2025 — and 40.8% of the automotive market — expected to be worth $29.1 billion in 2025. However, Arm’s share of the cloud computing chip market is smaller at 10.2% (2022). The cloud computing chip market is expected to grow at a CAGR of 16.6%, reaching $28.4 billion in 2025.
Is Arm Holdings a Buy, According to Analysts?
Arm Holdings has a Moderate Buy rating, according to analysts who have covered the stock in the past three months. The stock has 11 Buys, five Holds, and one Sell rating. The average Arm Holdings stock price target is $105.80, indicating 15.9% downside from the current share price. The highest share price target is $160, while the lowest share price target is $72. On this occasion, it appears that the meteoric rise in the share price has outpaced analysts’ forecasts for the stock.
The Bottom Line
Arm Holdings is certainly central to the chip world, providing semiconductor and software design to a sizeable and growing sector. However, the numbers simply do not add up, with the British firm trading at 106x forward earnings and with a PEG ratio of around 2.5x. Simply put, the market and earnings aren’t growing fast enough to justify the price tag.
