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Is Arm Holdings Stock a Buy?

Vaseline 1 month ago

Shares have cooled, falling 30% after surging out of the IPO gate.

Last year, chip design company Arm positions (ARM -16.90%) was one of Wall Street’s most popular IPOs. Stocks have corrected recently after surging out of the gate on hype over artificial intelligence (AI)-related tailwinds. Today, the stock is trading almost 30% below its high.

The company designs products that serve as the basis for modern semiconductors; About half of the world’s chips use Arm-owned designs. An increasingly digital world warrants greater demand for chips, which means more Arm royalties. But is the stock already overpriced despite the recent share price drop?

Here’s what you need to know.

Market share momentum indicates a competitive advantage

Arm develops semiconductor architecture, the fundamental design for chips. When companies build a chip based on an Arm design, it receives a small fee or royalty. This is a high margin business model with gross profit margins in the high 90% range.

Management expects the company to generate approximately $3.1 billion in revenue and be profitable this year. Analysts estimate the company will earn about $1.20 per share this year, with the stock priced at about 69 times expected fiscal 2024 earnings.

That’s the price. Is it a good value for investors? That requires a look at Arm’s growth prospects.

The company reported its market share trends for several end markets when it went public. This is important because investors can expect future revenue growth if Arm gets a bigger piece of the chip pie, especially if that pie (the chip market) grows.

Market share trends from 2020 to 2022 include:

End of market Market share 2020 Market share 2022 Market size 2022 Est. growth rate of the market until 2025
Mobile application 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%
Network 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 taken from Arm Holdings’ F-1 filing. IoT = Internet of Things.

Investors looking for Arm’s competitive advantage need look no further than its massive gains in market share in such a short time frame. The picture for longer-term growth is less certain. Consistent double-digit revenue growth will likely require continued gains in market share, as most of Arm’s primary markets are growing in low to mid-single digits.

Arm has been able to do this, but there is no guarantee that the market share increase will last forever. As Arm gains ground, competitors may become more aggressive in protecting their stock.

The good news is that chip companies can’t move away from Arm once they’ve designed a chip on its architecture. It would be like tearing down a house down to its foundations; designing a new chip is easier. That means revenues are very sticky.

Is there a safety margin in the price?

A great company can be a worthless investment if you pay the wrong price. Ideally, investors buy with a margin of safety, a buffer 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) chart

Arm PE Ratio (Forward) Data per YCharts; LT = long term.

The price-to-earnings-growth ratio (PEG) is one of my favorite tools for valuing a stock. It’s a favorite of Peter Lynch and shows how much you’re paying for a company’s expected earnings growth. Arm Holdings trades at a price-to-earnings (P/E) ratio of 69 based on estimated fiscal 2024 earnings. Analysts believe Arm can grow earnings at an average annual rate of almost 40% over the next three to five years .

The resulting PEG ratio is 1.7, which is higher than I’d like to pay (1.5 or less is ideal). It’s not that much higher that the stock price is unaffordable, but paying “full price” for a stock doesn’t leave much margin of safety.

What if Arm doesn’t grow its profits as analysts expect? Investing sometimes comes down to making good judgments, so you should always leave some wiggle room in case something goes wrong.

Is Arm Holdings a buy?

It’s hard to justify aggressive buying at these prices because the margin of safety that investors should be looking for seems absent. Remaining patient and waiting for a better buying opportunity may be wiser.

If you want to buy, consider dollar-cost averaging, which means buying a little at a time so you get a win-win situation. You’ll be glad you bought if the stock rises and are positioned to buy the dip if Arm Holdings continues to fall.

Justin Pope has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.