The recent Nasdaq debut of Arm, the UK-based chip design company, has left Wall Street scratching its head. While SoftBank, the company that spun out Arm after acquiring it in 2016, seems to be pleased with the outcome as the stock soared 25% to $63.59 after its initial public offering (IPO), investors are left puzzled by the company’s valuation. With a fully diluted market cap of almost $68 billion, it defies conventional wisdom for a semiconductor company that generated only $400 million in profit over the past four quarters. This staggering valuation has resulted in a price-to-earnings (P/E) ratio over 170, surpassing even Nvidia’s P/E ratio. Nvidia, known for developing graphics processing units (GPUs) used for AI workloads, trades at 109 times trailing earnings, even after its stock price more than tripled this year, outperforming all other members of the S&P 500. In comparison, the P/E ratio of the Invesco PHLX Semiconductor ETF, which measures the performance of the top 30 U.S. chip companies, is approximately 21. Such a wide disparity in valuations raises questions about the growth prospects of Arm.
The Growth Rate Conundrum
The key factor distinguishing Arm from Nvidia lies in their respective growth rates. Nvidia recently reported a doubling of revenue in the latest quarter and forecasts a 170% expansion in the current period, thanks to major cloud companies intensifying their spending on AI chips. Conversely, Arm witnessed a slight decline in revenue in the last quarter. “There’s no way you can justify a P/E ratio of over 100 for a no-growth company,” says Jay Ritter, a finance professor at the University of Florida and an IPO expert. Ritter suggests that Arm’s story must revolve around the development of new designs that will reignite growth and generate profits. Yet, at present, there is limited demand for Arm’s stock in the open market. SoftBank currently owns 90% of the approximately 1.03 billion shares outstanding after the IPO. SoftBank, which took Arm private in 2016 in a $32 billion deal, aims to generate liquidity after a string of challenging investments. The strategic investors that purchased $735 million worth of shares in the IPO include Apple, Google, Nvidia, Samsung, and Intel. This leaves only a small fraction of shares to be traded among institutional and retail investors, although trading volume was significant, making Arm the fifth most actively traded stock on the Nasdaq, with 126.58 million shares changing hands.
For long-term investors willing to invest at these levels, the primary consideration must be future growth potential. Arm’s prospectus argues that its technology will play a central role in the shift towards AI-based computing. Arm’s designs are currently found in nearly every smartphone, as well as electric cars and data centers. Arm CEO Rene Haas emphasized the significant growth in the cloud data center and automotive sectors, along with the omnipresence of Arm-based devices in the AI market: “It’s hard to find an AI device today that isn’t Arm-based.” According to Arm’s IPO filing, it expects the addressable market for products featuring its designs to reach $246.6 billion by 2025, up from $202.5 billion last year, representing an annual growth rate of 6.8%. To achieve greater prosperity, Arm’s path lies in gaining market share and improving its economics, as the company concedes that the cost and complexity of chip design will continue to increase. Arm believes it can contribute a greater proportion of technology to each chip, which would result in its royalties constituting a larger proportion of the chip’s total value.
Matt Oguz, the founding partner of Venture Science, points out that Arm maintains strong profit margins even with a slight dip in revenue, making it a “unique company” due to the ubiquity of its technology in key products. In fiscal 2023, Arm achieved a gross margin of 96% as it generates a significant portion of its revenue through royalties, rather than hardware delivery. In contrast, Nvidia’s gross margin in the latest quarter was 70%, surging from under 44% the previous year. Intel and AMD recorded gross margins of 36% and 46%, respectively. Arm’s ability to remain profitable, even during a period when many in the chip industry suffered due to a post-Covid inventory glut, underscores its differentiation from being a commodity company. Oguz acknowledges the complexity of calculating a multiple on future earnings given these considerations.
Arm’s Nasdaq debut with its remarkably high valuation raises eyebrows among investors. While Nvidia’s extraordinary growth rate justifies its premium valuation, Arm’s stagnant growth poses challenges to its exorbitant P/E ratio. Despite that, Arm’s future prospects in AI, cloud data centers, and the automotive industry offer hope for potential market share gains. However, Arm must capitalize on these opportunities to drive growth and improve its economics. Only time will tell if Arm can live up to its lofty valuation and prove the doubters wrong.
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