Every investor dreams of striking it big with a well-timed investment in a fast-growing company in a red-hot industry. Those who bought Arm Holdings (ARM -0.38%) shares soon after it went public in fall 2023 have already benefited from dreamy gains. The stock is up by about 75% this year amid optimism that its tech licensing business could benefit from a surge in demand related to the artificial intelligence (AI) trend.
But do the company's fundamentals justify the hype? Let's find out.
A dominant niche in the tech industry
Founded in 1990, U.K.-based Arm Holdings has become a key player in the global technology industry. It specializes in intellectual property, licensing central processing unit (CPU) architectures to other companies that build upon them, incorporating Arm's designs into a wide range of hardware. Arm-based processors are popular in consumer tech, and can be found in an estimated 99% of smartphones.
That said, Arm specializes in CPUs, not the graphics processing units (GPUs) that are used to train and power large language models like ChatGPT. The company will get indirect exposure to the AI space by licensing designs like its Armv9 CPUs, which are geared toward increased performance for more demanding smartphone tasks as more companies add chatbots and other features to their mobile devices.
Companies that are built around collecting licensing revenue can be attractive because of its stable, recurring nature and high margins. However, Arm faces several challenges that could hinder its long-term performance. For starters, the company is a victim of its own success.
Is this still a growth opportunity?
Arm-based processors already have a massive market share in smartphones and other consumer devices, limiting future growth potential. The company estimates that 70% of the world's population uses Arm-based products. Furthermore, many of the core industries it serves are mature. Smartphone sales, for example, are believed to have peaked in 2016. It's hard to see how new, AI-related opportunities can move the needle for a company that does most of its business in large but stagnant verticals.
Arm's fiscal 2025 second-quarter earnings highlight this dynamic. For the quarter, which ended Sept. 30, its royalty revenue jumped 23% year-over-year to $514 million, driven by the success of its new armv9 architecture in smartphones. However, this good news was overshadowed by weaknesses in the rest of the business, leading to consolidated revenue growth of just 5% to $844 million.
Arm's bottom line wasn't impressive, either. With just $64 million in operating income, its operating margin was just 8%, partially because of its massive research and development spending as it strives to stay competitive.
Image source: Getty Images.
Arm doesn't have an easy solution to these problems. Despite its huge market share, its CPU architectures aren't the only game in town. Rival Intel offers competing architectures like x86. Arm is also threatened by a free, open-source alternative called RISC-V, created by computer scientists at the University of California, Berkeley. These competitors could limit its pricing power and growth potential.
Arm's valuation has lost touch with reality
At the end of the day, Arm Holdings is a mature, slow-growing business with limited exposure to the AI industry. But its valuation doesn't seem to reflect this fundamental reality. With a forward price-to-earnings (P/E) multiple of 67, the company's shares are significantly pricier than the Nasdaq-100's average forward P/E of 27, as well as chipmakers like Nvidia and Intel, which boast ratios of 33 and 22, respectively.
For investors, the risks of buying Arm Holdings could outweigh the potential rewards. Shares look significantly overvalued and could give back much of 2024's gains in 2025 and beyond. This stock should be sold or avoided.
