TheChek News Flow

The Takeaway

Shares of chip design firm Arm have soared since its IPO to a valuation level higher than Nvidia’s, based on multiples of both revenue and profits. But Nvidia dominates the market for specialized chips used in AI whereas Arm has a more indirect AI business.

Since chip-design firm Arm Holdings went public last September, excitement around generative AI has sent its stock soaring, to a high last month of $188, more than triple its initial public offering price. While the stock has since fallen back a bit, investors are still valuing Arm at a big premium to Nvidia both on a multiple of future revenue and profits. That’s despite the fact that Nvidia dominates the market for specialized chips used in artificial intelligence.

The valuation gulf makes little sense. AI is a much smaller part of Arm’s business than of Nvidia’s. While Nvidia’s revenue soared 126% in its fiscal year ended January, Arm’s revenue rose 21% in its last fiscal year ended March.

There is a chance Arm’s revenue growth will accelerate based on AI features lifting smartphone sales, as well as other new businesses Arm has expanded into. Recent media reports also suggest Arm might be building its own AI chips to rival Nvidia’s, which has likely fueled Arm’s rally this year.

Even taking all that into account, Arm stock looks severely overvalued, trading at 33 times estimated next 12 months’ sales compared with 23 times for Nvidia, according to Koyfin data. AMD, a much more direct rival to Nvidia, is trading at just 8.5 times.

Investors might be better off getting exposure to Arm through buying stock in SoftBank, the Japanese technology investor that owns around 90% of Arm, according to senior partners Brett Simpson and Andrew Beale at Arete Research, an independent Wall Street firm.

Phones, Cars, Servers

Arm doesn’t make chips. Instead, it primarily creates blueprints for central processing units, the brain of computers. CPUs using Arm blueprints are in virtually every mobile phone as well as in cars, smart devices for the home and some data center servers. Arm’s customers—chipmakers and hardware producers such as Apple and Qualcomm—typically pay the company a licensing fee to use its designs, as well as a royalty fee for each chip they manufacture that incorporates Arm’s technology.

The company has lately talked up the potential of AI to boost its business. But it’s hard to tell exactly how much of Arm’s revenue is coming from AI, as its exposure is indirect. Arm doesn’t break down revenue growth from sales to different industries.

Investors are betting that the new AI features arriving on smartphones will lift Arm’s revenue. Those features—such as the Gemini assistant Google unveiled last week for Android phones—require more powerful chips.

Arm has renegotiated some of the licensing deals for its new v9 chip blueprints and has signed new ones, which carry royalty fees roughly twice as high as the previous generation’s, according to Arm executives.

Arm’s chief financial officer, Jason Child, told investors on a July call that phone makers’ upgrade to v9 helped the company lift its royalty revenue from smartphones 50% year over year in the latest fiscal quarter, even though sales of new phones barely grew.

Phone manufacturers are willing to pay up for the latest Arm technology because they want to invest in chips that “seem sustainable for the next several years” and that can potentially support the use of large language models on a mobile device, according to equity analyst John Vinh of KeyBanc.

But there’s no guarantee the AI features now being promoted on phones from upcoming iPhones to Google’s latest Pixels will be enough to spark a revival of the phone market. Smartphone sales have been flat for the past two years, as people are holding onto their devices for longer than in the past.

If the new AI services don’t spark the revival in sales that phone makers are banking on, Arm’s revenue won’t grow as much as investors seem to be expecting.

Arm’s future revenue growth could also be threatened if it loses a lawsuit it has filed against one of its customers, chip giant Qualcomm, Arete Research analysts say. Arm brought the suit arguing that Qualcomm improperly used some of Arm’s intellectual property. Qualcomm accounted for roughly 40% of Arm’s smartphone royalties in the most recent fiscal year.

Uneven Revenue

Another potential source of growth may come from Arm blueprints for chips used in data centers.

The graphics processing units made by Nvidia, which are needed to train and run AI models, have to be paired with CPUs in order to function. Nvidia sells a CPU called Grace, which uses Arm blueprints, alongside its GPUs, ensuring that Arm gets royalty revenue. That revenue should rise along with GPU sales.

Arm’s architecture also underpins CPUs such as Amazon’s Graviton, which can help generative AI models draw conclusions from data in a process known as inference. Arm only has about 15% of the market for chip designs used in cloud servers today—based on royalty payments—according to an investor presentation by the company last month.

Arete Research’s analysts reckon Arm’s market share will increase as companies such as Amazon, Microsoft and Google shift to developing more custom server chips similar to Amazon’s Graviton. But AMD, in particular, has also been moving aggressively to boost its position in the AI chip market for data centers. Indeed, it announced on Monday an acquisition of ZT Systems, which sells AI infrastructure for data centers. (Arm shares sold off on the ZT news, although they recovered within a few hours.)

That suggests investors shouldn’t bank too heavily on Arm lifting its share of the market.

To be sure, Arm’s revenue growth has accelerated in the past couple of quarters, jumping from 14% in the December quarter to 47% in the March quarter, then moderating slightly in the June period. And the company’s latest guidance indicates it expects to grow revenue by at least 20% this year and in each of the next two years, a projection many Wall Street analysts have adopted in their own estimates.

But Arm has a history of uneven revenue growth, which suggests investors should be wary of assuming steady expansion. While Arm’s top line jumped 21% in the year to March, revenue fell slightly in fiscal 2023, after it rose 33% in fiscal 2022.

Between 2015 and 2021, notably, Arm’s revenue grew only 35% from roughly $1.5 billion to just over $2 billion, judging by financial statements available from its time as a public company before SoftBank took it private and then public again more recently.

The Softbank Option

Arm’s deluxe valuation makes it less palatable even to investors who believe in its long-term prospects. And one reason for the high valuation is that the float of Arm shares—the number of shares available to trade—is extremely limited because SoftBank has retained around 90% of the stock.

That’s partly why the Arete analysts say buying SoftBank shares directly is a better way to get exposure to Arm’s business model, even taking into account the other assets and liabilities in Softbank’s portfolio. They estimate that SoftBank’s stake in Arm is receiving an implicit valuation of only $20 a share, less than half Arm’s IPO price, let alone its current stock price.

Getting exposure to Arm through SoftBank would also protect investors against the potential impact of SoftBank selling down its stake, which could put downward pressure on Arm shares.