After a better than expected quarterly report, Arm Holdings plc (NASDAQ:ARM) soared by almost 50%. While the chip design company has reported strong numbers and growing profits, the stock has mostly risen in recent years. months due to multiple expansion and not growth. My investment thesis is ultra bearish on the stock as it trades at levels not seen since the dotcom bubble and a select few stocks during Covid peaks.
ARM reported strong third quarter 2024 results after the close on February 7, as follows:
Even though the chipmaker beat estimates, one must understand ARM's business model. Much of the revenue comes from upfront licensing deals, leading to inconsistent quarterly revenue, where ARM can report a $61 million increase and only 14% growth for the quarter.
It can easily be argued that if ARM had guided itself correctly, the market would not have been impressed by 14% growth with an uptick in revenue. Additionally, the chip company released other metrics that weren't necessarily very impressive, despite the stock rising more than 50% for most of the following trading day:
- ARM chips shipped in the September quarter fell to 7.7 billion from 7.9 billion.
- The growth of FQ3 was the most isolated to double the royalty rate for Armv9 technology.
- Licensing revenues jumped 18%.
- Annualized Contract Value (“ACV”) only increased 15% year-over-year to $1.16 billion.
- Stock-based compensation (“SBC”) of $198 million represented more than 15% of total revenue.
Royalty revenues increased by only $45 million year-over-year, a growth of 11%, but the contribution of Armv9 technology jumped to 15% of revenues, up from 10% in just the previous quarter. At 15% of the $470 million in Q3 royalty revenue, ARM generated $71 million from the Armv9 royalty, suggesting that approximately $35 million of the revenue increase was due to double royalty rate compared to old Armv8 technology.
As we discussed last quarter, licensing revenues are very fragmentary and difficult to predict. Most of the growth came from increased licensing revenue during the quarter, with 5 new ATA deals during the quarter. ARM now has more than half of the top 20 customers under ATA, limiting some of the upside in this revenue bracket, where transactions contribute to significant initial revenue values.
These key licensing revenues were actually down from Q2 2024 levels of $388 million. Again, December quarter revenues were not that impressive, with total revenue only having grew only $18 million sequentially to $824 million.
Ultimately, the ACV metric did not meet any explosive demand for AI. ARM is seeing strong demand for AI, leading to strong growth expectations in the coming years, but the numbers likely aren't much different from AI. Taiwan Semiconductor (TSM).
As shown in the chart below, ACV reached $1.16 billion, a growth of only 15%.
In addition to the lack of growth metrics that support stock market exuberance, ARM has a substantial amount of stock-based compensation. While I'm not against SBC, the amount is excessive in ARM's case and erases the majority of the $338 million in adjusted operating income. Removing SBC's $198 million, operating profit would have been only $140 million.
The company now has 1.05 billion shares outstanding, and one of the main reasons for the stock's rise is the lack of free float, with only 10% outstanding post-IPO. The combination of a low float and high SBC will ultimately contribute to massive pressure on the stock as large amounts of additional shares are dumped into the market.
ARM has targeted fourth-quarter revenue of between $850 million and $900 million, with consensus analysts estimating it to be $860 million, representing growth of 36%. The March quarter growth looks impressive, but the first quarter was very weak, with revenue down from Q4 2022 levels of $657 million.
Multiple expansion won't last
A prime example of the stock market's excessive exuberance is that ARM is now trading at over 40 sales in progress and 37x FY24 guidance. The company has reached 3.18 billion in revenue dollars and the stock now has a market capitalization of nearly $120 billion.
As the chart shows, TSM is only trading at 10x sales targets. The chip company has significant capital expenditures, but the company generates similarly massive operating margins, in the 40% range. ARM only licenses the chip technology, while TSM or another chip maker is still needed to produce the chips.
TSM is only trading at 20x EPS targets of $6.27, while ARM now trades at around 100x updated FY24 EPS targets of $1.22. One can certainly understand the benefits of a high-margin licensing business, but a premium valuation of 5x that of the leading chip producer is more than excessive.
At the peak of Covid where sales jumped 100%, Zoom video communications (ZM) traded at over 40x sales targets when the stock was above $500. Zoom stock has completely collapsed since sales growth slowed, and now the stock is trading at only 4x forward sales targets.
The main takeaway for investors is that Arm Holdings plc has a bright future due to the demand for AI chips and the shift to ARM-based chips. However, the stock is currently largely disconnected from future opportunities, with ARM trading at multiples above a logical valuation that will eventually fall into the 10-15x sales range.
Investors should take advantage of the stock's current rise to exit ARM at its highest.