da-kuk
Shares of Arm Holdings plc (NASDAQ:ARM) have joined the AI craze which has been dominating the market in recent weeks, having comfortably doubled from its IPO which took place in September of last year. The company reports solid results and issued a decent outlook for the current quarter, but moreover, it were the words about further growth and strong momentum around AI which drove momentum in a big way, although that exuberance of trading action is displayed.
Future Computing
ARM plays a key role in the world of CPU (central processing unit) architecture, with over 280 billion chips based on its design since the company was founded. Standing at the very forefront and initial step of chip design, its architecture plays a key role in the design and production of chips, and consequently, the world as we know it today.
The company licenses this technology to manufacturers, with use cases ranging across the entire spectrum, from mundane sensor tasks to supercomputers. With demand for connected (devices) on the rise, and the design of chips becoming more complex and costly, the role of ARM is key to technological advancement. Moreover, the royalty and license fee business model of the firm looks very compelling, being an asset-light and more predictable cash flow stream.
The company has a rich history, with the British company being bought by Softbank back in 2016, and given its prominent role within the industry, it was no surprise that NVIDIA Corporation (NVDA) was interested in the business as well, willing to acquire the business back in 2020 for $40 billion. While Nvidia was a powerhouse already at the time, this was nothing compared to the strength of the business today. That deal, of course, did not follow through, for antitrust reasons.
Valuation & IPO Thoughts
After acquiring the business, SoftBank subsequently sold nearly 100 million shares (ahead of the green shoe option) at $51 in September of last year, raising a couple of billions. A share count of just over a billion shares granted the business a $52 billion valuation at the offer price, as net cash holdings of $2 billion worked down to a $50 billion enterprise valuation.
For the year which ended in March 2023, the company actually saw sales fall in a modest fashion from $2.70 billion to $2.68 billion. GAAP operating profits rose to $671 million, with net earnings of $524 million being equal to half a dollar per share.
First quarter sales for the fiscal year fell by 2% to $675 million, as valuations were rather demanding at over 20 times sales and over 100 times earnings, all while the business was posting flattish results at best, as shares rose to the low sixties in trading immediately after the public offering. Amidst all this, with Softbank being a willing seller and the regulatory outlook for mega-mergers being detrimental, I was naturally a bit cautious.
An Immense AI Run
Shares of ARM have traded in a $50-$70 trading range since the public offering in September, that is, all the way until pretty much a week ago, as shares displayed massive momentum post the release of the latest quarterly results. A period of elevated volatility followed, with shares trading as high as $164 per share, now trading at $128 per share.
In November, the company reported second quarter sales up 28% to $806 million, as the company posted a GAAP loss of $0.11 per share, with most of the losses due to elevated stock-based compensation in connection to the offering. Adjusted earnings were reported at $380 million (that is after taxes) for unheard margins, but this is of course after adjusting for stock-based compensation expenses, as it is hard to see what the regular cost of this line item is going to be going forward.
Arguably the second quarter was very strong, as the company guided for somewhat more modest third quarter sales, seen between $720 and $800 million, with adjusted earnings seen between $0.21 and $0.28 per share. For the year, revenues were seen at a midpoint of $3.02 billion, with earnings seen at $1.05 per share, plus or minus five cents.
The real shareholder momentum started following the release of the third quarter results. Revenues were reported at $824 million, up 14% on the year before, but moreover markedly coming in ahead of the top line of the guidance. Pricing and higher value-added products are key in this, with the number of ARM-based chips actually down slightly by just over 2% in unit terms, reported at 7.7 billion.
GAAP earnings came in at $0.08 per share, with adjusted earnings reported at $0.29 per share, yet the vast majority of the discrepancy stems from stock-based compensation expense, which seems quite structural.
The Talk Does It
While the third quarter results were solid, they were by far not impressive enough for shares to essentially double in the time frame of just a couple of trading sessions. The fourth quarter outlook was decent, but a $850-$900 million revenue guidance and $0.28-$0.32 per share adjusted earnings guidance were but not too spectacular.
The real promise was in the commentary, and thereby implicitly an outlook into fiscal 2025. The commentary focuses on the increased adoption of the Armv9 technology, with royalty rates being roughly double those of Armv8. The company furthermore announced that Armv9 makes up 15% of royalty income by now.
Other positive trends and commentary relate to market share gains in cloud servers, and a recovery in the smartphone market, among others. Moreover, the company implicitly guides that growth even accelerates with the emergence of AI, making its services ever more important to facilitate the rise of all these new technologies.
The mix of all this positive commentary sent shares flying as 1.03 billion shares outstanding value equity at nearly $132 billion, at $128 per share, including a modest net cash position of $2.4 billion here. Contrary to some AI momentum peers, the company is truly asset-light and hence does not need to finance this growth, in terms of working capital requirements or capital expenditures.
Even with revenues trending at an annual $3.5 billion, after growth accelerated nicely in the recent quarter, it is obvious that higher multiples have been driven by most of the share price gains with shares trading at 37 times annualized sales.
Exuberance, Or Not?
Arguably, it is the price reaction in recent days which looks highly speculative, with shares of such a big company doubling essentially in the time frame of just a few sessions (and some more at a given point in time).
Unlike names like Nvidia, or Super Micro Computer, Inc. (SMCI), the current growth of ARM is decent, but by far not as spectacular as the names mentioned before. That said, it really seems as if the upbeat commentary suggests that the real growth acceleration still has to come post the current fourth quarter.
This is needed as a 37 times sales multiple and earnings multiple ways beyond 100 times, is far too demanding, certainly with the six-month lock-up period post the public offering coming up in March. That will increase the float as well, as this is now relatively limited, thereby opening the window for speculative moves here.
To justify the current valuations, growth has to continue and accelerate for quite a while. On the other hand, while the current multiples look very demanding, the overall valuation of ARM was not too demanding in dollar terms if you consider its critical role in the ecosystem and the valuation of major users of its technology.
With revenue per chip coming in at just eleven cents, and the value-added of these chips being huge, perhaps ARM has huge pricing power to come, something more or less suggested by the comment that royalty rates on the 9 version are double the rates charged on the 8 series. After all, the chip design company here commands a >$100 billion valuation, while multiple clients or end users command multiples in excess of a trillion.
After all, while the current valuation is somewhat bubbly, a $130 billion valuation compares to a $40 billion valuation attached by Nvidia back in 2020, while the shares of Nvidia have risen by about a factor of 8 times ever since.
Amidst all this, I have absolutely no interest in getting involved in the shares here (either long or short) as the action feels really bubbly, but the fundamentals and strong enthusiasm make a short too dangerous to consider as well.
