It seems that Arm has evolved into the AI equivalent of a meme stock. The US-listed, UK-headquartered firm's shares have doubled in value since it reported solid profits last Wednesday, pricing the SoftBank Group-backed chip manufacturer at $153 billion. That level is arguably durable and hyper-inflated.
Arm chief executive officer Rene Haas has experienced a lot since the company went public in New York in September at a $52 billion valuation. After soaring well beyond his $51 per share listing price on the first day, the group's shares continuously declined at or below that level for more than a month. Investors didn't seem to be convinced by Haas' predictions that he could increase revenue by 11% in the year ending in March 2024 and then by 25% the following year, or that he could raise the operating margin of the company to more than 40%.
They have reason to suspect these things after last week's results. By a quarter in 2023, Arm's revenue decreased by 1%. However, Haas achieved a 14% year-over-year rise in revenue in the three months leading up to the end of December. Visible Alpha data shows that analysts expect Arm's margin to reach above 40%, while the company now projects top-line growth of up to 20% in the 12 months leading up to March 2024.
Arm's ability to convince five more unnamed clients to sign up for full access to the company's chip designs is a major factor in its revenue strength, as it allowed Haas to book a portion of this so-called license revenue up front. However, part of the margin bounce might be attributed to Arm's ability to increase the royalties it receives per chip by offering a more sophisticated model of its product, which increased the profitability of its primary smartphone business, in which it holds a dominant market share. Finally, Haas hopes to expand into the fields of AI applications and data centers, both of which are being designed by an increasing number of customers using Arm's energy-efficient intellectual property.
Nevertheless, based on Visible Alpha statistics, Arm is currently trading at 84 times the operational profit experts anticipate it will make in 2025, following investors' enthusiastic responses. This is far more expensive than Nvidia, the stock market favorite of AI, which is predicted to treble its revenue with an earnings-before-interest (EBIT) margin of 60% over the next two years on average. Despite its superiority in graphics processing unit chips that make it a clearer victor from the AI revolution, Nvidia trades at merely 29 times its projected operating profit in 2025.
According to calculations, Haas would need to treble its revenue in the year ending in March 2025 for Arm's most recent valuation to match analysts' estimated 45% operating profit margin. That seems dubious. Although more users are signing up to access Arm's designs, license revenue is unpredictable and lumpy due, in part, to the fact that most of the major chip groups have already subscribed to one. Haas will not be able to receive royalties during the year or longer it may take for customers to turn Arm blueprints into their own products; royalties only become due at the time the chips are shipped. In addition, Arm's main source of income, the smartphone market, may slow down, and the company's desired growth areas of data centers and electric cars may not materialize.
Arm's stock should be headed for an equally steep decline in light of all of that. However, that is not sure. Very little of Arm's stock is traded freely because SoftBank still owns 90% of the company. This makes it riskier to short because it magnifies any up or down movement. Shares of Arm would plummet if lock-up limitations for early owners expire on March 12, when Masayoshi Son, the head of the Japanese business, is expected to crystallize part of his post-IPO gains. SoftBank is eager to take advantage of its increased capacity to borrow against its significantly more valuable shares, based on remarks made by the company itself.
This puts investors in Arm in an odd situation. More than they may have imagined, their company is going well. However, it's possible that this has little bearing on where it trades right now.