Those who cannot remember the past are doomed to repeat it.
- philosopher George Santayana
It's easy to get swept up in the tech wave again. Companies are posting excellent results, economic strength is defying many prognosticators, and the market is pushing all-time highs on the back of soaring companies like Nvidia (NVDA) and Microsoft (MSFT). Actually, Nvidia, Microsoft, and Apple (AAPL) make up 20% of the entire value of the S&P 500. Crazy!
Many other companies, like Arm Holdings (NASDAQ:ARM), benefit from the AI boom. Arm is one of my favorite companies now, but I sold a large percentage of my holdings. Here's why I love the company, why I sold the stock, and the price I will dive back in.
The Nvidia Effect
Nvidia has truly powered the market, and it has large coattails. Its data center revenue growth is astounding, with 427% year-over-year (YOY) growth last quarter to $22.6 billion. The addressable market is massive and growing, and its competitors face a steep climb. However, the recent stock price climb stretched the valuation to a forward P/E well over 40. Some of this may be due to excitement over the stock split, which should make intelligent investors cautious.
Even with tremendous results, fatigue will eventually set in. Investors who buy going into a stock split often get victimized as other investors take profits soon after. If Nvidia stock swoons, many other AI stocks will fall as well. This is a textbook example of being fearful when others are greedy.
Arm Holdings is a Tremendous Company
Arm is a unique company in the semiconductor space, and this uniqueness makes it an attractive investment. Arm doesn't manufacture semiconductors. It designs the "architecture" for chips and licenses it to others to produce.
Revenue comes from royalties and license fees. But the key here is that Arm doesn't have tremendous capital expenditures (CapEx) for foundries and equipment like semiconductor manufacturers. In this way, its business model is much more closely linked to software companies-high gross margin, recurring revenue, and little CapEx. This business model makes companies like Microsoft, CrowdStrike (CRWD), and Palantir (PLTR) attractive. They are cash flow machines, and the high gross margins mean leverage at scale.
Consider this: Arm has a 95% gross margin, while the globe's leading semiconductor manufacturer, Taiwan Semiconductor (TSM), is just over 50%.
As shown below, Arm's free cash flow margin outpaces TSM's 29% to 20%.
But wait! This isn't an apples-to-apples comparison. Exactly! Arm makes more money when the semiconductor market booms but has little of the pesky overhead associated with manufacturing. Arm's CapEx is less than 3% of revenue over the last twelve months.
Another terrific part of Arm's business model is its ability to earn revenue on prior designs. New use cases don't cannibalize older models, as shown below.
Legacy royalties are nearly all profit.
The stock price has more than doubled since the IPO as a result:
And this is a problem. I sold almost my entire position recently. Here's why.
Is Arm Holdings Overvalued?
Artificial intelligence spending ushered in a new tech boom. While there may not be an overarching bubble, there are stocks that have swelled too much. If similar periods (2021, the recent example) taught us anything, it's that valuations still matter and patience really is a virtue.
Since Arm's margins are aligned with software companies, I'll use this as a comparison. By any reasonable measure, it is significantly overvalued.
The price-to-sales ratio is over 40 and over 35 based on next year's estimates.
Even high-flyers like Palantir and CrowdStrike would blush at this valuation as both are under 27 currently and near 20 on a forward basis, as depicted below:
The story is the same when measured on cash flow, as you can see below.
Arm guides for $3.8 billion to $4.1 billion in sales this fiscal year (18% to 27% growth), but this may not be enough to justify the current stock price.
Arm's current market cap is $142 billion. Because of my affinity for the business model and confidence in the company, I will start accumulating a larger position if it gets closer to 20 times sales. Based on the high end of this fiscal year's guidance, this would be a market cap of $82 billion or a share price just shy of $80 per share.
Arm Holdings deserves a premium valuation because it is a premium company; however, the current price is too rich for me. I held on to a small position, profited off the rest, and will look for a significant dip to dive back in.
Bradley Guichard
If you are a medium to long-term investor looking for an analysis of equities focused on cash flow, growth, and other critical metrics from a financial professional who knows financial statements inside and out, consider giving me a follow.While I am Tech-focused, I have a diversified portfolio, including growth and value equities, REITs, and dividend stocks. I like to use options for income and risk management when the opportunity arises.I have over 15 years of experience in the market. I am a practicing CPA; however, I have learned about investing more from avid reading, market watching, experience, and of course, making mistakes over the years. Also, am an admitted Excel junkie.I believe Benjamin Franklin when he said: "An investment in knowledge pays the best returns," and Warren Buffet that "The most important quality for an investor is temperament, not intellect." I am constantly learning and focusing on long-term goals - even when the market misbehaves.Thank you very much for reading, and please feel free to leave me a message in the comments or send a private message.All the best!
Analyst’s Disclosure: I/we have a beneficial long position in the shares of ARM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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