Arm Holdings: Hedge Funds' Favorite New Stock, But Is It Worth The Hype?

Arm Holdings plc (NASDAQ:ARM) has been the talk of the town among hedge funds, with many bullish on the company's prospects in the AI-driven tech landscape. The stock has surged by about 75% this year, fueled by optimism surrounding the company's licensing business and its potential to benefit from the AI trend. However, is Arm Holdings the best new stock to buy according to hedge funds, or is the hype surrounding the stock unjustified?

A dominant niche in the tech industry

Founded in 1990, U.K.-based Arm Holdings has become a key player in the global technology industry. It specializes in intellectual property, licensing central processing unit (CPU) architectures to other companies that build upon them, incorporating Arm's designs into a wide range of hardware. Arm-based processors are popular in consumer tech, and can be found in an estimated 99% of smartphones.

That said, Arm specializes in CPUs, not the graphics processing units (GPUs) that are used to train and power large language models like ChatGPT. The company will get indirect exposure to the AI space by licensing designs like its Armv9 CPUs, which are geared toward increased performance for more demanding smartphone tasks as more companies add chatbots and other features to their mobile devices.

Companies that are built around collecting licensing revenue can be attractive because of its stable, recurring nature and high margins. However, Arm faces several challenges that could hinder its long-term performance. For starters, the company is a victim of its own success.

Is this still a growth opportunity?

Arm-based processors already have a massive market share in smartphones and other consumer devices, limiting future growth potential. The company estimates that 70% of the world's population uses Arm-based products. Furthermore, many of the core industries it serves are mature. Smartphone sales, for example, are believed to have peaked in 2016. It's hard to see how new, AI-related opportunities can move the needle for a company that does most of its business in large but stagnant verticals.

Arm's fiscal 2025 second-quarter earnings highlight this dynamic. For the quarter, which ended Sept. 30, its royalty revenue jumped 23% year-over-year to $514 million, driven by the success of its new armv9 architecture in smartphones. However, this good news was overshadowed by weaknesses in the rest of the business, leading to consolidated revenue growth of just 5% to $844 million.

Arm's bottom line wasn't impressive, either. With just $64 million in operating income, its operating margin was just 8%, partially because of its massive research and development spending as it strives to stay competitive.

Arm doesn't have an easy solution to these problems. Despite its huge market share, its CPU architectures aren't the only game in town. Rival Intel offers competing architectures like x86. Arm is also threatened by a free, open-source alternative called RISC-V, created by computer scientists at the University of California, Berkeley. These competitors could limit its pricing power and growth potential.

Arm's valuation has lost touch with reality

At the end of the day, Arm Holdings is a mature, slow-growing business with limited exposure to the AI industry. But its valuation doesn't seem to reflect this fundamental reality. With a forward price-to-earnings (P/E) multiple of 67, the company's shares are significantly pricier than the Nasdaq-100's average forward P/E of 27, as well as chipmakers like Nvidia and Intel, which boast ratios of 33 and 22, respectively.

For investors, the risks of buying Arm Holdings could outweigh the potential rewards. Shares look significantly overvalued and could give back much of 2024's gains in 2025 and beyond. This stock should be sold or avoided.

Don’t miss this second chance at a potentially lucrative opportunity

Ever feel like you missed the boat in buying the most successful stocks? Then you’ll want to hear this.

On rare occasions, our expert team of analysts issues a “Double Down” stock recommendation for companies that they think are about to pop. If you’re worried you’ve already missed your chance to invest, now is the best time to buy before it’s too late. And the numbers speak for themselves:

Nvidia: if you invested $1,000 when we doubled down in 2009, you’d have $355,269!*

Apple: if you invested $1,000 when we doubled down in 2008, you’d have $48,404!*

Netflix: if you invested $1,000 when we doubled down in 2004, you’d have $489,434!*

Right now, we’re issuing “Double Down” alerts for three incredible companies, and there may not be another chance like this anytime soon.

See 3 “Double Down” stocks »

*Stock Advisor returns as of December 23, 2024

Will Ebiefung has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Intel and Nvidia. The Motley Fool recommends the following options: short February 2025 $27 calls on Intel. The Motley Fool has a disclosure policy.



Arm's business is simple to understand. Given its energy-efficient platform, it forms the foundation architecture in the mobile phone ecosystem. As a result, Arm controls 99% of the market, making it a well-entrenched dominant market leader with long-term revenue and cash flow visibility. Furthermore, Arm has diversified its business well beyond its smartphone leadership. Management underscored the success of its business expansion, noting revenue contribution of "65% coming from markets beyond mobile." As a result, the company believes its growth inflection from more Arm-based processors in other segments could drive further "share gains and market share growth outside of mobile."



Arm has benefited from Nvidia's (NVDA) dominance in the AI chips era, bolstering its GH series, which relies on Arm architecture. In addition, the broad adoption of Arm architecture across IoT, edge devices, automotive, and high-performance computing has also benefited Arm. Moreover, even the smartphone refresh cycle with Arm v9 (leading to higher royalty rates), and the AI PC cycle have lifted Arm's confidence of robust growth in 2024 and beyond. Notwithstanding the optimism surrounding Arm's growth cadence, could investors who joined last week's rally near its highs have taken their confidence too far ahead?

Arm's FQ4'24 guidance surpassed analysts' estimates with ease. Arm telegraphed an FQ4 midpoint revenue guidance of $875M, well above the consensus estimates of $779M. However, it suggests that Arm could report a sequential revenue growth of just 6.7%, hardly a big bang that could have led to such a massive rally last week. On a FY2024 basis, Arm guided for a midpoint revenue outlook of $3.18B, slightly above the more conservative analysts' estimates of $3.17B. As a result, Arm's outlook indicates a 19% growth from FY23's metric. I didn't glean such a substantial revision to its forward guidance that suggests it's deserving of such a high valuation multiple. As a result, I assessed that the market could have turned overly optimistic about Arm's ability to "graduate" more customers to its higher value Arm Total Access or ATA agreement.

Notably, the company signed five new ATA agreements last quarter, likely surprising analysts on the conference call. Management attempted to shape the narrative that it believes "the transition from AFA to ATA was an expected outcome of the program design." As a result, Arm investors can anticipate further progression moving ahead, suggesting the market should accord a higher value to Arm's ecosystem, with ARM deserving of a higher valuation multiple. I have confidence that Arm's robust adjusted operating margin could continue to increase. I based my optimism on the increased AI proliferation and Arm's ability to turn in higher rates or model transition (from AFA to ATA) to justify the value of its architectural improvement. However, with ARM valued at such a high multiple ahead of the expiry of its lock-up period, I urge significant caution.



ARM price chart (weekly, medium-term) (TradingView) With ARM staging a vertical flush-up price action last week, I'm concerned that it could have driven a late surge before a potential steeper profit-taking opportunity. Dip buyers in October could use the next four weeks to reallocate their exposure, anticipating downside volatility linked to the expiry of Arm's lock-up on March 12. As a result, I view Arm's valuation and price action with significant caution. Investors sitting on substantial gains should consider rotating their holdings, as ARM seems priced for perfection.



Rating: Initiate Sell. Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.