After Arm's Rally, is the Stock a Buy or Sell?

Recent share price gains takes Arm Holdings even further above its Morningstar fair value estimate

Javier Correonero 10 January, 2024 | 10:46AM
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Arm Holdings

Arm Holdings (ARM) went public in September 2023 at $51 per share. The stock closed at a post-IPO high of $77.47 on December 28, 2023, but has since fallen to around $72. Here is Morningstar’s take on Arm’s stock and the outlook for the company.

Arm is a good business. It has a monopoly in smartphones and wearables (99% market share in the former, very high in the latter), and it has begun to gain share in data centres and automotive, which are very attractive markets. In easy terms, this is because Arm’s chips are less powerful than x86 chips (architecture used by Intel INTC and Advanced Micro Devices AMD) but more energy-efficient.

We think Arm is in a financially healthy position, with $1.6 billion of cash on hand and no debt. The firm does not intend to pay any dividend on its ordinary shares, according to its IPO filing. We also don’t expect any significant M&A to happen, as Arm would probably face antitrust scrutiny for any mid- or large-sized deal, given its very high market share.

Given the lack of dividends and M&A opportunities, we expect Arm will use its internally generated cash flow to reinvest in the business through R&D, fund share repurchases, or simply bolster its balance sheet.

Arm is Overvalued After the Rally

With its 2-star rating, we believe Arm’s stock is overvalued compared with our long-term fair value estimate.

Our fair value estimate for Arm is $34 per share, which implies an enterprise value to EBIT multiple of 41 times and 31 times for fiscal years 2024 and 2025, respectively. At Arm’s IPO price debut of $51 per share, the enterprise value to EBIT multiples would be 59 and 41 times for 2024 and 2025, respectively.

Economic Moat Rating

We assign Arm a wide economic moat based on its intangible assets and switching costs. Arm is the IP owner and developer of the ARM (“Acorn RISC machine”) architecture, which is used in 99% of the world’s smartphone CPU cores. It also has high market shares in other battery-powered devices, such as wearables, tablets, and sensors.

Risk and Uncertainty Stem from China Exposure

We give Arm a High Uncertainty Rating, with key risks coming from China and the slow but steady adoption of RISC-V.

More than 20% of Arm’s business comes from China. Arm China is the only entity allowed to sell Arm’s IP in the country, but it is not controlled by Arm Holdings. Rather, Arm licenses IP to Arm China, which then sublicenses it to Chinese customers like Xiaomi or Huawei. Arm’s revenue recognition from the country is dependent on the information Arm China provides, and financial reporting controls have historically been weak.

SoftBank (Arm Holdings’ main shareholder) still has significant influence over Arm China, but if it departs, it would leave an intricate web of corporate subsidiaries. There could be attempts to steal intellectual property from Arm China, given geopolitical tensions between the United States and China. 2022 saw a series of corporate fights at Arm China. Previous CEO Allen Wu was accused of unethical behavior. It took months for SoftBank and other anchor investors to get rid of him, and he still has a stake in the company.

Morningstar Key Metrics For Arm

  • Fair Value Estimate: $34;
  • Morningstar Rating: 2 Stars;
  • Morningstar Economic Moat Rating: Wide;
  • Morningstar Uncertainty Rating: High.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
ARM Holdings PLC ADR99.88 USD4.00Rating

About Author

Javier Correonero  is an equity analyst for Morningstar

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