Arm Stock Is the New AI Darling: Value Investors Should Be Careful

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Arm Holdings (NASDAQ:ARM), a British chip designer, has the makings of the “next” NVIDIA (NASDAQ:NVDA). That’s either exciting or unsettling, depending on one’s perspective.

Momentum-focused traders might smack their lips at the prospect of another “moon-shot” stock to ride the artificial-intelligence (AI) hardware trend. On the other hand, value-conscious investors may wince at the thought of another AI-driven, hyper-growth market darling.

However, if the trend is supposed to be one’s friend, then it’s hard to argue with the bullish trend in ARM stock. Let’s arm ourselves with Arm’s fundamentals so we can make a more informed investment decision.

ARM stock rallies 29%: Don’t bother looking for reasons

On some days, a stock can spike just because the market really likes it. There doesn’t always have to be a new, identifiable catalyst.

A textbook example would be ARM stock, which jumped 29% on Monday despite the lack of company-specific news on that day. There wasn’t anything notable over the weekend either.

After Monday’s pop, Arm Holdings stock has more than doubled since the beginning of February, and the month isn’t even halfway over yet. Trying to make sense of this will most likely only lead to confusion and frustration.

Vertical share-price moves can lead to unexpected market distortions. The Wall Street Journal used “share price as a multiple of forward earnings” as a metric to show that Arm’s valuation is more than double NVIDIA’s.

The Wall Street Journal also observed that Arm CEO Rene Haas “mentioned AI 17 times” during the company’s recent earnings call. Does this mean there’s now a direct correlation between CEO mentions of AI and stock prices?

I’m only half-joking when I ask that question. One analyst called Arm Holdings’ valuation a “head scratcher,” but it’s not entirely a mystery. NVDA stock was once touted as a picks-and-shovels play because the company doesn’t create AI applications but manufactures the hardware needed to power those applications. Similarly, Arm Holdings designs the circuitry that underpins AI use cases in mobile phones, data centers and personal computers (PCs).

The market already knows this though, and now Arm’s trailing 12-month price-to-earnings (P/E) ratio is in the quadruple digits. This makes NVIDIA look undervalued by comparison.

Good results, optimistic guidance

Could Arm Holdings’ fundamentals possibly justify its lofty valuation? Let’s peek under the hood, and I’ll let you judge for yourself.

In the third quarter of fiscal 2024, Arm’s revenue grew 14% year over year to $824 million, exceeding the analysts’ consensus estimate of $761 million. Meanwhile, Arm Holdings’ quarterly adjusted earnings of 29 cents per share beat Wall Street’s call for 25 cents per share.

Are those monster, blockbuster beats? They’re pretty good but not what one would probably call earnings crushers. As such, they don’t seem to justify Arm’s current valuation — if justification is relevant anymore.

However, as you’ll recall, Arm Holdings’ management made an effort to mention AI repeatedly.

For instance, it said in the company’s quarterly shareholder letter, “We are seeing the demand for Arm technology to enable AI everywhere, from the cloud to edge devices in your hand… The most demanding AI applications are already running on Arm today.”

There are two AI mentions right there.

Along with repeatedly mentioning AI, Arm Holdings’ management gave the share price a nice boost by providing highly optimistic current-quarter guidance. Specifically, the company expects to generate revenue of $850 million to $900 million, versus Wall Street’s estimate of $780 million. Arm also guided for current-quarter earnings of 28 cents to 32 cents per share, while analysts had predicted 21 cents per share.

This optimistic guidance, along with management pounding the AI drumbeat, practically ensured that the ARM stock price would head higher. Inevitably, chatter of Arm Holdings being the “next NVIDIA” swelled in the financial media and on social media.

The reality check here is that again, Arm’s actual quarterly revenue growth was only 14%. That’s not bad by any means, but it’s also not spectacular.

It’s dangerous when a company’s hype comes from forward guidance rather than actual data. Now Arm Holdings has the unenviable task of living up to its own expectations.

It seems the market has already priced the best-case scenario into ARM stock. However, a share-price retracement may be averted if Arm Holdings delivers blockbuster results for the current quarter plus another round of ambitious projections.

That’s easier said than done, so sensible, value-focused stock traders might choose not to invest in Arm right now.

Disclaimer: All investments involve risk. In no way should this article be taken as investment advice or constitute responsibility for investment gains or losses. The information in this report should not be relied upon for investment decisions. All investors must conduct their own due diligence and consult their own investment advisors in making trading decisions.