Arm’s 90% Rally Shines Light on High Multiple, Low Growth

(Bloomberg) -- One of the year’s best-performing artificial intelligence stocks could be about to face a rude awakening.

Arm Holdings Plc is due to report results after the market close, and investors are skeptical that the chip-design company will be able to justify the almost 90% share-price jump that has made it one of the most expensive stocks in the market. Fiscal second-quarter revenue is expected to grow just 0.6%, a far cry from the explosive trends seen by other AI companies. The shares were trading 1.4% higher as of 10:27 a.m. in New York.

“At the end of the day, Arm is a company with a multiple far surpassing Nvidia, without anything like a Nvidia-esque growth rate,” said Dan Morgan, senior portfolio manager at Synovus Trust. “It is instrumental in all the new tech chipmakers are involved with, and there’s so much momentum surrounding AI, but I don’t know that we can make the case the growth justifies the multiple.”

Arm shares trade at more than 76 times estimated earnings, making it the third-most expensive stock in the Nasdaq 100 by this metric, and pricier than Nvidia Corp. at 37 times. In terms of estimated sales, Arm’s multiple is above 32, by far the highest in the index.

“Valuation investors have been asleep at the wheel with Arm, and therefore it wouldn’t be a surprise if this earnings report acted as a real corrective,” said David Trainer, chief executive officer of investment research firm New Constructs. “It would need to have huge earnings growth for years to justify this valuation,” he added, noting that Arm is operating in a “super competitive industry.”

Analysts are mixed on the stock. While more than half of those tracked by Bloomberg rate it a buy, the average price target suggests less than 2% upside for the shares over the next 12 months.

Bernstein’s Sara Russo became one of the few analysts with a sell-equivalent rating after downgrading Arm shares to underperform last week. “The long term equity story remains very appealing,” she wrote, “but at what price?” Given the stock’s year-to-date strength and valuation, “we struggle to find upside.”

While Arm’s AI-related businesses “are holding up fine,” she added, “we worry about the revenues outside of AI, given the cyclical headwinds our analog names are facing, especially ex-memory.”

Long-term bulls argue that Arm will grow into its valuation over time. However, it disappointed last quarter by failing to raise its annual sales forecast, which was seen as a tepid read on its growth potential. Revenue is expected to rise about 23% in Arm’s 2025 fiscal year and 24% in fiscal 2026, according to data compiled by Bloomberg. Net earnings are seen almost tripling this fiscal year but decelerating over the subsequent years.

In another potential question mark, Arm is canceling a license that allowed longtime partner Qualcomm Inc. to use its intellectual property to design chips. This issue has recently weighed on the shares, and is likely to come up on the earnings call.

Despite near-term risks, Wall Street remains extremely positive about the AI trade in general. Recent results from megacap tech companies affirmed their commitment to heavy spending on the technology, a trend that could follow through to companies like Arm. UBS expects AI-related spending by big tech companies to increase by 50% to $222 billion this year, and grow another 20% in 2025.

“There’s some desire to see excitement over AI turn into volume, but the numbers are moving in the right direction,” said Daniel Newman, chief executive officer of The Futurum Group.

“There’s a reasonable question about how quickly Arm grows into its valuation, but I’m not concerned about whether it will. It’s a question of time horizon.”

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