Arm, new microchips drive business. The stock is expensive on the stock exchange

It is a dual characteristic that recently characterises many of the semiconductor stars. Especially, when directly linked to the world of artificial intelligence. What is it? On the one hand, it is the fact that, thanks in part to their good financial results, the stocks of these companies have been running very high on the stock market. On the other, it is the condition that the same stocks, in the wake of the same market rally, have become expensive. Or, at any rate, they are not at a discount. Advanced RISC Machine Holding (Arm) offers proof of this. The British group, a global leader in the design of microprocessor architectures, listed on the Nasdaq on 14 September 2023 with a price of $51 per share. The stock currently trades at around $146 (closing on 25/9/2024). That is a real leap upwards of 168%.

On closer inspection, the dynamic was accompanied by the expansion of the company accounts. For example: in the latest quarterly report (first quarter of the 2024-2025 financial year), revenues - beating estimates - increased by 39% compared to the same period in 2023-2024. Non-GAAP earnings per share (EPS), for its part, rose to $0.40 (consensus expected 34 cents). True! Arm, on the stock exchange, immediately after the publication of the accounts plummeted. And yet, on the one hand, it cannot be denied that the numbers are nevertheless positive; and that, on the other hand, the market reaction is precisely the consequence of the high price. What has happened is that - among other things - while traders were hoping for an improvement, the company has left the guidance for the entire 2024-2025 unchanged. The situation, in a normal context, would not have caused any great upheaval. Or, at least, not on the scale that was seen (the share price dropped almost 10%). In this specific case, however, the high multiples of the share induced many to sell, taking home the capital gain.

That being said, the question is: does the condition still persist? The answer is positive. Arm, after falling for the entire month of July, has regained momentum since August. And, at present, it boasts not low multiples. According to Seeking Alpha, the ratio of price to prospective non-GAAP earnings (on estimates for 2024-2025) is about 94 times (as of 26/9/2024). That is higher than the industry median and, more importantly, than direct competitors. An example? Cadence design. The latter, according to the Bloomberg terminal, boasts a P/e on 2024 of 46.2 times. That is: much lower than that of the British company. Of course! Arm's strategic positioning is - according to experts - undoubtedly much stronger than its competitor. Moreover, its technology is cutting-edge and at the centre of the Artificial Intelligence (AI) revolution. That being said, however, the fact that Arm's shares are expensive remains. Not least because other indicators confirm the situation. Thus, according to Seeking Alpha, the forward-looking non-GAAP PEG (the P/e normalised for expectations of 3-5 year earnings trends) is 3.4 times (1.87 the industry median). Not only that: the price in relation to estimated sales is 38.7 times. In other words: again a value considered high by the experts. In view of this, the do-it-yourselfer must be very cautious about such a stock. You may object: the analysts' consensus - reported by Bloomberg terminal - points out that the majority (59.5%) is 'buy' (33.3% is 'hold' and 7.1% 'sell'). Nevertheless, the risk remains high. When a company's multiples are high, the stock may well continue its run but the likelihood increases that - at the slightest creak in the narrative about the company's business - there will be a rush to monetise the gain by those who already own the stock.

So far, some considerations on quarterly figures and stock market performance. In order, however, to understand what Arm's prospects are, it is useful to delve into its corporate purpose. The group does not make microprocessors, but designs their architecture. That is, it produces the logical scheme of their operation: from the mechanism through which the chip interacts with the memory of the product in which it is inserted, to the instructions on how to process the data, to the way in which the input/output is formatted. Among the most important solutions - which have also become industry standards - is the Arm CPU Architecture. That is: a central computer processing unit, characterised by lower power but higher simplicity and energy efficiency. It is based on the so-called RISC architecture. An approach which, on the one hand, entails lower operating costs for those who physically build the chip, and is therefore appreciated by customers/manufacturers; and which, on the other hand, because it requires less power, is very well suited to the world of smartphones, for example.

Yeah, smartphones. In the last quarter, advanced mobile phones contributed strongly to the increase (+17% compared to twelve months earlier) in royalty revenues, thanks mainly to the latest generation Arm V9 solution. A further boost - again to royalties - came from the automotive world (e.g. advanced driver assistance) and cloud computing (where artificial intelligence is developed and trained). Weak, on the other hand, were the end markets of the Internet of Things and network equipment (due to the reduction of overstocking by customers).These are contexts which, beyond the dynamics of individual sectors, bring it all back to the world of royalties. Which is fundamental to Arm's business model. The company, in fact, licenses chip designs to customers/manufacturers (from Nvidia to Apple), who pay a fixed fee for the use of the patent. Not only that. The group collects royalties for each microprocessor sold, based on the price of the chip itself (although the company has indicated that it wants to change the calculation, basing it on the value of the final device in which the semiconductor is inserted). In such a context, it is clear, royalties are the litmus test of the real market penetration of Arm's solutions. Well: in the last quarter these settled at 467 million (+17%), below the consensus. A trend that induced disappointment, contributing to the immediate drop in the share price. Arm, as can be seen from the indications in the conference call, did not share the disappointment. First and foremost, because royalties are supported by the adoption of Arm's cutting-edge V9 technology, which allows higher revenues than other technological solutions. Moreover, because - Arm itself indicates - one has to look at the annualised value of the licensing contracts entered into. An indicator which, unlike royalties, on the one hand is not structurally discontinuous and makes it possible to understand business trends over the long term; and which on the other hand - again in the first quarter of 2024-2025 - grew (+14%) in line with previous quarters. Lastly, because the definition of new licences normally implies - within 2-4 years - the collection of royalties. In short: the group does not seem to see any particular problems on this front.