One way for investors to get into trouble is by ignoring price. A great company can be a great investment at one price and a terrible investment at another price.
Arm Holdings(NASDAQ: ARM) and Nvidia(NASDAQ: NVDA), two chip stocks with serious competitive advantages, have won over investors. Arm went public last week and immediately soared, while Nvidia is riding the artificial intelligence (AI) wave to incredible profits. But both stocks are incredibly expensive, and neither appears to fully deserve its overheated valuation.
By all accounts, Arm Holdings had a successful initial public offering (IPO). The chip company, which licenses CPUs based on its Arm architecture as well as the architecture itself, saw its stock soar right out of the gate. Arm is now valued at around $65 billion after debuting at a $54.5 billion valuation.
Arm has a stranglehold on the smartphone market, with essentially every device powered by Arm-based CPUs. The company's chip designs are also prolific in the consumer electronics and embedded markets. More than 250 billion Arm-based chips have been shipped since the company was founded in 1990, with more than 30 billion shipped in fiscal 2023 alone.
While it will be next to impossible for a competitor to disrupt Arm's dominance in its core markets, that doesn't automatically make the stock a buy. The biggest problem with Arm stock is the valuation. Using a market cap of $65 billion, Arm stock currently trades for 24 times annual sales. The price-to-earnings ratio is equally lofty at about 124.
If Arm were growing rapidly, these sky-high valuation ratios would be understandable. But not only is Arm not growing rapidly, it's not growing at all. Revenue was down slightly in fiscal 2023, which ended on March 31, and revenue also declined on a year-over-year basis in the quarter that ended on June 30. The smartphone market is going through a downturn, and since Arm generates revenue partly based on the number of devices shipped, the company's top line is taking a hit.
Arm does have some growth opportunities ahead of it, including server CPUs and artificial intelligence. The server CPU market is dominated by the x86 architecture used by Intel and Advanced Micro Devices, but Arm chips are slowly gaining traction in the data center. In client devices like smartphones, the increasing need to run AI workloads directly will require more advanced chip designs and potentially lead to higher royalties per device.
These growth opportunities don't look compelling enough to justify Arm's valuation. At the right price, Arm could be a solid long-term investment. But right now, Arm stock is far too expensive to consider seriously.
Demand for AI accelerators capable of training the most advanced AI models has pushed Nvidia's revenue and profit to incredible heights. In the latest quarter, Nvidia's revenue more than doubled year over year, and net income was up by nearly a factor of 10. Nvidia's powerful data center GPUs and its extensive ecosystem of software give it a massive competitive advantage.
This bonanza is unlikely to last forever for a couple of reasons. First, the AI market is in what I like to call the "gold rush" stage. Massive clusters of GPUs are being built without much regard for return on investment. Start-ups are popping up and competing with the cloud computing giants, all of which are snapping up GPUs as fast as they can.
Meanwhile, actually delivering AI-powered services is proving to be an expensive proposition. Microsoft and Alphabet, for example, are both charging $30 per user per month for AI features inside of their respective productivity suites. The number of companies willing to pay such a high price for AI-powered tools within software they already pay for remains to be seen. Ultimately, demand for Nvidia's AI accelerators will depend on end-user demand for AI services, and that's a big question mark.
Second, competition in the AI accelerator market will only become more intense. AMD is launching its own high-powered data center GPUs, and Intel already has its purpose-built Gaudi 2 AI chip on the market. While it will take time for the competition to chip away at Nvidia's head start, Nvidia's exploding profit margins are almost guaranteed to eventually fall back to earth.
Nvidia is valued at nearly $1.1 trillion, which works out to about 21 times sales and 43 times earnings based on average analyst estimates for the current fiscal year. The stock doesn't look too expensive if you assume that Nvidia's sky-high profits will hold up. But with Nvidia's near-monopoly on AI accelerators unlikely to hold up, that assumption is a dangerous one to make.
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