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Will Arm Holdings Be a Trillion-Dollar Stock by 2035?

Motley Fool - Thu Apr 4, 5:00AM CDT

Arm Holdings(NASDAQ: ARM) has attracted a lot of attention since its initial public offering (IPO) last September. The U.K. chip designer listed its shares at $51, and they've already more than doubled to about $125 over the past six months.

Yet Arm's stock didn't blast off right away. Instead, it hovered near its IPO price for the first two months as investors scoffed at its slowing growth and high valuation. However, its growth accelerated again, the bulls rushed back, and Arm's market cap climbed to nearly $130 billion. Could it keep rallying to become a trillion-dollar stock by 2035?

An illustration of a semiconductor.

Image source: Getty Images.

Understanding Arm's business model

Arm was founded in 1990 as a joint venture between Apple, Acorn Computers, and VLSI Technology. It aimed to develop a new chip design that could challenge Intel's dominant x86 chip architecture.

By prioritizing battery life and technical flexibility over raw horsepower, Arm carved out its niche in smaller handheld devices instead of PCs and servers. Today, more than 95% of the world's smartphones use Arm-based chips. Intel, which stubbornly tried to shrink down its x86 CPUs for mobile devices, was driven out of that lucrative market.

Arm doesn't manufacture its own chips. It only licenses its designs to chipmakers like Apple, Qualcomm, and MediaTek. Nvidia also licenses Arm designs for its Tegra CPUs. That asset-light business model, along with its pricing power in the mobile market, enables Arm to keep its gross margin in the mid-90s percentages.

How fast is Arm growing?

Arm initially went public back in 1998, but it was acquired by the Japanese conglomerate SoftBank in 2016. SoftBank then nearly sold Arm to Nvidia for $40 billion before antitrust regulators scuttled the deal in 2022. After the attempted sale collapsed, SoftBank spun off Arm in a new IPO but retained a 90.6% stake in the company.

Arm's revenue increased 33% in fiscal 2022 (which ended in March 2022) as smartphone makers pumped out more 5G devices, but dipped 1% in fiscal 2023 after the 5G upgrade cycle slowed down. In the first nine months of fiscal 2024, Arm's revenue grew 13% year over year as the stabilization of the smartphone market, its growth in the cloud and automotive markets, and higher-royalty AI-optimized chip designs boosted its royalty revenue.

For the full year, Arm expects its revenue to rise between 18% and 20%. From fiscal 2024 to fiscal 2026, analysts predict its revenue will increase at a compound annual growth rate (CAGR) of 22%. That growth rate is impressive, but it might not be enough for a stock that is already trading at about 40 times this year's sales.

Does Arm have a path toward a trillion-dollar valuation?

Arm is trading at such a high price-to-sales ratio because it's being perceived as an artificial intelligence (AI) stock. But investors shouldn't casually toss Arm in the same basket as Nvidia. Arm is certainly generating higher royalties from its latest Armv9 designs -- which can be used to power AI features across premium smartphones, PCs, and even servers -- but they simply aren't as important for processing complex AI tasks as Nvidia's powerful GPUs.

Assuming Arm still trades at 40 times sales, meets analysts' expectations, and increases its revenue at a CAGR of 20% from fiscal 2026 to fiscal 2035, it could reach a $1 trillion valuation by that final year. That might seem like an achievable goal, but I doubt it can maintain that nosebleed price-to-sales ratio after investors' interest in AI stocks eventually cools off.

If Arm hits those targets and trades at 20 times sales by fiscal 2035, it would still be worth $500 billion. That would represent a four-bagger gain from its current price, but it might disappoint investors who were expecting even bigger returns.

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Leo Sun has positions in Apple. The Motley Fool has positions in and recommends Apple, Nvidia, and Qualcomm. The Motley Fool recommends Intel and recommends the following options: long January 2023 $57.50 calls on Intel, long January 2025 $45 calls on Intel, and short May 2024 $47 calls on Intel. The Motley Fool has a disclosure policy.

Paid Post: Content produced by Motley Fool. The Globe and Mail was not involved, and material was not reviewed prior to publication.

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