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IPO Stock Watch: 3 Things I Need to See Before I Buy Arm Stock

Motley Fool - Fri Nov 17, 2023

Arm Holdings (NASDAQ: ARM) was arguably one of the more anxiously awaited offerings for the semiconductor industry in recent years. The company designs central processing unit (CPU) cores, and companies such as Apple, Nvidia, Taiwan Semiconductor (TSMC), and others seek its architecture.

This gives Arm a tremendous advantage, namely that it can license its intellectual property rather than deal with the challenges that chip developers and manufacturers face. Consequently, it earned gross margins of around 95% in the first half of fiscal 2024 (ended Sept. 30).

Unfortunately, its IPO performance may not have impressed investors. After rising 25% on its Sept. 14 IPO day, the stock pulled back. This briefly took Arm below its IPO price of $51 per share before it made a partial recovery.

While this behavior does not preclude future growth, its short stock history indicates that investors should exercise care when buying this stock. To that end, they should consider three things before deciding whether to buy shares.

1. An investment strategy

One challenge is understanding what kind of investor would seek to buy Arm stock due to the unusual history of the company. The IPO came to the market as Japanese investment company SoftBank spun off Arm for a second public offering. This stands in stark contrast to peers such as Nvidia and Apple, which once traded as small-cap stocks.

Growth investors tend to like smaller stocks because of the potential for massive increases. A $2 billion market cap could grow to $2 trillion and still not reach a record high.

In contrast, Arm Holdings has a market cap of around $55 billion, meaning it debuted as a large-cap stock and at a much later stage of its development. Admittedly, a stock with a $55 billion market cap can still earn considerable returns over time. Nonetheless, even if growth reaches eye-popping levels, seeing Arm stock reach a $55 trillion market cap is unlikely.

However, such a level does not make Arm an income investment either. Unlike some of its larger clients, it does not offer a dividend. Moreover, due to the recent IPO, it has only posted one quarterly earnings report in its history. That factor makes it more difficult to make such determinations.

2. A sustainable growth path

Another challenge involves determining the company's financial growth strategy. This is difficult since what little investors can see from the company's first earnings report does not point to growth.

In its first two quarters of fiscal 2024, the company reported almost $1.5 billion in revenue, 12% more than the same period last year.

Additionally, research and development spending more than doubled during that time. Consequently, Arm reported a loss of $5 million in the first half of fiscal 2024, down from a $339 million profit during the same timeframe of the last fiscal year.

Research and development spending can pay off for a company in the long term, but that work is unlikely to help Arm anytime soon. Arm forecasts between $720 million and $800 million for the next quarter, a sequential decline from the $806 million revenue in fiscal Q2.

3. A reasonable valuation

Furthermore, other financials do not seem to match the stock's valuation. Despite its struggles, Arm stock sells for a price-to-sales (P/S) ratio of over 20, a level well above that of every major semiconductor company other than Nvidia.

Measuring valuation by earnings also brings challenges. Moves in and out of profitability left it with an approximate 165 trailing price-to-earnings (P/E) ratio. Still, if one looks at the forward P/E ratio of about 50, measuring Arm's valuation by earnings can make more sense.

Nonetheless, that leaves the company with a pricey valuation by any reliable measure. Given relatively slow profit growth and the recent return to losses, it could leave investors questioning whether Arm is worth a premium price.

Making sense of Arm stock

Under current conditions, Arm does not look like a promising IPO stock. Indeed, the importance of its intellectual property makes the company intriguing, and its chip designs will likely play a critical role in the semiconductor industry for years into the future.

Unfortunately, SoftBank only made the stock available to investors after it became a large-cap. The growth rates are also relatively slow, a challenging situation when investors have to pay a premium valuation. Under these conditions, investors should probably avoid this stock.

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Will Healy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple, Nvidia, and Taiwan Semiconductor Manufacturing. The Motley Fool has a disclosure policy.

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