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Morgan Stanley Names Arm Holdings a Top Pick: Here's Why

By: MarketBeat

September 12, 2024 at 08:55 AM EDT

the Arm Holdings logo is displayed on a smartphone screen

Arm Holdings (NASDAQ: ARM) is a renowned semiconductor IP designer whose chips power billions of devices worldwide. Arm has recently caught the eye of investors, surging in value on the back of a strong endorsement from Morgan Stanley (NYSE: M). The investment bank has declared Arm its "Top Pick," setting a $175 price target and fueling optimism about the company's growth prospects. This bullish sentiment stems mainly from Arm's strategic positioning in the rapidly expanding edge AI market, where its energy-efficient technology reigns supreme and a continued recovery in the mobile segment.

Riding the Edge AI Wave

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Morgan Stanley's bullish stance on Arm Holdings is deeply rooted in the company's unique position within the rapidly evolving edge artificial intelligence (AI) landscape. Edge AI processes data closer to its source rather than relying on centralized cloud computing and requires high performance with minimal power consumption. The Edge AI infrastructure creates a sweet spot for Arm's energy-efficient technology.

This advantage is evident in Arm's v9 architecture, which is being adopted in many devices, including smartphones. While the latest iPhone 16 leverages Arm's technology, it utilizes a more advanced chip beyond the A18, further showcasing the continuous innovation within Arm's ecosystem.

Looking beyond smartphones, Morgan Stanley projects a substantial 35% compound annual growth rate (CAGR) in Arm's mobile segment from FY24 to FY27. This growth will be fueled by mobile adoption and the anticipated momentum in the automotive and infrastructure sectors, where Arm is gaining traction.

Arm's v9 cores, designed for enhanced AI processing, are a key catalyst for this growth. These cores are expected to drive substantial revenue gains, particularly in the mobile segment. With analysts forecasting 230 to 260 million iPhones to be shipped in FY26, Arm could see hundreds of millions of dollars in additional royalty revenue. Beyond mobile, Arm's silicon IP is increasingly being deployed in custom silicon solutions across various industries, paving the way for higher royalty rates over the next two to three years.

Q1 Earnings: A Glimpse into the Future

Arm's earnings report for the first quarter of fiscal year 2025 (Q1 FYE25) showcased strong year-over-year growth. The company reported a 39% increase in revenue, reaching $939 million and exceeding Arm’s analyst community’s expectations by $32.5 million. However, the guidance for Q2 FYE25 fell slightly short of consensus estimates, projecting revenue between $780 million and $830 million, with earnings per share (EPS) ranging from $0.23 to $0.27.

This deceleration from the previous quarter's impressive growth sparked concerns about the sustainability of Arm's momentum. Despite the mixed Q2 outlook, Arm reaffirmed its full-year guidance, projecting revenue between $3.8 billion and $4.1 billion and adjusted EPS of $1.45 to $1.65.

The Powerhouse Business Model

Arm's success is underpinned by its robust licensing and royalty model. License revenue, representing upfront payments for the use of Arm's IP, surged 72% year-over-year in Q1, reaching $472 million. Royalty revenue, generated from each chip shipped using Arm's designs, remains a cornerstone of the company's business, growing 17% year-over-year in Q1.

The adoption of the v9 architecture, commanding higher royalties than previous generations, is a significant contributor to this growth. Arm's strategic partnerships with tech giants like Nvidia (NASDAQ: NVDA), Microsoft (NASDAQ: MSFT), and Amazon (NASDAQ: AMZN) further solidify its revenue streams as these companies increasingly leverage Arm's designs for their AI and data center needs.

Competition and Geopolitical Risks

Despite its dominant position, Arm faces significant headwinds. The semiconductor industry is becoming increasingly competitive, with rivals like Intel (NASDAQ: INTC) and American Micro Devices (NASDAQ: AMD) vying for market share in key segments. Geopolitical tensions, particularly those related to China, pose another challenge.

China, which accounted for 14% of Arm's revenue in FY24, presents a complex economic and political terrain. Uncertainty surrounding export controls and the need for US and UK regulatory approvals could impact Arm's ability to fully capitalize on the Chinese market.

A Premium Valuation: Justified or Overstretched?

Arm's current valuation reflects the market's high expectations for the company's future growth. With a forward price-to-sales (P/S) ratio of about 33, Arm trades at a premium compared to the sector median. This premium valuation hinges on Arm's continued dominance in the AI and semiconductor markets.

However, some analysts express concerns that Arm's growth may not fully justify its current valuation, particularly compared to other high-growth semiconductor companies like Nvidia and AMD. The high multiple leaves little room for error, making the stock vulnerable to any potential slowdown in performance or shifts in market sentiment.

The Verdict: Riding the AI Wave with a Cautious Eye

Arm Holdings is strategically positioned to capitalize on the burgeoning edge AI market, fueled by its power-efficient technology and an ongoing mobile sector recovery. The company's licensing and royalty model, coupled with its strategic partnerships with industry leaders, provides a solid foundation for continued growth.

However, investors must carefully consider the potential risks, including intensifying competition and geopolitical uncertainties, as well as the stock's high valuation. While Arm's prospects are bright, a prudent approach, informed by both fundamental and technical analysis, is crucial for navigating the stock's potentially volatile future.

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