Nvidia has been one of the biggest beneficiaries of the artificial intelligence (AI) boom, due to its dominance in data center accelerators. The company's shares have surged 750% since ChatGPT launched in November 2022, and it remains a foundational AI stock in many portfolios. But Nvidia has a market capitalization just shy of $3 trillion, so the odds of similar returns in the future are slim.
Accordingly, some investors have shifted focus to Arm Holdings (NASDAQ: ARM) in the hopes of finding the "next Nvidia." Arm stock has more than doubled since the company went public in September 2023, but Lee Simpson at Morgan Stanley believes the momentum could continue. His bull-case price target of $300 per share implies a 130% upside from its current share price of $129.
Here's what investors should know about Arm.
Arm has an attractive business model and is gaining share in key markets
Arm designs central processing unit (CPU) architectures and licenses the intellectual property (IP) to other companies, which use the IP to build custom chips. The company further supports its clients with development tools and services that streamline product engineering across hardware and software. It earns revenue via licensing fees and pre-chip royalty fees, so it benefits when popular products (like iPhones) are built with its IP.
Every CPU has an instruction set architecture that defines how the hardware interacts with software. Arm architecture has historically been associated with power efficiency, whereas the x86 architecture from Intel and AMD has been associated with computational performance. As a result, Arm chips are widely used in battery-powered devices. For instance, the company holds 99% market share in smartphones and 67% market share in other mobile devices.
Meanwhile, Intel and AMD processors have historically been the industry standard in consumer electronics and cloud computing. But Arm has been taking share in both end markets with more powerful chips. In the last two years, its market share in cloud computing CPUs has increased 6 percentage points to 15%. Its market share in consumer electronics CPUs has increased 6 percentage points to 30%.
Moreover, Arm IP has found its way into many popular products. Apple and Microsoft have introduced personal computers (PCs) outfitted with Arm-based processors, and Amazon Web Services, Alphabet's Google Cloud, and Meta Platforms have developed Arm-based CPUs for their data center servers. Nvidia has also introduced an Arm-based data center CPU purpose-built for artificial intelligence (AI).
In summary, Arm has an attractive business model. It gives customers the flexibility to build custom chips but still reduces time to market and research and development (R&D expenses), compared to semiconductors designed from scratch. Accordingly, Arm CPUs are ubiquitous in smartphones and other mobile devices, and the company is gaining share across key end markets like cloud computing and consumer electronics.
Arm's dominance in mobile devices means the company should benefit as more AI workloads run on edge devices
Morgan Stanley believes Arm is particularly well-positioned to monetize edge AI, meaning AI workloads that run on end-user devices like PCs and smartphones. The opposite of edge computing is cloud computing, where information is sent back to centralized data centers for processing.
The upside of cloud computing is more powerful chips, but the downside is application lag time. Edge computing reduces lag time by processing data at the device level, rather than sending it through the internet to and from data centers.
Arm-based processors are already the industry standard in smartphones and other mobile devices, and the company's chips are becoming more popular in PCs, so Morgan Stanley makes a very compelling argument. In fact, there's already evidence of Arm benefiting from edge AI. Arm-based CPUs will power Apple Intelligence on iPhones and MacBooks and some Copilot+ PCs recently introduced by Microsoft and other OEMs like Dell Technologies and Hewlett Packard. Copilot+ PCs are a category of laptops designed for AI.
CEO Rene Haas recently told Reuters that Arm could capture more than 50% market share in Windows PCs within five years. That would represent a significant shake-up for the PC industry, given that Arm-based processors accounted for less than 15% of PC CPU shipments last year, according to Counterpoint Research.
Arm stock trades at an expensive valuation, compared to its future growth trajectory
Wall Street expects Arm to grow adjusted earnings at 29% annually through fiscal 2027 (ends March 2027). But Morgan Stanley has outlined base-case and bull-case scenarios in which earnings grow at 46% annually and 69% annually, respectively. The base-case scenario corresponds to a fair value of $190 per share, while the bull case corresponds to a fair value of $300 per share.
Importantly, Morgan Stanley's price targets are the highest on Wall Street, so other analysts are more pessimistic. Arm carries a median price target of $125 per share, which implies a 3% downside from its current share price of $129.
I doubt Arm's earnings will increase much faster than the Wall Street consensus in the coming years. Company guidance implies 22% earnings growth in fiscal 2025 (ends March 2025), which actually falls short of the consensus. Moreover, that projection makes the current valuation of 94 times adjusted earnings look expensive.
Arm has an attractive business model, and its strong presence in mobile devices leaves the company with substantial growth prospects, but I doubt the stock will deliver triple-digit returns over the next year.
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An Artificial Intelligence (AI) Stock Some Investors See as the "Next Nvidia" Could Surge 130%, According to a Wall Street Analyst was originally published by The Motley Fool