Missed Out on Nvidia? Be Careful Before Checking Out This Other Semiconductor Stock.

Artificial intelligence (AI) has the power to disrupt all sorts of technology applications. Among the most important pieces stitching together the AI fabric are semiconductors. High-performance graphics processing units (GPUs) are playing an important role in generative AI, machine learning, and quantum computing.

At the center of the AI semiconductor landscape are Nvidia and Advanced Micro Devices. Both of these companies have commanding leads over smaller players, and demand for their respective chips is off the charts.

Over the past year, Nvidia stock has turned $1,000 into more than $3,000, and investors might be worrying that they have missed the boat. If they’re looking for lesser-known names, they might find Arm Holdings (NASDAQ: ARM). The company went public last year and has since flown under the radar, overshadowed by other opportunities in the semiconductor space.

But earlier this month, Arm blew away Wall Street’s expectations during its earnings call for its fiscal third quarter, ended Dec. 31. After reporting earnings on Feb. 7, Arm’s stock nearly doubled over the next three trading days.

The price jump is eye-popping, but is the stock a buy now?

Arm Holdings just smashed expectations

One thing to make clear right off the bat is that the semiconductor industry is cyclical. Demand for chips is going to ebb and flow, and challenges from supply chains and even geopolitical concerns can bring added layers of complexity.

As a result, semiconductor companies can experience dramatic swings in revenue, margins, and profit. Arm has been no stranger to this dynamic, with inconsistent financial and operating performance over the last few years.

But the semiconductor industry is operating in high gear at the moment, and Arm is a beneficiary. For the quarter ended Dec. 31, the company reported revenue of $824 million — an increase of 14% year over year. This handily eclipsed Wall Street’s consensus estimate of $761 million.

Perhaps even better, Arm had a strong performance on the bottom line as well. The company reported adjusted earnings per share (EPS) of $0.29, narrowly beating the high end of its prior guidance. This  outperformed analyst estimates of $0.25 per share.

What might have sent the stock parabolic was management’s guidance. For the current quarter, the company is expected to generate between $850 million and $900 million in sales. Yet again, Wall Street’s consensus estimate was far below this range. Management’s forecast was more than $100 million above analyst estimates.

Arm is benefiting from secular tailwinds fueling the overall semiconductor market. And while this dynamic is good for business right now, the stock is getting bought up.

A person holding a microchip in a laboratory.

Image source: Getty Images.

Valuation is a concern

As of the time of this writing, Arm’s market cap has increased more than twofold since it reported earnings.

With trailing-12-month revenue of $2.9 billion, the company is trading at a price-to-sales (P/S) multiple of about 40. That is in line with Nvidia’s P/S — and Nvidia is a much larger, faster-growing business with significantly more market share in AI chips.

While Arm’s management deserves credit for the company’s impressive performance, the stock price and the company’s valuation relative to underlying results (and benchmarked against peers) are disconnected.

Is Arm stock a buy now?

To be clear, I do not view Arm as a poor investment choice. However, at its current valuation, it seems that there is a lot of momentum at play. My hunch is that short-term traders have bought the stock in the hope of booking a quick profit as AI stocks continue to soar. Participating in such a movement carries immense risk and could leave you holding the bag.

If you’re interested in adding names in the semiconductor space to your portfolio, Arm could represent a decent option beyond mainstream opportunities. But there is a lot of potential downside in buying the stock right now at an inflated price.

I think the most prudent thing to do would be to keep an eye on the company’s performance and assess if management is executing. If the company continues to beat its own guidance and outperform analyst expectations, then a premium valuation could be warranted.

But for now, I see the stock as overvalued — perhaps even entering meme territory. I think there are safer alternatives for gaining exposure to AI, and chips in particular. Arm could represent a solid option in the long run, but I’d stay away from the stock for now.

Should you invest $1,000 in Arm Holdings right now?

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Adam Spatacco has positions in Nvidia. The Motley Fool has positions in and recommends Advanced Micro Devices and Nvidia. The Motley Fool has a disclosure policy.

Missed Out on Nvidia? Be Careful Before Checking Out This Other Semiconductor Stock. was originally published by The Motley Fool

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