Summary

• Arm Holdings' valuation is at risk due to China's DeepSeek AI tool, which could reduce demand for AI chips and infrastructure spending.

• Arm's high P/E ratio and inflated valuation are unsustainable, especially with recent weak revenue growth despite the AI boom.

• The company's heavy R&D spending and partnerships with tech giants can't justify its current valuation amid potential declines in AI chip demand.

• The new AI "Space Race" between the U.S. and China warrants caution for investors.

News on Monday of China's DeepSeek artificial intelligence progress led to a -10% fall in Arm Holdings. I believe this is the start of further losses and the company's high valuation needs to be adjusted.

Introduction to Arm Holdings

Arm Holdings is a UK-based chip design firm that came to the market in a September 2023 initial public offering. The company was bought for $32 billion in 2016 by Japanese conglomerate Softbank. The company still owns a large amount of the company's shares. The niche of Arm's offering is that it licenses the intellectual property of its chip designs to other manufacturers and thus has low capex and high margins.

DeepSeek can reduce demand for AI chips

Donald Trump's inauguration day saw the arrival of a game-changing artificial intelligence tool that complicate his term. Developed by a Chinese hedge fund manager, the key takeaway from DeepSeek is that it only cost $6 million dollars to create, compared to the billions that have been spent by U.S. tech rivals.

Silicon Valley venture capital investor Marc Andreessen called the new tool, "AI's Sputnik moment," in reference to the start of the Space Race between the United States and The Soviet Union.

Trillions of dollars in market cap evaporated from U.S. stock markets early on Monday as investors tried to digest the implications as R1 topped the Apple App Store download charts. Some nefarious activity was already reported with DeepSeek reporting "large-scale malicious attacks" later on Monday.

That could highlight the level of panic in the United States after this release.

Chip demand and infrastructure spending in focus

One of the ironies is that the creation of DeepSeek and its R1 application were partly driven by U.S. control over its chip industry.

With limited access to GPU chips from the likes of Nvidia (NVDA), the development of the R1 tool relied on different methods than those applied by the big-spending U.S. tech firms.

There is a huge amount at stake for Big Tech CEOs after they were on course to spend $240 billion on AI-related materials. "In the first half of 2023, tech giants poured $74 billion into capital expenditure. By Q3, that number had jumped to $109 billion. In mid-2024, spending reached $104 billion, a remarkable 47% rise over the same period a year earlier. By Q3, the total hit $171 billion," an article from AI News reported.

It would be a very embarrassing situation for the U.S. tech sector if much of that spending may now have been rendered worthless.

Much of the spending went to data centers and infrastructure, and it also calls into question, the announcement by President Trump of $500 billion in data center infrastructure. Standing by his side at the announcement was Oracle (ORCL) CEO Larry Ellison and Sam Altman, CEO of the ChatGPT AI tool that has just been usurped by DeepSeek as the number one AI app.

Lower demand will mean lower valuations

In my view, the end result of the latest development is that AI spending may drop on GPU chips and infrastructure. Tech CEOs will have to navigate a soft landing to protect their lavish outlay on the sector in the coming quarters.

Some analysts are saying the recent market sell-off was overdone, but I believe the rally to get here was also overdone. Arm Holdings (NASDAQ:ARM) could be a stock that suffers from lower AI chip demand.

Bernstein analyst Stacy Ragston said the idea of a “death knell of the AI infrastructure complex as we know it looks overblown.”

But it is naive to believe that we will not have the potential for a reduction in price for high-performance chips.

Raymond James analyst Srini Pajjuri said the latest development may “drive even more urgency among U.S. hyperscalers to leverage their advantage (access to GPUs)” to build more powerful models.

I also believe that is a naive statement because it assumes that the hyperscalers will build a commercially viable, mainstream product and so far, that has failed to materialize.

A non-GAAP price/earnings ratio for Arm of around 120x is 370% higher than the sector median, according to Seeking Alpha data. Price to cash flow is now around 1,000% higher than the sector average at a crazy 246.48x.

I warned investors that they should sell Nvidia back in August as I suggested that U.S. Big Tech spending could not remain elevated into infinity and the stock was on course for a -17% loss on Monday. I believe that ARM was lucky not to match that number.

Arm's growth is not that impressive

Arm Holdings had a strong 33% year-over-year revenue growth of 33% into March 2021, but that is on course for a 9% return on a trailing twelve-month basis.

Arm Holdings Sales and Spending (Seeking Alpha)

That must be the most obvious alarm bell for investors if a huge demand for AI chips has not led to a year-over-year increase in sales. Sometimes all boats can be lifted in a rising tide and Arm may have been a beneficiary of hype.

It is that sales weakness that has caused the valuation to balloon to current levels. Arm Holdings can be given a pass on its strong profit margins as with a gross profit margin above 92%. That is impressive but the company spends the bulk of that profit on research & development costs.

The company needs to do this to stay at the forefront of new chip technology and will likely remain to do so. But the company's sky-high valuation has been built on expectations for big AI spending to continue.

In its most recent earnings release, the CEO noted developments and partnerships with the likes of Nvidia, Meta, and Microsoft Azure as signs of a strong future. Arm does have some diversification with products for smartphones, IoT, automotive, and networking devices.

The company will likely continue to be at the forefront of increased AI demand, but I believe that the current valuation is unwarranted and is at serious risk as investors weigh the DeepSeek implications.

Implications of a new 'Space Race'

If we are at the start of a new Space Race between the United States and China in artificial intelligence, then it's possible that we could have another TikTok problem on our hands, with Donald Trump possibly considering a ban on the new tool. That may not come, but Trump said it was a "wake-up call" for Big Tech, and we may see further chip controls.

U.S. officials said on Monday that DeepSeek was a "national security concern" and Wired Magazine reversed its previous news-driven DeepSeek articles to later say that the app was "explicitly sending U.S. data to China".

A tidal wave of similar criticism may come to defend the U.S. market, but I believe that the current developments have exposed the Big Tech industry's bold moves and investors may pay the price.

Risks to the investment thesis

There is a risk that the demand for AI products could lead to an increase in revenue at Arm that can catch up to the valuation.

The recent quarterly performance does not suggest that, with a drop in quarterly revenue from $939 million to $844 million.

Arm Holdings Quarterly Sales (Seeking Alpha)

Arm is a trusted partner of Nvidia and is a vital cog in the production of the company's new Blackwell platform. Arm stock has gained around 100% from January 2024 and some of that upside can be attributed to the expected demand from Nvidia.

"Another proof point of our data center momentum is NVIDIA’s pending shipments of its Grace Blackwell superchips," Arm management said in the latest shareholder letter.

They also noted that Microsoft (MSFT) and Google (GOOG) had been working with the firm on data center chips and that the company "now powers all three leading cloud service providers."

Microsoft is set to release its latest earnings following the DeepSeek release, and it would not surprise me if the firm has scrambled to adjust management guidance on AI capex. Companies will come under shareholder pressure on margins if DeepSeek gains in popularity and if they are forced to cut AI spending, then that will hurt the outlook for Arm.

If China has actually changed the game on AI, then there could be trouble ahead for the sector and caution is warranted.