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Arm Holdings Faces a Huge Test This Week. Will the Hot AI Stock Fly or Die?

Move over, Nvidia. There’s a new artificial intelligence (AI) stock making waves across Wall Street.

Arm Holdings (ARM -6.65%) has been public for less than six months, but the chip company best known for licensing its low-power processor designs has edged out even Nvidia so far in 2024. Through March 6, Arm stock is up 82% for the year, compared to a 79% gain for Nvidia.

Arm shares surged on its earnings report in February after the company beat quarterly estimates and raised its guidance significantly for the fiscal year. The company also made it clear that it was fully participating in the AI boom.

“The AI wave drove licensing growth, as these new devices require Arm’s performant and power-efficient compute platform,” said CEO Rene Haas in the fiscal Q3 2024 press release. The company further noted that its better-than-expected license revenue growth of 18% was due to demand for more advanced Arm CPUs as companies ramp up spending on AI.

This coming week, Arm will face arguably its biggest test as a publicly traded company. The company’s post-IPO lockup period will expire on Tuesday, meaning that insiders will have an opportunity to sell their stock for the first time. For high-flying tech IPOs like Arm, lockup expirations often create share price volatility.

If there’s major selling among insiders, the stock is likely to fall as the share price finds a new equilibrium at a higher float count. However, if the insiders hold their shares, Arm is likely to gain, as that would be a sign of confidence in its future from those who know the company best.

What to expect from Arm’s lockup expiration

Less than 10% of Arm’s 1.03 billion shares outstanding are currently publicly traded. Prior to the IPO, Arm had been owned by Softbank Group (SFTBF -2.59%), which took the company private back in 2016.

Softbank sold 95.5 million shares in the IPO and gave underwriters the option of selling an additional 7 million shares. That left Softbank with roughly 90.6% of the stock. In addition to Softbank Group and CEO Masayoshi Son being able to sell that stock, Arm employees will also be able to sell 11.4 million restricted shares that had previously been off-limits.

Why Arm stock should pass the test

Some Arm employees are likely to take advantage of their opportunity to sell, as the company’s shares have nearly tripled from their IPO price of $51, but a little game theory should explain why Softbank is likely to hold on to its stake in the company.

Son has over $100 billion worth of Arm stock, and he wants to protect its value. Dumping a significant amount of stock and crashing the share price would be a terrible mistake. It is likely that Softbank will unload Arm shares gradually over time as the company chose to take Arm public, but it won’t jeopardize the value of the stock in doing so. Softbank could also retain its entire stake, as Arm looks like its most promising play on the AI boom at the moment.

Softbank has had both hits and misses over the years. Famously, the company lost billions on WeWork, and Son surely wants to protect the gains he’s made with Arm, which his company took private for $32 billion in 2016. Therefore, a post-lockup share price crash seems unlikely, as that would only happen if Son started selling a significant piece of Softbank’s stake.

Whatever happens, Arm looks like a good long-term buy

While the stock is likely to be volatile this week, long-term investors should look past the noise and focus on the company’s fundamentals and its bright future in AI.

Arm stock is expensive, trading at a price-to-earnings ratio of 112 based on this year’s expected adjusted EPS, but the company has several competitive advantages that should help its growth accelerate as AI applications go mainstream.

First, it has a close working relationship with Nvidia, which tried to buy it in 2020. Nvidia, for example, is licensing Arm’s technology for its GH 200 Grace Hopper Superchip, which is a key component in AI servers from Super Micro Computer, Dell Technologies, Hewlett Packard Enterprise, and others, and represents the next generation of the enormously popular H100, which has been in high demand for running AI models since the launch of ChatGPT.

Additionally, Arm’s unique business model should also give it an advantage. Rather than selling its products directly to end users like most semiconductor companies, Arm licenses its technologies to chip partners like Nvidia or Alphabet‘s Google, and receives royalties as they sell products that use Arm’s architecture. That gives Arm a smoother revenue stream than most chipmakers. Part of the reason the stock soared so much on its earnings report last month is that Arm’s licensing revenue jumped more than expected, which bodes well for its royalty revenue in the coming quarters, as royalties follow new licenses.

In the same vein, Arm’s low-power CPU architecture, which is prized in smartphones, is also highly valuable in running AI models, which tend to use relatively enormous amounts of power. That advantage should also lead to increased demand for licenses over the coming quarters and more royalties down the road. The company did not offer guidance for its fiscal 2025, but sales and profit growth are likely to accelerate as it benefits more from the AI boom.

Current shareholders and those considering buying the stock should pay attention to what happens when the lockup period expires on Tuesday. However, the business looks well positioned for strong growth over the coming years, no matter what happens this week. Still, if the market reacts to the lockup expiration with a significant sell-off, it would present a good buying opportunity for the hot AI stock.

This post appeared first on fool.com

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