Newly public Arm Holdings (ARM 4.11%) stock price soared after the company released a strong earnings report earlier this month. Anticipated increases in demand for ARM's central processing unit (CPU) designs helped the stock explode, and it has more than doubled from its September initial public offering (IPO) price.
ARM's growth potential is legitimate, but the 110% share price action since the IPO that investors are seeing is partly due to the existing IPO lockup -- which could pour water on the stock's momentum when it expires next month.
Investors should fully understand the dynamic between ARM's stock and its fundamentals and how the expiring lockup could soon send shares lower. Here is what you need to know.
Is the stock getting bubbly?
Arm Holdings is an important but under-the-radar company in the semiconductor industry. It creates designs for CPU chips, which are essentially the brains of a computer and are found in virtually every computing device, ranging from smartphones to servers. Arm sells the rights to its designs, collecting licensing fees and royalties. As of 2023, roughly half of the world's CPUs use Arm-based designs.
High-growth end markets, including artificial intelligence (AI), automotive, the Internet of Things (IoT), and more, are increasing demand for CPUs, often designed around Arm's intellectual property. Arm reported a strong quarter, and you can see the optimism below, reflected in the increased earnings estimates for Arm's current fiscal year and beyond.
ARM EPS Estimates for Current Fiscal Year data by YCharts
But it could be time to pump the brakes.
The stock trades at an eye-popping 102 times the increased earnings estimate. Analysts have even scrambled to raise their forecasts for Arm's long-term earnings growth. Yet the stock's PEG ratio is still high at 2.5. In other words, the stock is expensive, even if Arm follows through on these higher expectations. I generally look for a PEG ratio of 1.5 or less.
Why the party could end next month
Investors looking to try to capture Arm's sudden momentum should be cautious. As a newly public company, a lot of Arm's stock is restricted by an IPO lockup. It's an agreement that was part of its IPO that doesn't allow certain parties, like insiders or institutions that participated in the IPO, to sell their shares for a certain amount of time.
Since the lockup is still in effect, only about 9.5% of ARM's total outstanding shares are being traded. The remaining 90.5% become eligible to be traded once the lockup expires on March 12. Investment firm SoftBank (SFTB.Y 1.75%) owns most of the locked-up shares, and the stock's strong momentum could incentivize SoftBank and others to start selling to realize their gains.
Arm's long-term potential is genuine, but the extreme reaction to earnings seems almost like a short squeeze, where many buyers are chasing a small supply of available shares. As the classic law of supply and demand stipulates, the expiring lockup could dramatically increase supply, lowering demand and the share price.
What should investors do?
If you're fortunate enough to read this while sitting on massive investment returns, consider selling some of your Arm stock to lock in some of the returns you've enjoyed. Those looking to buy shares should stay patient because you may get a better buying opportunity next month.
Investing is a long-term gain, but taking the low-hanging fruit is sometimes OK. Nobody knows what any stock will do in the future, but it might hurt if shares give up these remarkable but sudden gains and you're left without anything to show.
