Is Arm Holdings a smart way to play the booming AI market? Experts break down 2023’s biggest IPO, and why you should invest with caution.

• Shares of the chip designer Arm Holdings priced at $51 per share in their IPO.
• The stock is going public after Softbank failed to sell the company to Nvidia last year.
• Arm is an essential part of the AI ecosystem, and its debut is the biggest of 2023 so far.

A key AI player is stepping into the limelight.

Arm Holdings, a British semiconductor and software company, is set to go public on Thursday in the largest IPO of 2023.

This year has seen a surge in excitement and the market for artificial intelligence. AI is expected to be a $900 billion business within the next three years, according to Bank of America, while Congress is deciding how to regulate it.

On paper, Arm appears to be a perfect fit for investors looking to profit from artificial intelligence. Some on Wall Street are concerned that Arm insiders will be the only ones to profit, and that retail investors who try to jump on the AI bandwagon with the Arm IPO will be disappointed.

Here’s what the experts have to say about Arm’s IPO and whether it’s a good buy right now.

What is Arm Holdings, what does it do, and why did it IPO?

This is not the first time that Arm shares have been made available to the general public. Arm initially went public in 1997, riding out the dot-com bubble before rising in the mid-2000s on the back of the rapidly expanding mobile phone market.

SoftBank Group paid $32 billion to take the company private in 2016. Since then, SoftBank has pushed Arm to expand rapidly, expanding its CPU offerings into new markets such as tablets and televisions, but its core business remains the mobile phone market. Arm stated in its public F-1 filing that its CPUs “run the vast majority of the world’s software.”

To be clear, Arm does not manufacture semiconductors in the same manner as, say, Taiwan Semiconductor Manufacturing Company. Instead, Arm focuses on designing CPU architecture — or, in layman’s terms, designing the key components of a CPU for other companies to manufacture. Its revenue is based on licensing and royalties.

So, while the company is not a semiconductor manufacturer in the traditional sense, it can still benefit from the AI boom due to the skyrocketing demand for computing power and computer chips. After all, as AI-enabled technology becomes more prevalent in markets, there will be a greater demand for advanced processors such as those developed by Arm.

Given the hype surrounding AI and the boost that any stocks remotely related to it have received this year, it’s no surprise that SoftBank chose to go public now.

The Japanese investment firm wanted to sell Arm to Nvidia for $40 billion in 2020, but the deal fell through in 2022 as Arm’s customers revolted and regulatory scrutiny sank the acquisition. However, this may be a blessing in disguise for insiders, who will see the company valued even higher when it goes public.

Everything you need to know about Arm’s IPO

On Wednesday, ARM announced that it had priced its 95.5 million shares at $51, the upper end of the $47 to $51 range that it had marketed. According to Bloomberg, this valued the company at $54.5 billion, which is less than SoftBank’s recent valuation of $64 billion earlier this year.

While price is important, many market observers are more interested in how many shares will be available for purchase.

SoftBank was expected to offer the public only 10% of its existing stock. That’s an unusually small float for such a hotly anticipated IPO, and the small size may drive demand to unprecedented heights, paving the way for a sudden surge in share price.

Furthermore, Arm has stated that it will reserve approximately $735 million in shares for “cornerstone investors,” which include some of the company’s largest customers such as Apple, Google, AMD, Samsung, and Nvidia.

According to Seth Farbman, chairman of VStock Transfer and an IPO expert, the concentrated ownership of so much of Arm in the hands of so few “might be a point of contention for some potential investors.” However, in the case of the cornerstone customers, interested investors should take their presence as a positive sign.

“Yet, major tech players such as Nvidia, Samsung, Intel, Google, and Apple have given their support.” “They aren’t just investing financially; they are essentially endorsing ARM’s pivotal role in the future of technology,” Farbman wrote in an email to Insider.

Wedbush Securities analyst Matt Bryson agreed that the small float and concentrated ownership may cause some concern, but he’s not concerned. He drew a comparison to Globalfoundries (GFS), which went public in 2021 and was in a similar situation.

“As such, even though Arm is arguably pricing at a rich valuation using FY’24 or FY’25 numbers, we believe, as with GFS, there is a strong probability that the scarcity of available shares combined with a model that looks increasingly attractive in the out years (given assumed sales growth and margin gains) could allow Arm to lift from its initial IPO price,” Bryson wrote in a note to clients on September 11.

In terms of the IPO’s timing, Peter C. Earle, an economist at the American Institute for Economic Research, is concerned that “these are not optimal economic conditions for a public offering.”

“We’ve got a significant credit contraction underway, stubborn inflation, and a handful of assets that are more competitive against equity returns than they have been in years,” he wrote to Insider. “On the other hand, there’s nothing hotter than AI right now, and the small float of this offering – about 10% of total shares – will most likely push valuations higher.”

Should investors buy shares of Arm Holdings now?

With that said, investors eager to buy Arm and cash in on the AI boom should pause for a moment before doing so.

However, while most analysts wait for a newly public company to report its first set of earnings before making a recommendation on the stock, Arm has already received its first ‘buy’ rating.

Bryson, on the other hand, is wary of purchasing at the current price.

“The valuation will appear rich in comparison to historic numbers,” Bryson wrote. “However, projected revenue and, more importantly, margin gains over the next few years should lead to ARM being valued at far more reasonable levels.”

Indeed, much of Bryson’s analysis has less to do with Arm’s current business and the price at which shares were issued, and more to do with where the company is headed in the future.

Earle concurs with this assessment. “It’s been a bad year for IPOs,” he wrote, “but this one could not only buck the trend but pave the way for a few other brave firms to sell stock.” “The fundamental question has always been and will always be: what are realistic expectations for future growth, and how should valuations reflect those?”

With that in mind, Bryson examined Arm’s operating margins and revenue projections to determine a reasonable stock valuation. Arm management believes that the AI boom will boost revenue by 11% in fiscal year 2024 and push it into the mid-20% range by 2025. Bryson agrees with this assessment and predicts that Arm’s operating margin will rise to 50% in fiscal year 2024, owing to the company’s history and the combination of lower R&D expenses and higher sales in the coming months.

Overall, Bryson believes Arm will earn $1.40 per share in fiscal year 2025, giving it a forward earnings multiple in the mid-30s today.

That would make Arm stock extremely expensive in comparison to peers in the technology sector. “This valuation, for example, would imply Arm is more expensive than the most expensive semiconductor company in our coverage, NVDA, which is trading at 30X our FY2025 estimates (and we use a mid-30s multiple to calculate its price target),” Bryson wrote.

However, while Arm shares appear to be expensive today, if the company lives up to its lofty expectations, the price will begin to look more reasonable.

“The valuation will appear rich in comparison to historical numbers,” Bryson wrote, “but projected margin gains over the next few years would lead to ARM being valued at far more reasonable levels (assuming those gains are realized).”

However, investors should be wary of how reliant China Arm is in the future. According to Bryson, China accounted for approximately 25% of sales in fiscal year 2023 and 21% of sales in the first fiscal quarter of 2024, making chip wars between the US and China Arm’s most significant risk factor.