SFTBY - Arm Holdings: Is This An Attractive IPO?

2023-08-23 08:36:27 ET

Summary

• Arm Holdings is preparing for its initial public offering (IPO) with strong intellectual property and connections with major players in the chip design industry.
• The IPO will be conducted by Japanese SoftBank, the current owner of Arm Holdings, and is expected to generate a market capitalization of $60 billion to $70 billion.
• Despite its strong tech and intellectual property, the high valuation of Arm Holdings may make the shares too expensive for investors unless they drop substantially after the IPO.

Article Thesis

Arm Holdings Limited ( ARM ) will soon have its initial public offering. The chip design player has strong intellectual property and connections with major players. From a tech perspective, Arm Holdings could be an attractive investment. Whether ARM will be an attractive investment following its IPO also depends on the share price when the stock begins trading - it would not be surprising if shares are bid up and thus traded at a rather expensive valuation in the beginning.

Company Overview

Arm Holdings Limited is a UK-based semiconductor company that operates with a fabless business model, meaning it does not manufacture any chips itself. Many other semiconductor companies operate in a similar manner, instead having foundries such as Taiwan Semiconductor Manufacturing Company ( TSM ) do the capital-intense manufacturing.

Arm Holdings is best known for the ARM architecture that is widely used in different chips, including in the SOCs that Apple ( AAPL ) designs and uses, such as the A16 Bionic that is used in the current iPhone model or the M1 that is used in Apple's Macs. These designs are licensed by other companies from Arm Holdings, for which Arm Holdings receives compensation.

The company also designs its own chips, mostly CPUs, but also GPUs and other products. For example, one recent product introduction is Arm Holdings' Immortalis-G715 GPU, which will be used for gaming and other graphics-heavy tasks in high-end smartphones.

Its fabless and design-focused business approach is described in the following way in a recent SEC filing :

Arm had 5,963 full-time employees across North America, Europe and Asia as of March 31, 2023. We are an engineering-first company, with approximately 80% of our global employees, as of March 31, 2023, focused on research, design, and technical innovation, and we have global operations and research and development ("R&D") centers in the U.K., Europe, North America, India, and Asia-Pacific. Our headquarters are located in Cambridge, U.K.

Arm Holdings IPO

Arm Holdings has recently started the IPO process, and it is expected that the company will go public later this year. Right now, Arm Holdings is owned by Japanese SoftBank ( SFTBY ), and Softbank will be the seller of shares. Arm Holdings itself will not sell any shares to the public, meaning that no new cash will be generated for the company - instead, the proceeds will end up at Softbank, which will be able to partially monetize its position in the British chip company.

In the SEC filing linked above, Arm Holdings shows recent results and the financial performance of the company in the most recent quarter and fiscal year.

So far, we don't know yet about the price of the shares of Arm Holdings that Softbank will be selling, and we thus also don't know yet about the exact market capitalization of the company once it has gone public. This, in turn, means that we won't know about the exact valuation of Arm Holdings' shares until we get more details. We do, however, have some estimates about the market capitalization range that Arm Holdings and lead underwriter Barclays ( BCS ), which is also from the UK, are targeting. According to some reports , a market capitalization of around $60 billion to $70 billion is the target for the IPO. While that wouldn't make Arm Holdings the most valuable chip company by far - NVIDIA ( NVDA ), for example, is valued at around 15x that amount - the $60 billion to $70 billion figure could still be rather elevated, as things have to be seen in perspective, which gets us to the next point.

Arm Holdings IPO Valuation

While the ARM architecture is widely used around the world, the payments that flow to Arm Holdings aren't overly high. There are billions of chips in circulation that utilize the ARM architecture, and yet, Arm Holdings only generated a relatively small revenue number. The company's recent SEC filing, linked above, states the following:

For the calendar year ended December 31, 2022, we estimate that our TAM was approximately $202.5 billion and we forecast that our TAM will grow at a 6.8% compound annual growth rate ("CAGR") to approximately $246.6 billion by the end of the calendar year ending December 31, 2025. We estimate that the aggregate value of chips containing Arm technology was approximately $98.9 billion in the calendar year ended December 31, 2022, representing an approximate 48.9% market share as compared to an approximate 42.3% market share as of December 31, 2020. We estimate that our royalty revenue as of December 31, 2022 represented approximately 1.7% of the industry TAM containing Arm-based chips. We expect that the cost and complexity of chip design will continue to increase, and that we will be able to contribute a greater proportion of the technology included in each chip, resulting in our royalties comprising a greater proportion of each chip's total value. Our calculation of TAM is based on a combination of third-party sources, customer reports and our own internal assessments and judgment.

While ARM-based chips are a gigantic market, Arm Holdings does only get a pretty small portion of all the revenue that these chips are generating. After all, a large portion of the revenue ends up at the companies that design the specific chips (e.g., Apple with the A16) and at the companies that do the manufacturing of these chips, such as Taiwan Semiconductor Manufacturing Company.

Over the last year, Arm Holdings has generated revenues of $2.7 billion, which was down 1% over the previous year's quarter. While a small revenue decline is not great in absolute terms, it is far from a bad result, considering the macro environment for semiconductor companies. Companies such as Advanced Micro Devices ( AMD ), Intel ( INTC ), and even NVIDIA experienced revenue declines of -18%, -15%, and -13% during the first quarter, respectively. On a relative basis, Arm Holdings' revenue performance was thus attractive - the company outperformed many other semiconductor companies in a tough macro environment.

Arm's gross margins are incredibly high, as a large portion of the company's revenue consists of licensing payments, and the net margin is pretty attractive as well, at around 20%. However, this means that Arm Holdings generated net profits of "only" a little bit above $500 million over the last year. Considering this level of profits, a $60 billion to $70 billion market capitalization seems pretty high to me, as this translates into a valuation of around 120x net profits. That is a far higher valuation compared to how AMD, NVDA, etc. are valued - and one can argue that even a company like NVIDIA, at around 60x forward profits, is pretty expensive.

While Arm Holdings has strong tech and while its intellectual property definitely has significant value, profit ultimately decides about the company's ability to return cash to its owners. With around $500 million of profit per year, the company will have to grow at a fast pace for many years in order to justify a valuation of $60 billion and more. I personally thus deem shares too expensive if Arm Holdings really goes public at a valuation this high, and do not plan on buying shares after the IPO unless they drop substantially.

Takeaway

Arm Holdings will IPO in the not-too-distant future, and while the company's margins are attractive and its IP is strong, the stock will likely IPO at a pretty high valuation. Investors should thus consider the implications of buying a stock at 100x earnings or even more - even if the company continues to grow meaningfully for years, attractive total returns for shareholders are far from guaranteed. In fact, when one buys shares at a valuation this high, share price compression can occur even if underlying business growth remains attractive - Cisco ( CSCO ) during and following the dot.com bubble is a good example of that.

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