SFTBY - ARM Holdings: Plenty Of Smoke But No Fire

2023-09-15 10:16:08 ET

Summary

• ARM Holdings is set to go public with a valuation of over $50 billion, making it the largest IPO since Rivian debuted in 2021.
• The IPO is backed by a number of major tech companies and is reportedly 10x oversubscribed, suggesting strong retail demand.
• I believe the company is richly valued considering its stagnant core mobile market and concerns about licensing and royalty revenues in China.

Summary

With an implied valuation in excess of $50 billion, Thursday's scheduled ARM Holdings PLC IPO is the largest since Rivian ( RIVN ) in 2021. The listing is backed by a number of prominent tech companies that are core customers. Reportedly 10x oversubscribed , it should be met by substantial retail demand out of the gate. In my opinion, the implied valuation is rich relative to growth expectations considering the stagnant mobile market and geopolitical concerns surrounding licensing and royalty revenues in China.

Author's Note: This article was originally submitted prior to the IPO on Thursday, Sept 14, 2023.

Introduction

After a seven-year hiatus, Arm Holdings ( ARM ) is returning to public stock markets with a blockbuster listing on the Nasdaq Global Market valuing the company in excess of $50 billion. The IPO features an A-list of lead underwriters, including Goldman Sachs ( GS ), JPMorgan Chase ( JPM ), Barclays ( BCS ), and Mizuho ( MFG ) as well as heavyweight investors such as Apple ( AAPL ), Alphabet ( GOOG , GOOGL ), Nvidia ( NVDA ), Samsung, AMD ( AMD ), Intel ( INTC ), Cadence Design Systems ( CDNS ), MediaTek, and (possibly) Taiwan Semiconductor Manufacturing Company ( TSM ). After acquiring the remaining 25% stake from its own Vision Fund at a premium (in what was hardly an arm's length negotiation reflecting fair value) just a couple months ahead of the planned IPO, SoftBank ( SFTBY , SFTBF ) plans to sell a modest 9.4% stake, raising up to $4.87 billion at the top of the indicated price range of $47-$51 a share (assuming the underwriters exercise their overallotment).

While this valuation is lower than the $60-70 billion SoftBank previously hoped for, it's still considerably higher than the $40 billion takeover offer from Nvidia a year ago that was abandoned due to pressure from regulators and ARM's own customers. As the company will still be a tightly controlled entity subject to relaxed foreign private issuer requirements, a lack of transparency and limited influence by public shareholders may be an issue.

The Bull Case

A fabless semiconductor designer, ARM has enjoyed solid growth since it was formed in 1990 as a joint venture between Apple, Acorn Computers, and VLSI Technology. The company's Instruction Set Architecture (ISA), known for its efficiency and low power consumption, is particularly widespread in SOCs and GPUs and CPUs for mobile, IoT, and embedded applications. Riding the tailwinds of global smartphone adoption, the company has increased its sales by over 70% from 2016 when SoftBank acquired it and took it private.

As the largest IPO since Rivian in 2021, ARM offers risk-averse investors the opportunity to participate in a prominent semiconductor designer with an established track record of growth and profitability.

Investors with a longer time horizon will be betting on the company's ability to capture a greater share of the market in high-growth, high-margin segments such as artificial intelligence ( forecast to grow at a CAGR of 37.1% through 2031 ), machine learning, and automotive. While ARM currently enjoys around a 99% share of the mobile market, the company only holds a 41% share of the automotive market ( where the connected cars segment is forecast to grow at a CAGR of 15.7% through 2027 ) and a 10% share of the cloud computing market ( forecast to grow at a CAGR of 20% through 2030 ). Unlike new entrants to these segments, ARM's long-standing relationship with major semiconductor manufacturers should make it easier for the company to penetrate these markets. There's even a sizable opportunity in the slower growing PC and server market, where Apple's M1 MacBook and Samsung's Galaxy Book Go are now using ARM as opposed to x86 architecture.

While licensing fees currently only account for approximately 1.7% of the ASP of chips based on ARM's architecture, the company has implemented a number of value-added measures, such as offering customers access to a bundled platform of ARM ISAs, combining multiple ARM CPUs in a single chip, or bundling an ARM CPU with a GPU or other ARM IP. The recent launch of the 9 ^th generation ARM ISA, ARMv9, offering improved performance and security, has the potential to drive overall sales growth and command higher royalties.

The Bear Case

With ARM's IPO priced at over 20x sales and 100x 2023 fiscal year earnings, there's little margin for error, especially considering that the company's sales and earnings have flatlined ($2.68 billion in sales and $524 million in net profit in the past fiscal year compared to $2.7 billion and $549 million, respectively, the prior year). While this valuation is lower than industry darling Nvidia (34.7 P/S and 110 P/E) and the company's gross margins are high, I think it's still rich in relation to the growth prospects. The question that then needs to be asked is: was this just a product of the post-pandemic environment (and the glut of semiconductors) or the sign of a more persistent issue?

While ARM has enjoyed torrid growth since its founding, it was assisted by the secular tailwinds of global smartphone adoption. In 2016 only 49% of people in the world owned a smartphone. Today the figure is over 85%. As most of that growth came from penetration into developing markets where consumers often lack the money to invest in a replacement device, new innovations like folding phones may not be enough to duplicate the rapid market growth of the past decade. This throws a wrench in the investment thesis. As smartphones become a mature market, I think the small but growing portion of sales in faster growing segments, such as AI, machine learning, and automotive, is likely to be overshadowed by stagnation in the company's core mobile segment.

ARM is moreover facing formidable competition from the cheaper, open-source RISC-V architecture introduced by QUALCOMM ( QCOM ) and NXP Semiconductors N.V. ( NXPI ), which threatens to capture a significant share of the market for smartphone, IOT, embedded system, AI, industrial, and data center chips. As for the overall RISC-V-based CPU market, it is forecast to grow at a blistering 146.2% CAGR between 2018 and 2025.

RISC-V is already being used by leading companies such as Amazon, Google, Qualcomm, Intel, Sony ( SONY ), ZTE ( ZTCOF ), and Western Digital ( WDC ). With no royalties to pay, a higher compute density, lower development costs, and customizable, expandable instruction sets, RISC-V is a cost-effective alternative, especially in entry-level smartphones and tablets or wearable devices, where processor footprint is always an important factor. While RISC-V won't take over the market overnight, it's bound to erode ARM's market-leading position and impose pricing pressures. Another risk factor that shouldn't be overlooked is ARM's geopolitical exposure in China, which accounted for 24.5% of its licensing and royalty income last year. In the F-1, the company notes that “political actions, including trade and national security policies of the U.S. and PRC governments, such as tariffs, placing companies on restricted lists, or new end-use controls, have in the past, currently do and could in the future limit or prevent us, directly or through our commercial relationship with Arm China, from transacting business with certain PRC customers or suppliers, limit, prevent or discourage certain PRC customers or suppliers from transacting business with us or Arm China, or make it more expensive to do so, which could adversely affect demand for our products.”

These trade and technology transfer restrictions may impact new high-margin products, such as the company's high-performance Neoverse V-series CPU IP, which the company is prohibited from selling in China. The filing goes on to mention that due to export control and national security matters in the PRC, the company expects royalties and possibly licensing revenues to decline. As if this isn't enough cause for concern, there's the common issue of transparency with Chinese-listed companies. As ARM China operates independently of ARM Holdings, the company cautions that “...Arm China’s payments due to us are determined based on the financial information that Arm China provides to us. Accordingly, we are dependent on Arm China providing us with reliable and timely financial information.”

The "Sizzle"

As the IPO is said to be about 10x oversubscribed, investors who suffered through the IPO drought of the past two years are obviously eagerly embracing ARM. Due to the scarcity factor (one of only two big-name tech IPOs expected this year), I expect ARM Holdings to burst out of the gate and open significantly higher than the offer price. The IPO should receive a warm reception in the aftermarket due to the familiar name, track record of growth and profitability, and backing of an all-star list of prominent tech company investors and lead underwriters. In spite of the excessive valuation, I fully expect retail investors to chase this IPO for a week or two as was the case with the recent VinFast Auto ( VFS ) public SPAC offering.

Nonetheless, I consider ARM Holdings to be more of a tasty Crepe Suzette than a satisfying entrée. Sure, there may be some instant gratification, but as soon as that sugar high wears off, you're likely to have a bad case of indigestion. At or near the offer price, it may be worth flipping this crepe before it pancakes, but longer term, I'm just not sold on its prospects.

Rating (on a scale of 1-5, where 1 pepper is a supreme fail and 5 peppers is a smashing hit)

The "Steak"

Call me a pessimist, but with the core smartphone market maturing and the income stream from China threatened, I can't help but wonder if SoftBank hasn't chosen the perfect time to monetize its stake in the company. While I applaud ARM's ambition to penetrate new markets such as AI, cloud computing, and automotive, I'm skeptical whether this growth can offset the flattish trajectory of the much larger mobile segment. Unfortunately, ARM hasn't published a breakdown of its revenues by segment. However, based on their reference to “diversification into new target markets” in the Q1 2022 report, I can only assume that these sales are growing at reported “double and triple-digit” rates from a very modest base and are therefore unlikely to have much of a near-term impact on the company's overall revenue growth or bottom line. Thus, I just don't see a growth story here, and progress on the topline, I think it's questionable whether the company can grow earnings fast enough to justify a premium valuation.

In short, there's simply too much fat on this steak for me to recommend it.

Rating (on a scale of 1-5, where 1 pepper is a supreme fail and 5 peppers is a smashing hit)

Overall Rating

For further details see: