SFTBY - The Importance Of Arm Holdings For SoftBank Group's Valuation

2023-08-23 00:47:59 ET

Summary

• Arm Holdings plans to go public via an IPO at the Nasdaq, with parent company SoftBank acquiring an additional 25.1% stake for $16.1 billion prior to the listing.
• Arm Holding's valuation will be crucial to SoftBank's overall valuation, and failure to meet ambitious targets could negatively impact SoftBank's share price.
• A $70 billion valuation for Arm Holdings may be difficult to justify, as the company does not display rapid growth and may face increased competition from RISC-V architecture in the future.

Arm Holdings Ltd. recently filed its form F-1 with the SEC, thus announcing its intention to once more go public via an IPO at the Nasdaq (under the ticker ARM ). The filing also reveals that parent SoftBank Group KK ( OTCPK:SFTBF ; OTCPK:SFTBY ) acquired a 25.1 percent stake for $16.1 billion at an equity valuation of $64 billion.

Going forward, I believe that Arm’s performance as a listed company will be an important factor for SoftBank’s overall valuation. Therefore, I think that failure to meet or maintain ambitious valuation targets during and after the IPO could be a downward catalyst for the share price of SoftBank. Below, I will explain my thesis in detail.

Kindly note that there is also SoftBank KK ( OTCPK:SFBQF ; OTCPK:SOBKY ), a telecom company in which SoftBank Group has a 40.5 percent equity share. Following, "Softbank" will refer to SoftBank Group unless otherwise stated.

Arm is Central To Softbank’s Valuation

Softbank divested most of its once massive holdings in Alibaba Group Holdings Ltd. ( BABA ). Therefore, Arm (or the 90 percent stake Softbank will continue to own post-IPO) is now its most significant individual asset. As such, I am convinced that its valuation will be crucial to the parent's share price going forward.

First, we should take a look at the value of Softbank’s portfolio overall. The value of the group’s remaining stake in its telco subsidiary can be quantified relatively easily as it is a listed entity. The current market capitalization translates to a value of around $21.3 billion. Yet, I would argue that one should apply a certain conglomerate discount to this figure in practice, given that it is grouped together with a plethora of unrelated businesses. The same is true for a 4.5 percent equity stake in Deutsche Telekom AG ( OTCQX:DTEGF ; OTCQX:DTEGY ) which has a market value of about $4.65 billion at the time of writing.

The Vision Fund segment is considerably harder to value. Using a multiple of AUM is not suitable, in my opinion, because Softbank is itself the largest equity holder in its funds. With regard to the Vision Fund 1 there is also the issue of outside investors holding a majority of their respective interest in preference units paying a fixed 7 percent coupon. The most optimistic valuation would be at reported fair values. That would translate to $33.2 billion for the wholly owned Vision Fund 2 and just shy of $30 billion for Softbank’s holding in Vision Fund 1 (management fees paid by outside investors being more than eaten up by the aforementioned 7 percent coupon) plus $6 billion for the LatAm Fund. That adds up to a total of close to $70 billion.

Now, keep in mind that this is the most optimistic valuation I could come up with. Given the composition of the portfolio of mostly unprofitable, high multiple businesses combined with an environment of relatively high (and rising) interest rates and a less than stellar track record, I believe that a discount would probably be in order here, too. For example, one of the Vision Fund’s largest investments, WeWork Inc. ( WE ), has declined to the point of becoming a penny stock and now includes a going concern statement in its most recent 10-Q filing (for a more in-depth look into this I recommend this article by WYCO Researcher), after Softbank put in close to 20 billion. The fund also sunk billions in names such as Oyo or Greensill.

Softbank reported cash and equivalents of around $50 billion (¥7.3 trillion) as of June 30 ^th . At the same time, the company had close to $235 billion in total liabilities, $44 billion (¥6.4 trillion) of which interest-bearing debt. Based on the assumption that a stake of around 10 percent will be sold, one may expect cash proceeds from the Arm-IPO of around $7 billion. However, it must be kept in mind that Softbank paid $16.1 billion to the Vision Fund. So, all in all, the Arm transactions in aggregate will probably result in a reduction of net cash by about $9 billion give or take.

Arm had total liabilities of $2.8 billion and cash and equivalents of $2.2 billion as of June 30 ^th so the transactions do not materially move the needle with regard to the group’s consolidated debt figures.

Consequently, Softbank’s consolidated net debt post Arm-IPO should be somewhere in the range of $190 to $195 billion. Notably, Softbank itself prefers an adjusted net debt figure which takes into account only interest-bearing debt at the holding level while excluding liabilities of self-financing subsidiaries.

That, I believe, makes sense to a degree, as the debt of a listed subsidiary is already figured into its share price. Therefore, I believe it would be prudent to adjust the net debt figure by subtracting $30 billion in Softbank Corp. liabilities consolidated by the parent as well as Arm’s $600 million net debt. I will not, however, deduct debt of the Vision Fund segment, nor will I (unlike Softbank itself ) preclude the entirety of non-interest-bearing liabilities. This brings the (adjusted) net debt post Arm-IPO to somewhere in the vicinity of $130 billion.

Softbank currently has a market capitalization of slightly above $65 billion at the time of writing. In order to justify that valuation using a sum of the parts approach, Arm and the asset portfolio that Softbank refers to as “ Investment Business of Holding Companies segment ” (ex Deutsche Telekom as the corresponding value has already been figured in) as well as subsidiaries Fortress and Fukuoka Hawks (a Japanese professional baseball team) would need to be worth at least about $96 billion.

The remaining Alibaba stake of just below 4 percent alone has a market value in excess of $8 billion. Softbank also continues to own about 43.338 million shares of T-Mobile US, Inc. ( TMUS ) which have a market value of close to $5.9 billion. However, Deutsche Telekom has a call option on close to 7 million shares for a total price of around 700 million, so the true value has to be adjusted slightly downwards to around $5.6 billion.

While the precise value of the remaining assets is difficult to pin down, I will assume that the Investment Business of Holding Companies segment ex-Deutsche Telekom plus Fortress and Hawks will have a value of $20 to $25 billion (once again, I am using a figure that I feel is rather generous).

That, in turn, means that Arm would need to achieve a valuation at the upper end of the $60 billion to $70 billion range in order not to lead to downside potential for SoftBank's stock.

Arm Valuation

The question is: does ARM justify a valuation of $70 billion or more? Arm is highly profitable. According to the F-1 filing, the company generated operating income of $671 million (+6 percent YoY) and net income of $524 million (-4.5 percent YoY) in the fiscal year ended March 31 ^st . Total revenue amounted to $2.68 billion (in line with the previous year).

A $70 billion valuation, however, would translate to earnings multiple of more than 130 and 26 times revenue. That is a rather rich valuation, but considering that NVIDIA Corp. ( NVDA ) trades at pretty similar levels, it does not appear unprecedented at first sight. However, Arm does not display rapid growth (in fact, it did not at all grow in the year ended March 31 ^st ). Most of its revenue comes from smartphones, an increasingly saturated segment. While I would not rule out that Arm might indeed benefit from chips tailored to AI applications, it has as of yet to deliver proof. Just remember that the IoT vision laid out in 2016, when Softbank acquired Arm, failed to play out so far. There is no guarantee that history will not repeat with regard to AI.

Another risk is the company’s reliance on its former Chinese subsidiary, Arm China, which accounts for close to a quarter of sales. The company explicitly mentions this in the filing:

“We depend on our commercial relationship with Arm China to access the PRC market. If that commercial relationship no longer existed or deteriorates, our ability to compete in the PRC market could be materially and adversely affected.”

- from page 13 of Arm's F-1 filing

Also, Arm China’s status as an independently operating entity makes it easier to target for sanctions directed at keeping Chinese hands off critical technology.

Furthermore, the emergence of the open-source RISC-V architecture may pose a risk (no pun intended) to Arm. As is, the company has a de facto monopoly on smartphone chip architectures, as well as a strong market position for certain kinds of energy-efficient semiconductors. RISC-V based designs might lead to materially increased competition and, therefore, cause significant disruption to Arm’s business model.

One interesting side note: the Vision Fund investors would probably not have agreed to a 64 billion price tag if they were confident that in a few weeks, the value of Arm would be materially higher. Also, it is, I believe, rather telling that Nvidia is reported to have proposed a valuation of $35 to $40 billion in talks regarding a role as anchor investor.

To be fair, I will also admit that, in terms of timing, I feel that Softbank is making the right move as it may now take advantage of the AI hype – as demonstrated by Nvidia elevated multiples. But in the long run, tangible results will have to underline a valuation. Delivering those is certainly possible for Arm, but it is far from a given. I am, thus, skeptical regarding the company’s ability to maintain a valuation of $70 billion or higher.

Conclusion

All in all, I believe that there is a real possibility of Arm trading at a valuation significantly below the $70 billion that Softbank’s current share price seems to imply for the chipmaker. And even success would merely justify the current valuation, not provide additional upside. Strong operational performance, not only of Arm, but also of the telco subsidiary Softbank KK and the Vision Fund segment – especially the latter appears doubtful given the macro environment - are already priced in.

In the medium term, I believe that there is downside potential of about $15 to $20 billion to Softbank’s equity valuation. That translates to a share price of $32 to $36 (net of potential buybacks, an instrument of which Softbank has historically made use rather aggressively, but is not currently employing after November 10 ^th , 2022 ). That, in turn, represents a downside of 20 to 30 percent. Consequently, I rate Softbank Group KK a sell at the current share price.

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