2023-09-20 11:01:38 ET
Summary
- Arm's successful IPO comes with a significant valuation premium over the broader chip design peer groups.
- While market's optimism for Arm's AI opportunities are overshadowing the company's exposure to China risks, its fundamental performance shows otherwise.
- Despite Arm's mission-critical role in enabling next-generation technologies, we think it faces a greater-than-normal exposure to ongoing China risks relative to peers, which is not factored into its valuation premium.
Arm Holdings ( ARM ) has raced out of the gates last week as the highest valued IPO this year, breaking a yearlong drought as the stock seeks to ride the coat-tails of AI momentum. The offering was oversubscribed by more than 10x at IPO, pushing its opening price to $51 apiece. The stock surged to as high as $69 (+35%) on Monday, before paring some gains at about $58 (+14%) during Tuesday's session.
In addition to a mixed recovery outlook, emerging from the troughs of a cyclical downturn, the semiconductor sector also remains caught in the middle of a heated trade and national security crossfire between Washington and Beijing. While that is nothing new, Arm's recent listing brings to light again the related impacts which have largely been overshadowed by AI optimism in recent months. Although Arm has yet to experience a material impact to its business under the recently imposed U.S. export curbs on advanced chip technology to China, the company is bracing for heightened unpredictability to opportunities within its largest market. This is further corroborated by declines in licensing and royalty revenues from China during the June quarter, which management expects to persist as a result of ongoing trade restrictions, alongside broader macro-driven demand uncertainties in the region.
Currently trading at more than 20x LTM revenue, Arm boasts a lofty valuation premium relative to the 13x average observed across chip designer peers with a similar growth profile, such as Cadence Design Systems ( CDNS ) and Synopsys ( SNPS ). The lingering impact of a slow-recovering consumer end-market critical to Arm's royalty revenue stream, as well as its significant exposure to China risks is likely to counter AI optimism currently baked into the stock's market valuation.
Arm's Exposure to China Risks
The bulk of Arm's revenue exposure is concentrated in the Chinese market, which accounted for a quarter of Arm's fiscal 2023 revenue and about a fifth of its June quarter revenue. This is consistent with Arm's predominant market share (~99%) in mobile application processors, which is primarily driven by demand in China - the largest smartphone market in the world.
Arm currently sells to China via its affiliate "Arm China", which it has an indirect equity interest of 4.8% in through its 10% stake in a SoftBank-controlled subsidiary, Acetone Limited:
Author, with data from investors.arm.com
Arm China operations are independent on Arm. Ensuing revenues are stipulated in the IP License Agreement ("IPLA") between Arm and Arm China, in which the latter has "certain exclusive rights" to sublicense Arm IP to the Chinese market. Arm currently commands about 90% of total Arm revenue under the IPLA. The remainder of the affiliate's sales are primarily generated from the development of its own IP independent of Arm's technologies.
Arm revenue derived from sales to Arm China are separately disclosed under license and royalty revenues from related parties. Of the $654 million in total related party revenues generated in fiscal 2023, 99% are attributable to Arm China sales. And recent weakness stemming from U.S.-China tensions, alongside broader demand weakness in the Chinese consumer spending environment is corroborated by accelerating y/y declines in related party revenues during fiscal 2023 and the latest June quarter. Specifically, royalty revenues generated from related parties have been on the persistent double-digit decline since fiscal 2021, while license revenues generated from related parties have also traded in robust double-digit growth for double-digit declines in the June quarter. This is consistent with risks disclosures in the IPO prospectus filing , which cites expectations for persistent macroeconomic impacts to business in the region to be exacerbated by "export control and national security matters".
The near-term increase in Arm's exposure to China risks is also evident in accelerating June quarter related party revenue declines. In addition to a slow Chinese demand environment, Arm has highlighted "trade protection and national security policies of the U.S. and PRC governments" as the primary culprit.
Risks to AI Optimism
Although much of Arm's current valuation premium is likely driven by market's optimism for AI, the extent of said opportunities is unlikely to material over the immediate term for the chip designer. This causes us to stay incrementally cautious over the durability of Arm's premium at current levels, given near-term China risks will likely emerge with predominance over longer-term AI tailwinds for the company. This is largely opposite to anticipated trends observed in notable AI share gainers and Arm partners, such as Nvidia ( NVDA ).
While management is optimistic about Arm's prospects in emerging AI/ML opportunities, with expectations for "significantly faster growth than the overall cloud compute market", we see several immediate roadblocks to realizing said ambitions.
- Displacement of general purpose CPU data centers : The advent of increasingly complex workloads, such as AI/ML, is accelerating the transition from general purpose CPU data centers to accelerated GPU-based data centers. As highlighted in Arm's risk disclosures, the company's CPU-focused technologies "may become less important" to customers with the emergence of AI/ML. This is in line with Nvidia CEO Jensen Huang's recent estimates that "$1 trillion of [CPU-based] data centers is in the process of transitioning to accelerated computing and generative AI". This could potentially risk displacing some of Arm's recurring revenue opportunities stemming from royalties generated on legacy Arm design wins. Specifically, royalty fees generated from the sale of Arm-based processors represent a critical "long-term recurring revenue opportunity from design wins", and is key to optimizing its investment returns - close to half of Arm's royalty revenues are currently generated from designs introduced between 1990 and 2012.
- Ramping up Neoverse-based processors : In order to stay technologically competitive, Arm has optimized its highest performance Neoverse cores based on the Armv9 architecture for high-performance computing ("HPC") and AI/ML-accelerated workloads. Nvidia's Grace CPU Superchip is currently based on this technology, enabling "up to 10x" better performance and energy efficiency in facilitating AI workloads. The next-generation GH200 Superchip Platform , which starts shipping in calendar 2024, also features 144 Neoverse cores, optimized for surging demand in accelerated computing. Although management expects increasing incorporation of Arm technologies into next-generation chip designs, it is currently uncertain whether Neoverse-related sales and the company's future AI/ML deployments will be accretive or disruptive to existing royalty revenues generated primarily on sales of market leading Arm-based mobile processors. Specifically, AI/ML-related revenue likely remains a nominal contribution to Arm's annual consolidated sales as well, which is in line with its still budding cloud computing market share in the low double-digit percentage range. This is likely to dull some of the stock's recent momentum, as investors gradually turn to a wait-and-see approach for Arm's underlying fundamentals to grow into its lofty valuation attributable to AI opportunities.
Fundamental Considerations
While Arm has yet to publicly disclose any of its forward guidance for the company, preliminary data gathered from its " investor roadshow " prior to the IPO suggests expectations for 11% y/y growth in fiscal 2024, with expansion to the mid-20% range by fiscal 2025. Management also expects longer-term growth in the "high-teen percentage", driven primarily by robust demand for Arm technology critical to enabling AI applications.
However, we find it difficult to underwrite such stark reversals of accelerated declines observed during the recently completed June quarter. Revenue declines exiting fiscal 2023 and during the June quarter is a divergence to the eye-watering growth observed at AI chip leader Nvidia during the first half of calendar 2023 - this comes despite Nvidia's incorporate of Arm technology in its best-selling AI chips. Instead, worsening deterioration in Arm's related party revenue continues to highlight its exposure to China risks that have become increasingly pervasive over the same period. Meanwhile, modest growth in sales to external customers, dragged primarily by declines in royalty revenue, also suggests persistent challenges from the broader chip industry's mixed recovery outlook. This is further corroborated by key PC and smartphone makers' warning of a slower-than-expected recovery in consumer market demand during the latest earnings season, which will likely translate to persistent near-term weakness in royalty revenues generated from Arm-based chip sales.
The realization of AI tailwinds likely will not materialize for Arm until late fiscal 2025 to fiscal 2026 when its customers start to ship a larger volume of next-generation Arm-based processors optimized for AI/ML workloads. The extended growth realization timeline will drive elevated execution risks to Arm's performance, which we believe has yet to be reflected in the stock's current valuation premium.
As a result of the foregoing considerations, our base case revenue forecast expects modest growth of 8% in fiscal 2024, relative to management's optimism for 11% growth. Our assumption expects continued deterioration in Arm China revenues due to the fluid situation over Beijing-Washington tensions on trade and national security considerations, as well as the sluggish spending backdrop in the Chinese market. Meanwhile, revenue from external customers are expected to grow 15% in fiscal 2024, driven primarily by resilience in licensing deals.
Our forecast assumes a return to double-digit growth at 17% in fiscal 2025, helped by anticipated stabilization of Arm China sales with the incremental benefit of an easier fiscal 2024 compare, as well as stronger cyclical and AI tailwinds for sales to external customers. This would represent a three-year CAGR of about 7.9%, in line with the weighted average CAGR derived by Arm's TAM across key end markets.
Author Author Data from Arm Form F-1
Valuation Considerations
As mentioned in the earlier section, Arm currently trades at about 22x LTM revenue, which is a significant premium to the chip designer peer group average of about 13x. Based on our conservative base case revenue forecast for fiscal 2024 and 2025, the stock currently trades at about a 21x and 18x forward sales multiple, respectively, which represents 5% incremental downsides from current levels. Potential erosion of Arm's valuation multiple premium to peers could take anticipated near-term downsides another notch lower, in line with expectations for paring AI optimism on the name.
Author
Even in the upside scenario, assuming Arm does achieve 11% growth in fiscal 2024 and mid-20% range growth in fiscal 2025 (in line with weighted 3-year TAM CAGR of 19.7% by Arm's market share), the stock's current market value would imply a forward sales multiple of 20x. This valuation multiple still represents a more than 50% premium to the chip designer peer group average, on the back of NTM growth (+11%) that is 24% lower than the peer group average of about 14.5%.
Author
The Bottom Line
Arm's bull case narrative remains primarily supported by its mission-critical role in enabling technologies in the increasingly connected environment. This is bolstered by its technology's presence in devices used by 70% of the global population, underscoring Arm's extensive market reach.
However, uncertainties over lingering U.S.-China relations remain an overhanging risk. Meanwhile, Arm's capture of AI tailwinds is unlikely to materialize substantially in the near-term, with incremental uncertainties over whether related opportunities will be accretive or disruptive to its existing growth. In addition, royalty fee rates also decline over time "as total volume of chips incorporating Arm technology shipped increases" (i.e. flattening growth curve). This implies that Arm's share of AI opportunities will eventually lag expectations for breakneck growth in AI chip demand, currently proxied by Nvidia's outperformance. Taken together with persistent China and macroeconomic risks and challenges, we expect market's optimism over Arm's prospects and valuation premium attributable to AI opportunities to temper from current levels.
For further details see:
Arm Holdings IPO Highlights A China Vs. AI Dilemma For Markets