Economic Insights
Arm Holdings
Blockbuster IPO: Opportunistic or Opportunity?
Arm is planning to list on the Nasdaq today by way of an initial public offering (IPO), with owner Softbank expected to sell 10% of its stake in the business while holding on to the balance. When news of the listing first broke, investors were concerned that there may not be major support amid prevailing uncertain market conditions. However, the massive interest in AI enablement technologies outweighed initial scepticism and the latest news reports now suggest that the IPO is ten times oversubscribed. Arm has priced its IPO at $51 per share, implying a valuation of $54.5 billion.
Softbank recently took full ownership of Arm after buying the remaining 25% it did not own from its own Vision Fund at a valuation of $64 billion. Arm was listed between 1998 and 2016 when Softbank took the company private at a valuation of $32 billion. Arm was up for sale in 2022 but regulators blocked a proposed acquisition of the business by Nvidia for $40 billion.
'Cornerstone investors' such as Nvidia and some of the world's other largest chipmakers and technology companies including TSMC, AMD, Google, Samsung Electronics, and Apple, have agreed to buy shares in the IPO and will collectively own ~1.5% of Arm post the listing.
What is Arm?
Arm was founded in 1990 as a joint venture called Advanced RISC Machines Ltd. between Cambridge-based Acorn Computers, California-based VLSI Technology, and Apple.
The original joint venture set out to develop a processor that was high performance, power efficient, easy to program, and readily scalable. Arm architecture is different from the once-standard Intel-founded x86 chips. The x86-based chips use 'complex instruction set computing' (CISC) architecture, while Arm's chips utilise 'reduced instruction set computing' (RISC) architecture. RISC chips are more suitable for use in mobile devices since the emphasis is on energy efficiency (to prolong battery life).
According to its pre-listing filing, more than 260 companies reported that they had shipped Arm-based chips in 2022 including Apple, Amazon, Alphabet, AMD, Nvidia, Intel, Qualcomm Inc. and Samsung Electronics Co.
Financials at a glance
Revenue
Revenue is split into:
For the year ended 31 March 2023, revenue fell back marginally to $2.68 billion from $2.70 billion. For the quarter ended 30 June 2023, revenue fell 2.5% y/y to $675 million. License and other revenue grew due to new licensing deals as well as renewals of existing agreements. Royalty revenue fell slightly due to the macroeconomic slowdown and lower shipments to normalise inventory levels. Revenue from the US accounted for 57% of revenue (1Q23: 62%).
Operating profit
Operating expenses consist mainly of Research and Development (R&D) costs and Selling, General and Administrative (SG&A) expenses. R&D remains the company's single biggest expense and increased from 37% of revenue in FY22 to 41% of revenue in FY23. R&D costs rose 13.9% to $1.13 billion in 2023.
For the year ended 31 March 2023, adjusted operating income grew 7.1% to $783 million, with the margin expanding to 29.2% from 27.0% in FY22. This was supported by lower SG&A expenses. For the quarter ended 30 June 2023, adjusted operating income fell 8.4% to $272 million due to increases in R&D (+54.6% y/y) and SG&A costs (+28.1% y/y). The spike in R&D costs was due to higher investment in next generation products, and a portion of the increase in SG&A was driven by the IPO process.
Net Income
For the year ended 31 March 2023, adjusted net income fell 1% to $657 million. For the quarter ended 30 June 2023, adjusted net income grew 4.2% to $246 million. The difference between operating profit growth and net income growth was due to higher finance income on the back of higher interest rates on cash balances.
Balance Sheet
The company did not have any long-term borrowings on its balance sheet as at 31 March 2023.
Investment Case
Risks
Outlook and Valuation
Pre-listing, analysts estimated that the company will continue to show revenue growth of 6% for FY24 and approximately 15% per year over the next three years. Earnings per share are expected to decline slightly in FY24 due to the ramp up in R&D spend, but to recover strongly over the next few years as its new designs gain traction and R&D spend normalises.
The timing of the listing, during a period of major hype over anything AI is certainly opportunistic. But considering Softbank's annualised return on the business based on a $54.5 billion valuation of 7.9% since it took the company private - it seems the hype has been with us for some time.
If there is a bubble forming in the AI space, as with all emergent technologies, there will be companies with staying power and those that end up being 'fly-by night'. We think Arm falls within the former category but that the valuation is (and has been for some time) stretched. We would consider a position in the company once the dust (from the IPO and an eventual bubble pop) settles, and the company derates to more reasonable levels.
At $54.5 billion, the company will be trading on 30 times forward PE and 18 times forward sales, which is elevated compared to an average across the semiconductor value chain. That said, the company does not have a direct competitor focusing purely on architecture, so comparative value is limited. On a stand-alone basis, the valuation does not look particularly cheap either - particularly considering the forecast risk attached. On historic numbers, a PE over 100 and a price to sales ratio of 20 times seems high.
