Arm Holdings: Complex (Architecture)

Shares of Arm Holdings plc (NASDAQ:ARM) have seen a very decent IPO, as the success undoubtedly aids to re-open the IPO window towards the end of the year. Shares of the Softbank-owned ARM jumped, as anticipations ahead of the offering were huge.

It is very hard to defend or even share the enthusiasm based on the fundamental performance of the business, yet the strategic nature of the business, its potential and limited float make it a dangerous company to bet against, making it easy to not get involved with the shares here.

Future of Computing

ARM plays a vital role in today's world of CPU architecture, with over 250 billion ships being shipped based on its design since the company's inception. Standing at the forefront and initial step of chip design, its architecture plays a major role in the final design and production of chips, and, thereby, the global economy as we know it today.

The design of the CPU by ARM has enabled a revolution as this technology can be licensed to technology manufacturers to make the actual chips and thereby allow billions of chips to be made at competitive prices, ranging from mundane sensor tasks to supercomputers, as this business model makes that ARM's architecture is found in the majority of chips.

The prospects for ARM continue to look good, amidst soaring demand. For starters, is the observation that consumers use more and more connected devices, for more complicated tasks and that increased complexity only increases the development costs to do this in-house, being a major hurdle for the largest global chip companies.

The company was founded in 1990, acquired by SoftBank in 2016 in a GBP 32 billion deal, and now has gone public again (with SoftBank selling a minority stake in the business). This move has been driven on the back of the enthusiasm of the market around the AI opportunity, and ARM's role and potential in this.

Valuation & IPO Thoughts

SoftBank sold 95.5 million shares of ARM at $51 per share, being at the high end of the most recent preliminary offering range of $47-$51, to thereby raise $4.9 billion in connection to the IPO - that is, excluding the proceeds from the greenshoe option. Of course, none of these proceeds will benefit Arm Holdings plc as they are earmarked to go to the selling shareholder.

With 1.03 billion shares outstanding, equity of the company was valued at over $52 billion at the offer price, which actually includes a net cash position of a little over $2 billion here, for an enterprise valuation of around $50 billion.

Sales for the fiscal year (which ends on March 31 of this year) actually ticked down in a small fashion from $2.70 billion in 2022 to $2.68 billion this year. GAAP operating profits rose by mid-single digits to $671 million, with net earnings reported at $524 million, equal to $0.51 per share.

For the quarter ending June 30, 2023, ARM saw sales being down 2% to $675 million, as net earnings fell quite a bit to $105 million amidst higher R&D expenses. Needless to say is that valuations are quite high here at nearly 20 times sales and about 100 times earnings, as the craze around AI is high and is not showing up in the results. While revenues have grown at a reasonable pace for a longer period of time (as this was a $1.6 billion business in 2017), I am not too convinced about the pace of growth, certainly not in recent times.

As shares have risen to $63 on the first day of trading, the enterprise valuation has risen to $63 billion here. This is a huge valuation given the fundamental performance discussed above, at around 23 times sales (which are currently not growing) and over 100 times earnings. While the strategic importance of ARM cannot be overstated, the question is if current investors need to pay up for this, as SoftBank desperately needs a success after its Vision Fund is full of investments which (so far) have not played out as envisioned.

Concluding Remark

The reality is that besides the sky-high valuation of Arm Holdings plc stock, there are some other risks as well. This includes the fact that the company generates over half of sales from China, the fact that competition for chip-design can be intense, as well as other factors related to licensing practices and the fact that the business remains majority owned by SoftBank.

While these risks make it easy to get very cautious or perhaps even bearish on ARM, I have not forgotten about a failed acquisition attempt by Nvidia (NVDA) during the ownership period by SoftBank. Nvidia clearly is a savvy operator which sees the value in this firm, but antitrust prohibited a takeover (and likely will in a future attempt, if that were to occur).

Given all this, I approach Arm Holdings plc with caution here, as I see no reason to get involved with the stock here, with a bearish position looking too risky amidst the hype, strategic value and limited float.

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