Arm IPO 2 – The Search for More Money

Twenty years ago we purchased a burglar alarm for D2D headquarters. We had researched the subject extensively, including reading the financials of all the suppliers, and we landed on a system from Brink’s. They were widely seen as the best alarm company on the market, they were known to value customer retention as a key operating metric. The biggest cost these companies faced was customer acquisition, and they worked hard to reduce churn, with the added benefit of high customer satisfaction. Somewhere along the line, Brink’s was acquired by ADT, which had a checkered history with a heavy private equity influence in the mix. Over time, that trusted Brink’s customer service deteriorated. The new management team was focussed on metrics that matter to private equity investors. This meant the company had dozens of internal IT systems which were too expensive to integrate. Complaints got lost. They lost all the manuals and training modules so no one knew how to repair the old Brink’s systems. Today, the company is focused on value extraction even if it means greatly angering customers with hidden fees and systems that do not work.

We thought about that a lot this week as we reviewed Arm’s IPO filings. We chronicled our review of Arm’s F-1 IPO prospectus (and here). We would like to say there was some fantastic surprise in it. Or that it made for a compelling investment thesis. But we cannot make either argument. As a company, Arm looks to be in fairly solid shape underpinning our digital world. That being said, as a stock, there is little to get excited about. It is hard to escape the impression that Softbank is largely focused on extracting maximum value from its investment in Arm and has let the company slide under its ownership, and is now looking to leave the problem with public market investors and the current management team somewhere down the road.

Our chief concern is growth. Revenue and earnings declined last year. Given the company is heavily exposed to handset sales, a market which is struggling, the outlook for this year is not great. Admittedly, other markets are growing at a better clip, Arm is generally gaining share, and at some point handsets will start to pick up again. So the company can reasonably expect to grow in the current fiscal year and thereafter. But how much can it grow? This is of course a critical question. We think the company has put in place a number of new products and growth initiatives. Some of these will succeed and some will not. Critically, the company is also trying to increase its share of value, as evidenced by their lawsuit against Qualcomm. All of these share a multi-year time frame, so while they could add a lot to long-term growth they are neither certain nor coming any time soon.

Another major concern we have is the value the company will seek in its IPO. Softbank recently transferred ownership of its shares in Arm from one internal division to another, a common enough accounting transaction which somehow, mysteriously leaked to the press. In that transaction, Softbank valued Arm at $64 billion, an amount which the press now thinks is the target valuation for the IPO.

Put simply, this is a suicidal figure.

At $64 billion, Arm would trade at 20x Enterprise Value to Revenue and 61x EV/EBITDA. By contrast, Nvidia is currently trading at 27x and 120x respectively, but we are writing this on the evening of another massive Nvidia earnings blow out, so the figures are likely to come down meaningfully. Moreover, Nvidia is growing at a pace that is setting records for the semiconductor industry. Their last two earnings reports are a phenomenon that no one in the industry has ever seen before and probably will not see again, in terms of percentage of upside relative to the size of their already large numbers. Arm may grow next year, but there is no way it will grow at any where near the pace Nvidia is growing.

So maybe we should compare Arm to another company, Qualcomm’s share price is cyclically depressed, so we picked AMD, not a perfect comp, but close enough. AMD is trading at 8x EV/2023 Revenue. At that level, Arm would be worth $25 billion. Five years ago, prior to Nvidia’s acquisition bid, Arm explored the potential of going public, and most investors we spoke with who heard the pitch came up with a valuation of $20 billion, so much closer to that lower figure. Arm can credibly make the argument that a fabless semi company is not the right comparison. They sell software, could they be valued like a software company, but at those levels the stock would be again trading in Nvidia territory which will be a hard pill for the Street to swallow.

After reading the prospectus, the cause of this disconnect is painfully clear: Softbank wants to maximize its exit. This deal bears all the hallmarks of a private equity exit, where the PE owner extracts al the value it can from a company and then lists it with a crippling debt load. Here, there is no debt, but a $64 billion valuation would provide the functional equivalent. Let’s say doubling revenue over 2023 and 2024 would merit that $64 billion valuation, Arm would have to grow revenue 40% a year between now and then to hit that target. We see no reasonable way Arm could accomplish anything like that in that time frame.

Now it is fair to ask if we are being overly pessimistic about this set up. The trouble is we have seen this exact play of events many times before. So many times that we wrote a book about the problem. Outgoing shareholders want to maximize value, which leaves the incoming public shareholders holding the bag. And everyone advising the Arm executive team and board at this stage views the IPO valuation from the perspective of those outgoing shareholders.

The irony is that this strategy is self-defeating. Softbank will still own 75% of Arm after the IPO, a position it would take years to unwind in the open market. Promising the Street numbers which would justify a $64 billion valuation will lead to disappointment from the company’s first earnings report after the IPO. That disappointment will leave a mark with the Street a mark which will be reflected in the share price. Far better to start at a lower valuation, with lower expectations, and then work their way up.

As long as we are speculating wildly, we have to at least consider the possibility that Softbank may not care about Arm stock’s long-term prospects. We have to think they have at least considered the possibility of selling their stake in Arm after the IPO. We could easily imagine a consortium of Arm licensees and a private equity sponsor stepping into buy Softbank’s stake. We have even written about this possibility in the past. This seems highly unlikely, but not impossible.

Ultimately, Arm’s valuation will be determined by the markets. IPO order books are a messy process but they are not so wild as to bridge the gap between $25 billion and $64 billion. And we think many public market investors will do the same math we have.

An old truism among investors is that good companies do not always make for good stocks. That holds true for Arm. They are a good company, but they are not a high flying tech company. They emerged from years of sleepy, private ownership with no major changes, no added excitement. They will grow, Arm processors remain important for semiconductors, but neither their growth nor their current economics merit a high-flying valuation.

Leave a Reply