Arm has launched the road show for its IPO, with the executive team now traveling the country pitching its shares to the Street. In addition, they have updated their prospectus and unveiled a road show video. Most critically, news has now come out that they are seeking a $52 billion valuation for their shares. In our previous posts (and here) we had cautioned that the company originally sought a $64 billion valuation. We labeled that figure as ‘suicidal” and it seems that the market (and Arm’s bankers) agreed. The new $52 billion figure is not what we would consider suicidal, but it is still very challenging.
The Street’s favorite valuation method is to compare the company to its peers, comparable analysis. The trouble is that finding comps for Arm is not easy. Most analysts will likely compare the company to semiconductor design companies like AMD, Qualcomm and Nvidia, but this is problematic because Arm has a very different business model and cost structure. Given the amount of time Arm devotes in its road show video (more on that in a moment) to the topic of software, we suspect the company would like to valued as a software company. But again, this does not quite fit. Arm licenses intellectual property (IP) which its licensees use to create products. Software companies have a much more direct approach selling the final product to their customers. Probably the best peer group is the EDA companies, Cadence and Synopsys, makers of software tools for semis companies. So a similar customer group to Arm. Those companies also license a lot of IP as well. Not a perfect match, but fairly close. Those two companies currently trade for an average PE of 72x trailing twelve month earnings, as opposed to the 99x Arm is seeking. At the EDA average, Arm’s value comes in at $38 billion.
We have viewed the company’s road show video. (It should be available publicly, but we have not been able to find a public link yet.) In this the company lays out its financial model, but with little detail. They are essentially positioning their growth story on the prospect of increasing their share of value extraction from the industry. As we noted in those prior posts, this is a reasonable ambition, its just that putting in place will prove difficult. If Arm can pull that off, it would add considerable appeal to their valuation. Some numbers can help illustrate this point. The company said that last year, their licensees shipped $98 billion of chips, while Arm earned $2.7 billion in revenue, which works out to a 2.7% royalty rate. Below we create a sensitivity table showing how changes in royalty rates and net margins affect the company’s earnings growth through 2025.
3 Year Net Income CAGR 2022-2025
This chart shows (despite the vagaries of WordPress’s table function) that increasing the royalty rate from the base rate (2.7%) by 1 point has as much impact on earnings growth as increasing operating margins (i.e. cutting costs) by 10%. The company has little scope to cut costs – they need to invest heavily in R&D and now have public company expenses, so in theory raising royalty rates may prove to be the ‘easier’ path to raising earnings. Of course, raising rates is not going to be easy, especially when step one in their plan involves suing one of their largest licensees. Nonetheless, seen in this light, their lawsuit against Qualcomm makes at least some sense. Crucially, the company does not break out revenue by segment. We strongly suspect that this data would show a very wide range of royalty rates – with the critical mobile segment likely showing far lower rates than the corporate average 2.7%. Which is a very mixed message. On the one hand, raising royalty rates for mobile will be hard given the major customers here are Apple (who is very demanding on suppliers) and Qualcomm (again, lawsuit). On the other hand, the company is growing much faster in other segments with more room for share gains and healthier price conversations.
Finally, the latest date release answers one of the two big questions about Arm’s plans for its business model. The company has so far only dropped hints about their plans to take a larger hand in designing chips and working directly with device makers. But they did disclose their new(ish) subscription pricing model. The company is now moving licensees to what is essentially a perpetual license – agree to long-term commitments to certain royalty rates and licensees get access to all of Arm’s IP, with various tiers depending on the licensees’ size and plans. This model has the benefit of making Arm look a lot more like a software as a service business model. Probably more important, it also removes a major overhang of the lumpiness around license renewals. This is a big problem for Interdigital, a licensor of wireless IP, whose stock rises and falls around the timing of its very concentrated customer base’s renewal schedules. Arm now has a much higher level of predictability on its revenues.
By their nature, IPO prospectuses tend to paint companies in the most conservative, worst-case-scenario light – all those risk statements are not there to cheer people up. With this latest release the company can now start to tell its story with a bit more leeway. Not surprisingly, our takeaways from this data increase our confidence in the company’s long range plans. They even put a positive spin on their operations in China, albeit an spin delivered by the CFO which does not inspire much enthusiasm. (Why do CFOs always get tasked with delivering delicate, bad news?) That being said, while the company’s valuation remains challenging, we are starting to see the outlines of ways in which Arm could grow into that valuation, maybe, someday.