ARM's IPO Imminent - What is the Company's Quality and Profit Potential?

ARM has confirmed its IPO price at $51 per ADR, the highest price in the previously announced price range of $47-51 per ADR. The company plans to issue at least 95.5 million ADS, representing 9.4% of ARM's total share capital, and aims to raise $4.87 billion in its IPO. After the issuance, SoftBank will hold a 90.6% stake.

According to Bloomberg, ARM's IPO has received strong demand, with over 10 times oversubscription, which could potentially boost the stock price once trading begins. The high demand is attributed to ARM's customers, including Intel, NVIDIA, Apple, Samsung, and TSMC, who do not want ARM's technology to fall into the hands of a single company and risk being constrained by their technology. This was also the reason why NVIDIA's acquisition of ARM was previously blocked.

At this issue price, ARM's fully diluted valuation would reach $54.5 billion, but it is still lower than the $64 billion valuation given by SoftBank when it acquired ARM shares held by its Vision Fund, and lower than SoftBank's initial valuation target.

There were reports that the price would be raised to $52/ADR, but it was vetoed by Masayoshi Son, indicating that ARM's attitude towards this IPO is relatively cautious overall. As the US is currently in a high interest rate environment, it is not conducive to an increase in ARM's valuation. Therefore, SoftBank, which owns about 90% of the shares, still hopes to sell more shares at a better price.

ARM is a company that specializes in designing RISC CPUs (Reduced Instruction Set Computer processors), with low power consumption and low cost advantages, which have achieved near-monopoly status in the mobile device market. As of December 31, 2022, ARM's market share in smartphones was close to 99%, thanks to the rapid growth of demand for consumer electronics products such as smartphones.

ARM does indeed have a dominant position in smartphone CPUs, but in other industries, ARM is still in the process of expanding its presence. Because the computing power of the ARM architecture is not as powerful as Intel's X86, ARM's market share in large computing fields is much smaller. ARM's current goal is to achieve incremental revenue from new areas such as cloud computing data centers to reduce dependence on the stagnant smartphone market. For example, AWS's Graviton is a data center processor designed based on the ARM architecture, and NVIDIA's latest Grace Hopper super AI chip uses the Grace CPU chip based on the ARM structure.

In addition to CPUs, ARM is also beginning to enter the GPU field, such as the new flagship product Immortalis-G715, but it is still in its early stages and has average performance.

ARM adopts an IP licensing business model. Unlike Intel's CISC CPU (Complex Instruction Set Computing processors), ARM licenses its core technology to downstream chip design manufacturers for use, rather than designing chips itself, reducing risk and costs. Simply put, ARM collects patent fees, charging 1-2% of the sales price of the chip as a patent fee.

The bargaining power depends on the position in the industry chain. ARM's chip architecture design is in the most upstream position in the entire semiconductor industry chain, but downstream chip design manufacturers such as Qualcomm, Broadcom, and NVIDIA have strong bargaining power, so ARM's room for price increases is actually limited.

ARM has reportedly notified customers of planned adjustments to its fee structure since last year, hoping to raise prices. According to ARM's adjustment plan, patent fees will be calculated based on the average selling price of mobile devices (about $335), rather than the chip selling price (about $17-40). If the price increase plan takes effect, ARM's revenue will double.

The problem now is that ARM's price increase plan has been rejected by customers, and even Apple has not participated in discussions on adjusting fees. Why are downstream customers so confident? Because large customers have a high market position in downstream markets, ARM is heavily dependent on large customers, with income from the top five customers accounting for 56% and 57% of total revenue in the fiscal years ending on March 31, 2022 and 2023 respectively, with Qualcomm as the largest customer. In the mobile chip market based on ARM, Qualcomm has a 34% share, Apple has 31%, and MediaTek has 24%. If ARM angers large customers, it will also cause significant damage to itself.

Although changing the architecture is troublesome, it is not impossible. For example, Qualcomm has already planned to use the RISC-V architecture in the next generation of chips, and RISC-V is a free and public architecture, which can reduce R&D costs to some extent. Apple computers also switched from X86 to ARM architecture before. Therefore, when pushed too hard, powerful downstream customers may choose not to play.

ARM's current performance has declined slightly, with future growth expected to be between 10%-20%. According to the company's IPO disclosure, ARM's revenue for the fiscal year ending in 2023 is $2.68 billion, lower than the $2.7 billion in fiscal year 2022, with a net profit of $524 million, lower than the $549 million in the same period last year. The gross profit margin for fiscal year 2023 is 96%, and the operating profit margin is 25%. In the latest quarter ending on June 30, sales were down 2.5% compared to the same period last year, indicating a slowdown in revenue growth.

Regarding performance guidance, Arm recently stated in its investor roadshow that due to the demand for data center and AI chips, revenue is expected to grow by 11% in fiscal year 2024 and around 20% in fiscal year 2025.

If we use the net profit of the fiscal year 2023 as an estimate, the PE valuation of this IPO is more than 100 times, which is far higher than the industry average. ARM's valuation level is similar to NVIDIA (PE 109 times), but NVIDIA's revenue growth rate and future prospects are far superior to ARM's. Based on ARM's current growth prospects, it is difficult to maintain such a high valuation in a high-interest-rate environment.

In addition, the company has a relatively large proportion of revenue in China, which poses certain geopolitical risks. As of March 31, 2023, and the fiscal year 2022, ARM China accounted for approximately 24% and 18% of total revenue respectively, making it the most important source of revenue. Now that the relationship between China and the United States is tense, and there is also a chip export ban, the future uncertainty is quite high.