The technology business world loves hype, and sometimes this hype works in mysterious ways. The amount of hype and excitement behind the initial public offering (IPO) of shares in U.K. chip designer Arm has been astounding.
Arm, which started trading today on the Nasdaq under the symbol ARM, has sucked all the oxygen out of the finance room. It has been discussed nonstop this week across business media channels (I guess I’m not helping). Much of this is because the tech IPO market has been in a deep slump, and many hungry for a big-name IPO to reinvigorate the market.
I get that. But the big question is whether this event warrants valuing the company at $58 billion — on not even $3 billion in sales. If you look under the surface, Arm’s challenges are many, it’s valuation is super high, and its path to future growth is unclear, making it very hard to justify the premium valuation the market has given it.
The chip design company, which is owned by technology conglomerate SoftBank (run by global tech mogul Masayoshi Son) was priced for an IPO by its bankers at $51 on Wednesday night. Shares further rocketed out of the gate, climbing to $57 in early trading, a gain of 10% from the initial offering price. The IPO raised about $5 billion for the company and gives it a valuation of about $50 billion at the current share price. Even after the IPO, SoftBank retains about 90% of the company and will control most of the shares.
How Arm Got Here, and Where It’s Going
Some of the excitement about Arm is understandable. It has been a powerful and influential chip design firm with key intellectual property purchased by the largest companies in the world, including Google, Apple, Nvidia, and Samsung. It’s estimated that its designs are used in 99% of the smartphones on earth, giving it large market share and influence. Arm rose to prominence by figuring out better ways to make chips that consumed lower amounts of power, making it great for smaller devices. Apple, Google, Nvidia, and Samsung have all acquired shares in the IPO.
The company’s trajectory was changed a bit in 2016, when SoftBank bought the company for $32 billion. SoftBank’s original exit strategy was to sell Arm to Nvidia (Nasdaq: NVDA) back in 2020 for $40 billion. But that deal was challenged by regulatory hurdles, and in February 2022, SoftBank and Nvidia abandoned the plan.
The IPO certainly represents a good result for SoftBank, with the company currently going public at a price that’s 20% higher than the price Nvidia was offering. But the larger question is where it goes from here.
Forget the FOMO (Fear of Missing Out)
In the days running up to Arm’s IPO, much of the hype and chatter was about people clamoring to get in. With SoftBank retaining 90% and big investors such as Apple and Nvidia buying up shares, there wasn’t a lot left over for institutions to distribute to retail investors. Many complained about the lack of allocations.
Feeling left out? Don’t. Many IPOs eventually trade down after the initial euphoria and after the lock-up period on insider shares is lifted, giving liquidity to owners who want to cash out. For example, data from Nasdaq shows that two-thirds of IPOs underperform the market within 3 years of their IPO.
In this case, there are plenty of reasons to avoid the Arm euphoria and to wait if you are considering investing in the company. Let’s take a look at the main reasons – many of which were detailed in the company’s IPO prospectus:
1. The valuation is high. The mean price/sales ration of a semiconductor company is 5 times sales, and most trade below 10X sales. At its current valuation, Arm is trading at nearly 100X current earnings and 23X sales. To offer a comparison, Nvidia, the company that tried to buy Arm, is trading at a similarly high valuation. But Nvidia is the best chip company in the world, and it’s growing sales at 100% a year and growing its earnings nearly 70% a year. Arm is not even growing.
2. Slow growth. As mentioned, Arm’s revenue and profits have been stagnant. For the most recent quarter ended June 30, 2023, Arm posted revenues of $675 million, down 2.45% from $692 million for last year’s quarter. it’s annual run rate is about $2.8 billion in sales. Worse, net income from continuing operations came in at $105 million for the quarter, a year-over-year decline of 53%.
3. RISC-V. Arm was fueled by it having the right processor architecture for the right applications — particularly smartphones. In its IPO filings, Arm pointed to the threats of reduced instruction set computing (RISC)-V, an open-source chip architecture that has been gaining momentum and could present big competition to Arm’s architecture, especially in the AI market. “If RISC-V-related technology continues to be developed and market support for RISC-V increases, our customers may choose to utilize this free, open-source architecture instead of our products,” stated Arm in its prospectus.
4. China. Geopolitical tensions and slow China growth continue to contribute to uneasy feelings about business in China. This has elevated the risks for companies with a large business in China. For example, Apple shares have recently taken a hit on the Chinese government’s restriction of iPhone use. Arm’s got a large risk there, with about 20% of its business coming from China. Qualcomm, a top chip company with similar risks, has recently seen its share price held back by the China question. Qualcomm is trading at a price/sales (p/s) multiple of 3.3, while Arm’s p/S multiple is closer to 23.
5. IPO risk in general. The last cycle of IPOs has been weak, with many of the most recent technology IPOs trading below their IPO price. As noted earlier, the data from Nasdaq shows that 64% of IPOs are trading below their IPO price three years after their IPO.
Why the Hype?
For all these reasons, it seems odd to give Arm a valuation that stretches to four times the industry average, given that its financials show a mature company with lackluster growth. The average price/sales multiple of stocks in the semiconductor industry is 5, according to data from NYU.
The main driver of the hype might come down to SoftBank, which will still control the company and raise money doing do. SoftBank CEO Masayoshi Son is behind the deal, and he’s not likely to let it fail. Arm has strong engineering pedigree and low-power chip designs that could be used in AI, a factor Arm pitched in the IPO documents.
Let’s also not discount the incentive for the bankers to support this IPO. There is a lot at stake. Lead underwriter Goldman Sachs would like to keep Mr. Son happy, as SoftBank is one of the leading technology investors in the world and produces a large pipeline of IPOs. What’s good for SoftBank is good for Wall Street.
For a different price, I could get excited about Arm. What is hard to understand is the sky-high valuation. We won’t know for sure until the shares are unlocked for insiders, at least three months down the road. Given the pattern of recent technology IPOs, there’s a very good chance these shares will offer investors a much more reasonable price for entry in the future.
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