adminShares of chip designer Arm Holdings plc (NASDAQ:ARM) have come under pressure following the release of its first quarterly earnings report since its September return to the stock market. Unfortunately, I believe that there may be more pain ahead for the company. Below, I will explain why I believe that the troubles of parent SoftBank Group Corp. (OTCPK:SFTBF) (OTCPK:SFTBY) may lead to further downside for Arm’s stock. If you are interested in a more detailed discussion of SoftBank’s problems, I would refer you to my article focused on that topic.
Kindly note that there are two companies with similar names: SoftBank Group, the parent, and SoftBank Corp. (OTCPK:SFBQF)(OTCPK:SOBKY), its telco subsidiary. Following, “SoftBank” will refer to SoftBank Group, unless otherwise stated. “SoftBank KK” refers to the telco subsidiary.
SoftBank Needs Dollars
For better or worse, Arm has to always be assessed in the context of SoftBank. The Japanese technology investor is Arm’s largest shareholder by far, owning more than 90 percent of the company. As I have recently explained, SoftBank needs capital in order to keep investing in portfolio companies. Most of these financial needs denominate in USD rather than Yen. They acknowledged the negative impact of a weak Yen in their presentation of fiscal Q2 results. Its main source of liquid funds in meaningful quantities (other than borrowing), on the other hand, is its 40.5 percent stake in telco subsidiary Softbank KK which generates its revenues predominantly in Yen. Naturally, it also pays its dividends in Yen. Sales of Arm shares, on the other hand, would generate income in USD, not Yen.
The fact that Arm does not expect to distribute dividends, makes it even more likely, in my view, that SoftBank will monetize at least parts of its remaining position in Arm eventually, either by selling part thereof or via lending against it. Notably, that was also the approach to the now largely divested stake it held in Alibaba Group Holding Ltd. (BABA) lately. Arm stock being used as collateral would, obviously, be less of a risk for Arm’s share price. At first glance, it would therefore be in SoftBank’s interest to prioritize this option, if it seeks to monetize its shares. It would also be more consistent with the company’s past approach. On the other hand, what makes outright divestment instead of secured borrowing more likely from my point of view is that rising interest rates tend to make all kinds of borrowing more expensive. And SoftBank already is rather indebted. The LTV rose 32 percent QoQ.
The positive news in that regard is that SoftBank may not immediately begin to liquidate Arm shares due to a 180-day lockup period following the IPO. That lockup period expires on March 12.
By the basic law of markets, increased supply without increased demand tends to lead to sinking prices. Any disposals by SoftBank will inevitably increase the supply of Arm shares. At the same time, I doubt that there will be a significant spike in demand. Strategic investors such as Apple Inc. (AAPL), Nvidia (NVDA), Samsung Electronics Co. Ltd. (OTCPK:SSNLF) and Intel Corp. (INTC) only needed to get a foot in the door. They have now. Further purchases are unlikely, in my opinion. Neither do I see a catalyst for heightened interest from financial investors at the moment. On the contrary.
The Burden of High Valuation
Arm’s problem is not that it is a bad business. In fact, I would argue that it is a rather fine business. The major downside is that it is expensive at the current valuation.
The operational performance during the quarter in and off itself was relatively good. At the very least, not too bad. The (Non-GAAP) operating profit grew to $381 million (GAAP-based figure: – $154 million). The net loss of $110 million appears worse at first sight than I think it really is. The main reason is one off cost of around $500 million connected to the IPO. Revenue grew 28 percent YoY to $806 million. The caveat here is that, while license revenue more than doubled, royalty revenue slightly decreased (-5 percent YoY), despite higher royalty rates. QoQ, on the other hand, the segment grew by 4.5 percent. As a result, both segments now account for similar shares of overall revenue (license revenue: 48.1 percent; royalty revenue: 51.9 percent). Please note: the license revenue figure includes “other” revenue. Long term, I would expect an annual net income of $500 to $600 to be realistic. Based on the current share price, that would value the company at about 94 to 113 times earnings. That strikes me as expensive, bordering excessive. For perspective: Nvidia currently trades at a forward PE of 43.
Arm is not a rapidly growing company. An increasingly saturated smartphone market makes that unlikely to change in the near future. On the other hand, it has a wide moat and high profit margins. Its uniqueness, naturally, means that there are virtually no directly comparable companies. Personally, I believe that ASML NV (ASML) may serve as a suitable yardstick. Obviously, the companies, while both part of the broader semiconductor industry, have vastly different products. The common denominator is the current lack of alternatives to their respective services. Their customers could neither immediately replace Arm’s design IP, nor ASML’s lithography machines, even if they wanted to. ASML trades at a forward PE of around 30. Arm does not require physical assembly and has higher profit margins and less marginal cost at scale. I therefore believe a certain premium to be in order. A PE multiple of 45 would be fair in my view. A multiple of 60 is still justifiable.
China Increasingly Risky Amid Global Tensions
Amid increasingly strained relationships between China and the nations of the free world, the US in particular, Arm’s Chinese business is a further risk factor. Arm China accounts for around a quarter of sales. Arm depends on the commercial relationship, but has no direct control of its former subsidiary. The F-1 filing explicitly mentioned those risks. Also, Arm China’s status as an independent entity makes it easier to target sanctions directed at keeping Chinese hands off critical technology. That, in turn, could incentivize China to prioritize developments based on, for example, open-source technology such as RISC-V, endangering the longevity of Arm’s de facto monopoly on smartphone chip architectures. The Biden Administration’s recent actions intended to cut off Chinese access to certain kinds of semiconductors should at least be the reason for heightened caution in that context. Sanctions or other events negatively impacting the relationship with Arm China could be additional downside catalysts going forward.
Conclusion
Arm is a good business, but currently at too high a price. The IPO was supported by a relatively low supply, the news of strategic investments by important customers, and tailwinds from the current AI hype. SoftBank’s willingness to acquire the 25.1 percent of the company it did not already own at a valuation of $64 billion mere weeks before the IPO might have helped, too. Compared to that figure, the IPO range optically appeared as a discount. Based on a PE multiple of 45 to 60 and the assumption of $600 million in net earnings, a share price of $27 to $32 on an undiluted basis would be fair, in my view. From today’s price, that represents a downside of about 37 to 48 percent. I believe that SoftBank beginning to sell down its stake could be a catalyst for a significant correction toward that range. Consequently, I view the stock as a sell at the moment, despite liking the business on principle.
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