High IPO valuation for Arm would be a warning to investors

The long-awaited listing of SoftBank-owned Arm has just moved one step closer to the market. A high market valuation for the UK chip designer, which confidentially submitted a draft registration statement to the US regulators, would help SoftBank chief Masayoshi Son counter criticism about his deal making capabilities. For battered SoftBank shareholders, it would provide much-needed relief.

Arm is one of those rare companies with unrivalled control over a global industry. Ninety-five per cent of premium smartphones use its technology and its chips are used in PCs, artificial intelligence development and servers. There has been little alternative for a long list of customers that includes Apple, Samsung and Qualcomm.

Until now, that ironclad grip has meant Arm’s simple business model — which charges chip designers licence and royalty fees to access its technologies — had been more than enough to sustain margins. Its profit margin exceeded 50 per cent on sales of $746mn in the latest quarter.

That stands in stark contrast to SoftBank’s earnings. Losses are piling up, a net loss of $5.7bn in the December quarter followed record losses last year. Its shares have halved from a 2021 peak. A wide IPO valuation range of $30bn to $70bn has been estimated for Arm — which SoftBank acquired for $30bn in 2016, at a 43 per cent premium to the market. At the top end, it would eclipse SoftBank’s own $55bn market value.

Arm’s chip designs have become world leading for good reason. Its processor architecture uses a much simpler instruction set than peers, especially compared with the technology offered by Intel, which had been its main rival in the early 2000s. That simplicity means less power consumption — and less overheating and battery drain for servers and devices. Equally as important has been the low cost for clients to use Arm’s design. Arm’s royalties are reported to be about 1-2 per cent of the chip selling price.

But that small cut has capped Arm’s revenues. Even when global chip sales hit a record $550bn in 2021, the company’s sales were a small fraction at $2.7bn. Now that the industry is facing a glut for many types of chips, the outlook is increasingly challenging. Worse, a continuing decline in global smartphone shipments since 2016 suggests that the market where Arm’s designs currently dominate may have peaked.

Two well-timed developments in recent months have been a source of hope for would-be Arm investors: it is seeking to raise prices by altering its royalty programme and it is developing its own prototype chip. On the surface, that should make the listing an easier sell. But both moves will be much harder than they look.

Rapidly changing chip technology, including the increasing adoption of open-source alternatives to Arm’s designs such as RISC-V, now means raising fees carries the risk of accelerating the shift of clients and investment dollars into developing those substitutes.

Making chips presents a much bigger challenge. People close to Arm insist the chips will not be for sale and are only intended to showcase its technology to clients. But Arm’s recent hiring of chip engineering veteran Kevork Kechichian from chipmaker NXP Semiconductors in February to lead its solution engineering team, and a collaboration agreement with Intel, has sparked speculation the company may be moving further up the supply chain.

Yet developing its own chips would deliver a critical blow to one of Arm’s biggest strengths: being a neutral party that does not compete with its chipmaking and chip designer customers. Arm’s biggest clients are fierce rivals. Arm as a competitor might raise awkward questions about how much confidential detail, such as production timelines and order volumes, clients disclose during contract negotiations.

Chip sector sentiment has soured dramatically in recent months as chip demand and prices plunged. That is reflected in the shares of Arm’s peers, which trade at an enterprise value to sales of about 4 times. Arm at its lowest estimated valuation would already be several multiples higher.

Arm has proven technology but the question now is whether its business model can still offer enough growth to sustain those expectations. A high valuation will be a key metric of success for Son, but the same should be read as a warning sign for investors.

june.yoon@ft.com