Arm’s $52 billion IPO value sets stage for a fall

LONDON, Sept 13 (Reuters Breakingviews) - Arm Chief Executive Rene Haas has given himself no room for error. The UK-based chip designer on Wednesday, opens new tab priced its initial public offering at $51 per share, implying a market capitalisation of $52 billion. Anything but flawless financial results will prompt a post-IPO tumble.

Arm’s roadshow had two key selling points, according to people who heard the pitch. First, the company owned by SoftBank Group (9984.T), opens new tab reckons revenue will rise by 11% in the 12 months to March 2024 and around 25% the year after that, suggesting a $3.7 billion top line in the next fiscal year. Second, Haas is targeting a more than 40% adjusted operating margin, excluding one-offs and some share-based compensation. The implication is that Arm will generate at least $1.5 billion of adjusted operating profit in the year to March 2025, almost double last year’s level, opens new tab.

On that basis, it’s just about possible to justify Arm’s valuation. The company’s enterprise value-to-operating profit multiple, based on the next fiscal year, is 34 after including $2 billion of net cash. Public peers Cadence Design Systems (CDNS.O), opens new tab and Synopsys (SNPS.O), opens new tab on average trade at a multiple of 30, using Visible Alpha data for the same period. Arm’s IPO investors are effectively paying a slight premium while also betting that both growth and profitability are about to soar.

Haas’s revenue goals could work if Arm processors become more integral to the semiconductors of the future, contributing a greater proportion of the technology in each chip. Haas could then charge higher royalty rates. In the last calendar year, the company estimated that its royalty revenue equated to 1.7% of total worldwide spending on Arm-based chips. Haas hopes to get that up to 3% in the coming years, a person familiar to the matter told Breakingviews.

Meanwhile, the 40% margin target would only mean re-instating pre-SoftBank profitability. The main culprit for bloated expenses since the Japanese group’s 2016 acquisition is research and development, which mostly includes engineers’ salaries. Arm reckons it can quickly run a tighter ship, potentially even hitting a 60% margin over time.

Yet the targets involve several leaps of faith. It’s not clear how many important Arm customers like Apple (AAPL.O), opens new tab, Nvidia (NVDA.O), opens new tab and Samsung Electronics (005930.KS), opens new tab have agreed to pay higher royalty rates. Pushing too hard may incentivise chip designers to experiment with competing technologies like RISC-V, an open-source alternative. Nor will rising royalty rates necessarily compensate for possibly ongoing sluggish sales of smartphones, its key historic market.

Finally, the implied R&D cuts seem implausibly steep. Assume that direct costs and selling, general and administrative expenses together account for 32% of revenue, as they did last year. Hitting a 40% operating margin would require reducing R&D spending to 28% of sales, from 42% last year. Investors are implicitly assuming that Haas can pull this off without affecting top-line growth. If he fails to deliver, they might not stick around for long.

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(The author is a Reuters Breakingviews columnist. The opinions expressed are her own. Refiles to add link.)

CONTEXT NEWS

Arm on Sept. 13 said it had priced its shares at $51 each in its initial public offering, the top of the indicated range of $47 to $51, implying a market capitalisation of $52 billion.

The British chip company said its selling shareholder SoftBank Group would raise proceeds of up to $4.87 billion through the float.

Arm's shares are scheduled to start trading in New York on Sept. 14.