Arm IPO: Can Arm stock maintain or grow its premium valuation?

Key takeaways

• Arm IPO was priced at $51 per share, giving it a $54.5 billion valuation.
• Current owner Softbank has listed less than 10% of Arm’s float, and a large chunk of this is expected to have been snapped-up by major tech companies that are Arm customers.
• Based on its most recent annual earnings, Arm came to market with a valuation multiple of around 98x – three-times the average on the Nasdaq 100.
• Arm shares closed up 25% on its first day of trading, but has since pulled back and lingered not far above its listing price
• Arm is underpinning its valuation on new prospects stemming from a shift in strategy that will see it design more comprehensive, advanced and financially-rewarding chips rather than the business as it is today.
• Rising US-China tensions may cause concern for Arm as it threatens to disrupt its second largest market.

Arm IPO earns $54.5 billion valuation

Arm priced its initial public offering at $51 per share, giving the British semiconductor designer a valuation of $54.5 billion. The share price popped as high as $66 on the first day of trading before falling back and closing up 25% at $63, showing that demand was strong upon listing. However, it has since pulled back and traded within a range of $50 to $57 as of October 9, 2023. 

The IPO raised $4.87 billion for its current owner Softbank, which offloaded less than 10% of its stake as part of the offering. Arm did not raise any proceeds. A chunk of the shares offered were snapped-up by an array of tech companies from around the world that were eager to invest. We don’t know exactly which companies have invested and how much yet, but we do know AMD, NVIDIA, Apple, Cadence Design, Alphabet, Intel, MediaTek, Samsung, Synopysys and TSMC were among those that expressed an interest.

The valuation was not as high as the $60 billion to $70 billion that Softbank was originally aiming for and below the $64 billion price tag earned when Softbank bought the 25% stake in Arm it didn’t already own ahead of the IPO. It is, however, favourable compared to the $32 billion that Softbank spent to take Arm off the public markets and into private hands in 2016.

Can Arm stock demand a premium valuation?

The IPO market may have been in a drought for the last couple of years, but those that invested in major IPOs when the floodgates were open in 2020 and 2021 will still be haunted by the steep drop in share prices we have seen in in companies such as Rivian, Coinbase and Roblox since they went public.

That was because markets were buoyant back then. The initial shock of the pandemic faded and tech stocks came into their element, prompting many companies to take advantage and demand lofty valuations. That provided bumper profits for existing investors, but has resulted in those that invested in the IPO being burnt and seeing their investment largely wiped-out since the tides turned in 2022.

With this in mind, Arm generated $524 million in net income in the last financial year that ran until the end of March 2023, or $0.52 per share. That means Arm rejoined the public markets with a price-to-earnings ratio of 99x, which may stoke fears that it is falling into the same trap as so many tech stocks did in 2020 and 2021. That multiple is even higher following the positive start made by Arm shares.

The valuation multiple is all the more significant for investors considering any gains to be made have to come from share price appreciation because Arm doesn’t pay a dividend and has no intention of paying one anytime soon.

Why are tech companies investing in Arm?

Most of the companies that said they could invest in the Arm IPO are customers and have been for years, if not decades. Arm has earned huge respect and applause from the tech industry and it has therefore attracted many big names.

For example, it is a no-brainer that Apple was among those considering making an investment considering it was one of the companies that originally created today’s Arm way back in 1993 and has been licensing designs from it ever since. In fact, Arm and Apple have a deal in place that will keep their relationship alive until at least 2040! It also isn’t a surprise that chipmaker NVIDIA was looking to buy shares given it tried, and failed, to buy Arm for about $40 billion back in 2022.

Arm hopes that these cornerstone investors can show the markets that its valuation is reasonable and underpin $54.5 billion as its floor, in the hope that it can continue rising. If Apple and NVIDIA are willing to pay $51 per share, as the theory goes, then so should the rest of the market. Notably, there were reports that demand for its shares was so strong during the roadshow that Arm considered raising its IPO price, but it appears to have decided against that as chasing a mild increase in proceeds wasn’t worth risking its debut.

Arm: Smartphone stalwart

One argument in favour of Arm’s premium valuation is how prolific its products are used across the entire tech industry.

Arm has earned its reputation by designing the building blocks for semiconductor chips. These designs are licensed to over 250 companies, ranging from semiconductor makers AMD, NVIDIA, Qualcomm and Samsung to cloud computing giants Amazon and Alphabet. That impressive customer base then incorporates Arm’s designs into their own to create their own chips and products.

That has led to Arm becoming the go-to company. Arm’s designs are used in 99% of the world’s smartphones and about one-third of all consumer electronics! All-in-all, about 70% of the world population uses products that are underpinned by Arm’s CPU designs.

In short, if chipmakers are regarded as the pick and shovel play of the tech industry, then Arm is the one selling the shovelhead.

Arm: Where does new growth come from?

Arm has carved-out a monopoly in the smartphone industry and a dominant position in most of its other markets. There is little doubt surrounding the long-term fundamentals of its business as everything in our homes and businesses becomes digitized and ‘smart’, which will require more chips.

However, Arm paid the price for its reliance on consumer electronics considering it struggled to grow last year as depressed demand for devices caused revenue and profits to fall. Still, its popularity in such a variety of devices means it has proven more resilient to the slowdown than most.

(Source: Arm IPO prospectus, financial years run to the end of March)

That may raise questions as to why Arm is earning a valuation that is some three times above the average across the tech-heavy Nasdaq 100. NVIDIA, which is Wall Street’s favourite stock of 2023 after becoming the first to reap significant financial rewards from AI and one of the most expensive megacap stocks on the market, saw its multiple hit as high as 66x earlier this year and markets are still debating about its valuation today despite it dropping below 33x!

But fear not, as Arm hasn’t earned its premium valuation based on its business today, but on what it hopes to be in the future…

Arm: Can it design more lucrative chips?

Arm is shifting its strategy. Currently, it sells designs that make up just a fraction of the overall semiconductor chip that is ultimately made by its customers. These are generic and sold to multiple customers, providing scale that allows it licence its designs on the cheap. Customers like this because they are safe in the knowledge that Arm’s foundational designs meet industry standards and the price tag means it is much cheaper to licence them than develop their own in-house.

Now, Arm is looking to supply more comprehensive designs for specific applications, such as to run a datacentre or an electric vehicle. The plan is that it will add more value by focusing on more advanced designs and that more of Arm’s design will end up in the chip, which should increase royalties and, as a result, make Arm larger and more profitable.

Arm pushed this message to investors during the IPO roadshow and it likely to keep pushing this message going forward. This may explain why cornerstone investors didn’t bat an eye lid at Arm’s valuation, knowing it is underpinned by a solid business today and major new growth prospects in the future.

Still, shifting strategy doesn’t happen overnight and isn’t cheap. Fortunately, Arm is a capital-light business as it doesn’t manufacture anything and is purely a designer. However, this does mean that most of its money goes into research and development, specifically on hiring and retaining the brightest minds that are needed to invent the next big technological leap. This may see R&D expenditure rise and impact profitability in the short-term, but Arm knows how rewarding a breakthrough design can be considering some of its products are still earning royalties some 25 years after being invented! Bearing that in mind, any short-term pain is worth the long-term gain.

Is Arm an AI stock?

One of the biggest questions for Arm is how much it can benefit from the eruption of interest in artificial intelligence, machine learning and large-language models that every tech business is racing to adopt, with investors pondering whether it can be a big winner just like NVIDIA.

NVIDIA is finding much healthier rewards selling the advanced chips needed to power AI compared to what Arm makes flogging the chips used in smartphones and other everyday devices. This further reinforces Arm’s plan to move into more advanced designs.

Arm has said it will be “central” to the transition to AI and machine learning and that its CPUs are already running new workloads on billions of devices like smartphones, whether on its own or as part of a GPU made by the likes of NVIDIA. It believes the need to lower the power consumption of more advanced algorithms will keep its products in demand and it is already working with companies like Alphabet, Cruise, Mercedes-Benz, Meta and NVIDIA to deploy Arm technology to run AI workloads.

However, Arm is also aware how fast technology is developing and warned ahead of the IPO that its general purpose CPUs that it flogs to everyone may not be suitable for AI and machine learning as they evolve, which risks making its processors less important in the grand scheme of things. This is another reason why Arm wants to design more complete chips for key growth markets, to ensure it can capitalise.

Chip stocks: Competition is intensifying

The change in strategy will be welcomed, but it does put Arm on course to compete directly with some of its biggest customers as semiconductor stocks try to show they can add the most value and reap the biggest rewards from the all-important chips that power the world’s technology.

That also comes at a time when some of Arm’s biggest customers are eyeing its bread-and-butter, opting to develop more of their own chips in-house. For example, Apple, Microsoft and Amazon are among those major customers that have been working on producing more of their chip designs in-house, although all of them still rely on Arm’s architecture for now and the company remains confident its position in the market remains unshaken.

“With the complexity of CPU design increasing exponentially, over the past decade no company has successfully designed a modern CPU from scratch,” Arm said in its IPO prospectus.

One reason to believe that this threat to Arm is low, for now, is that its offering is still strong. One of the reasons so many massive tech companies buy from Arm is because, at the bottom-line, it is cheaper to licence from Arm than it is to develop their own alternative in-house.

Arm: Will investors worry about China?

The spotlight is on China right now as tensions with the US continue to rise, injecting fresh concerns about major Western companies that rely on China for growth. This is demonstrated by the recent selloff in Apple shares amid reports that Chinese government workers and citizens could be shunning its iPhone in favour of domestic brands.

The future of Taiwan, the biggest semiconductor hub in the world, and the risk of it being annexed by China also lingers on the minds of the markets over the longer-term.

In light of this, there may be some concerns about Arm. Arm does not have any of its own operations in China. Instead, Arm makes all of its sales in the country – which is its second largest market – to a company named Arm China, which then sells them on to various companies across the country.

Don’t let the name fool you though, as Arm China is an independent business that neither Arm nor Softbank has any control over. Arm relies on this as its sole route to access markets in China and that has resulted in Arm China being Arm’s largest individual customer, accounting for 25% of its entire revenue in the most recent financial year.

(Source: Company prospectus)

Arm has already had to jump through loopholes like other semiconductor stocks because of the escalation in tensions between the US and China. While a British company, many of its designs land in the hands of American companies that have been told to stop exporting their most advanced chips that are needed for AI to Chinese customers. Arm’s royalty growth from China slowed last year and it has warned it expects to “continue to see declining royalty revenues” from the country, and potentially in licensing revenue too.

Arm, alongside others like AMD and NVIDIA, have maneuvered so they can keep chips flowing to China. Arm has admitted it is highly unlikely to obtain the special licence needed for advanced chips to keep being exported to China because of the national security implications, and it has therefore licenced the most advanced designs it can without infringing on the new trade restrictions.

“We anticipate additional changes to US export control regulations in the future, but we cannot forecast the scope or timing of such changes,” Arm said in its prospectus.

It is no secret that China wants to stymie the influence of American tech companies and promote domestic champions. It has an open ambition to be 70% self-sufficient in semiconductors by 2025, although is thought to be way behind schedule.

Against that unnerving backdrop, Arm has reluctantly listed the access that Arm China has to some of its intellectual property as a risk. Arm China is contractually obliged to protect Arm’s designs and has agreed not to develop its own chips. However, Arm has admitted that the Chinese business runs everything on its data infrastructure and that it can’t independently verify the level of protections in place. It has also said that there is always the possibility that “Arm China may independently develop competitive products other than microprocessor cores and could divert customer interest from our products to increase its market share to our detriment.”

Arm is likely to have tried to allay concerns over China to big investors during the roadshow, with many executives at companies to have invested in the IPO likely to be sharing the same challenges, and Arm would be wise to continue addressing fears of retail traders and the broader markets.

Conclusion: Arm hopes prospects can underpin valuation

IPOs are always tricky for companies. On the one hand, they want to maximise the value for existing investors that are launching the IPO as a way to create a market for their shares so they can cash-out and book a handsome profit. On the other, they don’t want to set the bar so high that the share price plummets after listing and leaves no upside for those brave enough to invest during the IPO.

Arm is coming to market with a lofty valuation, and this appears to be more underpinned by new prospects around designing more advanced and comprehensive chip designs. As for the business as it is today, the fundamentals are strong but not enough to justify a multiple that is three times higher than the average seen across the tech-heavy Nasdaq 100.

Markets are questioning whether NVIDIA’s valuation is too high and that currently sits at a much lower multiple – and that is based on predicted earnings over the next 12 months that are set to be driven by the huge influx in demand for AI chips. Arm is yet to show any tailwind from AI and is yet to switch over to its new, hopefully more lucrative strategy, but has managed to convince cornerstone IPO investors that it can wield its reliable reputation and unrivalled technology to break new ground.

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