(October 5th, 2023)
By (Ottavio De Noia, Equity Research Analyst)
Edited by (Lorenzo Fruttero, Head of Equity Research)
Introduction
On September 14th, 2023, Arm Holdings (NASDAQ:ARM) made its debut on the NASDAQ, after a long cessation of the IPO activities due to the unfavorable macroeconomic environment, positively impacting markets. (It has been the 2nd biggest U.S. IPO since 2021)
The initial share price of $51 per share accounted for a total valuation of almost $60 bn, with the first soaring more than 25% during its first day of trading.
The deal clearly brought confidence on the market for a further stimulation of the tech IPO activity, even though the general enthusiasm might have provoked the stock to be sold at a very high premium.
In this article we will analyze the company and objectively address the reasons for which we believe it might be overvalued.
Overview of the company
Although people may not be familiar with ARM Holdings, they are most probably belonging to their “loyal customers”, using their products nearly every day, in a continuous upward trend.
ARM is a British semiconductor chip company, mainly operating in the field of designing CPUs and other chips, which are currently running the 70% of the total number of electronic devices in the world and around the 95% of the world’s smartphones.
ARM’s business model is simply founded on the lending of their intellectual property (IP) for which they receive a royalty when a chip manufacturer borrows their IP. Among some of the biggest customers are: TSMC, Intel, Samsung, Apple, Broadcom and Lenovo.
To deeply understand their products, we should deep dive into different ISAs (architecture of the instructions set) on the market: x86/x64 and ARM.
Between those two, what really distinguishes one from the other is the set of instructions given to it: while ARM relies on a RISC (Reduced Instruction Set Computer) design, much faster but capable of running only a limited amount of information at a time, x86/x64 systems rely on a CISC (complex Instruction Set Computer) design, thus being able to interpret much more complicated instructions.
But then why are the majority of devices dependent on a much simpler system (namely the RISC)?
The answer is that RISC is capable of performing operations in a much more energy-efficient way, and that is why it has been implemented in the majority of smartphones.
Potential threats
RISC-V is one of the latest entries in the market, funded by massive investments from a consortium of firms currently depending on the ARM design (NVIDIA, Samsung, Google) and it consists of a royalty-free system specifically designed to rival the ARM “monopoly”: since it is an open-source project, producers may become less dependent on ARM’s intellectual properties in a way to avoid the royalty payment.
While ARM releases new projects, RISC-V is not a viable option as of today anyways, due to a lack of developer community and lower performance, but it is still something that tech companies are trying to take advantage of, securing a sales CAGR of about 35% through 2027, consisting in a potential threat for ARM.
Financials
Considerations on financials are crucial when talking about a firm as Arm, which is thriving in a very competitive economic environment, but the company seems really resilient in all its aspects: sales are spiking after the COVID-19 downturn to more than $2.6 bn with a large profit margin (around 20% in both 2022 and 2023)(see exhibit 1) and as far as leverage is concerned, the business is fairly driven by both equity and debt, with a debt-to-equity ratio of 0.7 in 2023 and nearly no interest expenses.
Furthermore, the company is extremely liquid, with a current ratio very similar to the quick ratio since they hold nearly no inventory, attested at 2.60 in 2023 while their only big expense is the large amount of money invested in R&D (nearly $1.2 bn in 2023).
Exhibit 1
Source: Bloomberg Terminal.
Valuation
We carried out a two-layer valuation by comparing the results of a DCF and a comparative analysis with other firms in the industry.
Thus, the company is overvalued by around the 30%, for an intrinsic value of $37 per share.
The assumptions were made by reflecting data and estimates from the Bloomberg Terminal to project Free Cash Flows. In addition, to compute the cost of equity, we assumed a Beta of 1.4 (median of the peers), a risk-free-rate of 4.59% and a market return of 6% (estimate by NYU professor A. Damodaran), while the cost of debt was 5.30%, resulting in a WACC of 5.65% and a total valuation of $40 bn, much more sensible and in line with peers, unaffected by the IPO hype. (see Exhibit 2)
As far as the relative valuation is concerned, and by using relatively more mature peers as: TSMC, NVIDIA, Intel, Broadcom and Qualcomm, it is relevant to show that the average EV/Sales is 12.5x: on this metric, Arm would be valuated at $33 bn (less than the DCF Equity Value) and the situation worsens if we take out NVIDIA from the analysis, with the average attested at 6.1x (implying a $16 bn valuation for Arm).
The exact same results are obtained if EV/EBITDA multiples are analyzed: the average for the peers is almost 30x (NVIDIA skews the multiple to the right due to its 83x) while Arm’s EV/EBITDA is 37.5x, thus indicating that the firm is overvalued.
Conclusion
Although Arm’s IPO has brought very much to the table in terms of investors’ confidence, it is clear that the $54 bn valuation is indeed exaggerated. The reasons for that are multiple and the most accredited ones are the AI boom that both market and society is experiencing altogether with the sudden and long-awaited awakening of the IPO market, which might have brought general euphoria in investors’ choices.
Although the company has very solid performances and financials while holding a pretty unique competitive advantage for the large market share that they control, it is also unarguably true that as of today, the IPO valuation hides a huge premium on top of it, which many investors may not be aware of.
References:
Bloomberg Terminal
Yahoo Finance, https://finance.yahoo.com/quote/ARM/balance-sheet?p=ARM
ION analytics, https://community.ionanalytics.com/arms-fair-ipo-valuation-closer-to-usd-40bn-on-stunted-growth-peers
CNBC, https://www.cnbc.com/2023/09/14/arm-ipo-arm-starts-trading-on-the-nasdaq-in-win-for-softbank.html
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