ARM Holdings: Its Business Model Needs Immediate Fixing (ARM)

Investment thesis

Despite the fact that Arm’s shares (NASDAQ:ARM) are down by approximately 28% from its recent peak at $69, we think that there is still downside potential. The Cambridge based company is priced for perfection despite some serious challenges ahead. Prominent amongst them is the slowdown of its growth rate due to the difficult economic environment, the emerging threat from the open-source architecture RISC-V and the company’s exposure in the Chinese market. We don’t believe that these challenges are fully priced in. On the other hand, the continuation of the AI frenzy, a potential successful transition of its business model and the underlying technological trends on smart devices and EVs could keep the shares at overvalued levels. We rate the stock as a “sell” with a target price of $42.40.

Business model under review

To begin with, Arm’s revenues have two components. License fees and royalties. Its business model is better illustrated in the following picture.

License revenues which account approximately for 40% of total revenues are unsteady. They also have reached at a saturation point due to the fact that the majority of the big players in the industry are already Arm’s customers. At the same time, the revenues that come from royalties (60% of total) are also approaching a critical point due to the company’s dominance on the end markets. This trend is further intensified by the current global economic headwinds.

As an antidote, Arm’s management is considering to introduce two major changes in its business model. First, it plans to substitute its licenses with total access agreements. These will be essentially something like a license with the right to use a broader array of the company’s designs. Second, ARM is considering charging its customers a royalty fee based on the ASP of the final product rather than the ASP of its chip.

These plans highlight emphatically the limitations of the company’s current business model and the challenges ahead. A company that faces such issues does not deserve a nosebleed valuation like the current valuation of Arm. Moreover, the changes in royalties could give further impetus on the freely available RISC-V architecture or cause fines for abusing the company’s monopolistic power.

The emerging threat of RISC-V

It is not a secret that the chip industry is about to experience a major shift as the RISC-V architecture is emerging. This trend will accelerate significantly if major Chinese companies decide to adopt it for geopolitical reasons. These are definitely not good news for ARM, whose market share faces an imminent and serious threat.

RISC-V offers 2 main advantages to companies. First and foremost, it is open-source and help them to avoid licensing fees. Second, it enables them to break their dependency on ARM and increase their bargaining power. Unfortunately for ARM, RISC-V has the unwavering support of some of the largest chipmakers in the world like Qualcomm and Nvidia. The worst part is the fact that according to analyst Charles Shi, RISC-V is quickly improving its performance standards and closes the gap with both x86 and Arm’s architecture.

Customer concentration

Despite the fact that ARM has a sizeable customer base, its customers are highly concentrated. For FY2023, its largest five clients contributed around 57% of the company’s total revenues. Moreover, ARM China which is ARM Holdings biggest customer was responsible for approximately one quarter of ARM’s total sales. This is a risky situation mainly for 3 reasons. First, because ARM is particularly vulnerable to unfavorable developments on its clients’ businesses. Second, due to the fact that this situation has granted significant bargaining power to these companies. This could potentially impact the future revenues of the company. Last but not least, because the loss of even one of these key customers could result in lost revenues that will be extremely difficult to be replaced.

Not an AI company

ARM’s management tried really hard in order to create the impression that the company is an indispensable player in the booming AI industry. The below graph speaks on its own.

This was done for profound reasons and it seems that it worked quite well. ARM secured a $ 54.5 billion valuation in its recent IPO. Its main selling point was that both NVIDIA’s new Grace CPU and the CPU included on its Bluefield -2 DPU are based on ARM’s architecture. But according to NVIDIA’s website the ARM-based CPU in Bluefield-2 “is industry standard“, hence it cannot be considered a true differentiator. Even though ARM does not provide more details about its revenues, it seems that its cooperation with NVIDIA accounts for a small part of them. In addition, in Q2 2023 Arm’s sales declined by 2.5% in comparison with the prior year while at the same time NVIDIA’s revenues more than doubled. Thus, we can conclude that ARM has not been able to reap significant benefits from the AI boom so far. Hence, it wouldn’t be wise for investors to value it as an established AI player.

Foreign private issuer

Another one issue that investors should bear in mind before buying ARM’s shares is the fact that the company is considered a “foreign private issuer”. Due to this status ARM has been granted an exemption from complying with certain rules and regulations of the SEC. In other words, ARM is subject to reduced reporting requirements in comparison with U.S. issuers. For example the company is not required to file its Form 20-F sooner than 120 days after the end of each fiscal year and it is also exempted from Fair Disclosure Regulation. Moreover, its executives “are exempt from the reporting and short-swing profit recovery provisions of Section 16”. All in all, it is definitely not a good omen and particularly encouraging when a business decides “to be less transparent”.

Arm China

Arm China not only accounted for approximately 24% of Arm Holdings total revenues in FY2023 but it was also its main growth engine. Its revenue grew by 38% during the year while the non-China revenue fell by 9%.

The main problem for investors arises from the fact that Arm China is essentially independent. Arm Holdings has only a 4.8% stake in Arm China and no voting rights. According to its F-1, the company in some instances in the past couldn’t obtain prompt and reliable information from its Chinese business counterpart. This is of critical importance because this financial information is the basis for the calculation of ARM’s revenues from the Chinese market. Moreover, the company had also faced issues with delayed payments. Long story short, ARM China is not the epitome of trustworthiness. On top of that and given the critical importance of the semiconductors industry, Arm Holdings could even end up losing Arm China entirely. This is the worst-case scenario obviously but even a single threat from the Chinese government could be enough to send the stock at much lower levels. As a consequence of all the above, ARM Holdings states that it expects a decline in revenues from the Chinese market.

The Role of SoftBank

Regarding the role of SoftBank, the first thing that investors should do is to try to find out the true reason of Arm’s IPO. According to SoftBank’s CEO the company is trying to raise cash in order to invest it in AI companies. But this is highly contradictory. If Arm is going to benefit handsomely from the development of AI, as its management argues, why does SoftBank sell even 10% of it?

A second reason that should make investors worry, is the fact that a few weeks before its IPO, SoftBank increased “artificially” ARM’s valuation. This was done through self-dealing in the same way that SoftBank inflated WeWork’s valuation prior to its IPO.

Last but not least, SoftBank controls around 90% of Arm Holdings. This fact raises questions about its ability to take decisions with the best interest of all shareholders in mind. On top of that, any decision to sell even a part of its stake on the company would put significant downward pressure on Arm’s stock.

Valuation

In order to find the fair value of ARM’s shares we use the P/S ratio. Our choice was based on the need to accommodate for the significant differences between the growth rates and net income of ARM’s peer universe. We modelled a 12.28% CAGR for the company’s revenues during the forecasted period. This rate corresponds to the CAGR of the global semiconductor market for the period between 2023 and 2032 as forecasted by Precedence Research. As ARM is already well-established finding new clients won’t be easy. Hence its growth is expected to mimic the growth of its broader industry. So, our target P/S ratio for the company is 9.1 which is the average P/S ratio of the company’s peer universe as we defined it in Alpha Spread. This leads us to a target price of $ 42.40 per share.

Risks

No investment decision is entirely free of risk. As a consequence, the sellers of Arm’s shares should be aware of 3 main things that could potentially make them regret about their decision.

The first of them is the continuation of the AI frenzy. In such case it is more or less certain that the price of Arm’s stock will stay elevated for longer. This development should particularly concern short to medium term investors.

On the contrary, medium to long-term investors should focus more on a successful transition of the company’s business model. As we explained above ARM’s management is considering to introduce two major changes in order to increase the company’s revenues. These changes along with the possibility of forming more strategic partnerships like this with Apple, could totally change the rules of the game.

Last but not least, as demand is expected to shift further from traditional devices towards smartphones and wearables due to their increased computing capabilities, ARM’s TAM is about to widen. The same is also expected to happen due to the shift from ICE vehicles towards EVs. Arm is an innovative and well-established company that it is undoubtedly capable of capitalizing on these trends.

Conclusion

ARM possesses a stable wide moat due to high switching costs and its Intellectual Property. Despite this fact the company faces significant challenges ahead and it is already priced for perfection. According to our opinion the long-term probability of outcomes seems to be negatively-skewed. Hence, we rate ARM’s stock a sell with a target price of $42.40 and a downside potential of 16.9%.