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A few takeaways from ARM's IPO
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This week, I wanted to touch on a few interesting takeaways from Arm’s business journey and IPO that took place a few weeks ago. Arm is a very important company in the semiconductor and broader technology ecosystem despite not being as well known as it should be.
I. A winding company journey
Arm began as a joint venture between Apple and the now defunct Acorn Computers and VLSI Technology in 1990.
The plan of the original JV was to develop a processor that was high performance, power efficient, easy to program and readily scalable, which continues to remain ARM’s mission today. Intel at the time had considered and rejected the simpler RISC (Reduced instruction set computer) architecture, which was what ARM set out to use, aiming to become a global standard.
“Arm’s first CEO, Robin Saxby, had vast ambitions for the then startup. “We have got to be the global standard,” he told his colleagues. “That’s the only chance we’ve got.” (From The Chip War)
While it wasn’t initially able to compete with the x86 Intel architecture on PC at least in the early days, the energy-efficient nature of it made it suitable for portable devices such as PDAs and some of the early phones at the time.
The company went public in 1998, and remained a public entity until 2016, when Softbank purchased it for $32B and took it private.
II. Luck and Market Timing
Probably the most important moment in Arm’s 33 year company journey was Intel’s decision to not make chips for the Apple iPhone.
At the time, Intel had recently struck a deal to make chips for Apple’s mac computers. Shortly after that, Jobs went to Intel CEO, Paul Otellini with a new pitch: to make chips for the first iPhone. Intel declined, as discussed in excerpt below from The Chip War.
Would Intel build a chip for Apple’s newest product, a computerized phone? All cell phones used chips to run their operating systems and manage communication with cell phone networks, but Apple wanted its phone to function like a computer. It would need a powerful computer-style processor as a result. “They wanted to pay a certain price,” Otellini told journalist Alexis Madrigal after the fact, “and not a nickel more…. I couldn’t see it. It wasn’t one of these things you can make up on volume. And in hindsight, the forecasted cost was wrong and the volume was 100× what anyone thought.” Intel turned down the iPhone contract.”
Apple then looked elsewhere for its phone CPUs, and turned to Arm’s architecture which in fact was optimized for energy efficient devices such as phones. Apple still uses Arm-based chips today.
It was a case of good market positioning and timing coupled with good luck for Arm.
III. A hidden monopoly
Today 70% of the world’s population uses Arm-based products, and ~30B Arm-baed chips are shipped per year. That’s almost 4 per person in the world!
Arm chips are used in all kinds of devices from PCs to watches to tablets to TVs to XR headsets.
But it’s the smartphone market where Arm really dominates. In the mobile applications processor market (i.e., the primary mobile chip), Arm has a greater than 99% market share!
A consumer can buy an iPhone or a Samsung or LG phone — but they’re all going to end up relying on an Arm-based chip.
IV. An asset-light business model
Arm doesn’t design or manufacture chips. It develops the IP and building blocks such as the Armv9 instruction set architecture which others can use to design chips, and then either manufacture themselves or using a foundry.
Therefore, it’s approach is asset-light but R&D heavy, to continue pushing on the IP they have developed. It also means that there business model is quite flexible, in that they can license its IP to a wide range of customers, including fabless semiconductor companies, integrated device manufacturers (IDMs), and system-on-a-chip (SoC) designers.
The origins of their model come from their very first CEO Saxby over 30 years ago. He believed that Silicon was a bit of a commodity like steel and didn’t want to build chips. Instead, he wanted to sell the architecture to fabless design firms that would customize it for their own purposes, and then outsource the manufacturing to a foundry (such as TSMC). This vision of a disaggregated chip industry largely played out, and Arm has stuck to the approach that he envisioned.
Arm makes money in two ways:
License revenue which represents revenue related to licensing, software development tools, design services, training, support, etc. The products Arm licenses essentially enable companies to design and manufacture chips they need depending on their use case. Arm has ~230 customers that drive license its technology, on a variety of limited term or more flexible arrangements.
Royalty revenue which rerpesents royalties on every Arm-based chip sold and is either a fixed-fee per chip or a portion of the average selling price of the chip (1-2% of ASP typically). Over 60% of Arm’s revenue comes from royalties.
Arm made ~$2.7B in revenue in 2023 and 2022, on roughly ~30B chips shipped in each year, implying that in aggregate they make about $0.09 per chip in licensing + royalties.
Their gross margins are ~96% (by nature of them essentially selling licenses/IP other than some support), and their operating margins are ~25%.
V. Operating model congruent to business model
Arm can basically be considered as being in the IP business, and the most important driver of their business is continued R&D to generate and improve upon their IP which then gets sold.
Given this, R&D is by far the biggest item of spend in the company, with over $1.1B per year spent on R&D.
They also view themselves as an engineering-first company, and their headcount makeup suggests that: approximately 80% of our global employees, representing over 4700 employees are focused on research, design, and technical innovation.
In this way, Arm’s operating model and headcount makeup is sensible and congruent with their business model.
VI. A well-planned IPO
Arm went public two weeks ago, raising ~$4.9B. Arm today trades at $54/share, a market cap of $55B. While the stock performance post going public has been muted, with shares closing the first day at $64/share and now down 15%, this has actually been quite a successful IPO, when you consider that they made $2.7B in revenue growing ~0% in the previous year.
Arm trades at over 20x in revenue, and ~80x in operating income as a low-growth business!
How did it manage this? I think it was down to a mix of factors:
Timing and Storytelling: With AI the talk of the town and companies like NVIDIA ripping, Arm was able to position itself in that ecosystem, playing up the demand for AI workloads and chips to support them. While Arm’s chips don’t excel in AI server workloads today, they may be an important part of AI on the edge, since Arm-based chips are well-suited for portable devices.
Strong Forward / Long-term Guidance: Tied to the above, Arm offered strong guidance of double digit expected growth in the coming years including 20%+ in 2025, from the aforementioned demand.
Strong anchor investors: Arm’s IPO had the support of a number of their strategic customers who were anchor investors as part of the IPO. This included Alphabet, Samsung, Apple, Microsoft, TSMC, Intel and Nvidia. This obviously helps increase demand for the offering and makes it easier to support a higher price.
Low float: Softbank still owns over 90% of the company with less than 10% of the company being floated in the IPO. In addition, with many anchor investors locked up, the shares available to be traded on any day is low, which helps maintain high prices because of low supply.
Regardless of this, Arm is still an incredible and extremely important business, but these factors certainly helped in achieving higher than I would have expected multiples.
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