Arm, the British chip design firm owned by SoftBank, filed to go public yesterday evening, following years of speculation around an IPO after the company’s plan to merge with GPU giant Nvidia fell apart a few years ago.
This morning, we’re perusing the company’s F-1 filing to better understand its business, with a focus on its profitability and growth. Unlike many other IPO candidates we’ve covered in recent years, Arm is quite profitable, but it hasn’t been growing much lately.
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This is an important IPO for SoftBank, which poured billions of dollars into Arm when it bought the company. It’s also an important IPO for the market in general, particularly for startups, even if Arm is not the usual venture-backed business that we usually cover.
Why? Venture capitalists and founders alike are currently enduring a liquidity drought, which this IPO could help resolve. If the listing is received well, it could bolster confidence in the public markets, which could in turn spur more companies to list. For the hundreds of unicorns currently stuck in the private markets, that could be big news.
On the other hand, if Arm stumbles on its way out the gate or is forced to sell its shares for far less than it expects to, the IPO could limit startups’ confidence in venturing out into the public markets and limit the number of subsequent listings. Quite a lot seems to be riding on this IPO.
Will investors be impressed with what Arm has on offer? Let’s find out.
An Arm-ful of potential
To put it simply, Arm designs computer chips and makes money from companies that use its designs to build semiconductors. In practice, this means that the company generates very high-margin revenue, spends a large fraction of that revenue on research and development, and has serious competition.
The bull case here is simple and alluring: As the world becomes increasingly digital, demand for chips — especially the low-power chips Arm often designs — will increase. It collects a portion of chip revenue through its commercial agreements, so you could reasonably argue that Arm will grow over time and generate lots of high-margin revenue as the market expands and more companies use its chip designs.
The bear case is similarly easy to understand: Arm’s margins make it a target. The company’s main competition is x86- and RISC-V-based processor technology, the latter of which is open source. Any company that can generate lots of income has a target on its back, and the more the chip market grows, the more tasty a target Arm will become. That could lead to lower margins and slower revenue growth at the company.
Now let’s look at Arm’s most recent financials to get a feel for how big this business really is.
Great profits, but slow revenue growth
Arm reported revenue of $2.68 billion in the financial year ended March 31, slightly less than the $2.70 billion it recorded a year earlier, despite an increase in the number of chips using its architecture. It had gross profit of $2.57 billion in both periods, resulting in gross margin of 96% and 95%, respectively.
That’s simply bonkers profitability. At SaaS companies, for example, it’s common to see gross margins in the 70% to 80% range, and even then, that’s a high target to aim for. Arm is on another level entirely.
But strong gross margins do not mean that the company converts most of its gross profit to income. In FY 2023, Arm spent 42% of its revenue on R&D (up from 37% the previous year), and operating income came in at $671 million ($633 million in the preceding year). The company reported free cash flow of $606 million in FY 2023.
In short, Arm’s revenue did not increase over the past couple of years, but the company did generate mountains of cash and income. It’s a powerhouse, in other words, even though its top line seems to have flatlined.
Zooming in
But things look less alluring when you consider the company’s results for the quarter ended June 30:
- Revenue: $675 million, compared to $692 million a year earlier.
- Gross profit: $644 million, down from $667 million last year.
- Operating income: $111 million, much lower than the $225 million it recorded a year ago.
That’s curious, isn’t it? The geopolitical importance of semiconductors and their production these days is no small matter, and it’s hardly like the digitization of the global economy is in danger of slowing down.
So, why is Arm seeing its revenue dip? Here’s how the company explained the matter (emphasis ours):
License and other revenue was $275 million and $258 million for the fiscal quarters ended June 30, 2023 and 2022, respectively. The increase in license and other revenues was primarily driven by new licensing deals as well as renewals of our existing license arrangement by customers to gain access to the latest versions of our technology IPs. Royalty revenue was approximately $400 million and approximately $434 million for the fiscal quarters ended June 30, 2023 and 2022, respectively. The decrease in royalty revenue was driven primarily by the macroeconomic slowdown and lower shipments to normalize inventory levels.
Revenue from external customers increased by $11 million during the fiscal quarter ended June 30, 2023, as compared to the fiscal quarter ended June 30, 2022, driven primarily by a $33 million increase in license and other revenue, which was partially offset by a $22 million decrease in royalty revenue. Revenue from related parties decreased by $28 million during the fiscal quarter ended June 30, 2023, as compared to the fiscal quarter ended June 30, 2022, primarily driven by a $16 million decrease in license and other revenue and a $12 million decrease in royalty revenue as a result of trade protection and national security policies of the U.S. and PRC governments, which adversely affected PRC semiconductor suppliers and customers.
This shows that companies cannot simply avoid politics in the modern economy, especially if they are a hardware technology firm.
I suspect that if investors choose to back the bull case here, Arm’s recent growth issues will not prove too worrisome — its potential for long-term profits will be more enticing than any bumps along the way. But since Arm seems intent on selling its equity at a steep revenue multiple, it will have to work really hard to reassure investors that there’s plenty of growth to come.
Arm is spending a lot, too. In its most recent quarter, the company’s R&D costs rose to 50% of its revenue, or $337 million. That’s a large chunk of change for a company with a wavering top line. But you could choose to see this in two ways: Arm could be spending heavily to retain its market position and margins, or it’s costing the company more to do R&D than in the past, which could lower its operating income and cash flow in the long run.
Investors may have other concerns, too: Is Arm positioned well enough to help power the current AI boom, for example? And given the company’s issues with its Chinese sister concern, how enduring is its access to China’s market?
It will be fascinating to observe how Arm is eventually priced on the public markets. We’ll have more thoughts on this when the company reveals its initial share price range.