The US flotation of British chip designer Arm Holdings (ARM) has been one of the highest-profile IPOs of the year, even if its second iteration has a public company has not exactly lived up to the hype. With a float price of $51, at the top end of the range, the shares soared 25% on September 15, the first day of trading. A month on, they’re barely $1 above this price.
This week Morningstar initiates coverage on Arm and our analysis reflects some caution over the company’s valuation. We assign the shares a $34 fair value, $17 below the float price.
"We struggle to justify Arm’s lofty IPO valuation despite its good growth prospects," says analyst Javier Correonero.
This $34 a share rating implies an enterprise value – a valuation measure relating to financial performance – to earnings before interest and tax (EBIT) multiple of 41 and 31 times for the 2024 and 2025 financial years. At $51 a share, the float price, that would imply multiples of 59 and 41 for those years.
Morningstar models an 11% revenue compounded annual growth rate over the next decade, with operating margins expanding from 23% in 2023 to 39% in 2026 due to operating leverage.
The company has a wide economic moat, according to our analysts. Correonero says: "our wide moat is underpinned by switching costs and intangible assets. Once a company develops a chip in a certain architecture, it implicitly accepts that further versions of the chip will be done in that same architecture. Even large companies like Apple can take years and millions of dollars to switch architectures, as it happened with Mac laptop CPUs switching from Intel's x86 to Arm.
"Arm has long-standing relationships with its customers, which gives it visibility into clients' future designs, facilitating R&D innovation. Arm products also have very long shelf lives, with 46% of company revenue still coming from products released between 1990 and 2012."
Other competitive advantages include Arm’s 99% market share in smartphone CPUs and 65% share in other mobile chips. But Correonero says Arm's largest growth opportunity lies in data centres.
"Energy is one of a data centre's main expenses, so minimising energy consumption is paramount," he says.
"Although [Intel’s] x86 remains the main data centre architecture, Arm has been gaining market share as having more power-efficient CPUs allows it to fit more units, increasing throughput and reducing the unitary power consumption. In automotive, the transition to electric vehicles implies maximising battery life, which also plays in Arm’s favour."
Still, Arm is assigned a high uncertainty rating. This stems from two factors: China and RISC-V architecture. Our analyst explains:
1) Arm China is the only entity allowed to sell Arm’s IP in China, however, it is not controlled by Arm Holdings. Arm licenses IP to Arm China, which then sublicenses it to Chinese customers like Xiaomi or Huawei. Arm Holdings’ revenue recognition from China is dependent on the information Arm China provides, and financial reporting controls have historically been weak. We also consider that Chinese employees could try to steal intellectual property from Arm China, given the continuous political tensions with the US.
2) RISC-V is a very simple and open-source architecture where developers can modify the architecture without paying architectural licenses. This provides lower startup costs and more design freedom, although it comes at the expense of higher time-to-market and poorer customer support. We don’t see RISC-V harming Arm in the next 10 years, but from then onward ecosystem adoption will depend on customers’ willingness to change and how aggressive Arm becomes with its pricing.
We covered the background to the Arm float in "Mixed Emotions in London as Arm Preps IPO" and its first day’s trading here "Arm Shares Surge on Nasdaq Debut".
