ARM-SoftBank: A One-Sided Deal?

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If ARM Holdings Plc does not eventually become a prized possession of SoftBank Group Corp. it won’t be because the British company’s shareholders were opposed to the deal. They clearly got a great deal from the suitor. SoftBank’s owners, however, may rue not just the hefty 43 percent premium offered for the semiconductor IP vendor but also the acquisition itself in an industry infamous for a high level of uncertainty and very limited visibility into future product demand.

Even for a company famous for quirky deals, SoftBank’s offer for ARM was a surprise to many. Still, it is the kind of out-sized transactions investors had come to expect from SoftBank. It owns outright or has stakes in Sprint, SoftBank Japan (a telecom service provider) Alibaba, Yahoo’s Japan unit and a bunch of investments that, taken together, point in no particular direction.

The ARM deal would be one of SoftBank’s biggest investments and possibly the one that most boggles the mind despite the company’s efforts to sell it as critical to their next-generation growth strategy. It agreed to pay approximately £24 billion for a company that in 2015 reported annual sales of $1.49 billion, compared with $55.4 billion for Intel Corp., the company that is reportedly most at risk from ARM’s insurgence in the computing and connectivity (internet of things, IoT) markets, according to some analysts.

Some skeptical observers believe it will be quite a while before SoftBank can recoup its investment in ARM or generate the kind of returns that justifies this purchase. As a developer and supplier of intellectual property to the semiconductor industry ARM has grown at a rapid clip in recent years. The figures reported by the company are certainly impressive: Revenue nearly doubled between 2011 and 2015, rising to $1.49 billion from $785 million; the number of ARM-based chips shipped by semiconductor makers rose to an industry-leading 15 billion in 2015 and; licensing agreements signed last year climbed to 173 from 163 in 2014, giving it a total of 1,348 in active licenses.

The future of the company is expected to be even rosier, especially if the market for IoT products takes off as dramatically as many observers and chipmakers expect. Already, ARM claims 32 percent of the semiconductor IP market and 50 percent of new chips going into smartphones. Furthermore, the company expects its IP to be designed in future into a wave of new products from automobiles, to enterprise infrastructure, medical devices, industrial equipment, security and other white goods.

“We have long admired ARM as a world renowned and highly respected technology company that is by some distance the market-leader in its field,” said Masayoshi Son, chairman and CEO of SoftBank, in a statement. “ARM will be an excellent strategic fit within the SoftBank group as we invest to capture the very significant opportunities provided by the ‘Internet of Things’.”

There are no doubts that ARM has become a venerated company in the semiconductor industry but much of the noise surrounding the company centers on its perceived ability to curtail the dominance of Intel in the processor market and ensure this doesn’t extend into the newer and faster-growing sectors. While ARM has certainly been growing rapidly, it remains well behind Intel on a revenue basis.

This isn’t likely to change anytime soon. ARM continues to enjoy the patronage of chipmakers because – unlike Intel – it does not represent a direct threat to these enterprises. In fact, its IP offerings help smoothen out wrinkles in the market by ensuring product standardization. Its IP has also been embraced by chipmakers because it helps them cut down on engineering and product development costs.

It’s hard to see how SoftBank will benefit greatly from ARM’s leading IP position. The company itself does not make chips and, therefore, will not glean any direct advantage from its ownership of the IP vendor. As a result, the acquisition of ARM only seems to make sense for SoftBank as a strategic investment. The Japanese company is unlikely to see a strong boost to earnings as a result of its purchase of ARM, which in 2015 reported net income of £414.8 million on revenue of £968.3 million ($1.49 billion.)

So what can SoftBank reasonably expect from this transaction? The Japanese company could possibly spin off ARM in future and retain a stake in the business. This move would allow it to recoup the immediate investment, pay down loans that are now expected to exceed $100 billion and record what may be a substantial gain on the equity stake. It will have to wait years, perhaps up to 5 years, to initiate such a spinoff.

SoftBank has made at least two similar transactions in recent months. It plans to sell its stake in Alibaba for approximately $10 billion and in June, the company divested its holding in games developer Supercell Oy to a consortium controlled by China’s Tencent. The deal, valued at approximately $10.2 billion, is part of plans to reduce debts and leverage gains from previous investments to fund future acquisitions, according to chairman Son.

“Over the life of our investment, Supercell has operated as an independent company, and its unique culture of independent teams has proven itself repeatedly,” Son said in a statement announcing the Tencent deal. “Our decision to divest our shares is driven by our continued focus on monetization for the benefit of our shareholders and on capital structure discipline, both key pillars of our SoftBank 2.0 strategy.”

In the case of ARM and over the immediate term, though, SoftBank would have to ensure the new acquisition retain its leading position in the industry, assure customers it won’t interfere in the company’s strategic management decisions and put in enough R&D as well as product development capital investment to keep it ahead of Intel and other rivals.

There are indications SoftBank plans to increase investments in ARM. The company said it will keep ARM as an independent entity, retain the current management team, increase the number of employees in the U.K. and generally boost investments in the business.

“SoftBank has given assurances that it will invest considerably in the business, including doubling the UK headcount over the next five years and maintaining ARM’s unique culture and business model,” said Stuart Chambers, chairman of the board of directors at ARM, in a statement. “ARM is an outstanding company with an exceptional track record of growth. The Board believes that by accessing all the resources that SoftBank has to offer, ARM will be able to further accelerate the use of ARM-based technology wherever computing happens.”

Several pitfalls in SoftBank’s strategy are immediately obvious. First, ARM is attractive to chipmakers as an IP vendor because of what it is about to lose, its independence. Unlike Intel, the Cambridge-headquartered company is not a chipmaker and does not compete in any way with its customers. But while SoftBank is also not a semiconductor supplier, its ownership of ARM will eventually arise as a complicating factor for some customers. That loss of independence may compel them to consider developing second-source alternatives to ARM whose growing dominance may already be a concern for some companies.

By far the greatest problem facing this union, and the one that may derail it, is the amount of debts on SoftBank’s balance sheet. Prior to the announcement of the ARM transaction, SoftBank reportedly had more than $100 billion in debts, according to analysts. This enterprise should not be adding debts, according to an analyst quoted in a Reuters’ article.

SoftBank should also not be making the kind of commitment it has signed to seal the ARM deal. Perhaps due to concerns British regulators might scuttle the acquisition, SoftBank made various promises to increase the number of ARM employees over the next five years while ensuring the company remained in the U.K.

“SoftBank has given assurances that it will invest considerably in the business, including doubling the UK headcount over the next five years and maintaining ARM’s unique culture and business model,” said ARM chairman Chambers.

Why SoftBank feels compelled to make this commitment is a puzzle. Contrary to arguments made by both parties, ARM is not a “very significant UK business” but rather a very significant company that happens to be headquartered in Britain. ARM is an international business whose very existence, profitability and ability to sustain itself as a going concern rest squarely on its ability to operate and sell its IP to enterprises that operate mostly outside the U.K.

Britain is not and will not become ARM’s biggest market. The promise to double the payroll in Britain over the next five years is a wrongheaded move meant to secure a deal that might itself be a strategically weak decision on the part of both the buyer and the seller. ARM shareholders will likely be the only one smiling about this deal years from now if ARM trips or if SoftBank fails to generate the returns anticipated.