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OPINION

Irresistible Arm

Irresistible Arm
July 21, 2016
Irresistible Arm

For the past few years, 'TelecomsBank' might have been a more appropriate name for the Japanese company; roughly speaking, £50bn of its £65bn revenue in 2015-16 came from telecoms provision. True, the inclusion of Arm will barely make a mark on those revenues. Nor will it have much impact on profits. Despite Arm's wonderful profitability, including the Cambridge-based company in SoftBank's accounts will only add about 6 per cent to annual operating profits before financing costs.

However, the effect on SoftBank's balance sheet and - more important - its corporate ethos is likely to be profound. After all, it's barely an exaggeration to say that SoftBank's founder and boss, Masayoshi Son, is betting the business on Arm. He has made such moves before - diversifying into mobile telecoms via the £8bn acquisition of Vodafone Japan in 2006; buying a 70 per cent stake in US wireless operator Sprint (US:S) for $20bn in 2012 (subsequently raised to 80 per cent).

Such giant steps are consistent with Mr Son's past as a risk taker and serial entrepreneur; he does, after all, have the dubious distinction of, reputedly, losing more paper wealth in the dot-com crash of 2000 than anyone else - maybe $70bn. But the takeover of Arm would be his biggest move and - such is SoftBank's faltering performance and the rare attraction of Arm - you wonder if it will be challenged.

On the face of it, SoftBank has made an unbeatable offer. The 1,700p-per-share cash offer is 43 per cent above the closing price of the last day's trading before the announcement. It is 77 per cent higher than 14 June's 959p closing price after which, with the benefit of hindsight, it looks pretty clear that rumours started leaking into the market. It's even 42 per cent higher than the previous all-time high, reached in March 2015. For what it's worth - which isn't much - the offer has the recommendation of Arm's directors, who own just 0.14 per cent of the equity. In conventional valuation terms, it rates Arm at 25 times its latest full-year sales and 48 times earnings.

Yet putting up that amount imposes a strain on SoftBank, as the table implies. SoftBank is already as much an exercise in acquisition-driven financial engineering as it is a technology company. The acquisition of Arm will only add to that. The wonders of leverage mean that, using average data for the past five years, SoftBank turns a fairly ordinary 9 per cent return on assets into a 24 per cent return on equity. Yet the trends are going in the wrong direction. Profit margins and return on equity are both falling while net debt is rising. In March, net debt stood at £66bn in relation to £25bn of equity; if and when the Arm deal is completed, then, other things being equal, net debt will rise to £90bn.

 

How they compare
ARMSoftBank
Mkt Cap (£bn)24.348.5
Share price1,699p¥6,007
All-time high1,699p¥8,880
Revenue (£bn)0.9765.42
Pre-tax profit (£m)4156,763
Debt/equity (%)nil264
Profit margin (%)*37.416.2
Return on assets (%)*16.88.9
Return on equity (%)*14.524.2
Cash flow RoE (%)*21.5nil
5-year growth rates (% ave):
Income19.030.1
EPS41.322.2
*Average of past 5 yrs

 

Meanwhile, despite ultra-low interest rates, the size of the purchase price surely means that Arm will be a drain on SoftBank's cash profits for some years. That may not matter much since, as SoftBank's Mr Son boasts, acquiring Arm will bring the group a great chance to benefit from myriad opportunities provided by the 'internet of things'. Although that rationale could have been trotted out at any time in the past 15 years, it really is what the deal is all about.

No company is unique, but Arm gets close. Its low-cost, low-energy-consumption template for microchips has come to dominate the market for smartphones and tablets. It could do the same for the internet of things, which, at last, is looking like tomorrow's reality. If so, then Arm's future would be even better than the brilliance of its past 18 years. And that, roughly speaking, is why the bosses of the world's biggest technology companies won't just shrug their shoulders when they see the world's leading microchip designer being sold to an overstretched conglomerate.

So the question is: which company might go beyond a price that SoftBank can afford? Clearly no microchip design specialist can go there - Arm is out of the league of Nvidia (US:NVDA) or Germany's Infineon Technologies (ZTRA:IFX). That leaves only technology giants, such as Intel (US:INTC), Texas Instruments (US:TXN) or Qualcomm (US:QCOM). Yet you couldn't rule out Apple (US:AAPL) or Alphabet (US:GOOG) since every one of these would like to own Arm if its bosses thought they could sort out the antitrust issues. And, if that tells investors anything, it is that they might want to take a low-risk punt on Arm's shares in the coming months.