Tuesday, July 19, 2016

Why did SoftBank offer £24.3 billion (US$32.4 billion) in cash to acquire ARM Holdings? - Part 1

To make this purchase, SoftBank will need to part with cash-on-hand and take out an additional loan from Mizuho Bank of Japan, adding to its mountainous pile of debt?

ARM is the leading developer of RISC processor designs that are widely licensed for use in smartphones and tablets.  The company, which is based in Cambridge, England, posted 2015 revenue of £968.3 million. A total of 14.8 billion ARM-powered SoCs shipped in 2015, up from just over 12 billion in 2014.

SoftBank is mostly a telco, mobile operator and ISP business in Japan. It also owns the majority stake in Sprint, the fourth largest mobile operator in the U.S., as well as a substantial stake in Alibaba, China's leading cloud and B2B business.

Executives at both firms pointed to IoT as their common future.  Most analysts agree that there will be many years of tremendous growth ahead as the world goes about connecting every machine. ARM processors are already well positioned for this opportunity.  SoftBank's investments in Alibaba and Sprint should also get a boost as more connected devices take off.  But it is not apparent that SoftBank's ownership of ARM could boost its number of IoT design wins.  Nor should we expect ARM-based devices to generate any additional traffic or value just because they are on SoftBank infrastructure.

For ARM executives and shareholders, a 43% jump is valuation is certainly good news.  It more money to grow the business, and more money in the retirement account.

For SoftBank, what other reasons could be driving its decision to take on more corporate debt, especially in the highly-volatile semiconductor business, where it has now prior experience? 

Some considerations:

•   ARM Holdings is a profitable business and holds a 95% share of the market for processors used in smartphones.

•   SoftBank can borrow large amounts of cash at negative interest rates in Japan. The negative interest rates in Japan tend to force spare cash overseas.  Japanese lenders would rather put their money into a fast growing concern like ARM than see it languish at home.

•   The British pound has depreciated significantly versus the yen.  Today's rate is approximately 140 yen for 1 British pound, verses 190 yen for 1 British pound about a year ago.

•   ARM's RISC processors could play a key role in robotics, which is an area of intense interest for SoftBank and its chairman in particular. SoftBank owns the "Pepper" humanoid robots that have made quite a splash of late in Japan.

•   SoftBank may be forecasting a positive entry for ARM into the processor market for servers used in hyperscale data centres, such as those owned by Alibaba.  A strong entry in to this market could significantly weaken Intel.

It has also been revealed that the deal came together in great haste -- just two weeks.  Masayoshi Son denied that the timing was influenced by Brexit or the decline in the value of the pound, instead stating that he has admired ARM for many years. He decided to approach the company with his offer two weeks ago (that would be around June 30th). The SoftBank offer was so compelling that the ARM board decided to approve it rapidly (apparently without shopping around for any other alternative suitors) and to recommend it to shareholders.  ARM's financial advisors were Goldman Sachs and Lazard & Co.

The companies are expecting a straight-forward approval process because they have no areas of competitive overlap. Completion is expected by November 2016.

Masoyoshi Son said the deal is a mark of confidence in the UK, noting that some other Japanese companies he knew were considering whether they should move their European headquarters out of the UK. He said he strongly believes that now is the time to invest in the UK.

On the merger conference call, as well as in previous financial calls, Son reminds investors that SoftBank has the highest EBITDA operating margins and greatest free cash flow of any major carrier at 54%, ahead of Verizon, AT&T or China Mobile. ARM also enjoys nice margins.

Balanced against these reasons in favour of the giant SoftBank + ARM merger are several immediate concerns.  First, did SoftBank offer too high a price?  With a 43% premium over how the LSE valued the ARM business, SoftBank is certainly seeing positive prospects. We know that ARM devices are inside nearly every smartphone, that nearly everyone on the planet own or aspires to own a smartphone, and that these devices need to be replaced on a regular basis.

 Good for the UK?

Then there is a nationalist concern. ARM is currently at the top of its game and it has many bright prospects ahead in mobile phones, tablets, embedded devices, automotive, IoT devices, network infrastructure, and cloud servers.  It one of the few remaining British technology firms with a global impact. Selling out to a Japanese firm, raises the possibility that the UK's influence in the IT sector could be diminished by this transfer of ownership.  ARM and SoftBank addressed this issue at the top of their press event, stating that the ARM organisation would remain intact with its current senior management team, and that it would continue to be based in Cambridge.  The companies are also assuring that employee headcount in the UK will roughly double over the next five years, representing the addition of 1,500 or so high-paying jobs.

SoftBank has successfully kept its word with its other big properties. Following the acquisition of Sprint in 2013, there has not been any changed public perception of the company.  In other words, the U.S. consumer market accepts Sprint as a top four American mobile operator -- not as a Japanese carrier doing business in the U.S. (the same can be said of T-Mobile USA, which is also widely seen as a local player and not a German company).  In China, there is the potentially sensitive issue of a Japanese firm owning major shares of the country's leading cloud and B2B firm.  Whereas other Japanese companies have struggled through several recent episodes of public anger regarding China's political relationship with Japan, SoftBank has brilliantly navigated these waters largely thanks to Masoyoshi Son's charisma and personal friendship with Alibaba's Jack Ma.  As a Japanese citizen of Korean ancestry, Son has long been the outsider willing to take chances and disrupt the established order. His bold investments and entrepreneurial spirit have helped him open doors, whether in Tokyo, Silicon Valley, Hangzhou or Beijing.  Foreign takeovers are never easy, but Son's chances of adapting to Cambridge are probably better than others (just consider if ARM were to be bought by Huawei or Samsung).

ARM's business model as a licensor of intellectual property would also remain unchanged.  ARM is an intellectual property firm. Unlike Intel, which designs and fabricates its own silicon, ARM does not own or control the manufacturing process.  Building fabs is an extremely capital intensive business, especially as the lithography moved under the 90nm threshold a decade ago.  Each new fab is a multi-billion project that takes years of planning but with a short time window in which to recoup the investment.  ARM licensees build their own devices, largely in the fabs of TSMC, UMC, and Global Foundries. This type of manufacturing has long left the UK.  While the idea of a fab-less semiconductor company seemed radical in the early 1990s, the virtual enterprise is all the rage these days.  Investors much prefer a smaller company with very high margins to a behemoth with high levels of production but low productivity. As long as ARM can continue to improve its architecture so that its customers can continue the unending technology update cycle, the company will continue to prosper, as ARM has demonstrated since its founding in 1991.