Arm FQ3 FY22 – More questions than answers

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Updates below with more details on adjusted EBITDA vs. Pre-tax profit.

• Buried on page 24 of the earnings statement from SoftBank are details of the amortisation of intangibles taken by SoftBank during the first 9 months of fiscal 2022.
• This amortisation is not a write-down of goodwill but amortisation that has been scheduled over the course of SoftBank’s ownership of Arm to reflect that the value of the IP that Arm creates declines over time.
• I suspect that implicitly, there is goodwill in here also given how much SoftBank paid for Arm in 2016 but it is amortisation that belongs to SoftBank and not Arm.
• For example, the Arm7 processor IP was very valuable when it was first created but is worth much less now given how old it is and so it is this reduction that the amortisation is designed to reflect.
• Consequently, every period, amortisation related to the transaction is recorded as a cost to Softbank, but it has nothing to do with Arm itself.
• If this is reversed out one arrives at a pre-tax profit of JPY101bn representing a pre-tax margin of 35%.
• If one looks at where Arm was before the company was acquired (Q2 2016), pre-tax margin was around 38% well within the margin of quarter to quarter volatility allowing one to argue that Arm is pretty much back to where it was before Softbank acquired it.
• Whether or not the company is worth the $50bn that Softbank seems to be seeking for it when it IPOs is another question, but the situation around fundamental performance is much clearer.

Excellent top line, uncertain profitability.

• Arm reported excellent results setting itself up nicely for an IPO in 2023 just as long as it can sort out the mess created by the dispute with Qualcomm.
• FQ3 FY22 revenues were $746m up 28% YoY while adjusted EBITDA was $450m representing margins of 60.3%.
• Unfortunately, ARM didn’t disclose actual EBITDA or operating profit as per UK GAAP and so it is difficult to tell what the real situation is.
• SoftBank’s results for the same period reveal a 9-month adjusted EBITDA of $1.19bn on revenues of $2.12bn and states that historic revenue and adjusted EBITDA do not include the impact of the ISG business that has been transferred into SoftBank and is no longer part of Arm.
• ISG is the IoT business that was where a lot of the investments promised by SoftBank when it acquired Arm were made and its removal consequently returns Arm pretty much back to where it was before SoftBank acquired it.
• This is the main source of the huge improvement in profitability but given that Arm is still part of SoftBank we can’t tell for sure exactly how well it has recovered.
• One clue is buried in the SoftBank disclosure which includes a spreadsheet detailing the financial performance of the company in purely numerical terms.
• Its complexity is certain to ensure that only the analysts in Japan will look at it, but on tab 15 (see here) is the disclosure that in FQ3 FY22 Arm reported income before tax (PBT) of JPY19.27bn or $136.7m representing pre-tax margins of 18.3%.
• This means that between the adjusted EBITDA line item and income before taxation as defined by IFRS, 42% of margin has disappeared.
• Typically, between these two items would be stock compensation, depreciation and amortisation, expenses considered to be non-operational, one-off expenses and financial items.
• Financial items typically include interest income, income expense as well as gains and losses from financial instruments held on the balance sheet.
• This effect has been repeated for the entirety of the fiscal year so far as tab 15 shows pre-tax margins for 9mo FY22 to be 19.0% compared to the results presentation which focuses on adjusted-EBITDA margins of 56.1% (slides 59 and 60 (see here)).
• Pre-tax margins crashed in FQ2 FY22 to 6.3% and then recovered in FQ3 meaning that there are very likely to be some genuinely one-off items in there.
• However, it looks like there are meaningful other costs that are ongoing, potentially operational that are not being fully disclosed.
• Consequently, while there has been a clear recovery in profitability, I am unable to tell by how much margins have recovered and where they might be able to go on a sustainable and ongoing basis.
• While this does not matter now, it will be crucial for the IPO that SoftBank has said will occur during calendar 2023.
• On a fundamental basis, things are going very well with revenues and shipments of chips that use Arm IP (8bn in FQ3) growing at an excellent rate defying the current slowdown.
• This is because of market share gains in other segments such as automotive (for which Qualcomm was undoubtedly a significant contributor) and in the data centre.
• Smartphones have also bucked the trend as the new Arm9 architecture carries a higher royalty rate and the number of cores shipped per smartphone has also steadily increased which has allowed revenues to fare much better than those of its customers.
• This brings us to the strange situation that exists between Arm and one of its largest customers, Qualcomm where Arm has sued Qualcomm over Arm royalties payable on chips that it ships using processors developed by Nuvia which Qualcomm acquired for $1.4bn.
• The last thing any company that is about to ask the market to pay a chunky valuation for shares needs is to have a significant legal fight ongoing with one of its largest customers.
• The market tends to hate legal uncertainty more than anything else because the outcome is often impossible to predict, is driven by non-public information and the outcome can go either way regardless of merit.
• I think that this hands an advantage to Qualcomm because Arm needs this issue to go away in 2023 much more than Qualcomm does as the dispute will not stop it from shipping Nuvia cores for years to come even if it eventually loses.
• However, the valuation that the market is willing to pay in the IPO may be negatively impacted by a dispute of this nature which looks certain to drag on for a long time.
• Consequently, this dispute warrants further research.
• The net result is that barring the uncertainty around profitability, things are going well for Arm and it is setting itself up nicely for an IPO but, as always, everything will depend on the valuation.