Despite NVIDIA's exceptional reported earnings, its stock price still faced a decline

As of the second quarter of fiscal 2024, NVIDIA reported a record $13.51 billion in revenue, boasting a staggering quarter-over-quarter growth of 88% and a year-over-year growth of 101%. The company's data center, heavily tied to artificial intelligence, saw revenue soar by 141% quarter-over-quarter and 171% year-over-year, accumulating a staggering $10.32 billionFollowing this earnings announcement, NVIDIA's stock initially surged nearly 3.2%, with after-hours trading pushing its gains as high as 10%.

However, an overly optimistic market often leads to a backlash

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On the 25th, NVIDIA's stock experienced an initial spike but soon succumbed to profit-taking, closing with a meager gain of only 0.10%, which contributed to a wider sell-off in the U.Smarket

Despite NVIDIA's strong performance and optimistic projections failing to maintain momentum in the U.Smarkets, uncertainty looms with Federal Reserve Chair Jerome Powell's public speech slated for this weekFurthermore, this environment raises concerns for ARM, which has recently filed plans for its IPO and is expected to list later in mid-September

Both ARM and NVIDIA share comparable monopolistic standings in the tech landscapeFor instance, ARM's CPU architecture is the most widely used globally, being integral to more than 95% of smartphones

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With their leading technological advantages, including low costs, reduced energy consumption, and a robust ecosystem, major players such as Apple, Huawei, and Microsoft have all become loyal clients to ARM

These two firms dominate their sectors, but the question arises regarding how ARM's potential profitability might play out amidst the existing economic policy pressures and volatile U.SmarketsFurthermore, whether now presents a more auspicious entry point for AI stocks remains to be comprehensively analyzed

1. The Battle of Masayoshi Son

ARM is the second most notable investment for Masayoshi Son, the founder of SoftBank, with the first being the nearly liquidated Alibaba

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At one point, SoftBank held a 34% stake in Alibaba and emerged as the largest shareholderThis investment resulted in an extraordinary return on investment when Alibaba went public, resulting in a valuation that skyrocketed nearly 3,000-foldDue to his keen eye for investment, Son is often referred to as the "Asian Buffett."

However, in recent years, Son has transitioned from a partner in adversity to a figure leading the assault against Alibaba amid tough times for Chinese internet stocksIn 2022 alone, SoftBank sold off $29 billion worth of Alibaba shares, and in April of this year, slashed $7.2 billion in additional stakes, reducing its ownership from a peak of 34% to merely 3.8%. Son's misfortunes seemed to multiply as the decline in his investments brought considerable losses to SoftBank

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The investment firm reported staggering losses, leading to a downward spiral where they were forced to liquidate quality investments, starting with Alibaba

While Son had been celebrated as the "Asian Buffett" during his investment in Alibaba, outside of Alibaba, he had become a sinkhole for investmentsSoftBank has been reeling from consecutive years of significant losses, and its core fund business has seen near stagnationThis has made ARM's upcoming IPO critical for both SoftBank's future and the growth prospects of ARM itself

Recently, SoftBank acquired a 25% stake in ARM from its Vision Fund, with an estimated valuation just above $64 billion

On August 21, the group officially submitted its IPO filing with the SECGiven the previously mentioned stake transaction price, this IPO is poised to become the largest IPO on U.Sexchanges this year and may even rank among the largest tech IPOs in historyFor Son, while he may not reclaim the title of "Asia's Buffett," the goal valuation for ARM might help extricate his firm from the investment vacuum and restore his reputation

However, prior to the IPO, ARM could have belonged to NVIDIA entirely

In February 2022, during a financial results briefing, Son disclosed the reasons for abandoning the sale of ARMOriginally, there was a plan to sell ARM for up to $40 billion, where two-thirds would have involved a stock swap with NVIDIA, bringing total valuations to over $80 billion

However, facing intense pressure from global regulators and other semiconductor companies, Son stated that he never anticipated such fierce opposition, leading NVIDIA to abandon its acquisition plans at that time

Despite the backlash, companies that had initially applied pressure on the acquisition began transforming into cornerstone investors in the upcoming ARM IPOTech giants like Microsoft, Google, Qualcomm, Intel, Apple, and TSMC are currently in discussions with SoftBank regarding the IPOInterestingly, NVIDIA has reappeared among these discussions after a long absence

Whether in opposition to the merger or active participation in the IPO, the attention from top corporations underscores ARM's distinctive monopolistic hold in the tech market

2. Monopolistic Position

ARM primarily focuses on designing RISC CPUs (Reduced Instruction Set Computing), unlike Intel, which produces CISC CPUs (Complex Instruction Set Computing). Intel's CISC CPUs tend to have greater performance and higher prices, thriving during the personal computer eraIn contrast, ARM's RISC CPUs boast lower power consumption and costs, making them ideal for small mobile devicesBusiness-wise, rather than manufacturing chips like Intel—limiting itself primarily to the PC sector—ARM opted to license its RISC CPU technology to clients, spreading its market reach and minimizing risk

What does IP licensing involve? The chip design process can be likened to constructing a cityARM sells processor IPs—which constitute about 80% of its total revenue—acting similarly to essential infrastructure systems like sewage, communication, and electricity in urban developmentJust as every building—be it commercial, residential, or healthcare—must have these basic systems, companies like NVIDIA and AMD must first pay ARM to access these IP systems to design their own products in established infrastructure

With the end of the personal computing boom, the explosive growth of consumer electronics dominated by smartphones allowed ARM to swiftly expand its market, cementing its monopoly

As of December 31, 2022, ARM's processors powered 99% of smartphones worldwide, representing over 25 billion chips, which drive everything from the smallest sensors to the most powerful supercomputersAccording to ARM's estimates, around 70% of the global population utilizes products based on its technology, with chip shipments for architectures based on ARM exceeding 30 billion during the financial year ending in March 2023—a nearly 70% increase compared to March 2016.

To maintain its technological dominance, ARM possesses a portfolio of about 6,800 issued patents, many of which pertain to key technologies utilized in countless manufactured chips today

The company is progressively increasing its research and development investments to broaden its product rangeAs of the fiscal year 2023, ARM's R&D expenses totaled $1.133 billion—a significant rise from $995 million in 2022 and $814 million in 2021. In addition, ARM has also ventured into the GPU sector, launching its flagship GPU product, Immortalis-G715.

As an upstream design vendor in the chip industry, ARM's products are actively employed by downstream firms in various niche marketsBy 2022, ARM captured market shares of 10.1% in cloud computing, 25.5% in networking, 40.8% in automotive, and 32.3% in consumer electronicsIn 2022 alone, the total value of chips incorporating ARM technology reached approximately $98.9 billion, yielding a market share of roughly 48.9%, up from 42.3% in 2020.

According to market research by Precedence Research, the global semiconductor market size was $591.8 billion in 2022 and is expected to reach approximately $1.8837 trillion by 2032, marking a compound annual growth rate of 12% during the forecast period from 2023 to 2032. However, amidst such a vast total market value, how much profitability can ARM secure? Are the promising double-digit annual growth rates reflected in ARM's performance acceleration? These two questions have become increasingly concerning following NVIDIA's failure to acquire ARM

3. The Controlling Shareholder is Not NVIDIA

After the recent buyback of 25% of shares, SoftBank now owns a 100% stake in ARM, which has initiated its IPO process, anticipating listing on a U.Sexchange in late SeptemberInterestingly, while this IPO aims to raise funds for SoftBank by selling 10% of ARM's existing shares—expected to generate between $8 billion to $10 billion—the proceeds will not directly produce new cash flow for ARMInstead, the funds will flow into SoftBank's coffers, already in need of cash after significant losses

Despite its significant monopolistic position, several investors have raised concerns about the IPO, particularly regarding its valuation, current performance, and potential risks within the Chinese market—issues that could greatly influence investor confidence

According to disclosures pertaining to the IPO, ARM's revenue for fiscal 2023 was $2.68 billion, slightly down from $2.7 billion in fiscal 2022, with a net profit of $524 million, a decline from $549 million year-on-year, albeit with a high gross margin of 96% and an operating margin of 25%.

In the past year, the company's growth metrics have not been particularly impressive

Might ARM's situation have been different had it been absorbed by NVIDIA? Direct orders and support from NVIDIA could have provided ARM with strong growth opportunities rather than the current scenario where revenues and profits are in decline

Adding to the concerns, SoftBank assigned ARM a valuation exceeding that of NVIDIA

Following NVIDIA's remarkable earnings report this Wednesday, the company's PE ratio slipped to around 40 times relative to expected profitsContrarily, SoftBank proposed a valuation for ARM between $60 billion to $70 billion, despite it currently having annual profits only in the single-digit millionsThis puts ARM’s PE over 100 times, coupled with a year-on-year decline of 2.5% in its latest quarterly revenues, demonstrating an unclear pathway for performance growth

In addition to pre-existing financial performance declines, ARM also faces potential risks tied to its largest sales market, China

As of the fiscal year ending March 31, 2023, and 2022, revenue from ARM China comprised approximately 24% and 18% respectively of total revenue, marking it as the company's largest marketARM China primarily re-licenses ARM's processor technology under IPLA, generating revenue from licensing and chip salesWhile total revenue from ARM in China has increased year-on-year, the growth during 2022 to 2023 was likely influenced by Huawei's removal from the entity list—indicating that international political dynamics pose significant challenges for ARM's sales outlook in ChinaThis raises concerns about a continued decline in revenue generated from that region

Hence, despite ARM's robust market monopoly, elevating profitability and minimizing risks is essential for justifying its valuation; ultimately, only strong profit generation will determine ARM's capability to deliver investment returns

Jokingly, one might suggest that ARM, currently boasting annual profits of around $500 million, perhaps needs NVIDIA’s H100 GPUs to propel its growth trajectory and endeavor to catch up to the proposed $60 billion valuation

4. Conclusion

In the IPO documentation submitted to the SEC on August 21, SoftBank discloses an extensive underwriting team including Barclays, Goldman Sachs, and JPMorgan, yet conspicuously absent are cornerstone investors such as NVIDIA, Intel, and Apple, who have reportedly engaged in discussionsThis raises the question of ARM's precise shareholder structure and the specific investment amounts—essential factors that may heighten market uncertainty and impact investor perceptions regarding ARM's valuation

Some market perspectives suggest that ARM's valuation could align closer to EDA software developers where, as of August 21, Synopsys boasted a dynamic PE of 65 times, whereas Cadence held a dynamic PE of 69 timesThus, it could be argued that ARM's valuation should be adjusted downward to $34 billion

It is clear that evaluating ARM amidst the ongoing AI boom presents a situation where its valuation may not come cheap, but whether the initial trading prices reflect investor sentiment remains ambiguousConservative investors might find it prudent to await more defined corporate strategies in AI development or a lower valuation before making any further investment choices.