NVIDIA's (NASDAQ:NVDA) proposed acquisition of SoftBank Group's subsidiary Arm Limited for up to $40 billion in cash and stock will have a major impact on the semiconductor industry. Here are three things for investors to note.
1. NVIDIA on steroids
Over the last several years, NVIDIA has been growing its data center business. It adapted its graphics processing unit (GPU) technology to enhance the performance of servers' central processing units (CPUs) and with its recent acquisition of Mellanox, it expanded its footprint with networking capabilities. As a result, during its fiscal quarter ended in late July, revenue from its data centers segment reached $1.75 billion, which represented 45% of total revenue, up from 25% in the prior-year quarter.
By acquiring Arm, NVIDIA aims to complement its data center offering by integrating its GPU and artificial intelligence (AI) technologies with Arm's CPU designs. "Uniting NVIDIA's AI computing capabilities with the vast ecosystem of Arm's CPU, we can advance computing from the cloud, smartphones, PCs, self-driving cars and robotics, to edge IoT, and expand AI computing to every corner of the globe," NVIDIA CEO Jensen Huang was quoted as saying in a press release.
Last year, NVIDIA announced it was integrating with Arm's CPUs, but owning the chip designer will allow NVIDIA to fully commit to integrating solutions while leveraging significant synergies. For instance, NVIDIA's software platform should boost the adoption of Arm-designed CPUs in data centers while Arm's research and development capabilities will profit from NVIDIA's platform and infrastructure to develop data center solutions.
And there's more.
Arm licenses its technology (it doesn't manufacture any chip) to other companies for them to build CPUs and chips that run on all sorts of devices, such as smartphones, tablets, and cars. In total, 180 billion Arm-powered chips have been shipped so far -- 22.8 billion in 2019. NVIDIA plans to leverage that phenomenal ecosystem by integrating its technology and licensing it, which could create significant revenue growth opportunities beyond data centers.
Huang estimated that the acquisition will double NVIDIA's total addressable market to $250 billion.
2. Transforming the competitive environment
By selling Arm's technology, NVIDIA's position will become tricky, as the company will supply competitors such as Intel and Advanced Micro Devices.
Granted, semiconductor giants already compete and partner. For instance, NVIDIA equips its new AI system DGX with AMD's EPYC processors. And Huang promised to keep competition fair by retaining Arm's "neutral" licensing model, which consists of dealing with customers independent of competitive forces. That decision makes sense: NVIDIA will benefit from greater synergies as Arm attracts more customers.
Yet it remains to be seen how competitors will respond to the proposed acquisition in the context of intensifying competition in the data center market. With the acquisition, NVIDIA will threaten Intel's CPU-dominant position while Intel's GPU Xe will challenge NVIDIA's GPU leadership. Add AMD to the mix, and in the medium term, NVIDIA, Intel, and AMD will compete for integrated CPU and GPU solutions in data centers.
Given these competitive implications, regulatory approval of the deal by the U.K., U.S., EU, and Chinese authorities remains uncertain. Management's commitment to Arm's customer neutrality should favor a positive outcome, but nothing guarantees regulators will accept such an ambiguous situation. Moreover, tensions between the U.S. and China still represent a non-negligible risk as Chinese authorities may seek to gain negotiating power by opposing the deal.
3. Smart financing
If approved, the huge deal won't put NVIDIA's balance sheet at risk.
The transaction is structured as follows:
- $12 billion in cash, including $2 billion at signing and the remaining $10 billion at the close of the deal.
- 44.3 million shares of NVIDIA common stock valued at $21.5 billion. That number of shares will dilute existing shareholders by increasing the number of shares outstanding by 7.2%.
- Up to $5 billion in cash or common stock, depending on performance criteria that have not been communicated.
- $1.5 billion in NVIDIA stock to Arm employees at the close of the transaction.
Thanks to its solid balance sheet and the equity part of the deal, NVIDIA won't need extra debt to finance the transaction that is valued at $40 billion, assuming performance criteria are met.
The company will pay a large part of the cash component with the $10.9 billion of cash, cash equivalents, and marketable securities it had accumulated by the end of the last quarter. Free cash flow should cover the rest of the cash obligations when the deal closes, which it is expected to do by March 2022. Management didn't provide free cash flow guidance, but last year's free cash flow of $4.3 billion suggests cash won't be an issue. However, with this transaction, NVIDIA will give up the safety net and the dry powder its large cash position represents.
In addition, NVIDIA will use its shares as a strong currency to finance the non-cash part of the deal. NVIDIA's rich stock price -- 90 times trailing-12-month earnings -- mitigates the high valuation of the acquired assets. Given Arm's trailing-12-month revenue of $1.8 billion and EBITDA margin of 35%, the agreed transaction corresponds to 22.2 times sales and 63.5 times EBITDA. Those valuation ratios seem elevated, even when you consider NVIDIA's attractive integration opportunities with Arm's growing business, so financing a significant part of the transaction with NVIDIA's richly valued shares compensates for that steep valuation.
During the regulatory process that could last until March 2022, investors should observe whether NVIDIA's competitors will be looking for alternatives to Arm's CPUs. Beyond that risk, NVIDIA shareholders should welcome the acquisition of Arm, given the significant long-term growth opportunities it represents.