NVIDIA's (NVDA 3.51%) proposal to acquire Arm for $40 billion in a combination of stock and cash puts an exclamation point on NVIDIA's recent history of savvy capital allocation. 

Arm brings several benefits to NVIDIA's accelerated computing platform. It's one of two value-enhancing deals NVIDIA made this year, the other being Mellanox, that cements NVIDIA's competitive position in the data center market. The best part about the Arm deal is that NVIDIA pounced at an opportunistic time, using its highly-valued stock as currency to acquire one of the most dominant technology companies in the world.

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NVIDIA is very opportunistic with its capital

NVIDIA has spent the last five years building up cash on its balance sheet, almost as if it was waiting for an opportunity to make a game-changing acquisition to widen its competitive moat. 

From fiscal 2005 through fiscal 2015, NVIDIA returned approximately 70% of its free cash flow to shareholders through dividends and share repurchases. The repurchases increased in 2008 when the stock price fell sharply during the Great Recession that year. Share buybacks were paused for a few years between fiscal 2010 and 2012 before picking up again in 2014.

NVDA Market Cap Chart

Data by YCharts.

Usually, when companies accelerate their share repurchase activity, it's because management believes the stock is undervalued. NVIDIA stock has soared 1,900% since 2015, showing management knew a good deal when it saw one. After using a good portion of its free cash flow for share repurchases through fiscal 2015, NVIDIA then let the cash pile up on its balance sheet as the stock's valuation rose. Entering 2020, NVIDIA's net cash stood at $8.9 billion.

Striking while the iron is hot 

The proposed acquisition of Arm will be financed with $12 billion in cash and $21.5 billion in NVIDIA stock. Arm's parent company, SoftBank Group (SFTBF 1.46%) (SFTB.Y 1.94%), may receive an additional $5 billion in cash or common stock if certain performance targets are met, and NVIDIA is issuing $1.5 billion in equity to Arm employees.

"We believe the proposed acquisition of Arm is an outstanding use of cash," NVIDIA CEO Jensen Huang said on a conference call about the acquisition.

However, some might question the hefty price tag NVIDIA is paying for Arm, but it seems a fair price considering what NVIDIA is giving up. NVIDIA stock trades at a trailing price-to-earnings ratio of 90 as of this writing, which is quite high for a semiconductor stock. With such a high valuation, issuing stock is a smart approach to finance the deal.

The deal won't close for 18 months, so it's possible that NVIDIA's valuation could be lower by that time, but it's unlikely NVIDIA stock is going to suddenly lose steam with so much growth happening in its largest business segments like gaming and data center. The financing arrangement keeps the balance sheet free of excess debt, allowing NVIDIA to use its stock as currency to score a leader in chip design that will significantly expand the company's addressable market.

Widening the competitive moat

NVIDIA will have to overcome regulatory hurdles in getting approval for the deal, but both parties expect that will happen.   

Arm's chip design is in 90% of smartphones, which means most consumers come in contact with Arm products without realizing it. Arm will expand NVIDIA's developer reach from two million to 15 million. It will also provide Arm customers access to NVIDIA's artificial intelligence and graphics processor intellectual property. This will allow NVIDIA's GPU and AI technology to expand to the mobile market, in addition to PCs. 

Overall, NVIDIA is significantly increasing its addressable market and making good use of its pricey stock. What's more, NVIDIA expects Arm to be immediately accretive to adjusted earnings per share after closing the transaction.