Last Friday, Bloomberg reported that Nvidia (NASDAQ:NVDA) is in talks to buy Arm, the chip designer Softbank (OTCMKTS:SFTBY) took private in 2016 for $32 billion. The cash-and-stock deal could cost Nvidia around $55 billion, according to Hans Mosesmann, an analyst at Rosenblatt Securities. If successful, NVDA stock holders would cash in on one of the largest tech acquisitions in history.
Markets shrugged at the news, with Nvidia stock closing flat for the day on average trading volume. Investors, however, should pay close attention to how the deal plays out.
A successful merger between the world’s largest graphics processing unit (GPU) and the largest mobile chip designer will create an industry behemoth. An unsuccessful tie-up, on the other hand, could cost shareholders dearly.
The high-risk, high-reward situation makes Nvidia ideal for active investors with a quick trigger finger. Conservative and passive investors might find better value elsewhere.
NVDA Stock Needs Growth
Softbank’s asset sale could not have come at a better time for stock holders in NVDA. The chipmaker, which controls the majority of the world GPU market, has seen increased competition from freshly revived rival AMD (NASDAQ:AMD). According to industry tracker JPR, Nvidia’s market share sank from 81.2% in fourth quarter 2018 to 68.9% in Q4 2019.
Further declines may be on the way. As earlier reported on InvestorPlace, AMD’s recent 7nm chipset technology has created major headaches for the stalwart’s older 12nm technology. While Nvidia still holds the crown in many higher-end GPU categories, AMD’s entrants into the middling $400-$600 price range have more than doubled the company’s market share in recent years. In 2Q19, AMD shipped more graphics cards than Nvidia for the first time in five years.
The competition puts Nvidia in an awkward position. For over a decade, Nvidia led in the race for high-performance GPUs, the favored processor of the newly emerging world of artificial intelligence (AI).
However, AMD’s entrance into affordable GPUs suddenly puts Nvidia’s high stock valuation at risk. (NVDA currently trades at 64.4x EV/EBITDA, compared to its ten-year average of just 18x EV/EBITDA). And that’s where a savvy purchase of Arm might help.
Arm Might Bring Much-Needed Growth
Arm is far from a household name — few people outside the industry have ever heard of the company. Arm’s chip designs, however, are a part of everyday life. That’s because chip architecture is so complex that even chip makers like Intel (NASDAQ:INTC) and Qualcomm (NASDAQ:QCOM) outsource the job to a specialist like Arm. Today, Arm generates $1.9 billion from licensing its designs in everything from PCs to refrigerators. Over 90% of all smartphones and a third of all networking equipment run at least one Arm-designed chip.
In 2016, Softbank took the company private in a massive $32 billion deal. Softbank’s CEO, Masayoshi Son repeatedly called Arm his “crystal ball.” Masayoshi referenced the fact that virtually all tech companies rely on Arm’s intellectual property to build their chips, which are often developed years before the final product.
Now Nvidia’s management wants in. While Nvidia has dominated the PC and server GPUs market, it has poorly lagged in mobile applications. AMD’s energy-efficient 7nm chips further threaten Nvidia’s position in mobile computing.
To power its next phase of growth, Nvidia needs Arm.
Will Nvidia’s Buyout Work?
Here’s where investors should worry. That’s because there’s one open secret in the mergers and acquisitions (M&A) world: companies typically overpay for acquisitions. And Arm’s estimated $55 billion price tag looks no different. At 29x sales, the acquisition would value Arm almost three times higher than HP’s 2011 acquisition of Autonomy.
While Nvidia can use its highly-valued shares as currency to offset some costs, the cash-and-stock deal will also see a significant cash transfer from Nvidia to Softbank. With just $15 billion cash on hand, Nvidia will need to raise substantial capital to execute the deal. And taking on the debt would put its A3 credit rating at Moody’s at significant risk for downgrade.
There’s more bad news for Nvidia shareholders: Softbank is keeping some of the best parts of Arm for itself. In July, Arm announced it would spin off its two Internet of Things (IoT) Services Group to the parent company. In other words, the IoT Platform and the (aptly named) Treasure Data segments will remain off-limits to any would-be suitor. It’s also unclear whether Nvidia will receive Arm China, a Chinese joint venture, as part of the deal.
And IoT is one of the best growth engines at Arm. The company currently has a 90% market share for IoT devices, a segment estimated to grow 20%-22% annually.
Bottom Line on Nvidia’s Arm Acquisition
What will Nvidia get? The company stands to gain three things.
Firstly, the company will gain a pathway into the mobile phone market. Access to chip designs may help Nvidia break into a market long dominated by Qualcomm, MediaTek and Samsung Electronics (OTCMKTS:SSNLF).
Secondly, Nvidia will get a foothold in the emerging self-driving vehicle space, a fast-growing industry the company has long eyed.
Finally, the company will gain access to the “crystal ball” that Masayoshi Son at Softbank once paid $32 billion to acquire. With a broader base of intellectual property, a combined Nvidia and Arm may finally break into data, servers and cloud services, the stronghold of Intel.
Is management up to the task of integrating two industry behemoths into an even larger entity? Only time will tell. Investors, meanwhile, stock holders in NVDA will have to remain vigilant.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing. As of this writing, Thomas Yeung did not hold a position in any of the aforementioned securities.