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What Can Arm Holdings Do For Nvidia?

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Nvidia  (NVDA) - Get NVIDIA Corporation Report shares popped on the acquisition, the different factors of which could have a positive impact on Nvidia. Here are the pro’s, cons and what to expect going forward.

The stock rose as much as 7% Monday to above $510 a share after the deal was announced.

On the surface, the deal looks like a pure boost to Nvidia’s business and stock. Nvidia had a market cap of just under $300 billion entering Monday and the semiconductor innovator bought the profitable Arm Holdings from SoftBank for $40 billion, which is about 13% of Nvidia’s market cap. But Nvidia is using $21.5 billion of stock in the transaction and just $12 billion in cash, issuing a number of shares that is equal to 7% of Nvidia’s outstanding shares. The additional shares issued means some share dilution for Nvidia investors, but marginally so. Plus, the stock had popped a bit in August on the possibility of the deal and the stock gain did moderate throughout the day Monday. Nvidia has more than $13 billion of cash on its balance sheet and analysts aren’t worried, as the company is expected to generate more than $5 billion of free cash flow annually over the coming few years and it has more cash than debt. There is a $5 billion earn-out, meaning if Arm hits specified financial targets, Nvidia will pay the amount to SoftBank investors.

The reason the deal is immediately positive for the stock is indeed because the deal is “immediately” accretive to Nvidia’s earnings analysts say. Arm generated about $1.9 billion in revenue in 2019. Analysts at Alliance Bernstein expect that to grow and add about 9% to Nvidia’s $20 billion-plus revenue stream in 2022. Arm’s gross margin of 95% drastically increases Nvidia’s current gross margin of 65%, although Arm’s operating margin has been far from impressive. Overall, many analysts see this as accretive to net income. Needham & Co. analyst Rajvindra Gill says so in his note, while Alliance Bernstein’s analysis shows that Arm’s poor operating margin will only add 2% to Nvidia’s net income. Mixed in with the added shares for the combined company, Bernstein says 2022 EPS could be diluted by 5%.

But Arm is viewed as a growth company -- anyone can see Arm's valuation is about 20 times sales -- and there could be upside to estimates. Bernstein sees no immediate or material synergies.

Aside from upside to earnings and synergies, there are some positives the deal adds. So far, it has been additive to Nvidia’s valuation in the near-term.

Longer-term, "Strategically, we believe there are several advantages," Gill said. “In the near-term, Arm IP is ubiquitous in the mobile phone and tablet markets,” he added, noting the Arm has been taking about 95% market share in the “main" chip components for smartphones, which may come as a surprise to some, considering the size of the global smartphone market and Arm’s revenues. Clearly, Arm is tethered to the 5G cycle, which could have some upside, although 2021 is expected to be the explosive-growth year for the product cycle. The vast majority of Arm revenue is derived from its smartphone business and it has been growing royalties per chip. But the company has recently seen about 12% of its revenue come from the still-young, but growing segments in cloud and data center as well as automotive (cars are increasingly software-driven). Gill sees potential synergies to the deal down the road, but those are not yet obvious. For now, Nvidia does already have a data center (cloud-correlated) business, as well as an automotive business, so increasing a little market share doesn’t hurt.

There are a few major negatives to this deal, one of which is potential anti-competitive regulation from various bodies. But it’s also possible Arm isn’t all it’s cracked up to be. Against its lofty valuation, "With the exception of an immediate 5G upgrade cycle, it [Arm] does not represent a secular growth market, as we see it,” Gill said.

Bernstein analyst Stacy Rasgon wrote in a note, "our initial reaction when this newsflow began picking up several months ago was to hope [CEO] Jensen [Huang] would not go through with it,” but that "we have to sort of admire the boldness of the action; we're inclined to grant the benefit of the doubt. NVDA indicates they will maintain Arm's neutral, open-licensing model. That being said, if they can pull it off NVDA's dominance will be extended into virtually every important compute domain which has undeniable strategic value, giving the company the opportunity to potentially differentiate along that path through ownership in ways that they could not if they were simple licensees.”

The point: this deal could be nice one, but some may scrutinize where else Nvidia’s cash could have been more productive.

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