The Real Reason Nvidia Is Buying SoftBank's Arm

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Nvidia  (NVDA) - Get Report is buying SoftBank’s Arm Holdings at an arguably lofty price, especially considering the apparent growth-profile of the company. After Nvidia Founder and CEO Jensen Huang spoke to analysts, the rationale behind the deal became much clearer.

First off, here are the deal details and how Nvidia shares have recently traded:

Nvidia is buying Arm for $40 billion with $12 billion of cash, $21.5 billion of stock and a $5 billion earn-out. Many analysts see the deal as immediately accretive to earnings, as Arm will see revenue of close to $2 billion in the next year or so. While it lost money in recent quarters, it is generally a profitable company. Some analysts think the immediate earnings impact could be mildly dilutive to earnings per share because of the new shares issued in the transaction. Nvidia has a sturdy balance sheet with limited debt and generates several billions of dollars in free cash flow every year.

The stock rose about 5% the day the deal was announced this month, but has been recently caught up in the volatility in tech stocks, which is centered on an apparent valuation re-rating of growth companies. Many at-home services are seeing accelerated customer adoption, which may be pulling forward demand. Nvidia’s data center business, which powers cloud services, is a part of that re-rating.

The total price Nvidia is paying for Arm represents roughly 20 times forward sales estimates, a large valuation even compared to many well-known growth tech stocks in the U.S. today. After several years of solid growth, Arm's grew revenue at just over 3% in 2019. More than 80% of the company’s revenue has been derived from smartphones, which is no longer a fast-growing market. About 12% comes from other businesses, including data center. Arm usually takes about 95% of the market for its specific type of chip. This gets Nvidia exposed to smartphone at a lofty price, but this deal, according to analysts, is actually about the data center business, not anything else.

After Huang spoke to analysts about the deal, it became crystal clear this deal was highly strategic and centered on future developments that many people who are not Hunag cannot see.

Huang believes the entire infrastructure of the data center business — the chips of which power cloud software — is soon to change dramatically, Alliance Bernstein analyst Stacy Rasgon told TheStreet. Huang wants to remain competitive in making the best chips for data centers and Nvidia management believes “ARM is going be big in data center,” Rasgon said. The data center market is regarded as a growth one as businesses and consumers adopt the cloud. “They [Nvidia] thought the best way for them to capture that value was to own that ecosystem,” Rasgon said. This would unlock the ability for Nvidia to use its existing tech capabilities to enhance Arm’s offerings so the company can take meaningful market share in data center.

Analysts at Needham & Co. agree with Rasgon. "In order to process the next wave of heterogeneous workloads required by AI, we believe a multi-processor and multi-architecture framework will be paramount,” Gill wrote. "By having a cohesive platform of chips and SW that bridges the edge Internet of Things and data center together will be very valuable.” Nvidia can now "target the "trillions" of devices that will be connected to the data center.”

Gill raised his price target on Nvidia to $700, representing more than 40% upside from the stock’s current level of $484, for a market cap of almost $300 billion. Analyst Rajvindra Gill hasn’t yet raised near-term earnings estimates -- he writes in his note that he will -- but says Arm could add roughly 12% upside to Nvidia’s long-term eps power of about $12. Nvidia’s eps is expected to come in at around $9 for 2021, which implies a 53x multiple. Assuming a slightly lower multiple on earnings -- maybe 50X according to some analysts -- by the time the company gets to the higher earnings level with Arm, the stock could soon trade at close to that $700 level.

The point: the deal is a long-term play, engineered by the technology visionary, Huang. Rasgon said he has no regard for the near-term earnings impact and that Arm may very well be worth close to $40 billion under Nvidia’s roof. 

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