China risks cast cloud over Arm IPO

Investors anticipating this year's biggest IPO on the Nasdaq exchange may have to curb their enthusiasm after microchip design firm Arm revealed the many risks it faces in China, which contributes almost a quarter of its revenues.

In the 229-page prospectus it filed last week with the US Securities and Exchange Commission in preparation for the IPO, the UK-based company, owned by SoftBank, used over 3,500 words to elaborate on the problem in detail.

Set as early as next week, Arm's second public debut reportedly planned to shore up between $8 billion and $10 billion from the IPO based on a valuation of between $60 billion and $70 billion, but is now expected to raise less capital.

Arm's internal issues concerning its China business, and escalating US sanctions, are complicating its upcoming IPO.
(Source: Cseh Ioan/Alamy Stock Photo)

Arm is one of the most important chip companies in the world, selling licenses to an instruction set at the heart of nearly every microprocessor that powers smartphones, IoT devices, PCs and servers. In its SEC filing, the company estimates "approximately 70% of the world's population uses Arm-based products."

Problematic ties with Arm China

In a nutshell, Arm said the majority of its risks in China come from its fractured relationship with Arm Technology (China) Co. Ltd., an independent entity that distributes Arm technology to local chipmakers and collects royalties on its behalf.

Arm China serves as the company's gateway to the massive Chinese smartphone market. Arm China, listed as Arm's biggest customer, generated virtually all sales amounting to 24.5% of the latter's $2.68 billion revenue in fiscal 2023.

"We granted Arm China certain exclusive rights to sublicense our IP to PRC customers. We expect that our licensing relationship with Arm China will continue to account for substantially all of our total revenues from the PRC and represent a significant portion of our revenues for the foreseeable future. It would be difficult for us to replace any lost PRC-sourced revenue in the event that our commercial relationship with Arm China were to terminate or deteriorate," said Arm in its IPO filing.

The bond between the two companies is far from smooth.

Last year, SoftBank and Arm, along with other shareholders, ended a two-year battle for control of Arm China – ousting its local chief executive over allegations of conflicts of interest. The board room dispute is still the subject of ongoing lawsuits.

Still, it is unclear which shareholders control Arm China.

According to the prospectus, neither SoftBank nor Arm has control of the company. Arm has a 4.8% indirect holding in Arm China through its 10% non-voting interest in Acetone, a joint venture with SoftBank. Acetone owns 48% of Arm China and is the largest shareholder of the company. The rest of the shares are held by a group of Chinese investors and a private equity firm.

The prospectus also flagged Arm China's history of late payments. "In the past, we have received late payments from Arm China and have had to expend company resources to obtain payments from Arm China," Arm said.

In its latest financial statement for the fiscal year ended March 31, 40% of accounts receivable were attributed to China, indicating that Arm has not been paid for all products sold in China.

Furthermore, Arm also warned its Chinese partner-turned-customer could evolve into a competitor. While Arm China has agreed not to develop its own microprocessor cores, it has been developing its own IP that could compete with Arm in areas such as AI.

Airing 'dirty laundry'

Observers noted the company's exposure in China is not unique to Arm.

Apple, one of Arm's biggest customers, gets about 20% of its revenue from the country. Two leading US chipmakers Qualcomm and Media Tech sell a lot of chips to Chinese customers, while Intel also sourced over a quarter (27%) of its revenue from China last year.

"Nearly all semiconductor firms have troubling exposure to China, but Arm's problem is that they have had to air their 'dirty laundry' in an IPO prospectus," Woz Ahmed, a former senior executive at UK-based Imagination Technologies, a semiconductor design and intellectual property company, told South China Morning Post.

"What happens next depends on how people feel Arm can grow outside China. It is not clear cut. This will impact valuation," he added.

Economic and political risks

Besides the lack of oversight over its China business, Arm also said it was "particularly susceptible to economic and political risks affecting the PRC, which could be exacerbated by tensions between the US or the UK and the PRC with respect to trade and national security."

Like many foreign technology companies with fingers in the China pie, Arm is caught in the middle of escalating tension between China and the US.

According to Reuters, Arm's IP distribution business faces mounting challenges from US sanctions restricting sales of advanced technology to China. Arm reportedly lost at least $63 million in royalty revenue in its most recent fiscal year.

It is unlikely these US sanctions will taper off in the foreseeable future. Early this month, US President Joe Biden signed an executive order restricting US investments going to China. The executive order specifically covers the areas of advanced semiconductors, microelectronics, quantum information technologies and AI.

"The order seeks to blunt China's ability to use US investments in its technology companies to upgrade its military while also preserving broader levels of trade that are vital for both nations' economies," reports said.

The executive order is expected to go into effect next year.

Meanwhile, Arm said China's drive to be self-sufficient in chip manufacturing could slow its growth in the market. Eight years ago, the Chinese government set a target of having up to 70% of chips locally produced by 2025.

All these issues are casting doubt on Arm's long-term growth trajectory in China, and they are putting some investors on the fence.

"They are asking the market to buy what they admit are some big China risks but at Nvidia multiples, and that will take some effort," a fund manager told the Financial Times.

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— Gigi Onag, senior editor, APAC, Light Reading