Deep Dive: Arm Ltd
Can the global powerhouse in chip design live up to its hype?
Arm is a semiconductor IP company with an extensive influence in global chip design. Arm’s designs have long been the global standard for mobile devices. Every time you pick up your smartphone or use a connected device, there's a good chance you're engaging with Arm’s IP. It's estimated that ~70% of the world’s population interacts with Arm technology on a daily basis.
Arm has accelerated its growth investments since Softbank took ownership of the company in 2016. These efforts are now bearing fruit, with Arm gaining share in key sectors like cloud, automotive, and IoT.
As value investors, we don’t often participate in IPOs. Instead, we view them as an opportunity to study a business deeply and to build conviction, so that, when the time is right, we can act decisively. The semiconductor industry is always highly dynamic, and through all of this, we believe Arm is on the right side of change. In fact, we believe it is one of the highest quality companies in the world.
With Arm’s impending IPO this year, our goal here is to help investors stay informed and ahead.
This report delves into:
Arm’s origins and its significance in the semiconductor industry
The company’s evolution under Softbank
Arm’s licensing and royalty structure
The competitive environment, highlighting Arm’s advantages
Arm’s positioning and growth in new segments, including cloud and autos
Arm’s weaknesses, challenges, and risks
Thoughts on Arm’s valuation and where we would buy the stock
Our insights are sourced from interviews with experts, including former Arm employees, competitors, and other industry figures. We believe these discussions have yielded a fresh, in-depth perspective on Arm.
Arm was founded in November 1990 as Advanced RISC Machines Ltd. Arm began as an in-house project within a UK company called Acorn Computers to design chips utilizing a particular architecture known as RISC (Reduced Instruction Set Computing).
Acorn is not around anymore, but back in the day, it was best known for a computer called BBC Micro (below image, left) which found extensive use in the UK public schools during the 1980’s. To serve the needs of schools, Acorn aimed to build computers that were small, cheap and power efficient. The RISC chips were optimal for these criteria.
Acorn teamed up with a company in Silicon Valley called VLSI Technology, and later with Apple, to further develop RISC technology. At the time, Apple was working on its handheld computer Newton - an early form of PDA and a precursor to modern tablets (above image, right). In search of a low-power, cost-effective chip, Apple became interested in the RISC design. However, Apple was wary about relying on a competing firm for technology. Hence, the three companies - Acorn, VLSI, and Apple - agreed to establish Arm as a separate entity, to be carved out of Acorn, and jointly owned by the three parties.
Arm became a listed company in 1998 on the London Stock Exchange. It enjoyed modest success in the handset market, which was still nascent at the time, but struggled to gain traction in the much larger PC market which Intel came to dominate. Arm was a niche player in the early years of its existence.
The company’s trajectory shifted dramatically with the rise of smartphones. The release of the iPhone in 2007, which utilized Arm-based processors, kickstarted a new era. By the 2010’s Arm had essentially monopolized the smartphone market.
In 2016, Softbank bought out Arm for £24 bn (or $32 bn) and took it private.
Arm’s role in the industry
Arm is not a chip manufacturer. It creates intellectual property (IP) in the form of technology designs, which are licensed to chip designers.
One way to understand Arm's contribution to the semiconductor industry is through its role in standardization. Its architecture serves a role akin to being a common language in a device ecosystem. A key insight on the industry is that when the amount of software written for a device starts to meaningfully increase, the industry has the tendency to standardize around a common architecture. Standardization promotes efficiency in software development and allows for faster innovation.
“With the complexity of CPU design increasing exponentially, over the past decade no company has successfully designed a modern CPU from scratch.”
Similar to chip designers like Nvidia and Qualcomm, Arm operates as a fabless, R&D-focused organization. However, unlike these firms which do end-product designs, Arm's focus is on creating designs that can be considered the 'highest common denominator' among various design companies. It is about providing customizability while ensuring standardization for efficiency and time-to-market in the industry.
As mentioned before, Arm designs are based on specific type of processor architecture known as RISC (Reduced Instruction Set Computing). As the name suggests, it’s called “reduced” because the processor uses a smaller, simpler set of instructions. This is in contrast to CISC (Complex Instruction Set Computing), which is primarily represented by the X86 architecture utilized by Intel and AMD.
The choice involves trade-offs. RISC architecture excels in terms of energy efficiency and cost-effectiveness. This makes them particularly suited to mobile applications and embedded systems - dedicated computing setups integrated within larger devices to carry out specific functions (e.g. automotive systems like ECUs and navigation). In contrast, CISC architectures are better suited for high-performance applications where the emphasis is more on raw power.
Historically, Arm and X86 catered to different end-markets: X86 for PC and servers, and Arm for mobile and connected devices. However, that boundary has started to blur recently, with Arm waging its war on X86’s traditional strongholds, as highlighted by Apple’s transition from X86 to Arm processors in its MacBook lineup, and Arm’s wins in server chips including Amazon’s Graviton, Nvidia’s Grace, and Ampere’s offerings which are all built on Arm architecture.
While Arm was initially perceived as underpowered, its capabilities have improved a lot over the years. This is due to innovations like multi-core processing (which we'll discuss later). An industry expert provided a rough estimation: approximately 70-80% of computing tasks can now be managed with Arm cores. The remaining 20-30% may demand the higher throughput of a X86, but this added power also comes at a significant additional cost.
There will always be applications where that extra throughput will be desired, regardless of the cost. An example of such would be when designing a high-frequency trading system, as even the slightest deficit in performance can lead to big consequences on trading profit.
Revenue model: licensing and royalties
Arm’s revenue has two main components:
A one-time, upfront licensing fee which the partner pays to gain access to Arm’s designs. The partner then works on product development and testing, over a period of, say 3-5 years, before production commences.
Arm earns a royalty income for every chip shipped by its partners. Historically, royalty rates started at about 1% for low-end products like microcontrollers and smart cards, and went to about 2-3% for smartphone processors. In 2022, royalty payments from partners accounted for 63% of Arm’s revenue.
The chart below shows the breakdown of Arm’s royalty revenue into vintages. ~46% of Arm’s royalty revenue came from products released between 1990 to 2012. Arm is still making royalty from some designs struck more than 25 years ago! In this way, the business is highly cumulative in nature.
As of December 2022, Arm estimated that the aggregate value of chips containing its technology was ~$98.9 bn. On this base, Arm generated ~$1.78 bn in royalty revenue, representing an average royalty rate of 1.7-1.8%.
We can further breakdown the type of license that Arm offers: technology and architectural.
Technology licenses refer to Arm-designed cores, like those in the Cortex-A series or M-series (whenever you see the word ‘Cortex’ it’s referring to technology license). Essentially, customers are outsourcing the processor R&D to Arm, and are buying off-the-shelf core designs which they can readily incorporate into their own processors or SoC (System on Chip) designs. This saves customers from having to design a CPU from scratch.
For clarity, a “core” is an individual processing unit. A bunch of cores constitute a CPU, which in turn is a key component of an SoC (system on a chip). Arm’s core designs are its flagship offerings. But the company also provides more complete CPU subsystems which enables customers to outsource an even larger portion of their CPU design work to Arm.
On top of this, Arm has an array of other IPs, which customers can combine into their SoC designs. These includes GPUs, memory controllers, interconnects, physical IP, and machine learning solutions. While these are not nearly as ubiquitous as Arm’s core designs (faces a lot more competition in each), they allow Arm to offer a complete menu to customers.
In contrast to technological licenses, architectural licenses are more basic. Customers are only purchasing the rights to the most fundamental building blocks, called Instruction Set Architecture (ISA). Instead of relying on Arm's off-the-shelf core designs, companies with an architectural license opt to design their own unique cores in-house. Apple is one of the most notable architectural licensees, which it uses to build the M1 and M2 processors for its MacBooks.
This distinction is important because it directly relates to the amount of royalty income that Arm makes. As you can guess, when Arm provides a more ‘complete’ product with technology licensing the royalty is higher. A simple analogy here is that a coffee shop would much rather sell you their cinnamon-spiced caramel lattes at double the price instead of just a shot of espresso.
Now, imagine if a bunch of regular customers at the café got together and said: “let’s just buy the shot of espresso and make our own espresso drinks at home”. As you can guess, the café owner would surely not be pleased. We’ll leave it at this for now, but come back to this important issue later on.