Investors sound alarm over Arm’s exposure to China

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Potential investors in Arm's IPO have expressed worries about the UK chip manufacturer's vulnerability to China, following the company's alert about substantial risks within the nation.

Four managers at different funds who were considering investing in Arm expressed their concerns regarding the global semiconductor industry. These concerns were further confirmed by the details provided in the prospectus for Arm's upcoming listing on Nasdaq in September. This confirmation came at a time when diplomatic relations between Washington and Beijing were deteriorating.

Arm disclosed in its initial public offering (IPO) document on Monday that around 25% of its total income was generated from China. Furthermore, the company cautioned that it is highly vulnerable to potential economic and political uncertainties, especially those stemming from the strained relations between China and either the United States or the United Kingdom.

Several investors expressed the view that these concerns were more significant than SoftBank's argument that Arm would thrive due to the surge in chip demand, which played a role in Nvidia's impressive $1tn market value.

An anonymous institutional investor expressed their viewpoint on the risks highlighted by Arm, stating that it appears to be a significant amount of information for potential investors to understand. The investor mentioned that they are still uncertain about investing in the IPO and highlighted that Arm is essentially urging the market to buy shares, despite acknowledging substantial risks associated with China, all while expecting investors to pay a high multiple similar to that of Nvidia. The investor emphasized that this will require considerable consideration and deliberation.

In the past month, SoftBank Group engaged in an internal deal with its Vision Fund, which is a financial entity managed by the Japanese conglomerate. This transaction assessed the value of Arm, a company whose technological blueprints can be found in 90% of all smartphones worldwide, at $64 billion.

A notable concern for certain investors is a cautionary statement in the prospectus indicating that both Arm and SoftBank lack control over the day-to-day activities of their Chinese venture.

Although we heavily depend on Arm China for our commercial association with them, which includes generating revenue and accessing the crucial Chinese market, Arm China functions autonomously from us, according to the prospectus. It further stated that Arm does not possess any direct control over the management or representation on Arm China's board.

David Gibson, a financial analyst at MST Financial who specializes in SoftBank, mentioned that the level of risk in China outlined in the prospectus was greater than what the market had anticipated. Furthermore, he highlighted the declining revenue from licensing fees that the company receives from its clients.

"These earnings from royalties have faced challenges in the latter part of the period, heightening the worries about Arm's long-term growth," he remarked.

The business of Arm has already faced challenges due to the rising conflicts between Beijing and Washington. As a result of export controls imposed by the US, Chinese companies are now relying more on affordable chip designs from competitors in order to produce their own chips. In the second quarter, Arm China experienced a decrease in sales by 16 percent compared to the previous year, amounting to $139 million.

Kirk Boodry, an analyst at Astris Advisory in Tokyo working for SoftBank, mentioned that the management anticipates a decline in revenue from China in the future. However, this puts additional strain on other countries to achieve substantial growth in order to attain higher valuations.

Concerns have been raised regarding the intricacies associated with the ownership of Arm China.

Arm China has the sole authority to distribute the chip maker's intellectual property to customers in China. These customers include popular phone manufacturers like Xiaomi, Oppo, and Vivo, along with prominent cloud computing providers Alibaba and Tencent.

However, Arm lacks direct control or supervision over the company, which restricts its knowledge of certain significant global clients.

The company stated in its prospectus that they had faced difficulties in getting prompt and precise information from Arm China previously. They are of the opinion that the root causes of these problems have been addressed, but they cannot guarantee that their access to Arm China's records will not be hindered in the future. Additionally, the company has experienced delays in receiving payment from Arm China in the past.

The former CEO of the partnership, Allen Wu, has initiated several legal actions against the organization and continues to possess approximately 15 percent of the company's stocks.

In the initial public offering (IPO) document, Arm recognized the existence of "various legal cases" initiated by Wu and his colleagues, which could potentially have a significant negative impact if the Chinese courts ruled against Arm's partner in China and mandated alterations to Arm China's structure of leadership or organization.