Late Thursday, the news hit the headlines that the Federal Trade Commission has sued to block Nvidia Corp.’s (NVDA, Financial) planned acquisition of Arm from Softbank (TSE:9984, Financial), citing the deal’s anti-competitive nature.
When markets opened the following day, Nvidia saw its stock drop more than 5% to around $304.85 in midday trading, though the GF Value chart still rates the stock as significantly overvalued.
The announcement of efforts to stop the deal probably won’t come as a surprise to those who have been following the developments of the attempted merger. If Nvidia were to acquire Arm, a neutral company that provides the architecture used by most semiconductor companies, it would move control of this key architecture to a non-neutral company that has a vested interest in making things difficult for competitors.
What does come as a surprise is the FTC was the first regulator to sue. Those who were on the fence in terms of believing whether the deal would eventually happen were mostly expecting resistance to come from U.K. or Chinese regulatory authorities. The FTC’s decision to step in seems to practically guarantee that the acquisition will not happen.
Contrary to expectations, this might turn out to be a boon for long-term investors of Nvidia. If the deal falls through, it could prevent Nvidia from diverting its attention towards anti-competitive practices, which would ultimately distract it from innovation.
An anti-competitive deal
FTC Bureau of Competition Director Holly Vedova had the following to say about the matter:
"The FTC is suing to block the largest semiconductor chip merger in history to prevent a chip conglomerate from stifling the innovation pipeline for next-generation technologies. Tomorrow's technologies depend on preserving today's competitive, cutting-edge chip markets. This proposed deal would distort Arm's incentives in chip markets and allow the combined firm to unfairly undermine Nvidia's rivals. The FTC's lawsuit should send a strong signal that we will act aggressively to protect our critical infrastructure markets from illegal vertical mergers that have far-reaching and damaging effects on future innovations."
Given that Nvidia is in direct competition with most of Arm’s licensees in some way or another, it would be virtually impossible for the deal to not be anti-competitive.
Though spokespeople from Nvidia have repeatedly reassured regulators and the public that they would not take action to gatekeep Arm’s technology, the fact is that if the acquisition were to be allowed, everyone would simply have to rely on Nvidia to keep its word in this regard. The company would be free to back out of that promise any time it wished, and it probably would, since it would have both the ability and the incentive.
Arm’s designs have become the most utilized in the world because they are the fastest and most efficient among RISC (reduced instruction set computer) designs. RISC architecture has grown rapidly because this is the architecture used in smartphones, tablets and other small devices that favor energy efficiency and compactness over speed and calculation capacity.
If Nvidia were to gain control over these designs that most of its competitors use, it would be a simple matter to raise prices for licensees or end licensing deals with companies it believes are a threat to its market share.
No profits without gatekeeping
The Arm licensee that has been the most outspoken against the deal is Qualcomm Inc. (QCOM, Financial), which uses Arm architecture for Snapdragon’s CPU. In February, Qualcomm told the FTC, the European Commission, the U.K. Competition and Markets Authority and China's State Administration for Market Regulation that it was against Nvidia's plans to acquire Arm on the grounds that it could become the gatekeeper for Arm's technology, preventing other chipmakers from using it.
Qualcomm pointed out that due to Arm not being profitable, the only way Nvidia could profit off of the $40 billion acquisition in any reasonable time frame would be to restrict access to its technology in some way. By continuing to allow competitors use of the architecture at current fees, not only would the company be turning a loss, but it would also be allowing licensees a chance to develop new technologies that could compete with Nvidia. Arm licenses its technology to more than 500 companies, including giants like Apple Inc. (AAPL, Financial).
The alternative argument here is that the main value of the acquisition to Nvidia would be the free use of Arm’s intellectual property, not the licensing streams. With the help of Arm’s IP, Nvidia could potentially make progress in its efforts to redefine what a CPU is by breaking its memory and I/O free from its compute.
If Nvidia were to achieve unique innovation with the help of Arm’s IP, however, that would make it even more likely that the company would decide not to share innovations in Arm’s technology with competitors. In such a scenario, Nvidia would likely keep licensees at least a few steps behind in terms of the latest developments, selling only older versions of the technology. This would effectively slow Arm’s innovations to a crawl for everyone except Nvidia.
Nvidia doesn’t need the boost
Based on Nvidia’s hopes for the Arm acquisition to drive technological growth, it may seem that if the company could convince regulators to allow the deal to go through, it would be hugely beneficial for the company. Nvidia already has a three-year revenue growth rate of 20%; how insane would its growth be if it could deal a blow to competitors while becoming the unquestioned leader in processing?
While it may be good for the company’s growth in the short term, it would likely turn out to be a bad move in the long term. Monopolies are the death of innovation; conversely, more competition drives more innovation. The ability and temptation to focus part of its attention on dragging competitors down rather than building itself up could prove disastrous.
Moreover, while Arm’s designs are preferred by most semiconductor companies at the moment, that doesn’t mean other options are not available. Moving to limit competitors’ access to Arm’s technologies could even provide higher incentive for better architectures to be developed, which might set Nvidia behind on innovation.
Arm faces key competition in the RISC market from RISC-V, which provides open-source RISC architecture. The Swiss nonprofit company aims to break down barriers in the semiconductor market, allowing anyone to utilize its IP in an effort to drive faster development of computing technology. The RISC-V architecture has been gaining popularity in recent years, and it’s certainly not out of the realm of possibility that it or another competitor could surpass Arm in the future.
Given the potential of a merger to divert Nvidia’s focus from innovation to suppression of competition as well as the fact that Arm’s designs might not be the best on the market forever, it seems that Nvidia really doesn’t need this boost, since it is clearly achieving success with its current business model.
Since it looks like the Arm acquisition now has a low chance of happening, investors may be left wondering how much this will impact Nvidia’s valuation. Will the markets be unwilling to pay such a high earnings multiple now that the company’s chance of dealing a huge blow to competitors seems to be slipping through its fingers?
Not necessarily. The reason for Nvidia stock’s rapid rise throughout the past couple of months likely has little to do with its plans to acquire Arm. Looking at the timeline, Nvidia first announced its intention to acquire Arm in September of 2020. For half a year after that announcement, the stock traded in a fairly tight range from about $115 to $150. It was when Nvidia began reporting its quarterly earnings for calendar 2021 (fiscal 2022 for the company) that the stock really began to take off.
With some of the highest spending on research and development in its industry, Nvidia has built its success on building itself up faster than the competition, which is why I believe the failure of the Arm acquisition would actually be better for the company’s long-term growth. It will keep the company’s focus on innovation without the temptation to turn its attention toward tearing competitors down, which would ultimately be harmful not only for Nvidia but for the overall advancement of new developments in chip architecture.
While Nvidia’s stock is certainly richly valued at a price-earnings ratio of 94.54 and a PEG ratio of 2.86, the string of promising earnings results driven by leadership in GPU as well as next-generation growth markets such as artificial intelligence and metaverse infrastructure are what has pushed its stock to all-time highs.