Arm: The Silicon Blueprint - [Business Breakdowns, EP.200]
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This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you.

To find more episodes of Breakdowns, check out joincolossus.com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers, or affiliates may maintain positions in the securities discussed in this podcast. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I'm Zach Fuss, and today we're breaking down Arm Holdings.

Arm designs the architecture powering billions of devices, from smartphones and data centers to IoT devices and automotive systems. In this episode, we'll explore Arm's unique value proposition, how it thrives as a licensing giant in a market dominated by leading-edge manufacturers. We'll discuss its business model, the partnerships that drive its growth, and its role in enabling companies like Apple, Nvidia, and Qualcomm. We will also unpack Arm's business history, including its acquisition by SoftBank, its

its failed takeover by Nvidia, and its IPO earlier this year. Orm currently sports a $150 billion market cap, with sales approaching $5 billion, a rather robust 30 times revenue multiple.

This valuation is, of course, predicated on its 90% plus gross margins, complemented by ARM's dominant market share in mobile and its increasing share gains in markets like automotive, cloud computing, and IoT, with its technology being licensed in nearly 30 billion chips annually.

To break down ARM, I am joined by Jay Goldberg, who is the CEO and Lead Analyst at D2D Advisory, a technology and strategy consultancy, and who has spent various roles in the semiconductor ecosystem. We hope you enjoy this conversation. All right, Jay, it is great to have you back. The world continues to change and evolve, particularly as it comes to your area of expertise, semiconductors.

Today, we're talking about Arm. So to start things off, I know this is a loaded question, and it has a fair degree of complexity, may require a bit of a semiconductor 101 education for our audience. But let's start with a brief overview of Arm's business model, what exactly they do, and how they fit into the broader semiconductor ecosystem.

So I'm going to give you an analogy on Arm to give an intuitive sense of what they do. This is not 100% perfect analogy, but it's what we work with. Arm licenses its intellectual property, its IP, to companies that design chips. So they don't make chips themselves, and they license their IP to companies like Qualcomm or NVIDIA or Broadcom, these big chip companies, who then design that IP into their own chips, which then get manufactured at CSMC or one of the foundries.

So Arm is fairly early in the process of this whole semiconductor flow. The way to think about Arm is that the IP that they provide is almost like a blueprint, but a special type of blueprint. So imagine you're an architect and you're designing a house.

As an architect, you differentiate yourself by how the house looks. What's the curb appeal? How does the light flow? These big architectural features. Typically, as an architect, you don't get rewarded much because you have the best designed plumbing. You don't have the best designed bathrooms. Those are important in a house, but that's not really where you as the architect differentiate yourself. And especially in lots of places, bathrooms are generally very standard. And what

What you could do is just take the generic blueprints for a standard bathroom, and you're going to copy and paste those around your design. That frees you up to design the parts of the house that really matter, that are really going to drive your business as an architect forward. I think it's a good analogy for how Arm interacts with its customers. There's a certain amount of low-level plumbing workings

work that needs to be in lots of types of chips. Certain types of math, certain types of functions need to be in all chips, but there's no way that a Qualcomm or a Broadcom or NVIDIA really differentiates around those. It's a basic math things that need to get done. They license that IP from ARM, and then they work that into their chip, and then they can differentiate on things for Qualcomm. It's how their modems work, how their communication systems work, or for NVIDIA, how their graphics and AI processing works.

ARM plays a vital function providing a really important piece of the overall functioning of a chip. We're still allowing the flexibility for their customers, their licensees, to design their chips as they see fit. So what they do is they license that IP, their business model works essentially where they charge an upfront license payment, and then they take a royalty, some amount of money per chip that their licensee actually ships. That's a really helpful analogy to frame it.

In my research, clearly GPUs have ruled the day, at least in the last, call it 12 to 18 months. My understanding is that this is a CPU-oriented business. So help us to better understand the importance of their CPU versus the GPU architecture that people are working with today and the interplay between those two in a future world state. The CPU is very much a general purpose chip.

It can run any type of workload. It can run the low-level functions of the keyboard and the mouse and the hard drive for your computer. It can handle the operating system and the applications. It's a general-purpose, jack-of-all-trades chip. But because of the geometry and physics of semiconductors, you can always design a chip that does a single one of those tasks better than the CPU. So in the case of GPUs, they were first developed to run graphics really, really well. The

but a GPU can do graphics much better than a CPU. The GPU can't run the operating system well. It can't do all the low-level functions as well. It can do graphics really well. So in engineering, you're trading off what do you need the chip to do? You make those trade-offs and you assign different tasks to different chips. And with GPUs now becoming important tools for AI, these AI accelerator chips are even more finely tuned towards doing AI math. And that's similar to GPU math. We don't need to get into it. That's part of the NVIDIA story. In regards to ARM...

What's common to all this is you have certain general purpose functions that ARM sits at the heart of all those. So you don't need necessarily an ARM IP, an ARM core inside of a GPU because that's not what the GPU is there to do. But you're going to want it inside the CPU. You're going to want that functionality. So in most compute systems, you're always going to need some control node managing all the multiple tasks. So even in these big NVIDIA systems that have eight or 72 GPU cards all linked together,

There's going to be some number of CPUs in those as well. So the way to think about ARM in relation to the growth of AI, it's obviously the hot topic now, is GPUs are exploding. We're seeing so many more GPUs being sold. NVIDIA is doing really well selling all those GPUs around the world. There is some degree of CPU attached to that. And depending on where they source the CPU from, that can often be an ARM-based CPU. And in fact, NVIDIA probably prefers to sell its own CPU, GraceChip,

It often attaches those to its GPU systems and that CPU is ARM based.

So after we establish their unique business model and the CPU versus GPU dynamics, I guess what I want to really try to wrap it all around is that core technology. What is it about Arm's IP and their business model, how it designs chips that differ from their competition? So Arm really faces two elements of competition. Historically, they have been seen as in competition with x86. And I just want to take a step back and say,

ARM's IP is sometimes called instruction set architecture, an ISA. And that's just a framework for how chips are supposed to handle these types of math, these sorts of problems. 40 years ago, there were dozens of different ISAs. And over time, we winnowed down to two. There's the ARM architecture, and there's the x86 architecture. And today, there's two companies that provide x86 architecture, AMD and Intel. Intel started it, and then AMD joined along. And ARM is the other instruction set architecture.

which historically wasn't used for computers, wasn't used for PCs, really got a big boost from smartphones and mobile. That's changing. We can get into that. Historically, you'd use x86 in a PC and you'd use ARM in a smartphone. Most recently, we've seen another ISA enter the fold called RISC-V, R-I-S-C-V, RISC-V. And that scene is an open source, not exactly open source, but it's open source.

It's not owned by one company. It's designed by a consortium that anybody can contribute to and use freely. So RISC-V is out there as an alternative to ARM. It's still very early days for RISC-V. So it's on the, I'd call it an emergent potential competitor as opposed to certainly not a dire threat to ARM anytime soon. So if we think about how we got here and work from the start, my understanding is that the general familiarity with ARM came through the early days success they had with Apple. But how did they go from this, what I would call,

niche player to someone that's so dominant in the architecture of the future today? What is the business story?

Arm came out of England, out of the UK. There was a company called Acorn Computers. And this is back in the 70s when everybody was making computers. And Acorn was selling computers through other people's brands, typically, like the BBC. And they had a couple of hit products. And they realized that to be competitive, they wanted to design their own chip. So they tasked a team with designing a chip as a proto-CPU of the day. And that was the kernel of what would become Arm. Eventually, they split that off. The chip design team and the hardware team went their separate ways. And the

The genesis of Arm, the company today, was originally called Acorn Risk Machines and later Advanced Risk Machines. We can talk about what risk means later, but the point is it was part of Acorn. It got spun off into a three-way joint venture between Acorn, VLSI, chip company of its day, and Apple. Because Apple originally wanted to use this Arm IP for the Newton product. The Newton didn't do particularly well, but Arm actually did pretty well. It made a lot of money from Newton, which it then used to grow and grow as part of portfolio.

And from the get-go, Arm was an IP licensor. They stopped making their own chips when they spun off, and they licensed their IP first to Apple and then to many others. And slowly but surely, that grew. And then they started adding customers. I think after Newton, their first few big customers were fax machines, designing IP for fax machines, of all things. And then I think what really tricked them into the beginning of this big growth trajectory was Nokia. Yeah.

Nokia and their chip partner, Texas Instruments, started using ARM in the late 80s or early 90s. And the first ARM-powered mobile phone was actually the 8110, which is the Matrix phone. That was the first ARM-powered mobile phone. And very quickly, other mobile phone companies started to realize the appeal of using ARM IP, ARM architecture, in mobile phones. And the reputation I got from very early on was that it was much more power efficient than alternatives, especially something like x86, which at that point really evolved into something

That was meant for a device that was powered, a laptop or a PC that had pretty access to power. Mobile phones were so power conscious that ARM had a lot of appeal. So first it was in a lot of feature phones. Over time, their capabilities increased. And then what really, really kicked it into high gear was 2007, the launch of the iPhone and this explosion in smartphones. Because suddenly you needed very, very complicated, very advanced processors for your phone. And the best way to do that was to start with an ARM IP at the core of the phone. So to

To answer your question, really the big explosion came with the growth of mobile. So as history dictates here, ARM went on to dominate mobile devices. Presumably they have a growing presence in other markets, automotive, internet of things. My guess is that if I walk through my living room, there's probably eight or nine devices that have some ARM architecture license to them. But I guess most topical today is this increasing demand for AI in machine learning,

So I guess in contemplating why a business today that is run rating at close to $5 billion of revenue has $150 billion market cap, it kind of begs the question, what the heck is going on here?

So it's a few things. First is the arm of today is very, very different than the arm of just even a few years ago. For a long time, they had talked about expanding into new markets. By the mid-2000 teens, they were very much a smartphone-driven company. 90-something percent of the revenue was derived from smartphone chips. In the last decade, but especially in the last three, four years, they have made huge inroads into other markets, the most important of which is probably the data center, where

where they're helping all the hyperscalers, Amazon, Microsoft, Google, Facebook, Alibaba, ByteD10, this big Super 7, have all now designed their own CPUs to run web workloads. And those are all based on ARM chips. And this is an alternative to using expensive Intel and AMD data center chips. These companies went out and designed their own chips. The natural place for any of those companies to start with would be ARM, because there's really no other alternative. So I'd say data centers, first and foremost, their biggest growth opportunity

IoT is out there. IoT is a messy market. They're doing okay there, but nobody does stellar in IoT. It's too complicated and too messy. Automotive is certainly really, really interesting. I think they've made good inroads there with a lot of their partners. A lot of their licensees are doing well there. Automotive takes a long time to mature. These are long product cycles, five to 10 years to develop a chip into production for automotive as opposed to one or two years for everybody else. So we'll see how that goes, but it's looking pretty good right now.

So ARM is doing well expanding into pretty much everywhere. And I think you're right, AI is such the story of the day. And it's not quite as clean a story there because like I said, they're not necessarily going to have an ARM core in every GPU or every AI accelerator that's out there. But there is some attach rate. You'll need CPUs, you'll need other control functions. There's ARM cores in networking chips that sit next to all this to connect all these AI servers together.

So there's a lot of content going into stuff adjacent to the core NVIDIA AI accelerators. And ARM is absolutely benefiting from that hugely. But I personally think that ARM's valuation is justified by more than just AI. It's this broad expansion into so many other things.

So maybe to back up a little bit, I know there's kind of this classic debate amongst semi-enthusiasts around risk versus SISC and these two fundamental architectural approaches in processor design. It feels important here. So maybe we should just spend a little bit of time explaining those two and why ARM ultimately adopted a risk approach and how that contributed to its success.

It's funny, this RISC versus CISC debate is something that's been in computer science topics for a long time. Back in the early days of compute, this debate was incredibly important. I remember I took some computer science classes in the 90s, and that was the topic of the day was RISC versus CISC, and which is better? Lots of famous moments around it. But at heart, it's two ways to think about how you architect a chip. And RISC stands for reduced instruction set, and CISC stands for complex instruction set. And the

The basic idea is if you have a chip and the chip runs on zeros and ones, but a level above that, there are assembly language. There's human readable code that the chip then translates into zeros and ones. And the idea behind CISC is that each of the critical mathematical functions you want to implement in silicon, you have a separate instruction for those. And as opposed to RISC, where there's a much smaller number of instructions you can give the chip. And if you want to do more complex things, you have to string a few of those simpler instructions together.

So the simplest way to think about this trivial example, it's not quite perfect, but works is in a CISC architecture, you might have something like a square root function where it calculates the square root. It knows how to do that math and it moves the zeros and ones around to do the square root of a number. In RISC, you'd have to do a series of division, subtraction, addition steps in order to get that same command implemented. And people at the time used to get kind of religious about which one was better. And the truth is, I don't think you could say that one is better than the other.

There are just different situations when one works better than the other. There's always trade-offs. This is engineering. There's always trade-offs between what is good, what's right for the application in front of you. What ended up happening was RISC initially was very, very memory dependent. You needed a lot of memory because you had to remember all those steps. And at the time, Sys looked more appealing because it didn't need as much memory and memory was very expensive. Over time, on-chip memory got very cheap very, very quickly. And

And that made RISC much more attractive. And because it was this reduced instruction set, you can say it ended up requiring less power. That's oversimplifying it a bit. But at the heart of it, you needed less power to do these calculations because the steps involved in the complex instruction sets were complicated by design. And those ended up chewing up more power. So that's how RISC got its initial reputation for being much more power efficient than CISC. What ended up happening in history is x86 took the CISC path,

the complex path, and ARM took the RISC-reduced instruction set path. And that's how they diverged way back in the late 70s, early 80s. And it's humorous to me that it's still a topic that keeps coming up. We have the RISC-V project, which is very explicitly RISC-based, coming on stream today saying, hey, we have all the benefits of RISC. And I think as much as this is about low-level chip interactions, what it really, really meant, what this difference between CISC and RISC meant was RISC allowed

users a degree of flexibility in designing their chips. It wasn't just the power savings that made risk appealing. It was much more about the flexibility. I need risk to do something slightly different than what x86 has done. I'm going to take this other approach and I'm going to optimize for power savings. I'm going to optimize for this function and that function. And that flexibility was really important because one of the critical differences between x86 and ARM is that x86 is owned by two companies effectively, AMD and Intel, while ARM is available to be licensed by anybody.

It's very, very hard to license x86. Anybody with enough money can get an ARM license. So then take that a step further. One of the interesting things about RISC-V, this open source project, is that it is free for anyone to use, or at least to take the code. So it's even cheaper and more available to ARM. And it is, by design, even more flexible. You can really shape this around and use RISC-V in ways that you can't even do with ARM, which itself is already pretty flexible. Now, there are drawbacks to that.

Probably you don't have to get into them. Their software complexity is down the stream from that. But at heart, really, the debate is around flexibility of instruction sets to customize, tailor for each individual chip designer, each licensee to do as they see fit. It's not every day that you approach a business that trades at 30 times sales that has this classic innovator's dilemma where there's this open source, hypothetically free to use. Nothing obviously is free. Competitor?

But I think before we go into the competitive landscape and the dynamics around ARM and the x86 and RISC-V, I just want to better understand what that partnership and licensing model is really like. How does that model work going forward in a world where there's so much competition? And what are the key advantages to licensing its tech to Apple and Qualcomm and Samsung and others versus vertically integrating the business in a way that could help to maybe make their competitive advantage more durable?

This is a little complex to answer. Let me talk about historically, and then I'll speculate on where things are going. Historically, it was essential in ARM's early days that they didn't manufacture chips. Part of the problem when you manufacture a chip is, first, someone has to do the design. That's expensive. You have to hire designers to do that. And that's what Qualcomm and NVIDIA do. They design their chips. And then once you've designed your chip, you have to pay someone else to manufacture it, typically. So Qualcomm or Broadcom will pay TSMC to do the manufacturing for it. So that's a lot of upfront expense. There's a

There's a lot of work and capital involved. You have to pay for mask sets. You have to build inventory. You have to take ownership of all those chips. That's a lot of expense. And for Arm, back in the early days, it just wasn't financially viable. It was much simpler to just license their IP. It was also something the market really needed. So I think that was driven originally by necessity. And the earliest CEO was dead set on this model. He saw the opportunity and grabbed it and really ran with it.

And then as time emerged, you got this big ecosystem of lots of other customers, lots of licensees designing their chips that really helped grow the ecosystem. There was a period in the early 2000s when there was a big debate between x86 and ARM. And this was around mobile mostly, but others as well, where ARM was able to succeed because it certainly did its own set of R&D and innovation.

But then they had hundreds of licensees who are also innovating and exploring the market and finding every segment and every niche. And that drove a huge amount of volume of chip designs versus x86, which was Intel and AMD. Big, capable companies, but limits to how much they could explore. So ARM was able to, beyond the technical merits and the power savings available at ARM and Spones, they had this giant ecosystem, which was very, very powerful in expanding the university addressable market.

And then over time, because of the rise of phones, it also drove volume to the foundries. It really powered the growth of TSMC into the beast it is today. So you have this big ecosystem effect that worked really well in its favor. So now we're at a point today, though, where the market has consolidated a lot. There's always lots of competition in semis. The question is, does Arm want to build its own chips? And it's certainly, I think, in the realm of the possible, where they're going to move up a step and design their own chips.

I don't think they're going to go so far as to necessarily put their own label on a chip and design it and sell it into the market like a merchant solution. But I do think it's very possible that they will take a lot of steps to help their customers, their licensees, bring ARM chips to reality. Because there's a step in here that's important. In between having ARM IP and actually then sending it to the foundry to manufacture, there's a lot of steps that have to take place. We call it hardening the IP, taking the IP from just digital files and good ideas and

and translating that into the design for a chip. That's a fairly cumbersome process. And I think Arm is now taking a lot of steps to make that process easier, accelerate it. And I think what that will probably do is open the door to new customers who may not design chips today, but with Arm's help, they can bring those chips to market faster, better in ways that probably weren't possible before, just relying on merchant partners. And that's certainly what we're seeing with the hyperscalers. Arm has done a lot to help those companies

design their chips. And I think they're going to take a few more steps and get very, very close to doing a full design of their own chips. And when you consider those steps to designing chips and partnering with other technology companies that participate in other parts of the ecosystem, who else are you bringing together for this project, then ultimately spec yourself into something which I assume has extremely high switching costs on a go forward basis?

So I think that the chief complexity here is in the software realm, because chips don't exist in isolation. You build a chip so that it can run some form of software. There are certainly incremental steps in the design process, but I think what's more critical than any of that is the software that's going to run on these chips. And a big part of the ARM story of the last decade has been the amount of work that software companies are doing to make their software run better on ARM architecture.

So in theory, you have all these different ARM chips out there in the data center. Like I said, Amazon has one, Microsoft has one, Facebook has one. There's a fair degree of compatibility that if you have software that runs on Microsoft's CPU, you can fairly easily port that over to run on an Amazon CPU. And that's the real critical part of that. And there is a whole history of how ARM got there. It was a lot of work and a lot of blood, sweat, and tears that went into it. But it's at a fairly advanced stage now. And I think that's really critical.

That compatibility layer is very, very important and shapes how people think about what their choice of design and ISA.

So this business has a very interesting history in the way it's developed, but recent history has been full of all types of dramatics. There was the SoftBank take private. There was the NVIDIA transaction. There was a more recent IPO. What was everyone thinking as those things were going on from an industry perspective? Then also, what is the strategy behind the scenes as to why these different parties were so interested?

in an asset that at the time people thought everyone was overpaying for, but in retrospect, seemingly, they got a good deal. So SoftBank bought Arm about 10 years ago. And at the time, there was a lot of head scratching. They paid $32 billion for it. And I think many people, myself included, didn't quite see it. And then for a long time, for most of a decade, actually, Arm went to sleep. I think in part because they had done so well in mobile, they were the only story in town for mobile.

They got acquired by SoftBank at a point in which it was clear that ARM was going to be the only thing in mobile. x86 wasn't going to be there. All the last tiny ISAs that had left over from the 80s and 90s, they were all gone. ARM effectively had a monopoly on chip ISA for mobile phones, and that was a massive market. SoftBank acquired them, and they didn't have any pressure after that. They just had to do what SoftBank asked, but they didn't have the pressure of the public market asking them quarter after quarter, what's next, what's next? And then at some point, SoftBank

It's an investment fund. They needed an exit. They needed liquidity. And NVIDIA came along and offered to buy them for $54 billion, which if you're a soft bank, it's a great deal. You paid 30, you sell it for 54, especially because there wasn't a lot of growth left here. You didn't really know what to do with it. It's an interesting question as to why NVIDIA wanted to buy ARM. Certainly part of it was they were in the process then of designing their own CPU. They saw this growth wave coming for AI, and they knew that they would need more powerful, more capable CPUs. And

and they probably weren't particularly happy with the pace of advancement that Arm, the sleepy company, was delivering to them. They wanted to accelerate the work Arm was doing for data center workloads. Beyond that, it's a little tough to see the interest that NVIDIA had in Arm. NVIDIA didn't play in mobile at that point. And I think it comes down to Jensen Huang, the CEO of NVIDIA. His superpower, in my mind, is he's willing to make big bets, take big chances. He's not afraid of failure. And as much as he's this huge success today,

He's made a lot of mistakes along the way. And his real ability is his ability to not be afraid of those mistakes and to keep moving afterwards. Most other companies do some of the things that have befallen NVIDIA over the years. They would give up. CEO would give up. The board would kick him out. That didn't happen with NVIDIA. And he was able to keep pushing things through and making these big bets. And I think ARM was in that camp. It wasn't necessarily fully thought out. It was a need and they tried to acquire it. And then when it didn't work out, they moved on to something else. And then AI happened.

The ARM NVIDIA deal broke three years ago. And the one good thing that came out of that was it woke SoftBank up and said, oh, wait a second, we've been sleeping on this. We need to get this company back in gear. And they knew they had to take it public. So they brought in a new management team. They brought in a new CEO, Rene Haas, who has done a tremendous job of reinvigorating the company, waking them up and starting to get them really active and excited again.

and pushing them. He fixed all these things. He fixed pricing, he fixed product, he fixed marketing. Just go down the list. All these things that hadn't been done right, they've tripped up or overlooked, and he got them moving again and headed in really good directions. And I think at heart, what Arm is really trying to do today is increase the value capture that they can get from the industry. So if you look at it by numbers, in 2023, when they went public, Arm

On average, they earned about $0.07 per ARM chip shipped. So they license the IP, they get a royalty payment. That was about $0.07 per chip on average. Today, it's over $0.08, probably close to $0.09. Rough math, it probably gets to $0.12 over the next three, four years. And you think about it, ARM makes, in the case of NVIDIA, NVIDIA sells a system for $100,000. ARM probably makes a buck or two on that. So when you look at it in that context, you're like, well, maybe there's a little room for a little bit more going ARM's way. And then you multiply that across all the chips that ARM's in.

all these end markets, and you start to realize there is this potential to greatly increase their value capture. And just to illustrate how big that addressable market is and how often we interact with their licensed technology, can you just give an example of where their chips are? In some ways, it's like the inverse of where they're not, because they're seemingly everywhere. But I just want to illustrate that point to better drive home the market opportunity they have in the event that they can push pricing further.

So pretty much every electronic device in your house had some ARM content in it. Even PCs that run on x86 will have some ARM cores somewhere in there, maybe running Bluetooth or Wi-Fi or something. Everything has ARM content in it, everything electronic. PCs, smartphones, smart home devices, your Wi-Fi router, your thermostat, your lock. There are some advanced Apple plugs. You plug it into the wall. Some of those have very low cost ARM cores in them.

to do something who knows. Your AirPods, your speakers, all of that has ARM content in it. Your refrigerator probably has some in it. Your TV has lots of ARM content in it. Washers, dryers, cars, they have a little bit today. They're going to have a lot more in the future. Anything with any digital smarts is going to have some kind of ARM content in it.

It's really incredible. Part of this conversation, you obviously mentioned the importance of Jensen and his culture at NVIDIA. The semiconductor industry has become one with all these mercurial founders and executives. You have Lisa Su at AMD, Pat Gelsinger, who recently has stepped aside at Intel. How important is management to this business? And have they had as much influence directly as some of these other luminaries have in their particular businesses?

There's three people I think who deserve credit for Arm's success in the world. The first is Sophie Wilson, who was one of the founders of the Arm design team back when they were still part of Acorn. And I think she, more than almost anyone else, really led to the technical success that they had initially that positioned them to be appealing to Apple. And for reasons she didn't actually go to Arm when it got spun off.

But she's the often unsung hero of all this. The next important person would be Simon Saxby, who was the founding CEO when Arm separated from Acorn. He had come in from, I think, Motorola. He had this vision of Arm as an IP licensor, and he established the business model and really drove it to success. He's the one who got them into their first deals, got them into Nokia, and really positioned them to become where they are today. And then the third one is the current CEO, Rene Haas. I touched on this a moment ago.

where he has reinvigorated the company and really positioned it for its next big growth wave. It's a good case study in how management can matter. I don't want to throw shade on any of the past CEOs. Even when they were part of SoftBank, they had a decent management team then, but it was tasked for different purposes. But I think those three more than anyone else have really been the ones who are positioned, who've gotten armed to where it is.

Given how pervasive arms technology is throughout the semi-ecosystem, combined with their licensing and royalty model, I imagine it manifests itself in an incredible economic engine. I think I read prior to this that its margin profile is more emblematic to that of software with 90% gross margins, operating margins exceeding 40%. Can you just take us through the business's financial profile and maybe highlight the most important financial KPIs?

We've been talking a lot about abstract high-level things, about technology and their history. But deep down, they have this really powerful economic model as well. On paper, it looks a lot like a software company. You have gross margins in excess of 90% that flows through to the bottom line and operating margins that are 40, sometimes 50%. That's very powerful because what essentially is happening here is they have a big upfront cost. They have to do the R&D work

to keep pushing the technology forward. You've got to pay a lot of very smart computer scientists and electrical engineers to keep coming up with new advances, new products, new features. But then once that's done, once you've spent all that on R&D, the cost of marginal sale is essentially zero. On the royalty side, they're collecting a few pennies per chip. And it doesn't matter to them whether that's one chip or a million chips. It costs them no extra to sell that. And that

all flows through the bottom line. It's a very, very powerful model. If you think about the leverage that provides, the royalty rate is going to continue to increase over time, over the next few years. And even though it's only a few pennies nominal increase in royalty rate, all of that flows through the bottom line. It's just such a powerful amount of leverage in this model. I do want to caveat that a little bit. I say it looks like a software model, but it's important to understand that this is not software.

ARM is licensing IP. It's not software. There's some pretty important differences. If you think about things like you can't patch this software, website goes down, you can patch it, you can figure it, you can add new things on the fly. ARM can't do that. This gets baked in the chips. It's multi-year design process. And so I don't think you should think about it as software. It just has that sort of economic model that looks very, very similar to software. And over time, I think this model will evolve a little bit. We've adopted what looks like a premium platform

or a freemium model where they're using different pricing schemes to get users in the door. Again, it's not software, but they're using a lot of those growth tools that software companies use. I think that will flesh out their sales profile, their revenue growth as well. But they're also looking at new products, talking about moving up the stack, maybe getting

getting very close to building their own chips. That will come probably at the cost of lower gross margin percentage with the benefit of added gross margin dollars. So that trade-off's worth it, even if percentage points come down a few, absolute dollar pool gross. But for the most part, I think they'll keep doing this model and will continue to deliver these kinds of results.

And then I guess the next five to 10 years are going to be incredibly interesting for how everything evolves, both in the electrification of everything and the digitization of our entire consumer economy. But there are risks to this story. Growth won't necessarily run unabated, although they've gone from $1 billion to $2 billion to $5 billion in revenue quite rapidly.

What are the risks to this story? How real is that open source competition? What is the decision tree from here and where things could go?

And the best case scenario, the base case, and then if things were to deteriorate, what would have to happen? So I think it's important to understand that ARM's product, instruction set architecture, these ISAs are buried deep, deep, deep into chip functionality. And it's very, very hard to replace it. We saw this a few years ago, actually, when Apple moved from Intel x86 silicon to its own M-series CPUs for macOS. Apple spent years preparing architecture

all kinds of software support for that, preparing developers for that, really put a huge effort into getting people ready for that transition because that transition essentially broke software compatibility. So things that had written for macOS to run x86, Intel Silicon, wouldn't necessarily work on ARM. And so Apple had to spend a lot of money to make sure that they did, at least at some basic level, still function. And still today, if you're a programmer and you're dealing in some newer stuff, you download some new software package, some new language,

Oftentimes, there's still a distinction. Are you running this on Intel? Are you running this on Apple Silicon? So my point being that it's very, very hard to replace it. And that is an immense, immense barrier to entry. And we look at, there's this developing situation now where Arm is suing Qualcomm, and they've had difficult relationship for years. Qualcomm is probably one of Arm's biggest customers, one of its biggest licensees. They don't like Arm. They don't like being sued by Arm. But what choice do they have?

They can't just go out tomorrow and say, "All right, we're going to stop using Arm. We're going to switch to RISC-V." It would take them a decade to really work that through their whole portfolio. So the competitive threat that RISC-V posed was for a period, while Arm took its eye off the ball, RISC-V was able to capture a lot of new growth opportunities. So for instance, we see this big wave of new chip companies coming up in China. That explosion took place in the late teens when Arm wasn't quite ready for it, wasn't totally paying attention.

So there are a thousand companies in China today that are RISC-V centered. They're mostly doing embedded IoT low value devices. But that was the threat is that RISC-V would get its foothold there and slowly work its way up into other things. One of the big changes that took place when Haas took over as CEO is he fixed pricing in such a way to make RISC-V less attractive in comparison to ARM.

Just having access to RISC-V isn't the same as having it chipped. There's still a lot of work that has to take place to design that into a real chip to harden that, and Arm has a big advantage there. And by fixing the pricing and fixing some of the licensing terms, he greatly reduced, maybe eliminated the appeal of RISC-V for all kinds of use cases that otherwise RISC-V might have gone into.

I don't want to say RISC-V is not a threat, but I do think the degree of threat is not huge right now. And even if it were, it would take years to develop. I'm going to have my RISC-V friends get angry at me, but I'm going to say that RISC-V is not ready for data center workloads today. And maybe on performance metrics, like how fast it goes, that very raw technical spec is comparable, maybe. But in terms of everything else that goes into it, the design ecosystem, the hardware

the hardening, the software. We got years and years before RISC-V is really ready for smartphones, let alone data center. Now, I could be wrong. It could come sooner than we expect. There could be some breakthrough somewhere, but I don't see RISC-V today as an existential threat to ARM the way you could have forecast it to be a few years ago. So going back to your question,

The base case is they just continue to grow. They add value, they capture more value, they get into more markets. I would say the upside case is if they turbocharge that, where they really start to flex their muscle. They, in some senses, have a monopoly on ISAs, especially now that they've blunted risk-fraud advance. In many senses, they're not quite a monopoly legally, but functionally, they're pretty close.

And if they use that to increase their value capture to a big degree, and it really flats their muscles, and you start to get significant increases in royalty rates. And I think that's certainly possible. Even without that, if they just keep going at a steady incremental, slowly capturing more value pace, I

I think they're still positioned to do really well, but there's definitely a scenario where they really turbocharge that and it gets much bigger than even these numbers would suggest. The bear case is we just see a radical shift in how we do compute. I talked a little bit about the tap rate between AI accelerator chips and ARM-based CPUs. Depending on who you ask, it's something like two to one to eight to one today. If it goes to like a hundred to one, where you really just don't need that many CPUs, then the ARM market, the

the TAM, the addressable market is nowhere near as big as we would have expected. And so growth plateaus at some point. That's how I see it. The addressable market question is really where I'd be focused on exploring the bear case.

Just to go back to the economics, we're talking about pennies per device and billions of devices, some of which have NSRPs in the tens of thousands of dollars as it relates to automobiles, but also iPhones cracking thousands of dollars. How does the contract work such that they do receive such a de minimis revenue per chip? Is it crazy to think that that can go materially higher?

I think the chief criticism you could have leveled at Arm 10 or 15 years ago was that they just kept prices too low. If you really want to get into the mechanics of the model, like I said, there's two components. There's the upfront license payment, and then there's the ongoing royalty payment. And I think for a long time, they moved towards favoring big upfront license payments at the expense of lower royalty rates, which made sense as the industry consolidated and you started to have these massive customers and you needed to fund

fund the R&D that those customers needed to advance the ARM ecosystem, ARM architecture. And what ended up happening was new companies couldn't afford ARM licenses. So one of the things that's been fixed in recent years is they've reset all of that. And in a lot of ways, they have what are almost software-like pricing tiers now, where you pay a little bit upfront, like a premium model, where you get limited access for a small upfront payment. But then as you expand your usage, you pay more and more. Essentially, it's a lower upfront payment in exchange for

higher ongoing royalty payment. I think this really worked wonders. It's got a lot of people in the fold. The thing is, if you get people in the door and you have them designing on ARM, once you have that, they're almost locked in. Like I said, it's very expensive to switch to RISC-V. So lower the upfront cost significantly, get more people in the door, and then you make that up by having higher royalty rates down the stream. I

I think that's pretty much what they're moving towards. There's other things they have going on as well, where they're moving up the stack and doing more of the physical design work. That's another good way for them to increase their royalty rates. So there's a lot of levers they can pull. And then they've pretty successfully diversified their revenue streams from one that was primarily mobile to now networking, auto, mobile, internet of things, consumer electronics. But are there any other

other areas or market opportunities where they're underpenetrated and you feel like that story is just taking off? Yeah, I touched on it a minute ago was automotive. Automotive is the big opportunity I think that most semiconductor companies are looking at today where we can quibble over the exact numbers, but there's a few hundred dollars of semiconductor content in cars today. And that's growing double digits every year because just more and more things in the car are becoming electronic.

especially with electric vehicles, but certainly all vehicles in general, you have more advanced digital cockpits, infotainment systems, driving assist. And I'm not even talking about autonomy. Autonomy is huge, huge semiconductor content if and when it arrives. But even before we get there, there's just layer after layer of more semiconductor content in cars, and it's more compute. And more compute means more arms.

And our typical question in conclusion is, what are the lessons that you've learned through your studies for Arm that can be applied in evaluating other businesses in the ecosystem? And at the same time, for operators, investors in the space, what can be applied to their businesses in order to take some of these lessons from what Arm has done? And a business model that on paper sounds incredible and that they've licensed pervasive technology that you would apply elsewhere.

The first one is you need to invest heavily in R&D. They spend 20, 30% of revenue goes into R&D. It's expensive to do what they do. This is a company with very high gross margins, but also high operating expenses because they need to keep pushing the capabilities of their architecture further and further afield. So one of the areas where they underinvested, I think, was AI.

Tensor cores, graphics cores. They have those products today, just not many people use them because they just under-invested in them in the last decade. And there's definitely an alternate universe in which they hadn't done that. They actually invested heavily in AI and they'd be even more important today. And we'll see. That's certainly another one of those areas where I wouldn't count them out yet. They still have some big ambitions to increase their content and AI. But investing in R&D, it's expensive. You got to do it. It's lots of very expensive talent required. But

But do that and do that well. I think it's really important. The other really important lesson for Arm is having an ecosystem as a competitive advantage. And I don't think they exactly set out to do this, but in hindsight, it's just so powerful. The fact that they have hundreds or thousands of licensees all contributing in some way, participating, building up that ecosystem, building up the software compatibility, making it more appealing, exploring every market segment, every market niche.

That's been a huge, huge force multiplier for them. So you need the R&D to attract that ecosystem and keep them engaged. Once you have that in place, it's just immensely valuable. Well, this has been a fascinating case study and a business that clearly is on the right trajectory. And in order to grow into this valuation, we'll ultimately need to sustain it for quite some time. Seems like the pieces are all in place. We'll see how the future unfolds here.

Yeah, I have to admit, I think they're well positioned. It's fun to see. I've followed this company for a long time. It's nice to see them really hustling and moving again. Thanks so much. Thank you. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out joincolossus.com. That's J-O-I-N-C-O-L-O-S-S-U-S dot com.