Stockwatch: A mega-deal to worry about?

Is the takeover of ARM Holdings by Japan's SoftBank a strategic masterstroke, or "deal too far" exposing risks in the system? Does it underline a foreign takeover boom with sterling set to remain low in years ahead? This deal has plenty of upshots to consider.

It comes straight after Steinhoff International's agreed bid for Poundland, such offerors being of similar ilk and reviving the conglomerate model for opportunistic takeovers. An environment of ultra-low interest rates means investors are chasing up financial assets in a desperate search for yield; and companies are paying big premiums for control, especially where the target has a dominant position in a growth market. It's possible this trend persists plenty longer until a disruptive event forces a debacle.

Japan is a prime example at the macro level, its economy having experienced several decades of stagnation; and ARM Holdings at the company level, boasting an operating margin that has risen from about 30% to 42% in recent years. SoftBank is valuing the business on a price/earnings (PE) in the mid-forties, assuming earnings nearly double in the next two years; or about 40 on such a medium-term view after sterling's drop against major currencies.

That could be seen as modest if the profits re-rating follows, given ARM's historic annual PE has roughly averaged 70. SoftBank is betting "the internet of things" where a huge range of devices end up connected to the internet, will re-rate demand for low-power chips - where ARM is global leader, supplying the likes of Samsung, Alphabet, Google and Amazon. As yet there is no unified system behind all such products, which begs questions as to functionality and security (if hacked). So, while SoftBank is making a courageous technology bet, there's plenty to prove and it's hardly clear from ARM's releases, what extent "the internet of things" contributes currently.

Yet, if anyone cares to look at SoftBank's profile, risks are evident.

Combined chairman/CEO and soaring debt

The chief upshot of the 1992 Cadbury report on corporate governance was this vesting too much power at the top. It was the lead reason for debt-fuelled takeover binges in the 1980s that led to many such groups imploding in the early 1990s recession. It appears to take a modest 20 years for resurgent greed to pass this by: nowhere else is there mention or concern how Masayoshi Son is both chairman and CEO of Softbank.

This group has been transformed from a modest software distributor into a global technology giant, using debt opportunistically. Some of his bets have paid off, such as Alibaba the Chinese e-commerce group, although an 83% stake in Sprint Corp, the US's fourth-largest telecoms group, is struggling to return to profit and has so far proved value destructive.

"An exit strategy for Sprint is the key to unlocking SoftBank's growth potential" analysts at Nikko Securities have opined. But management is going off at a tangent, striking this deal with ARM, reminiscent how the 1980s conglomerates used to behave - until the game was up. Barely six months ago, with SoftBank's debt nearing $100 billion equivalent (£75.5 billion), finance professionals warned "enough is enough".

Under heavy interest-bearing costs, "management should strengthen its finances and focus on turning around Sprint Corp before engaging in other large-scale acquisitions..." Just a few weeks ago it was reported how asset sales were intended to reduce the debt load and gain flexibility for future investments - e.g. the stakes in Alibaba Group, GungHo Online Entertainment Inc and Finnish game developer Supercell Oy - albeit only to raise $14 billion via asset sales. Remarkably, the news regarding Supercell came straight after upping SoftBank's stake from 50.5% to 73.2% - hardly as if any methodical strategy. You wonder at the supervisory board's overseeing such maverick behaviour, although Volkswagen has a supervisory board and they never pre-empted the emissions scandal.

Now, there is the $32 billion acquisition of ARM Holdings, and we are told it's all happened very quickly. The public relations pitch involves doubling ARM's employment in the UK and prime minister May has seized on this as justifying Britain's investment appeal post the EU referendum. ARM's board is recommending the deal, although they are duty-bound under shareholder capitalism to maximise value. Meanwhile, ARM's founder says: "It's a sad day for technology in Britain."

SoftBank is ramping up its debt again to acquire ARM via a $17.5 billion equivalent "bridging loan". Some bridge!

Upshots for stock-picking and the investment context

Since the 23 June EU referendum, central banks have renewed a global stimulus effort against stubbornly low growth. Takeovers are set to increase given a relative lack of investment projects based on organic growth, and availability of cheap finance. It's partly why I've alighted on UK-listed stocks with high-quality brands doing well abroad - Supergroup and Walker Greenbank.

ARM Holdings shows it necessary to determine where long-term takeover potential exists, then ride out near-term frustrations and volatility. In the last year or so, fears of smartphone saturation have weighed on sentiment towards ARM shares, which also tend to reflect the trend in Apple Inc - recently sideways-down. So, an inflection point has resulted where caution has met rising hopes for "the internet of things" and an opportunist like SoftBank made a bold move to exploit it.

Referencing back to Poundland, profit warnings in the event of a UK slowdown are another potential catalyst: such a "special situations" tactic could average out rewardingly, given the market's tendency to over-react.

Does it mean long-term down-cycles in stocks are being defeated by central bank actions; that investors can look forward to a golden era as QE and the search for yield backstops market values? Such logic is reminiscent, however, of Irving Fisher's 3 September 1929 pronouncement, that "Stock prices have reached what looks like a permanently high plateau" and Gordon Brown imploring from May 1997, "No more boom and bust".

SoftBank's attempting to swallow ARM Holdings - its board and the financial/political establishment, blind to the risks - shows how corporate constructs are getting riskier as a result of debts increasing. History may not repeat itself, but it chimes. There are economists such as Steve Keen, the Australian professor at Kingston University, who warn this build-up of ill-disciplined debt will lead to a "Minsky moment" and the next financial crisis. In such context the SoftBank/ARM deal is a marker for the future and, while SoftBank shares have edged up on the news, it will be worth watching whether any hedge funds go short in due course.

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