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SoftBank's Big Bet On ARM Holdings Could Hurt Intel

Japanese telecom giant SoftBank recently agreed to acquire British chip designer ARM Holdings (NASDAQ: ARMH) for $32 billion, a 43% premium to its previous closing price. That purchase could shake up the tech industry, since ARM's designs power 95% of smartphones, 80% of digital cameras, and 35% of all electronic devices worldwide. However, one company could be caught directly in the blast zone of this acquisition -- Intel (NASDAQ: INTC).

SoftBank's Pepper robot. Image source: SoftBank.

Why is ARM valuable?

To understand how SoftBank's purchase of ARM could hurt Intel, we should understand why the telco wants to buy a chip designer.

ARM's chip designs conquered the mobile market over the past decade because they were generally considered cheaper and more power efficient than Intel's x86 designs. ARM doesn't sell any chips -- it licenses the designs to chipmakers like Qualcomm (NASDAQ: QCOM) and Apple (NASDAQ: AAPL), which pay ARM royalties and licensing fees. Chipmakers have the option to use ARM's standard architectures or modify them into "custom" designs like Qualcomm's Kryo or Apple's A9.

ARM only generates a small amount of revenue from those fees. Analysts expect its sales to rise just 7% to $1.6 billion this year -- a tiny amount compared to SoftBank's $86 billion in revenues last year. Those mismatched figures, along with SoftBank's soaring debt ($113 billion as of last quarter), have led many investors to question its $32 billion offer. However, SoftBank believes that it's getting ARM at a discount due to the pound's post-Brexit plunge, while the company only generates about 1% of its revenue from the U.K.

Overlapping interests with Intel

SoftBank sees ARM as an investment in mobile devices and the Internet of Things (IoT), the growing market which consists of wearables, smart appliances, and other gadgets all connected to each other and the cloud.

Intel, which launched a dedicated IoT chipmaking business in 2013, believes that the number of connected devices worldwide will soar from 15 billion in 2015 to 200 billion by 2020. However, Intel faces fierce competition across the IoT space from ARM-based chipmakers like Qualcomm and MediaTek. Qualcomm's Snapdragon processors already power 80% of all Android Wear smartwatches worldwide, and the Apple Watch's S1 SiP (system in package) is also powered by an ARM-based CPU.

Intel's Curie IoT module. Image source: Curie.

Back in April, Intel CEO Brian Krzanich discussed how Intel would transition away from the slowing PC market with investments in the cloud, IoT, 5G, and programmable chips for data centers. A month later, Intel announced that it would discontinue its SoFIA and Broxton 4G mobile chipsets, surrendering the smartphone market to ARM to focus on the development of 5G modems.

Why Intel should be worried

But if a major telco like Softbank, which also owns Sprint, is willing to go all-in on ARM, many other telcos could be thinking the same thing -- that ARM is the future of IoT and 5G networks, not Intel. That makes sense, since Qualcomm, ARM's top licensee, already combines application processors and baseband modems in its Snapdragon SoCs (system on chips).

For Intel to gain any ground in 5G modems, it must rely on the handful of companies that install both components separately, like Apple. Intel pulled a portion of iPhone 7 baseband modem orders away from Qualcomm, but that victory could be short-lived if Apple develops its own integrated baseband modem for its ARM-based application processor.

Another problem is that ARM has been targeting the data center market, where Intel holds a 99% market share. Back in 2014, ARM boldly claimed that it could control 10% of that market by 2017. ARM will likely miss that target, but Qualcomm recently launched 64-bit ARM-based server chips, which might chip away at Intel's dominant position.

If SoftBank closes the ARM deal, it will likely invest more heavily in R&D for data center chip designs, which have higher margins than IoT and mobile ones. To showcase the technology, SoftBank could also install ARM-based server chips in its own servers. If SoftBank demonstrates that ARM-based server chips are more cost-effective than Intel's Xeons, other telcos might follow its lead and dent Intel's second biggest business.

The key takeaways

It's unclear if the SoftBank deal will be approved, but the purchase isn't as random as some analysts make it out to be. SoftBank is merely betting on a future filled with connected objects powered by ARM-licensed chips -- which is bad news for Intel's hopes of expanding beyond PCs into the IoT and 5G markets.

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Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends Apple and Qualcomm. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.