We believe that an investor can conservatively realize 95% appreciation in a year's time on an investment in LAVA at current prices with limited downside.

 

 

If you have a cell phone, you own at least one device that was designed using LAVA's software. LAVA develops EDA software for IC development selling time-based licenses (typically 3 years) along with engineering and support services. While little known to the investment community, LAVA is well known among EDA customers boasting a top-tier client base and a broad array of designs reliant on their products. As the fourth largest public EDA company, LAVA differentiates by focusing on next generation process nodes with products able to tackle quickly and precisely the hardest and biggest design projects. LAVA has its roots in digital implementation but has expanded into analog/mixed-signal, circuit simulation and physical verification. Industry applications include wireless, memory, broadband and other digital applications.

 

 

 

In the past six quarters LAVA has expanded op margin by over 23%, reduced and refinanced debt and resumed revenue and bookings growth. Meanwhile, LAVA more than doubled its addressable market and entered a significant growth cycle with bookings expected to grow 30% this year. LAVA has clear revenue and earnings visibility, generates healthy cash flow, and has a capable, experienced, and committed management team. Despite this, investors can participate in the stock for 5-10x normalized FCF.

 

The three keys to the story are core business stability, growth via new products, and continued margin expansion. Digital Implementation is LAVA's core and contributes 70% to the top line. LAVA has long-term contracts with many of the largest IC developers in the world and despite recent product refreshes we assume this business remains flat. The growth story is Circuit Simulation; a newer market opportunity based on their FineSim product. FineSim currently books roughly $6m per quarter in revenue though we expect that it'll book roughly $20m per quarter exiting FY11 (Apr) due to its vast speed advantage with no trade off in accuracy. LAVA seeded the market with FineSim over the last couple of years and as competitor licenses expire LAVA's customers are making a full switch to FineSim. Given the typical length of contract in the industry we believe bookings will be very strong over the next 12-18 months as Synopsis contracts roll off. Having said that, we still fail to arrive at the lofty growth numbers given by this conservative management team.

 

In recent discussions, management has stated that they expect core digital implementation to reduce to 50% of revenue from 70% but expect an increase in absolute digital implementation dollars. The implication is a more than 40% firm-wide growth rate over the next 2-3 years. The profitability impact of this growth will be compounded by significantly expanded margins.

LAVA had historically generated 23% pro forma operating margins. Lengthy litigation (settled) with Synopsis cut these margins by more than half in '05/'06. In '07, LAVA expanded engineering heads by ~30% and still were able to get back to the 17% mark before the recession hit. In fact, Q2/3 '09 were the only two quarters in company history that op margin was negative and LAVA has since steadily marched back to 12% with 20-25% being the mid-term target. Additionally, LAVA had generated 23% op margins with products that required 2-3x more support cost than those from which growth will come in the near-term.

 

What's more is that LAVA was generating $20-40m of annual cash flow during '04 to '06 and we believe they can get back there in the next 18-24 months. At an average of $25m of normalized FCF, LAVA trades for less than 8x. If LAVA can achieve $35m of FCF (which we believe is feasible) the equity is trading for around 5x fully diluted.

 

 

 

 

LAVA has its roots in Digital Implementation and the core business centers on Talus, a software product for the Place and Route stage in the design of integrated circuits (ICs). The first step (placement) involves deciding where to place all electronic components, circuitry and logic elements in a generally limited amount of space. This is followed by routing, which decides the exact design of all the wires needed to connect the placed components. This step must implement the desired connections while following the rules and limitations of the manufacturing process. This boilerplate regurgitation is meant to give readers an appreciation for how mission critical and complicated Place and Route software is.

 

With relatively smaller resources, LAVA has been a successful competitor by focusing on next generation process technology. The driving force behind the manufacture of ICs is miniaturization, and process technology boils down to the size of the finished transistor and other components. The smaller the transistors, the more transistors in the same area, the faster they switch, the less energy they require and the cooler the chip runs all else equal. The size features are ever smaller; having once been measured in micrometers they're now measured in nanometers. Rather than competing on older process nodes, LAVA has found success competing at the leading edge.

 

Our work suggests the core business is stable with potential upside. Management is focused on maintaining their enviable customer base. Key customers such as Texas Instruments and NVIDIA have contracts out to 2013 / 2014 respectively. Qualcomm and Broadcom have another 18 months on their contracts. Meanwhile, LAVA is introducing new products with enhanced functionality and significant measurable improvements in processing times to combat competitive threats and provide leverage in contract negotiations.

 

 

 

The high cost of photolithographicmasks and other manufacturing prerequisites make it essential to design a circuit to be nearly perfect before a newly designed IC is first built. Simulating the circuit with a "Simulation Program with Integrated Circuit Emphasis" (SPICE) is the industry-standard way to verify circuit operation at the transistor level before committing to manufacturing an IC.

 

LAVA acquired ACAD Corp in July 2006 and subsequently introduced the FineSim Pro Circuit Simulator for analog and memory design. This represented a new and large market for LAVA. The acquisition brought an unmatched architectural framework for Circuit Simulation allowing LAVA to dramatically increase performance. LAVA is able to demonstrate a 3-5x performance gain over Synopsys' solution while providing more accurate results.

 

LAVA has already deployed FineSim in 13 of the Top 25 semiconductor companies. Primary adopters are AMD, Hynix, Maxim, Panasonic, Toshiba, TSMC, Samsung. The tool has also allowed LAVA to enter the memory business, help existing customers verify mixed-signal circuits, and expand the customer base to analog companies. The industry's typical length of contract however, is 3 years. We've confirmed that even though FineSim provides for significant efficiencies, semi-cos wont double pay for design software (i.e. they wont shelve the Synopsys solution and pay for a broad rollout of FineSim until the Synopsys contract lapses.) In response, LAVA has sold FineSim only into the most power hungry applications at leading semi-cos and once the Synopsys contracts roll, FineSim has been broadly rolled out.

 

Given the performance advantage and unique market position FineSim has become the fastest growing product LAVA has ever had as a company. FineSim has booked an average of $6m per quarter but ramped to $20m in F4Q10 (Apr). For FY10 LAVA booked roughly $40m in revenue and while they expect bookings to increase in FY11, they're only baking in $40m for FineSim to remain conservative. 

 

We believe that FineSim's performance advantage has plenty of runway as Synopsys has had a difficult time even coming close to the speed. Feedback from the industry suggests Synopsys' issues can only be resolved through an architectural overhaul which would be expensive and take several years.

 

 

 

During '03 and '04 LAVA was generating 23-24% pro forma operating margins. During '05 and '06, Synopsys brought litigation against LAVA for patents relating to design methods. The legal costs cut margins by half or more until the case was settled for a paltry $12.5m. Around December '06, LAVA began adding heads to their R&D team to the tune of over 100 additional engineers. Even with this significant investment in talent LAVA was able to get back to the 17% op margin level before the recession hit and brought op margins negative for two quarters.

Exacerbating the margin impact of the recession was management's decision to move the business to a ratable revenue recognition model which delayed recognition of revenue. It took management a couple of quarters to figure out how deep the recession was and made restructurings accordingly. As such, Q2/3 '09 were the only negative op margin quarters in the history of the company. As ratable revenue begins to flow through to the income statement LAVA has steadily recouped op margin achieving a pro forma 12.7% in the most recently reported quarter, up from -17% in F2Q09.

 

More importantly, we believe there's room for significant op margin expansion from here. In the '03/'04 time frame during which LAVA was generating 23% op margins they were doing so with product families that were much more support intensive. With new product families like circuit simulation, one Application Engineer can perform five evaluations whereas the Talus product could take three to five application engineers to perform one evaluation.  This is a significant improvement in efficiency which we believe will further boost margins.

 

 

 

As EDA is a mature market, LAVA has taken steps to expand their revenue opportunity through product development and acquisition in adjacent markets. For example, many of LAVA's customers were using their tools for digital design but were also doing mixed-signal designs. LAVA developed capabilities to meet their needs for developing analog IP in mixed-signal chips (Titan).

 

($mm)	Mkt. Size	Original	Current	Product
Place & Route	550	1	1	Talus, Tekton
Synthesis, DFT	365	0	1	Talus, Tekton
Analysis	150	0	1	Talus, Tekton
Sign-off	120	0	1	Talus, Tekton
Circuit Simulation	325	0	1	FineSim
Physical Verification	235	0	1	Quartz
Analog Mixed-Signal	200	0	1	Titan
Total		550	1,945

 

 

 

Adjusting LAVA's balance sheet for the recent debt transactions and assuming full notes conversion and stock options results in a $217.8m market value and $191.8m enterprise value.

LAVA has made significant strides in restructuring its balance sheet. Late last year LAVA did a notes exchange during which more than half of the converts expiring 5/15/10 were exchanged for converts expiring in 2014. The new 6% converts were struck at a very low $1.80 but given the debt market and the impending redemption date I don't know that I wouldn't have done the same. The remaining original notes were ultimately paid down just a few weeks ago and so the balance sheet will look slightly different than the most recent quarter end. As such, I thought it would be helpful to lay out the adjusted capital structure in an easy to understand table.

 

CAPITALIZATION
	5/2/10	Adjustment	5/15/10	Adjustment	Assume Dilution
Current Price	2.61		2.61		2.61
Basic Shares	51,561		51,561		51,561
Converts	0		0	15,702	15,702
Options	0		0	5,000	5,000
Market Value	134,574		134,574		188,606
Cash & Equiv.	57,518	(23,206)	34,312		34,312
ST Investment	16,837		16,837		16,837
Total Cash	74,355		51,149		51,149
Secured Credit Line	11,162		11,162		11,162
Term Debt (Current)	1,688		1,688		1,688
Convertible Notes	23,206	(23,206)	0		0
Short Term Debt	36,056		12,850		12,850
Convertible Subordinated	28,263		28,263	(28,263)
Term Debt	13,312		13,312		13,312
Long Term Debt	41,575		41,575		26,162
Total Debt	77,631		54,425		26,162
Enterprise Value	137,850		137,850		163,619

 

Please note that the Conversion assumption will hit LAVA's GAAP income statement only after LAVA generates $1.5m in quarterly GAAP pre-tax earnings at which point excluding conversion shares would be anti-dilutive. I assume conversion in my EPS and valuation however, as well as an additional 5.0m options for a 2011 total of 72.3m diluted shares to remain conservative.

Financials and Valuation

What's more is that LAVA was generating $20-40m of annual cash flow during '04 to '06 and we believe they can get back there in the next 18-24 months. At an average of $25m of normalized FCF, LAVA trades for less than 9x. If they can achieve $35m of FCF (which we believe is feasible) they're trading for around 6x.

 

 

Period	0.0	1.0	2.0	3.0	4.0	5.0	6.0	7.0	8.0	9.0
Year	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
Sales	131,107	144,218	165,851	182,436	191,558	201,136	211,192	221,752	230,622	237,541
Growth %	6.5%	10.0%	15.0%	10.0%	5.0%	5.0%	5.0%	5.0%	4.0%	3.0%
EBIT	16,536	21,633	29,853	36,487	38,312	40,227	42,238	44,350	46,124	47,508
Margin %	12.6%	15.0%	18.0%	20.0%	20.0%	20.0%	20.0%	20.0%	20.0%	20.0%
Tax	5,787	7,571	10,449	12,771	13,409	14,079	14,783	15,523	16,144	16,628
Rate %	35.0%	35.0%	35.0%	35.0%	35.0%	35.0%	35.0%	35.0%	35.0%	35.0%
NOPAT	10,748	14,061	19,405	23,717	24,902	26,148	27,455	28,828	29,981	30,880
Other Adj.	3,000	1,033	(3,245)	(2,488)	(1,368)	(1,437)	(1,509)	(1,584)	(1,331)	(1,038)
Unlevered FCF	13,748	15,095	16,160	21,229	23,534	24,711	25,946	27,244	28,650	29,842
Discounted	12,498	12,475	12,141	14,500	14,613	13,949	13,315	12,709	12,151	11,506
Net Present Value	129,856
Terminal Value	161,418
Enterprise Value	291,273
Net Debt	(24,987)
NOL Carryforward	50,000
Equity Value	366,260
Share Value	5.07
Diluted Shares	72,263

Other

Management