Description

Description:

Mentor Graphics, based in Wilsonville, Oregon, makes electronic design automation (EDA) tools. Mentor customers use these tools to make the latest cutting-edge electronic devices--anything from super computers to pocket PCs, wireless handsets to smart cards. Great EDA tools play an essential role in the development cycle of these innovative products in an overall market where function and fashion demand a high degree of technological innovation.

The beauty of Mentor’s business is that it is now a leader in many of the niche areas it serves, including system design, system-on-a-chip, and deep submicron physical verification. An established leadership position is extremely valuable because customers tend to hold on to their EDA tools for 15 years or so. This is because of the cost to the customer of retraining engineers and because the customer has linked Mentor tools with other tools.

Mentor had been the market leader in its field in the 1980s but had lost its way by not making the transition to developing tools based upon hardware description language. In 1993 Waldon C. Rhines was brought in as CEO. He has refocused the company on developing tools for emerging markets. It is the result of this push by management that has put Mentor back on top. It now has the youngest tool portfolio in the industry, with legacy revenues representing less than 15% of total revenues in 2000.

Mentor has a very clean balance sheet, excellent ROE, trades at 14X next year’s earnings and should be able to grow the top line in the low teens and the bottom line in the low 20s for the foreseeable future. It is a value gem hiding in the tech wreck of the last year.


Business Characteristics:

At $17.5 (the close on 6/29) the market cap is $1.1Bil. At this price it trades at a 14X this years expected earnings and 16X trailing earnings. The business throws off lots of free cash. Operating cash flow was 89m in 2000, up from 61m in 1999. This is despite the fact that R&D is 21% of sales. Margins have been improving. Gross margins in 2000 were 80%, up from 75% two years previous. Not bad for a company trading at only 2X sales. Net margins are 11%. Both gross and net margins are expected to improve as the product mix becomes more dominated by the newer niche tools and management’s cost-cutting initiatives continue to be implemented.

Given the margins and the cash-generating characteristics of the business, it is no surprise that the balance sheet is clean--no debt and 132mm in cash ($2.07 per share). Mentor’s customer base is diverse and fragmented. As a result, no customer is responsible for more than 5% of revenue. More than half of revenue is overseas, up from 45% two years ago, so there is exposure to currency fluctuations as well as to the European business cycle. Primary competitors are Cadence Design, Synplicity, and Avant! However, there are many smaller competitors.


Why so Cheap Now?

The stock has been cut almost in half recently because of an earnings and revenue disappointment announced by a competitor (Synplicity) and because of one analyst’s downgrade of the sector. This analyst was focused on ongoing weakness in the semiconductor sector (a major customer of the EDA market).

Why these Concerns Are Overblown:

First, while Synplicity’s warning is certainly not a positive for Mentor’s business outlook, the two companies differ in several ways. Only about 10% of Mentors revenues overlap with Synplicity’s. And the Synplicity’s customer mix involves smaller and more vulnerable companies. Second, while the chip sector has experienced negative growth, this does not necessarily doom the EDA sector to the same fate. In 1998, the last chip-related slowdown, the EDA market grew in the high teens. Traditionally the EDA expenditures are the last thing chip companies are willing to cut because in cutting here they are cutting their future product growth. Even the analyst who downgraded the sector expects growth in semiconductor R&D and thus commercial EDA to continue in 2001. Because of Mentor’s young tool portfolio, it should be even more immuned to any slowdown. Given that Mentor trades at 16 times trailing earnings, that top line growth should continue at 15% and that bottom line could well grow 20% or more for the next 5 years, at these prices, with this balance sheet, Mentor is a compelling risk reward.


Management ownership:

Management currently owns 3.9% (Wally Rhines owns 2.2%) and has options exposure to an upside move.

Catalyst

1) Continuing on the current growth trajectory. 2) Share Buy Backs: Management has begun to use free cash to repurchase stock, which should continue. 3) Mentor should benefit from the legal travails that Avant! is experiencing in its ongoing battle with Cadence, as customers potentially defect to a more stable supplier.
This has been occurring on the margin but is not substantial yet.