Description

Synopsys (SNPS) is a world leader in electronic design automation (“EDA”), with it and Cadence operating as a duopoly in the global market for chip design (with Siemens' Mentor Graphics as a distant third). Industry titans like NVIDIA, Intel, and Xilinx rely on SNPS tools to create faster, more energy-efficient chips within the physical limitations of silicon. Synopsys sells its suite of EDA tools and associated services ratably, with recurring revenue representing 90% of the portfolio. An EDA engineer trains under a specific set of tools – much like a financial analyst and their Bloomberg terminal – leading to customer stickiness that travels with the engineer from firm to firm. The EDA industry grows in the mid-to-high single digits with modest cyclicality. Recently provided guidance points to continued growth near 10% as demand for chip innovation intensifies. Synopsys is also expanding its addressable market through ventures in security (Software Integrity; #1 market share) and ready-made circuit designs (Intellectual Property; #2 behind Arm Ltd.). And after a product refresh in its core EDA Fusion Compiler during 2017-2018 (resulting in temporarily elevated R&D costs), SNPS is now entering a multi-year period of margin expansion.

With the newly introduced “Rule of 45” target over 3-5 years, we see meaningful upside to F2022 estimates and for shares to re-rate closer to industrial software companies like Ansys, Autodesk, and PTC. At a 33% margin and 9% revenue growth, we estimate earnings near $7.75 vs. consensus at $7.11. Using a 40x P/E multiple – not unreasonable given 80-90%+ FCF conversion, an unlevered balance sheet, sustained 8-10% growth, and relative peer valuations – shares should trade near $310 by the end of 2021.

Synopsys’ suite of highly recurring software contracts is organized under its three product categories: EDA, IP & Systems Integration, and Software Integrity (security). Using round numbers, about $1.8bn of the $2.1bn of EDA revenue resides in multi-year license contracts (recognized ratably), with the remaining $300m earned from emulation technology (mix of hardware and services). Of the $1.2bn of IP & Systems integration revenue, about $900m comes from IP (pre-designed circuits used within chip designs) and $300m from systems and prototyping (mix of hardware and services). Finally, the $350m Software Integrity suite is sold as software suites (Coverity, Polaris, Black Duck, etc.) with associated managed services.

Products within EDA include the Fusion Compiler (refreshed in 2018), RTL Architect (allows designers to predict power, performance, and congestion of design changes), and DSO.ai (AI predictions that aid the design process). Checks with industry experts highlight a near 100% win-rate for the Fusion Compiler and (modest) share gains vs. competitor Cadence. Synopsys also leads Cadence in the IP business by a multiple of 3-4x. IP products allow customers to purchase predefined circuitry designs for specific chip applications. Today, about 65% of the IP market is outsourced, with pockets of further opportunity (<50% outsourced) in security, analog, and wireless.

With leading shares in both EDA and Intellectual Property, SNPS formally entered a third market in 2014. The Software Integrity business contains a suite of tools to identify and fix security defects during the development process. The $5bn market is currently fragmented with many point solutions offering incomplete product sets. While this segment only contributes 10% of SNPS revenue, analysts endow it with oversized prominence given the size of the market opportunity. The end-market grows in the mid-teens and penetration remains low at 15%. SNPS targets long-term growth of 15-20% annually for the segment vs. a mid-to-high single digit growth goal for the core EDA market.

Demand for Synopsys’ products roughly correlates to customer R&D growth. When semis are contracting or slowing investment, SNPS usually grows in the low- or mid-single digits. But during an expansion phase, SNPS can grow revenue well into the high-single or double-digits. After a lean year of R&D spending in 2019, semiconductor R&D entered another up-cycle during 2020. An analysis from Baird demonstrates this correlation over time, with the expectation of higher semiconductor R&D growth through the end of 2021.

Over the cycle the EDA industry has grown in the mid-to-high single digits for many decades. Industry representative body SEMI publishes its own assessment, found within the ESA Alliance Newsletter (https://www.semi.org/en/communities/esda/resources). These reports show demand for CAE (“Computer Aided Engineering”), SIP (“System-in-Package”), and IC Physical (“Integrated Circuit Physical Design”) all growing steadily since 2009.

In addition to more customers designing customized circuity, ASP growth comes from ever-increasing chip complexity: a 5nm chip is estimated to be 100% more expensive than a 7nm design, the 7nm chip was 35% more expensive than a 10nm chip, and so forth exponentially.

With its EDA and IP business recording steady growth, SNPS has shown mixed performance in its Software Integrity business year-to-date. After 20% growth in F2019, the segment reported +4% growth in Q1 F2020 and +6% in Q2 F2020. Management cited prolonged selling cycles during COVID-related stay-at-home orders that prevented clients from implementing new tools and systems.

Commentary and discussions with management suggest that SNPS was also too quick to drive profitability and slowed its pace of innovation. Management plans to rectify this in F2021 with increased investment into Software Integrity with the goal of achieving 15-20% order growth and exiting the year at double-digit revenue growth before accelerating in F2022. A new General Manager (hired in Q3 F2020) and an already leading product suite make these targets appear credible: Gartner ranks Synopsys Security Testing as the most complete product suite in the market. We think the resumption of double-digit growth in this segment would push SNPS to a valuation comparable or above its peers, including CDNS.

Even with this increased investment in its smallest division, SNPS should achieve healthy margin expansion. Initial guidance calls for 8.5-10% revenue growth and 12-13% earnings growth, equating to 100bps of EBIT margin expansion. But with the 2017-2018 EDA product refresh, steady performance in IP, and expanding TAM, Synopsys raised its multi-year targets on its November call. The new “Rule of 45” targets a combined figure of revenue growth + Adj. EBIT margin of 45% within the next 3-5 years.

While Cadence remains an industry leader, it began focusing on its operating margins years before SNPS. Synopsys only began prioritizing margin in F2019 and F2020, leading to 300bps of annual margin expansion. And still, a gap of 600bps sits between the two competitors. Synopsys’ larger IP business (consulting revenue related to IP selection earns lower margins than EDA software sales) only explains a small portion of this gap, leaving ~4-500bps of margin expansion opportunity for Synopsys as this gap narrows.

With incremental margins near 50% and a much lower S&M expense than software peers, SNPS can manage itself towards a mid-30s EBIT margin as it leverages existing R&D investments (still 35% of revenue today). This ties to the Rule of 45 where EBIT margins climb to 35%+ with 8-10% revenue growth in 2023-2025.

If margins reach 33% in F2022 (250bps of annual expansion, consistent with recent results), we calculate EPS of $7.75 vs. consensus of $7.11, with further upside through F2024 as margins enter the 35-37% range and the Rule of 45 is achieved.

Using our F2022 target and a 40x P/E, we expect shares to reach $310 by the end of 2021 vs. a share price near $230 today. Industrial design companies like Ansys and Autodesk trade near 40x while peer CDNS trades for 37x C2022E. We think SNPS’s superior margin trajectory and ability to sustain 10% revenue growth will re-rate it to levels comparable to these industrial design peers.

Two risks to the thesis (in addition to a global economic contraction) are SNPS’s growing exposure to China (11% of revenue) and its modest customer concentration to Intel (~12% of revenue).

The China business grew 30% to $421m in F2020 with 24% growth in F2019, even amidst U.S.-imposed restrictions on Huawei, SMIC, and other Chinese chipmakers. SNPS ceased direct sales to the affected parties in 2020 with little impact to the core business. Fears of front-loaded orders were also quashed by management on its last earnings call, “We have no indication of pull forward from China. Obviously, there's always questions around that, but nothing really out of the ordinary, except the fact that we had very strong business with also quite a number of additional new customers.”

In fact, Synopsys expects its China business to sustain above-market growth, “…the Chinese economy has rebounded post-COVID, but in general, is in a phase of growth where technology is important to where that country is going. And we see many new companies entering the fray for chip design and other areas that we can provide them tools with. And of course, we see many of the companies that have now a number of years under their belt designing much more sophisticated chips. So I expect that to continue for a long, long, long time” (SNPS FQ4 2020 Call).

As for the Intel relationship, it expanded in F2020 after contracting in F2019 with ambitions for steady growth into F2021. Intel sources some tools from Cadence but has long favored Synopsys. Revenue concentration was much higher in the past (18% in 2017) and continues to decline as more and more technology companies enter custom silicon design. Overall, company backlog grew 12% in FQ4 2020 to $4.9bn, indicating steady demand from China, Intel, and Synopsys’ broader customer base.

Even with its path to substantial multi-year earnings growth, SNPS trades at a discount to EDA peer Cadence and industrial software companies with comparable growth. With the upside we foresee to consensus estimates, ample FCF generated on an unlevered balance sheet, and ongoing market dominance, shares offer 35% upside through the end of 2021. 

Catalyst

- Margin expansion, multiple expansion
- Accelerating growth in Software Integrity business