Description

I recommend buying SNPS, an excellent business that is one half of the global electronic design automation (EDA) duopoly.  EDA tools are the software and hardware that make up the essential business tools for the design of semiconductors, and as design has grown more complex, SNPS growth has accelerated, creating opportunities for further margin improvement with scale.  I believe SNPS is in position to compound earnings at ~20% per year and valuation today offers a compelling entry point for a dominant vertical software solution.

Business overview

SNPS operates in three main segments: EDA (50% of sales, 11% two year growth cagr), IP and Systems Integration (40% of sales, 29% 2 year growth cagr) and Software Integrity (10% of sales, 14% two year growth cagr).  EDA is the core product here, the product portfolio consists of seat based software licenses and hardware for simulation and emulation processing.  The market is dominated by SNPS (32% share), CDNS (30%) and Siemens EDA (18%).  The rest of the market is point solutions and open source tools that are mainly used in academic and research settings and are not advanced enough to be used on chips at leading nodes, where most of the new design activity takes place.  Within the markets there are a few different design verticals.  SNPS leads in digital chip design while CDNS has the best portfolio analog and mixed use chips and some hardware.  Siemens is very strong in certain hardware subsegments through their acquisition of Mentor Graphics, but doesn’t compete in most of the market.

IP and Systems Integration is a fast growing market where SNPS is the #2 player with 19% share behind Arm Holdings (40% share).  IP blocks are reusable units of chip design that can be lifted into new designs.  Over time as chip design and production have been separated by the fab model, design as a whole has become more modularized and IP building blocks from Arm and SNPS have become critical inputs to the design process.

Software Integrity is a new growth adjacency that SNPS has expanded into via acquisition in recent years. The business is focused on addressing software design risks across the software creation life cycle and key assets include Coverity and Black Duck.

Thesis 

EDA has strong competitive advantages and growth has durably accelerated- Roughly 80% of SNPS revenue is recurring in nature from seat based software licenses, maintenance and services.  The semiconductor industry goes through its boom and bust periods, but chip R&D has been a durable high single digits growth market through the cycle.  Design activity runs ahead of commercialization by two plus years so cutting investment today is a last resort since it is pulling directly from future profits.  The vast majority of R&D investment is also on headcount, in an industry that is short labor cutting heads is further problematic.  In addition to non-cyclical high single digit growth from the traditional semi cohort, in recent years EDA growth has accelerated on the back of large investment in custom silicon from the hyperscalers.  With Moore’s Law slowing, companies have turned to custom silicon to improve performance by more tightly integrating their hardware and software.  Hyperscalers operate quietly and market information is scarce, but there is no question they have significantly expanded the EDA addressable market.  For context, Apple is the most advanced of the hyperscalers and is reported to have several thousand employees in their silicon division.  Companies like Apple are now using EDA software, IP from Arm (and SNPS) and production from TSMC fabs to create world class chips including the M1, Graviton and TPUs.  Despite the scale of these companies, they continue to launch new chip initiatives and many are still early in their custom silicon journeys. Use cases including various consumer devices, autos, IoT and data center are still tremendous opportunities. Overall we believe the continued rise of custom silicon use cases (and potentially Intel’s opening of x86 and their shift to the IDM model) will continue to be accretive to growth in EDA and IP applications in the intermediate term.

Beyond the TAM expansion, this is a duopoly with very strong pricing ability, though again they are strategically tight lipped about pricing decisions.  Based on my conversations with both management teams I believe the companies are taking 300 - 400bps of pricing annually with relatively little customer push back in the current inflationary backdrop.  In terms of the risk of churn, customers can attempt to switch between CDNS and SNPS, but this is a rational industry that does not compete on price.  Further, deciding to switch between tools risks upsetting employees in an industry that is chronically short labor.

SNPS has significant margin expansion opportunities as they digest prior investments and scale Software Integrity- SNPS reports adjusted EBIT margins of 32% in FY22 (October year end) but I believe these can inflect positively rather quickly in the coming years. For point of comparison, CDNS’s LTM adjusted EBIT margins were 40.9%.  The main driver of the delta is SNPS’s software business, which did ~10% EBIT margins as management has invested to reinvigorate the sales organization and drive future growth.  Several major hires were made recently growth is reaccelerating after muddling along in the mid single digits for nearly two years from 2020 to 2021.  With grow reaccelerating and investments on both the EDA and Software business slowing I believe SNPS is well positioned to drive operating leverage and deliver margin expansion comfortably in excess of management’s 100bp target.  For context, CDNS saw EBIT margins expand nearly 7% from 2018 to 2021 as they digested a similar period of product investment.

China risk is overstated as it affects only a small amount of EDA business- The bear case on EDA and SNPS today is that the revenue they derive from China (~15% of total sales) is at risk.  I believe this is de-risked following the October sanctions and updates to the export restriction list.  Following that update, SNPS issued an 8K detailing that this was not material to their financial results.  Since then, both they and CDNS have reported with small hits to backlog (2-3%) but no major financial impact.  The reason they dodged the worst of the impact is that the export restrictions were primarily focused on blocking the export of leading chips for AI applications (thus the large impact at NVDA) and fab tools (thus the semicap impact). In contrast, only select suites of EDA capabilities used for nodes that are not yet in production were blocked.  I get the sense that the EDA companies were closely involved with the drafting and design of the order and the verdict came out in a good place for the companies.

Valuation 

Today SNPS is trading at ~31x forward earnings (note that they are on an Oct FY and 2022 is complete), that will no doubt put some here off but with SNPS’s unique competitive advantages, strong growth tailwinds and latent margin opportunities I believe this is reasonable entry point.  Looking at other vertical software as a group (Cadence, Veeva, Adobe and Ansys), the median multiple from 2013 to 2019 was 30x.  Multiples will swing around, but I believe from here returns are likely to compound in line with growth in earnings.  Digging into the numbers, I expect SNPS to grow revenue at a ~13% annual rate the next few years with EDA growing 11%, IP growing 16% and Software Integrity growing in the high teens.  With 1.5% annual margin expansion, I get EBIT growth in the high teens. Management recently expanded their buyback facility and announced a $300M accelerated repurchase, with a 1% annual reduction in share count (a ~$500M buyback, well below the $900M management has done in the last twelve months) I get to 20% annualized growth in earnings and 2025 EPS of $15.75. At 30x that EPS I have a two year price target of $472, which is 47% absolute upside and a 20% IRR.

Catalyst

Compounding earnings