Synopsys (SNPS, Financial), an electronic design automation company, has been gaining traction in the stock market.
The stock is up around 28% during the trailing 12 months. Consistent positive earnings surprises along with the growth of the EDA industry resulted in the stock’s uptick. However, analysts are basing their price targets and calls on the non-GAAP EPS of the company, which doesn’t result in the fair estimation of the company’s value.
About the company
Synopsys, a technology company, belongs to the semiconductor equipment and materials industry. The company provides tools and software for semiconductor chip design and verification. The company also provides semiconductor IP that are off-shelf circuit designs to be used by clients for chip design. Regarding revenue, the company generates most of its revenue from the U.S. followed by the Asia Pacific and Others segment.
*SEC filings, nine-month ended 2016
Regarding product classification, the company generates most of its revenue from Core EDA services followed by IP, Systems and Software integrity.
SEC filing 10-K, year ended 2015
Moreover, the company primarily uses a time-based licensing model for revenue generation. During the first nine months of the fiscal year, the company generated around 80% of its revenue from time-based licensing. The company was established in 1986 and is based in Mountain View, California.
Industry prospects
The EDA industry, along with the semiconductor IP industry, is set to witness high single-digit growth going forward. The main drivers of growth include adoption of smartphones in emerging markets, growth of IoT and wearables, growth in the automotive market and the node shrinkage in the semiconductor industry.
In emerging markets, penetration of smart devices is still low. Going forward, increasing adoption will demand more designs, which would lead to more EDA services. IoT and wearables require smaller and complex semiconductor parts, vitalizing the role of EDA services. Same holds true for node shrinkage. Foundries are already laying plans for 10nm and 7nm process nodes.
ReportsnReports forecasted that the EDA market is expected to grow at CAGR of 9.93% during 2013-2018. Market research analysts predict the global EDA market in industrial electronics will grow at a CAGR of over 6% during 2015-2019. Regarding the Semiconductor IP market, it’s expected to grow at CAGR of 10.55% during 2016-2022 to reach $7.01 billion. Semico is more bullish as it expects the semiconductor IP, or SIP, market to reach $8 billion by 2019. According to the company’s own forecasts, the total addressable market for EDA and semiconductor IP stands at $9.3 (pdf) billion.
Investors’ presentation, August 2016
Overall, growth is expected for the segments in which Synopsys operates. High single-digit growth is plausible for the company as it generates around 90% of its revenue from EDA and SIP.
The problem with valuation
Most of the analyst estimates for Synopsys are based on non-GAAP earnings. Consensus EPS stand at $3.02 and $3.25 for 2016 and 2017. But the GAAP basis midpoint EPS for 2016, according to the guidance, is $1.76. The difference is primarily because of the stock-based compensation and amortization of intangibles. The problem is that Synopsys adds back amortization while reaching at non-GAAP earnings.
However, intangibles are a vital part of the company’s operations. This is because of two key facts.
- The company deducts a large part of the amortization from the cost of revenue, which indicates that intangibles are closely related to revenue generating activity.
SEC filing, 10-K 2015
The company acquires new businesses, mostly intangibles, frequently and accounts for them on the balance sheet. Therefore, adding back amortization to reach at non-GAAP earnings doesn’t fairly reflect the earnings of the company.
Source: Morningstar
As amortization of intangibles account for 6% of the company’s revenue, using non-GAAP earnings for valuation purposes can lead to distortion of the price target. We can see this in the market as investors are basing their investment decisions on the company's consensus non-GAAP earnings.
Let’s apply the EVA valuation technique to get a clearer picture of the valuation. Assumptions for the EVA valuation include:
- Earnings growth of 10% is assumed during 2016-2020; 1% growth is assumed in perpetuity.
- CAPM is used to calculate the required rate of return; NASDAQ return is used as a proxy for market return.
- Invested capital is assumed to grow at the required rate of return during 2016-2020.
Focus Equity estimates
The EVA model reveals a price target of $55.1 based on the non-GAAP earnings. This price target is close to the current market price indicating that the market is pricing Synopsys based on non-GAAP earnings.
This doesn’t reflect the company's fair value given that the company is not registering the effect of amortization in non-GAAP earnings. In simple terms, by not accounting for amortization, the company isn’t registering the effect of expense incurred in acquiring the intangibles. It’s just putting the asset on the balance sheet without putting related expense on the income statement. Therefore, amortization shouldn’t be added back to earnings in order to see the company's true value. Depreciation on tangible assets isn’t ignored while calculating non-GAAP earnings. Same principle should be applied for amortization.
To arrive at the fair value, the EVA model is adjusted to reflect the effect of intangibles. As amortization is 6% of the revenue consistently, the same is used for the EVA model
Amortization, SEC filings, 10-K 2015
Focus Equity estimates
The valuation model adjusted for amortization tells a different story. The price target comes around $40, which is below the price for which the stock is trading. Note that valuation models are just a point of reference and don’t reflect the exact price for which the stock should trade.
A cash-flow model is also used to value Synopsys. For the model, operating cash flow is expected to grow at 10% p.a. given the growth of the EDA and SIP segments of the company. Capital expenditures include the expenditure on PPE and the acquisitions. The average of the last three years’ CAPEX is used as a starting point. CAPM is used for cost of equity.
CAPEX extract, SEC filing 2015
Focus Equity estimates
Cash flow-based valuation reveals a price target of $50, which is also below the current trading price. Note that cash flow-based valuation takes care of the amortization problem in EPS through CAPEX. As it directly records the CAPEX, there’s no need for depreciation or amortization.
Final thoughts
To sum it up, non-GAAP-based valuation for Synopsys is misleading as it doesn’t reflect the company's fair value amid exemption of amortization. There’s growth in the industry and Synopsys is doing well as it managed to consistently beat earnings estimates. On the flip side, as consensus is based on non-GAAP; earnings management is easy using amortization.
Investors should focus on the GAAP earnings of the company. Note that on GAAP basis, Synopsys is trading at a forward PE of 34. This is lofty as earnings are expected to grow at 10% p.a. during the next five years. All in all, the market is mispricing Synopsys. It’s a good pick at $40 given the cash-flow target of $50. But, above $50 there’s not much value. At the current stock price, Synopsys is a sell.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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