Synopsys: Is There More Juice Left?

Synopsys Inc. (SNPS, Financial) – an electronic design automation company – reported its second-quarter results yesterday, beating on revenue while posting in-line earnings per share.

Revenue grew 14.2% year over year to $776.8 million. Analysts were projecting revenue of $775.6 million. Non-GAAP earnings per share was $1.08, registering 22% year-over-year growth.

Synopsys is guiding for mid-point revenue of $772.5 million for the third quarter, ahead of analysts' estimates of $700 million. Earnings per share are expected to fall between 89 cents and 93 cents. Analysts are modeling for 78 cents.

On a full-year basis, management expects revenue to reach approximately $3.1 billion, up 14% on a year-over-year basis. Earnings per share are projected to be $3.83, ahead of the consensus of $3.72. Despite decent earnings and healthy guidance, the market was not thrilled as the stock has shed 2.5% of its market cap since the earnings release.

How does revenue look?

The company has been consistently growing its revenue, up 10% per annum over the last three years, and results from the second quarter were no exception.

Note Synopsys generates its revenue from the sale of software licenses, maintenance and services and, to some extent, from hardware products. During the second quarter, the company generated most of its revenue from time-based licensing, which includes technology subscription licenses (TSLs), with the term of license averaging around three years. Revenue from upfront products – including revenue from perpetual licenses – also contributed significantly to the company's top line.Â

From a product perspective, the company generated most of its revenue from electronic design automation, followed by semiconductor IP and systems. Electronic design automation contributed 59%, while semiconductor IP contributed 36%.

What has been fueling growth?

Synopsys has been riding on the increasing complexity of semiconductors, the trend of digitization across industries and the race for miniaturizing semiconductors for the past several years. Note the company's products span across digital, custom and mixed-signal designs and support multiple technology nodes, including 16/14 nanometer, 12nm, 10nm and 7/8nm.

Semiconductor players like Intel (INTC, Financial) and Advanced Micro Devices (AMD, Financial) are in a perpetual race to jump onto the next node, increasing design complexity and, as a result, boosting software and services revenue of electronic design automation players like Synopsys.

Moreover, increasing digitization across industries, including the rise of internet of things and digital automotive components, is helping Synopsys register top-line growth.

In short, increasing semiconductor design complexity, shrinking nodes and the rise of interner of things has been fueling Synopsys' growth

What about future growth?

Synopsys will probably post single-digit top-line growth over the next several years. Even if the business takes a turn for the worse, revenue can’t disappear overnight as the company generates most of its sales from time-based contracts that have an average life of around three years. Red flags will definitely appear if the growth situation deteriorates. This, however, is not the case right now as the company is expected to post double-digit growth in 2018.

Furthermore, the demand for integrated circuits has been on an exponential rise, so companies like Synopsys can benefit from the increasing number of designs across industries. For instance, the rise of electronic content in automobiles, or advance driving assistance systems, requires more chips. Therefore, semiconductor companies will continue to turn toward electronic design automation providers like Synopsys for software and services

There are several risks that can affect the growth prospects of the company, however, including the rate of innovation and competition in the market. Specifically, the use of extreme ultraviolet lithography will eliminate multi-patterning in semiconductor manufacturing, at least in the short term. This will limit the use of electronic design automation software tools in this specific area.

As foundries are deploying 7nm processes right now, with extreme ultraviolet lithography to follow, the revenues of electronic design automation companies might come under pressure. Once the industry moves past 7nm, however, multi-patterning might come into play again. To summarize, Synopsys’ top line can be affected to a certain extent by the use of extreme ultraviolet lithography in semiconductor manufacturing in the short run.

Is there a strong case for buying the stock?

Due to the predictable nature of Synopsys’ revenue, most of the growth is already baked into the stock price. Synopsys is trading at more than 22 times forward earnings, while supporting an expected earnings growth of 10% per annum over the next five years. The valuation is on the high side for Synopsys to provide value for long-term investors. Moreover, competition as well as extreme ultraviolet lithography can put pressure on revenue over the next serveral years. Therefore, buying at the current price doesn’t offer much of a reward. The economic value-added valuation also indicates the stock is a bit overpriced currently.

Assuming 10% per annum earnings growth between 2019 and 2022 and 3% growth in perpetuity, the stock is trading ahead of its value as depicted in the economic value-added valuation above. Synopsys has to improve its growth rate to justify a higher price target. Even the valuation based on non-GAAP earnings indicates the stock is priced for perfection.

Final thoughts

Although Synopsys reported strong results, an even stronger guidance and is exposed to the growth prospects of semiconductors, the stock doesn’t offer much of a value proposition. Growth seems to be baked into the stock price. Even a minor slip-up in growth can set the stock on a downward trajectory. Given expected revenue pressure from extreme ultraviolet lithography, deployment and rich valuation, Synopsys isn’t worth the risk right now.

Disclosure: I have no positions in any stocks mentioned and have no plans to initiate any positions within the next 72 hours.