Synopsys: Time to Take Profits

Synopsys Inc. (SNPS, Financial) – an electronic design automation company – reported the results of its third quarter yesterday, beating both revenue and earnings estimates.

Revenue increased 12.1% year over year to $779.7 million. Analysts were expecting $773.1 million. Synopsys also registered bottom-line growth with non-GAAP earnings reaching 95 cents per share, which was 3 cents ahead of the analyst consensus.

Synopsys raised its guidance for both the fourth quarter and full fiscal 2018. Management expects revenue to be approximately $789 million, ahead of the Street’s consensus of $764 million. It guided for earnings of 78 cents per share, which is also ahead of analysts’ average estimate of 71 cents.

For full fiscal 2018, Synopsys is targeting midpoint revenue of approximately $3.12 billion, up from previous revenue guidance of $3.08 billion.

The market reacted positively, sending the stock up about 6% on Thursday .

What drove performance?

In a statement, Co-CEO Aart de Geus attributed the company's performance to “strong products and customer relationships in EDA and IP, as well as our rapid growth in software security and quality."

The company is riding the growth wave of electronic design automation, enabled by miniaturization and rising design complexity of semiconductor circuits.The EDA specialist generated most of its revenue from time-based licensing, including technology subscription licenses. Although perpetual licensing revenue grew 19% year over year during the second quarter, it stayed essentially flat during the third quarter.

The graph above shows that maintenance and services was the fastest-growing segment during the quarter, while the time-based segment contributed the most to total revenue. Due to a slowdown in revenue from upfront products, year-over-year growth fell from 14% to 12%.

From a product perspective, Synopsys generated 55% of its total revenue from electronic design automation, followed by semiconductor internet protocol and systems.

What’s the outlook?

The electronic design automation industry is set to rise further going forward, but the market is getting ahead of itself when pricing Synopsys’ stock. Forecasts suggest the EDA market will grow in the range of 6% to 12% per year over the next five years. Wall Street is slightly cautious about the company's growth prospects and is expecting 10% per year earnings growth over the next five years. The market, on the other hand, is overestimating Synopsys' prospects, pricing the company for 20% growth in earnings.

While Synopsys will likely beat the industry's growth forecast, as it is expected to post 14% top-line growth for 2018, this doesn’t validate the stock's valuation.Â

The table shows that a valuation based on reasonable assumption reveals a price target of $83 for Synopsys, which is well below its trading price on Thursday.To reach the current price, the company has to grow its earnings 20% per year for the next five years.

The implied valuation clearly shows that 20% per year growth in earnings is necessary to justify an above-$100 price target for Synopsys.

Given the industry is expected to grow at around 12% per year and analysts are expecting 10% per year growth for Synopsys, the current earnings growth expectations seem stretched. Put simply, the company is overvalued due to the market’s unrealistic growth expectations.

Takeaways

• Synopsys has been posting decent performance consistently, which has made the market complacent to the company’s stock price.
• While Synopsys reported double-digit growth during the quarter, the market is implying much higher long-term growth.
• Synopsys’ regular earnings beats, thanks to Wall Street’s cautious estimates, continue to catalyze its stock price.
• The EDA tools designer, however, is overvalued due to the market’s unrealistic implied growth assumption, which is being fueled by the Street's downbeat estimates.

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