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Making IT Seem Simple

Posted: Aug 31, 2007 13:24 PM by Dean Lundell

Tickers in this Article: KLAC, F, INTC, MENT, SNPS, CDNS

All those simple electronic gadgets we take for granted every day require an enormous amount of complex engineering. They make it seem so simple, so user friendly. Ah, but who's "they"?

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"They" are companies involved in the business of electronic design automation (EDA). EDA is the software and other tools that engineers use to design chips and circuit boards for all these little electronic marvels. The EDA business is something of an oligopoly, with a small number of players that have each carved out a niche. In this article we'll take a look at two of the big, EDA players, and one of the smaller up-and-comers in the field.

Sharper Customer Focus
Cadence Design Systems (Nasdaq:CDNS) has a very well balanced product suite with a solid mix of analog, digital and verification applications. Cadence generates over $1.5 billion in sales and has a market capitalization of just over $6.4 billion - a 4.1 market cap to sales ratio and the highest of the group.

What is new at Cadence is its CEO, Michael Fister, who hails from Intel (Nasdaq:INTC). Fister is implementing some changes that are long overdue in the software business and at CDNS. For years, engineers would design a product and then search for an application. That is no longer the case - Fister has focused the firm on customer needs first and then designing a product to fit.

When engineers can verify the functionality of a chip while it is still on the drawing board, the company can save millions in development costs and that is one area where CDNS has paid a great deal of attention. The results have been promising. With CDNS now spending over 30% of its sales on research and development, its return on equity has climbed from a five-year average of 3.9% to a current 9.5%.

Leveraged But Lethargic
Synopsys (Nasdaq:SNPS), with a market capitalization of just over $4.0 billion and sales of $1.1 billion, is the other heavy weight in the EDA business along with Cadence. Technological prowess aside, SNPS has two problems: First, roughly half of its revenue comes from digital EDA, while it has virtually no presence in analog. Second, the firm is highly dependent on Intel for a great deal of its sales. However Synopsys has a strong balance sheet with no debt and about half a billion dollars in cash and short-term securities.

On the plus side, Synopsys' growth is being driven by the demand for increasingly complex chip designs. The downside is SNPS is seeing price competition from a small company called Magma Design Automation (Nasdaq:LAVA), while at the same time Cadence has locked up the analog side and is now pursuing the digital side. Management at Synopsys seems content with the status quo, preferring not to compete with Cadence for the analog business.

The firm now devotes 32.7% of its sales to research and development. This is a big improvement over previous figures and has resulted in an improved return on equity of 6.3% - certainly better than the -1.4% it averaged for the previous five years.

Niche Dependent
Mentor Graphics Corporation (Nasdaq:MENT) is our small cap entry in the EDA business with a market capitalization of just over $1.1 billion and $792 million in sales. It also has the smallest market-cap-to-sales ratio of this group at 1.4.

Mentor does a fine job at niche applications and is also pursuing non-EDA business such as wiring harnesses for Ford Motor Company (NYSE:F) but the firm is facing an uphill battle. From the bottom, Magna Design Automation has chosen to compete on price, and from the top, Cadence has formed a joint venture with Intel, KLA-Tencor (Nasdaq:KLAC) and a private firm to compete more effectively in niche products.

For the time being, MENT is showing good results with earnings growth:
- Five-year average: -6.4%
- Three-year average: 44%
- Growth last year: 370%

Mentor Graphics has seen the light on R&D, and is now allocating 29% of sales to it; however, return on equity still lags at 5.5%. In addition, MENT's balance is weak to the point that it has very limited flexibility.

A Change in Atmosphere
The atmosphere at these firms used to be collegial and academic. No more - It is now customer-centric and shareholder driven. No more monopolies, no more niches - everything is fair game.

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By Dean Lundell

Dean Lundell is a former vice president at Merrill Lynch Capital Markets, a principal of a regional investment bank, an independent futures trader and licensed commodity trading advisor. He has written for McGraw-Hill, the Chicago Mercantile Exchange and several financial magazines. Prior to his career on Wall Street, he served with the 82nd Airborne Division in Vietnam.

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