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Synopsys, Inc. (NASDAQ:SNPS)

Morgan Stanley Technology, Media & Telecom Conference

February 25, 2013 6:25 pm ET

Executives

Aart J. de Geus - Co-Founder, Chairman and Co-Chief Executive Officer

Analysts

Adam H. Holt - Morgan Stanley, Research Division

Adam H. Holt - Morgan Stanley, Research Division

We'll go ahead and get started as folks are filtering in. So thanks so much for joining us. For those of you that I don't know or haven't met, my name is Adam Holt, and I run the Software Practice on the Equity Research side. And I'm very happy to have our next conversation with Aart de Geus, the Chief Executive Officer from Synopsys. So first off, thank you so much for coming.

Aart J. de Geus

Thanks for having me.

Question-and-Answer Session

Adam H. Holt - Morgan Stanley, Research Division

And why don't we start with a couple of general questions? The one that we were just -- I was just sort of complimenting you on is that your business seems to be one that is not only robust but continues to be very consistent over a multi-year period. Can you talk a little bit about why that is, why you think you're positioned so well and what you see in the market right now?

Aart J. de Geus

Well, it's always good to be thankful for the position one has, but I think there are 2 primary causes to the position that we have: a technology set of causes and a business model set. Let me start with the second one. One of the reasons for the stability of the company is, a number of years ago, we converted to a business model where instead of selling software and then trying to get some maintenance money for it, we essentially went to multi-year ratable transactions. Think of it as people renting the software. The -- while the transition to get there was quite difficult, the -- what is great about the business model is that, with a very large backlog built over a number of years, we essentially come into a year with about 80% of revenue in hand, come into a quarter with about 90% of revenue in hand and just saying that, there's a fairly low risk, that we're going to be way off the numbers. Now on top of that, we have been able to diversify the position of the company technically to the point of now covering very well our space, also having a great position in the IP that relates to EDA and doing that in such a fashion that for many customers, we can easily be viewed as the most attractive partner if they want to really build a strong relationship with an EDA vendor. And that last point is very relevant because with the challenges of modern design, we need to really have a good relationship with a supplier to get the best out of the tools, the best out of the IP and, thus, have the best chances at doing well on the chips. So we bring all of these things together; it's really the result of many years of incremental decision-after-decision. And last but not least, we have been quite proactive on the M&A side of things, realizing that not only our customer's field is gradually consolidating, but the provider field must consolidate in order to be both a technical and economic critical mass. And we have the privilege of being the leader of our industry and, therefore, being able to continue to invest at a high level in R&D, which is clearly necessary.

Adam H. Holt - Morgan Stanley, Research Division

So if you were to take a step back and look at your end markets, could you maybe talk about 2 different things? One, where you see relative strength and weakness, and two, what are some of the key drivers for your end markets?

Aart J. de Geus

Well, there's no question that in semiconductors, the number 1, 2 and 3 end markets is called mobility. And the reason is very simple: It drives both enormous amount of volume, as we all know by virtue of the mobile phones that we have, but it also drives a very high degree of sophistication because, fundamentally, the phone is a supercomputer that runs on very little power. And right there, you have the essence of what is driving semicon technology forward today, which is, "How can I get more performance for less power or some modicum in between?" And that drive is so strong that people are not hesitant to invest large amounts of money in developing the next generation of technology, putting the manufacturing in place. And this comes into multi-billion dollar increments. And yet, the minute the technology is reasonably workable, it gets adopted very quickly. So the mobility market is absolutely the #1 driver. And by the way, this is true for design as well because everybody knows, if you have a design only a few months earlier to market somebody else, you can gain substantial market share very quickly. So time-to-market is absolutely key. If you look at the next big markets, well, the one that follows is actually the entire infrastructure that follows this. And this contains, of course, all the -- what's sometimes referred to as the cloud or the compute centers that support this infrastructure, the communication and mechanism and, thus, the server world. And that world will continue to follow the deployment of mobility and by the time we arrive at mobility not being just person-to-person but also being inanimate objects, so "Smart Everything," we're going to see way more traffic again, and that infrastructure will continue to develop. Lastly, I would just lump everything else together in the notion that "Smart Everything" is happening, and you have to only look at the amount of electronics you find in a car or you're soon going to find in health products, for example, to see that there's all sort of opportunity for more electronic.

Adam H. Holt - Morgan Stanley, Research Division

And how would you describe the current state of the semiconductor market?

Aart J. de Geus

Well, I think the semiconductor market has, all in all, fared reasonably well in an overall economic landscape that has obviously been very stressed a lot since the '08, '09 downturn. And I think the reason it has done reasonably well is because the demand for semiconductors and for the potential brought by semiconductors on the software industry is enormous. At the same time, there's no question there, too, there is stress for costs and there is stress towards critical mass, meaning that you have to have enough wherewithal both technically and economically to be able to play. And you can see that the people that have great business opportunities right now are just racing forward to adopt technology even faster in order to see if they can accelerate their differentiation from others.

Adam H. Holt - Morgan Stanley, Research Division

Okay. Why don't we drill into some of the product drivers, if you will? Why don't we start with the opportunities for your customers to move to some of the more advanced technology nodes? Can you talk about what exactly that means and what the opportunities ahead is for there?

Aart J. de Geus

Sure. Well, I think that is a very interesting moment to ask this question because, of course, we all know that for many years, the so-called Moore's Law has been, go to the next smaller node, meaning smaller transistors. Because of that, get more transistors on a chip. And this has worked really well for this industry for 40 years. It will continue to work well. We also know that smaller is more difficult. That's one of the reason it's more costly. The reason this is interesting timing is because we are now on the verge of seeing much broader adoption of a new type of transistor. And without going into too much technical detail, fundamentally, the last 40 years, transistor has been horizontal, sometimes also referred to as planar. And they have had one challenge, which is, while becoming more performance, they have continued to utilize a large amount of power. The idea has been, if we could build a vertical transistor that has some other electrical characteristics, can we get the same performance with lower power or flip it around? Can you get more performance for the same amount of power? And the answer is yes. And it is now provably so yes because there are products on the market today, specifically from Intel, that are shipping in production FinFET transistors. That's what these vertical transistors are called. Well, because of this promise, there is now a race going on among all the foundries, all the other people producing semicon technology to see how quickly they can, too, have a similar-type offering while going to smaller nodes, also going to these vertical transistors. Sometimes, there are sizes attached to these nodes. So if you look at the most advanced, fairly broadly being designed today, 28-nanometer. There's a next node at 20-nanometer, and then there's a next node that contains FinFETs that's called the 14-nanometer node. What is likely to happen is that while a number of people will move from 28 to 20, a number of people will want to jump as fast as they can to FinFET the minute it's available at an economically satisfactory level. That is a big step. That's a big opportunity for new products. It's also certainly a big opportunity for us as the design community to provide the tools, provide the libraries that go with this. And because the race is so intense, people are spending quite a bit of money to make this happen. Because it's not easy, it's not completely predictable when it will be there. But in general, it's viewed at the end of this year, beginning next year, we're going to see some serious design there. These are fabulous opportunities, and without overstating it, I would assign another half decade to a decade of Moore's Law just on the basis of this transition to FinFET. But in other words, I think there's a lot of opportunity coming for exciting new products that will benefit from this low power.

Adam H. Holt - Morgan Stanley, Research Division

And how does that translate then into demand for your products?

Aart J. de Geus

Well, it's already translated a little bit very early on because as you design the transistor, you use tools to simulate it, so-called 3-dimensional TCAD tools. They essentially simulate a single transistor literally in 3 dimensions, which requires a lot of compute power, but is possible today. Once the transistor is sort of well-simulated, there's demand for the circuit simulation tools, which is tools that look at multiple transistors together. And we are the prime provider of that. Once you can do that, you can now move to the digital building blocks. And now you have a lot of demand for the new so-called place and route tools. Those are the tools that take all of these digital clumps and connect them with each other. And when I say clumps, we're talking about logic gates, of which there can easily be many hundred millions on a chip. And so you can imagine that connecting this up is complex. And this is the capability that we have today. As a matter fact, it's completely ready for FinFET utilization right now. And then once you go there, there's a question of, well, why would you design all of these logic? Why not reuse building blocks from a library? And we've had the privilege of building, over the last decade, a substantial business in IP blocks. We are the #2 supplier after ARM, which provides processor building blocks. We provide many of the interface blocks. What you find on the back of your computer, be it the USB or HDMI, those typically come from Synopsys. And so there's a whole food chain of things that all have to occur by the time people actually build chips. And we touch this food chain at virtually every place. And in that sense, we are very much at the center of coordination of making this happen together with the foundries.

Adam H. Holt - Morgan Stanley, Research Division

And do you think that you're -- from a competitive perspective, there's anybody else that has that same breadth of offering?

Aart J. de Geus

Well, everybody is racing towards that, of course. I don't think anybody has the breadth of offering. Neither do I think that anybody has the amount of depth that we have in all the advanced technology. Not to downplay any of our competitors that have point strength at a number of places. And the reality is, it's always a race among multiple players. At the same time, I think Synopsys have benefited from a DNA that has said for the last 10, 15 years, "Be best in point tools, be best in integration." And because of that, I think we are very, very involved in virtually every one of the advanced designs.

Adam H. Holt - Morgan Stanley, Research Division

If you look at the more traditional processors, there are also, obviously, opportunities to reduce power consumption. How do you enable your customers to do that?

Aart J. de Geus

Excellent question, because we often team up with ARM or any of the other processor cores to help our customers optimize these cores for their specific technology and specific situation. Let me take an example. You take an ARM core. While these ARM cores are often used in a variety of application processes, like in many of the phones, and so we will collaborate incredibly closely with the most advanced users of these cores that are, of course, super interested in getting maximum performance, lowest power because that's their differentiation of their apps processor, which is then what goes into any of the popular phones or pads. And any advances that we can push forward have directly material impact on the effectiveness and power of the devices that you can see many in this room right now.

Adam H. Holt - Morgan Stanley, Research Division

If you were to look at the spend of your customer base across verticals and across geographies, could you tell us what you see in your pipeline right now? We're getting a lot of questions throughout the rest of the day in terms of particularly the federal vertical. Can you just talk a little bit about what you see from an end customer perspective?

Aart J. de Geus

Sure. Let me start backwards here because the federal vertical obviously has all the questions on what happens with sequestration and so on. The reality is, not that there are not some really, really capable designers attached to efforts on the federal government, but typically, that is not the most leading-edge technology solely that goes into broad product distribution. There may be some people that are highly specialized, doing a state-of-the-art satellite. It's not a piece of cake. So don't read me wrong as putting them at a different state. It's just that the people that do the massive investments in semiconductor technology today are commercial companies that are designing something that has to go into a mobile phone or iPad or any other form of pad. And so no matter what happens with sequestration, I don't expect that to impact our field all that much, period. Having said that, I alluded to the fact earlier that the mobile side of the market is clearly driving things from a technology adoption point of view as fast as possible. If you look at it from a geography point of view, right now, the United States is actually a bit on the slow upswing but an upswing, nonetheless. You can clearly see Asia Pac has continued to be typically the highest grower. Japan is going through a lot of reconciliation of the industry structure, specifically in semiconductors and the fields around that. And Europe right now is mostly a set of individual countries with a number of companies that are as much system companies as they are semiconductor companies. And the system companies have a lot of opportunity because they benefit from semiconductors, but they're a little less tied to the most state-of-the-art semicon technology.

Adam H. Holt - Morgan Stanley, Research Division

You touched earlier on your IP business. That's obviously been an area of focus over the last several years. Remind us how big the IP business is now.

Aart J. de Geus

Well, we lumped IP and systems, but it's roughly $450 million to $500 million today, so 1/4 of the company.

Adam H. Holt - Morgan Stanley, Research Division

And how should we be thinking about the growth drivers there over the next 2 to 3 years?

Aart J. de Geus

Well, the first driver to understand is that, a number of years ago, there was no such thing as IP reuse, commercially that is. Inside of companies, people would build design building blocks that hopefully they could reuse from 1 project to another. But as it often is the case in large companies, the project guys that design the block for their project, they're not going to really spend a lot of time to make it useful for another project because there's no real incentives and they have such a pressure on developing their project. Because of that, gradually an industry developed, that said, "Well, we can make building blocks and then it's a build versus buy. And if I can do it cheaper for you and it's equally good, you're probably going to buy." Well, gradually, these blocks became more and more complex, and there became more and more of them. And, again, I'd like to use an example everybody knows because you have it on your computers. The USB controller in your computer but also in your camera, that's a standard. You cannot really do a better standard, then you're not a standard. So you have to be on a standard. Well, we provide the vast, vast majority of those as building blocks that people just design into their chips. And so it is examples like that upon which our business is built. As a contrast example, ARM's businesses would be on the processor core. Imagination's business would have been on the graphics core. But it's the same principle. Now as these cores become more and more complex, there's another dimension that becomes more and more difficult, which is the core also has to map into 28-nanometer and 20-nanometer and 14 FinFET. Oh and by the way, in high performance and low power; in all these variations. And so if one has a good way of designing them so that you can map them with, let's say, relative ease, now there's the potential to use the same engineering effort and sell it to multiple companies and while adapting it to their needs. That is what we've done. And it took a long time to sort of know how to do it. And in the last few years, this has been a business that has not only continued to grow in the solidly double digits growth but also has, step-by-step, become gradually more profitable. Initially, you have to invest. Now we can fund the investments with the growth quite well. And so we see it as a big opportunity.

Adam H. Holt - Morgan Stanley, Research Division

Terrific. You mentioned also that you combined the IP and the systems business. Can you talk about some of the newer offerings from the systems side?

Aart J. de Geus

Sure. And just like IP 10 years ago, what's not viewed as part of EDA was sort of wrong. Good idea, maybe. Well, the systems side, we often refer to as the boundary between hardware and software. And you can already see the problem there, which is, if you focus on hardware, will the software run on it? If you focus on software, when can I have something to try my software out before the chips are ready? Well, we invested in an area called prototyping, which is a way to essentially mimic the hardware before it's ready. And we use so-called FPGAs to do that. And with these mimicking models, if you like, people that do software can already start running it before they actually have the chips, which may take another 6 to 9 months. And 6 to 9 months makes a big difference if you can start debugging before the real goods are there. And so this was a business that is now gradually growing. And you can see that the people that have the biggest complexity issues are also the ones that are gravitating first towards this. And lo and behold, we're back to mobility again.

Adam H. Holt - Morgan Stanley, Research Division

I'm going to touch quickly on some of the recent results and some of the outlook, and then I'll open it up for any questions. So you're just off of a good quarter; can you talk about what you saw in the quarter and how you set the table for the outlook going forward?

Aart J. de Geus

Sure. And let me start with setting the table. We enter the year typically with a guidance that our objective is to achieve high single-digit earnings per share. And that's precisely what we did again this year. The last 2 years, we entered with that. We exited the year with substantially better than it in both cases. That's how we entered our Q1, which starts in November. And so by the end of January, we were fortunate to be able to report not only that we had a very good quarter, that the acceleration we see in technology bodes well for the future. And so although it's still early in our year, we already have the buildup of confidence. And then the little cherry on top of the cake was that the R&D tax has been approved. And so that added a bit to the results. To make a long story short, we felt comfortable enough already after the first quarter to change our guidance for the year, which is now solidly in the double digits, and most importantly, raised the midpoint of the earnings per share by, I believe, $0.09 to $2.35 to $2.40.

Adam H. Holt - Morgan Stanley, Research Division

How should we think about the mix between organic growth and acquisitions going forward?

Aart J. de Geus

It's a question that I dread every time because I don't quite know how to answer it, partially because the way we build a company is both making heavy investments on the R&D side, which is about 30% of our revenue, and then making a number of investments through, let me call it, delayed R&D, which is through the balance sheet through M&A. And the reason to do it like that in a field that is changing very rapidly is that nobody has a monopoly on great ideas. And, of course, the return on investment on your own R&D is very high, but the return on investment on M&A is very fast. You buy it, you have it. And so because of that, we have essentially walked this now for a number of years. Just last year, we did 9 acquisitions. In our history, we probably did over 70 or so acquisitions. And in a field that has rapid change, I think that is a good recipe. Nonetheless, I think the other way to answer the question is to say, well, in the core EDA over a long period of time, we have communicated that we think it tends to grow at mid single digits. The IP and systems area is growing clearly at double digits. And that's how we arrive at the high single digits. But so far, we've been able to do better than that, and that should be the quest.

Adam H. Holt - Morgan Stanley, Research Division

And 9 deals last year, 70 deals over the last several years; how do you think about IRR and balancing acquisitions versus other ways to return on capital?

Aart J. de Geus

Well, the first thing to realize is that acquisitions have to have some strategic impact. Because if the only thing you do is just adding bulk, then you may be much better off investing internally to it. The strategic impact for me is always thought through the length of saying, well, what future competitive advantage does it give? And so invariably, it tends to be something that broadens your position or that fulfills the position and makes it more complete with a customer. And I think that is the strategy that has worked out pretty well. In terms of the return on investment, we are looking at a higher return at our own cost of capital. We don't give too much detail about that. I would first want to say that it's hard to measure, partially because by the time we acquire, 6 months later, we are very, very fast integrators. And so now, is our product doing well because we bought it or because we integrated it well or because we replaced it with something better? What is very important is that one of the keys is the relationship with the customer. And every time we acquire something, invariably, we find some situation where there's stress with a customer. Great opportunity because you have full attention, and we've been able specifically on the acquisitions made last year, I think, to make good progress precisely because of that, because people were looking for a partner that was stable, that can invest for the long term. And bear in mind the essence of the IRR for us.

Adam H. Holt - Morgan Stanley, Research Division

All right, we've got time for some questions in the audience. On the left?

Unknown Analyst

On the chart on the Magma customers, can you talk to anyone leaving this table since you took them over?

Aart J. de Geus

Actually, good question because that's actually mentally, exactly what I was referring to. We identified early on which customers we thought would potentially be perturbed or upset or worried about the fact that we had acquired a company. We immediately went to see them, and we looked at it very much from the biggest to the smallest, so parade of graph [ph] down, and immediately engaged them on a number of premises. The first premise is, no matter what, we will protect your investment, your chips, the project that is yet ongoing, whichever set of tools you want to use. Secondly, we will do that as long as needed until you're happy with the results. Third, here is the roadmap that we see going forward on technology, and here are our reasons why, in our opinion, you have to change here but you don't have to change there, because technology will demand some complexity that's not supported by this tool or that tool. And fourth, how do we jointly get there so that this transition is not just a transition but actually something that gives you a better return on either the cost or the impact? It has worked remarkably well. With all the tough things that we have identified as something where we wouldn't know what would happen, in all of them, we have excellent results; in a number we have substantially grown our business beyond what the sum of the 2 companies were doing.

Unknown Analyst

Okay. And just a follow-on. They'd been quite aggressive on the discounting side before you took them over. Can you talk to the outlook for pricing and whether there's any gross margin uplift still to be taken on the combined businesses?

Aart J. de Geus

Well, I mentioned that the earnings really -- that our sense this quarter was that we were faring a little bit better in pricing and in general terms. Now 1 quarter doesn't make a trend, but it's still a good sign that in general it sells, like customers were willing to invest with us, let's put it like that. I think one of the reasons is that customers are starting to realize that aside of, of course, being a cost factor, we are a supplier. At the same time, we're also a differentiator. And that the degree of collaboration and working with us has material impact on actually the results they get. The value of those differences are much bigger than any differences on the actual cost of the tools. I'm sure that every supplier in the world thinks of themselves as that. But with the degree of complexity and interaction of tools and IP and technology, a lot of things that can go wrong in design. In other words, if you can make them go well, you have made your impact on the customer. And therefore, I think that we're entering a little bit of a different phase, which is a much more collaborative phase with our customers.

Adam H. Holt - Morgan Stanley, Research Division

We still have time for one more very quick one. If there is one?

Aart J. de Geus

All right. That was a very quick one.

Adam H. Holt - Morgan Stanley, Research Division

That was a very quick one.

Aart J. de Geus

Thank you very much.

Adam H. Holt - Morgan Stanley, Research Division

Thank you so much. Good to see you.

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