In late February of 2014, the herd began to stampede out of rapidly growing, small cap tech and biotech to find safer pastures in zero or low growth large caps. Even negative growth utilities found favor. For the moment old tech is even acceptable. For contrarian and value investors, the current shake up provides new opportunity to own shares in companies that in 2013 were gobbled up by momentum investors.
I screened tech companies looking for growth in capital expenditure, R&D budget, book value, and revenue. I then looked for those with buy ratings from both EVA Dimensions, which is a value-based analysis firm, and from Zacks, whose recommendations seem to drive momentum investors. One stock stood out in this screen: Mentor Graphics (NASDAQ:MENT).
Here is how MENT describes its business: "we are a supplier of electronic design automation [EDA] tools - advanced computer software and emulation hardware systems used to automate the design, analysis, and testing of complex electromechanical systems, electronic hardware, and embedded systems software in electronic systems and components. We market our products and services worldwide, primarily to large companies in the communications, computer, consumer electronics, semiconductor, networking, multimedia, military and aerospace, and transportation industries ...[where they are] used in the design and development of a diverse set of electronic products, including automotive electronics, computers and workstations, digital cameras, cellular telephones, medical devices, smart phones, industrial electronics, and manufacturing systems" (source: MENT 10K for FY14). As I understand it, Mentor's tools are primarily software, not hardware.
$2.4B market cap MENT gained momentum in mid-2013, then pulled back sharply and in-line with its previous rate of appreciation, but is still ahead of its larger peers SNPS ($5.7B market cap) and CDNS ($4.5B):
I would have assumed the greater stock price appreciation for MENT would have been driven by greater revenue growth, but that was not the case. CDNS had the greatest revenue growth:
Perhaps MENT grew profits faster. That was not the case either; CDNS outperformed in gross profits as well:
Profit margins were about the same for the three companies (not shown).
The major line items between gross profits and operating income are SG&A and R&D expenses.
MENT SG&A increased less than its peers over the past 5 years.
All three firms have hefty R&D budgets, but MENT spent less on R&D averaged over the past 5 years than its peers: 30% versus 33% for SNPS and 37% for CDNS. Also its R&D expenses accelerated less:
Less acceleration in spending meant that income from continuing operations accelerated more:
Summarizing so far, MENT had slower growth in revenue and gross profits, but its intense focus on expenditures, as discussed in recent annual reports, resulted in greater 5-year growth in income from operations.
ROIC that is consistently higher than that of competitors is regarded as evidence of an economic moat. ROIC = income from operations net of tax as a percentage of invested capital.
I looked up 5-year ROIC at morningstar.com. In the following table, the past FY was 2014 for MENT; for SNPS and CDNS the past FY was 2013.
|Past FY-4||Past FY-3||Past FY-2||Past FY-1||Past FY|
The current %ROIC values computed by David Trainer at newconstructs.com are comparable: 13.5% for MENT, 8.9% for SNPS, and 6.8% for CDNS.
One explanation for superior ROIC is the low effective tax rate MENT enjoys due to its foreign (including Irish) operations: average 5-year tax rate = 3 .7% for MENT versus 9.5% for SNPS and 4.9% for CDNS (source: morningstar.com). Mentor's tax rate was only 2% for FY13, 6% for FY14. See page 23 of the MENT annual report for FY13 for an interesting discussion of taxes.
Here is the comparison of 5-year %ROIC in graphic form.
MENT has had steadier growth in %ROIC due to a steady rise in operating income from operations.
Next I looked at P/E since January 2012, excluding earlier years because the multiples were so erratic:
P/E for MENT has declined to less than 16 and is the lowest. 5-year P/S ratios were less erratic and are in the following chart:
P/S ratio has expanded more for MENT but is still lower (currently 2) than for its peers (both currently have P/S = 3).
Mentor Graphics' Present and Future. In FY 2014, MENT was able to expand GAAP operating margin from 5.7 percent of revenues in fiscal 2011 to 15.8% of revenues in fiscal 2014, and exceeded the 20% fiscal 2014 non-GAAP operating margin goal set three years ago.
Mentor and its peers in the EDA industry should continue to benefit from the migration to smaller, mobile devices and the ongoing investment in shrinking nanometer designs and manufacturing activity for advanced chip designs.
Mentor management was confident enough about its future to initiate share buyback and a $0.18/share dividend in 2014, hiking it by 11% for FY15Q1.
An important facet of the MENT business is taxation, and I do not know the future implications of its very low tax rate.
- Mentor Graphics with the smallest market cap has grown its ROIC four consecutive years, and it currently exceeds that of its two peers.
- Mentor Graphics is priced for lower growth than its peers by valuation metrics P/E and P/S. P/EBV (Price-to-economic book value) is also less: 1.1 for MENT versus 1.53 for SNPS and 2.23 for CDNS (source: newconstructs.com). The market has thus priced MENT for much slower economic growth than its peers.
- Investing in the semiconductor industry without an understanding of it - as in my case - is risky, but it is also risky to invest in easier-to-understand industries like food products or utilities when they are as overpriced as they are now. I prefer the former to the later.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MENT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.