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Now that the hype surrounding the Synopsys (NASDAQ:SNPS)-Magma deal has died down, it is time to analyze the Electronic Design Automation (EDA) industry, where only 3 big players (Synopsys, Cadence (NASDAQ:CDNS), Mentor Graphics (NASDAQ:MENT) - henceforth referred to as the Big 3) are left.

The EDA industry is essentially a software (and partly hardware, which validates the software) industry, where the companies churn out software that engineers use to design and test chips. The EDA industry depends on the semiconductor and electronic industry and hence, a substantial portion of business and revenue depends upon the commencement of new design projects by semiconductor manufacturers and their customers (Semicon). Any downturn in these industries will reduce orders and revenue.

The revenue that the EDA companies generate, primarily comes from 3 sources:

  1. Fees earned from granting licenses (term based and perpetual) to use software and intellectual property (IP), and from sales and leases of hardware products
  2. Maintenance revenue generated by providing customers with technical support to facilitate use of proprietary software, IP and hardware solutions
  3. Payments received from service offerings that include engineering assistance and training programs

In some respects, the business characteristics of EDA industry are inherently simple. There are electronics engineers employed by the Semicon, the majority of whom work on software, made by one of the Big 3. As long as the engineers use the software, the companies that employ the engineers pay fees (license, support and/or training) to the EDA companies.

The upside is that the number of electronics engineers is increasing (particularly Asia-Pacific, which happens to be Big 3's fastest growing geographic segment) which means higher sales for the EDA industry.

One downside is the paradigm shift in technology marked by rapid technology developments and changes in Semicon standards. As such, the market share can rapidly change by dozens of points. Another downside is that some of the large customers may develop internal tools, thereby reducing demand for products.

To avoid being capsized by the wave of paradigm shift, the Big 3 have been on an acquisition spree, "gobbling" companies that are outside the Big3. Cadence acquiring Denali in 2010, Mentor acquiring Valor in 2010, Synopsys acquiring Synplicity in 2008, come to mind. Of course what is helping is the tendency of software companies to design tools as accessories that fit naturally into a larger vendor's suite of programs

Has there been the case where one Big 3 tried to acquire another? Unsurprisingly yes! In 2008, as Cadence states in last year's 10k filing,

..Cadence purchased approximately 4.3 million shares of common stock of Mentor Graphics Corporation, or Mentor Graphics, in connection with its proposed acquisition of Mentor Graphics. After the announcement of Cadence’s withdrawal of the proposed acquisition of Mentor Graphics and during fiscal 2008, Cadence sold its entire equity interest in Mentor Graphics...

Going forward what are the prospects of the EDA industry? In such a competitive industry, where each of the Big 3 acknowledges the other 2 as its rival (in 10k filing), it is hard to predict. The beneficiary though would be a “newbie,” who will be "eaten" by one of the Big 3, most likely at an astronomical multiplier!

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

Source: Future Prospects For The Big 3 In The EDA Industry