Mentor Graphics: Leveraged Buyout Recommended

Our third company in the EDA review is Mentor Graphics (MENT). As I said in the Cadence (CDNS) piece, if any company in the EDA industry is perfect for an LBO, it is Mentor Graphics. It has at least two excellent franchises - DFM and PCB design - and other players in the industry would be happy to buy those at strong premiums, making the private equity investors’ investment thesis one of chopping up the company into pieces, and selling off the parts.

Anyway, such prospects are currently not on the horizon. Mentor Graphics had previously announced on November 5, 2007 that its revenue was going to fall short for Q3, at $5.5 million lower than the estimate of $190.5 million. It was blamed on “revenue timing issues on certain key orders that impacted results for the quarter.” The loss was due to a customer who rescheduled a shipment until the following quarter, while another order qualified as a booking but not as revenue. In actual results, Mentor generated $186.3 million in revenue for Q3 ending October 31, 2007, and in line with its reduced guidance. Net loss totaled $9.2 million versus $2.5 million in Q3 2006.

Mentor’s full year guidance for 2008 projected revenue of $860 million, which would equate to Q4 revenue in the neighborhood of $277.5 million. For fiscal year 2009, Mentor expects a revenue of $920 million, but this comes across extremely optimistic given the last two cycles. However, analysts are also expecting a revenue performance of $918.7 million. As a result, this combined guidance could be a classic example of over promise and under deliver, especially when downturns in domestic GDP are usually followed by a slowdown in the integrated circuit business. If this cycle breaks, it would be due to the booming international markets. In particular, Mentor’s PCB business should gain from the worldwide boom, as the whole world wakes up to designing electronics for various products - from cars to cameras to phones.

The real company guidance was probably better stated by company President Gregory Hickley when, after the early guidance concern, he stated that the company sees “mixed economic signals.”

MENT currently trades at $11.50/share with a market cap of $1 billion and 89.7 million shares outstanding. The 52-week range has gone from a high of $19/share to as low as $10.50/share, and has not promised a return for investors any time soon. All of these factors again continue to make Mentor a target for acquisition, even more so now on the cheap.

I would really like to see this deal happen, as it would be a huge blessing for the EDA industry, which is caught in a box. As EDA’s prince charming Joe Costello had once described, the industry is like four dogs trying to fight for food from the same bowl.

The proverbial pie will only grow if adjacencies are brought into the fold. Meanwhile, the smart thing to do would be to euthanize two of the four dogs, and return the pricing structure to a healthier state.