Synopsys - Great Business, But What About The Investment Case?

| About: Synopsys, Inc. (SNPS)

Summary

Synopsys posts solid third quarter results, issuing a cautious guidance for the current final quarter.

The company makes great products and has a bright future ahead.

Despite this, the long term value creation track record is rather average.

Given the already premium valuation I am cautious on the share prospects although I will add shares to my watchlist if a potential dip might occur.

Synopsys (NASDAQ:SNPS) reported its third quarter results this week. Before I discuss the numbers and the latest trends, let's first introduce the company as it is relatively unknown.

Despite the great business which Synopsys runs, I doubt whether this translates into a great investment opportunity at this moment, making me cautious and refrains me from investing at this moment.

A Relatively Unknown Player

Synopsys is not a household name, so for those of you being unfamiliar with the business here is a quick overview.

The company is a player in the market for Electronic Design Automation which in turn is used to design chips. At the same time, it provides intellectual property which are used for the same purpose as well. These core competencies make the company a direct or indirect supplier of products used by the world's leading semiconductor businesses.

For a long time the business relied on personal computers but the mobile and internet revolution is revolutionizing the potential applications of the technologies. Smartphones have been driving growth in recent years with data, cloud, the internet of things and other new technologies resulting in accelerating demand going forward.

With these applications demanding greater energy and performance, developing these chips is costly and time-consuming. Synopsys states that new developments can take up to 2 years and can cost some $200 million, which is exactly the area in which the company comes into play. The company is the first to design 16/14 nm designs used by Samsung and Globalfoundries, among others.

Nearly two thirds of revenues are being generated from the core EDA business, roughly a quarter from intellectual property solutions and the remainder from other businesses.

Third Quarter Results

Synopsys posted third quarter sales of $521.8 million, a 8.0% increase compared to the year before. Revenues were in line with consensus estimates at $521 million.

Reported earnings rose by 25.5% to $65.7 million at the same time. As a result GAAP earnings jumped by 9 cents on a diluted basis to $0.42 per share. Non-GAAP earnings were up by 10 cents to $0.65 per share, beating consensus estimates by five cents per share.

Looking At The Results..

Synopsys provides very high quality services which are in great demand by investors. The already high gross margins expanded by another 180 basis points to 77.8% of sales. Unfortunately net profit margins are nowhere as high as it requires quite some effort to make sure the company holds onto its leading position in the future.

To illustrate the focus on the future and the quality of the solutions, R&D is the company's biggest expense at $182.8 million for the quarter. As such R&D expenses make up 35% of total sales over the past quarter, which are simply astonishing ratios.

All in all this results in still very nice operating margins, but not nearly as high as some investors might be anticipating after hearing about the very impressive gross margins.

..And The Outlook

For the current fourth quarter, Synopsys anticipates sales of $537 to $547 million. At the midpoint of that range sales are seen up nearly 4% on a sequential basis, and up roughly 7-8% on an annual basis. Analysts anticipated sales to improve to $547 million for the final quarter.

The earnings outlook is a bit disappointing as well with GAAP earnings seen between $0.32 and $0.38 per share, as non-GAAP earnings are seen between $0.59 and $0.61 per share. This implies a decline on a sequential basis as analysts anticipated non-GAAP earnings of $0.63 per share.

Valuation

At the end of the quarter, Synopsys held some $903 million in cash while having just $82 million in debt outstanding. This results in a very healthy balance sheet containing roughly $820 million in net cash.

With 157 million shares outstanding, and those shares currently trading at $39 per share, equity in the business is valued at $6.1 billion. This values operating assets at about $5.3 billion.

Consequently, operating assets are valued at 2.6 times anticipated annual sales of around $2.06 billion and 21-22 times forecasted GAAP earnings.

A History Of Growth Combined With Solid Prospects

Over the past decade Synopsys has roughly doubled its sales while it has improved its profitability significantly to about $250 million per annum at the moment. While sales which doubled looks very impressive, this implies average annual revenue growth of 7-8%.

Important to consider for investors in light of this growth is the fact that the company held the outstanding share base rather stable, as it offset share-based compensation expenses, while bolstering the balance sheet.

Of course, the company made numerous smaller and larger deals to aid growth in the process including the $334 million acquisition of Coverity which closed earlier this year.

The contribution of this deal to current operations is still very much limited, with this particular deal only adding $20-$25 million to 2014's anticipated annual revenues.

Final Takeaway

Before we get too excited about Synopsys, it is important to recognize that the company has been around for a very long time. Despite the reported growth and profits, long-term investors have seen very modest returns.

Between 1995 and 2012, shares have traded in a $15-$30 trading range, before breaking out towards current highs at $40 per share. Recent organic growth, the Coverity acquisition which provides an entry into the software quality and security market, as well as general strong market conditions have lifted shares.

Yet these returns have hardly been great to very long-term investors who have not seen dividends in the meantime. The more predictable current growth and current backlog of $3 billion at the end of 2013 have been comforting factors for investors however, especially as these orders are non-cancellable.

While I believe the solutions are in great demand and the company commences high margins, the company continues to pour in great amounts of R&D expenses to remain relevant in the future and grow the business. Annual R&D expenses amount to roughly 3 times annual earnings, which is very high! While I generally like investments in R&D, the levels are quite leaving me wondering about the productivity to some extent.

In that light, the current earnings valuation multiple in the low twenties is probably fair after backing out the cash holdings. A 20% premium versus the market is justifiable given the solid pace of historical growth and stable anticipated growth going forward. That being said, I miss the real appeal at the moment also given the relatively timid fourth quarter earnings outlook.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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