One of the most overlooked parts of the software business is something called electronic design automation, or EDA. EDA software helps engineers design the most complex semiconductors in the world, and it is a vital part of the electronics business. EDA tools not only help engineers design semiconductors, they can test and simulate real-world operating conditions. Semiconductor makers pay bucketloads of money to the EDA companies for the latest cutting-edge tools.
In the early 1990s, there were a whole slew of small EDA companies, but after an endless wave of mergers, the industry has been boiled down to about three companies -- Synopsys (SNPS), Cadence Design Systems (CDNS) and Mentor Graphics (MENT). Because of the impossibly dense engineering jargon thrown around by the companies, many investors have given up on the group, because it can be very difficult to figure out what management is talking about. Since the industry is so hard to understand, the stocks have outperformed the S&P 500 for the last five years.
Last night, Synopsys reported first-quarter fiscal 2013 revenue of $475 million and earnings per share of $0.67. Revenue was up 11.7% year over year. Because of a strong software upgrade cycle, management raised previous guidance for the second quarter. Management believes second-quarter revenue will be between $490 million and $500 million and earnings per share in a range of $0.63 to $0.65. For the full year, the company sees revenue of $1.96 billion to $1.98 billion and EPS of $2.35 to $2.40 per share, ahead of the average estimate for $1.96 billion and $2.29 per share.
The EDA software business is highly profitable. In the quarter, Synopsys reported an operating margin of 25%, and it expects operating margin to increase 100 basis points throughout the year. Last year, Synopsys was able to squeeze an additional 100 basis points of profitability out of its customers as well.
The semiconductors in mobile devices are the most challenging chips to design. These chips are impossibly small (20 nanometers), they need to sip tiny amounts of battery power, and they have to operate at very high frequencies. Mobile chip designers are driving the industry's revenue right now. Synopsys, for example, is predicting that revenue will rise 12% to 13% this year. But next year is a different story. Right now, analysts are looking for just 5% revenue growth in 2014, since most customers will have stocked up on all the latest tools.
Customers typically have three-year license deals, but the technology changes so fast, they can be quick to sign additional deals for new software products and additional seats if the need arises. Investors in the sector need to be aware that the industry is fairly small and subject to dramatic changes in market share. Also, the business can be lumpy. New releases and upgrades can cause customers to sign large software deals one quarter and nothing the next.
That said, I believe there is still some upside in Synopsys. It could reach the low $40s, since lots of semiconductor design houses need more tools to design semiconductors for mobile devices. Synopsys is No. 1 in verification tools with over 70% market share in advanced digital designs and 80% market share in analog simulation. Verification and simulation are two of the most important parts of getting semiconductor designs to market. Semiconductor makers can't send a flawed design to the fab. You'd end up cranking out millions of chips before anyone notices.
If you are willing to put in the time to figure out the EDA sector, you might just be in the chips.