2023-11-28 15:18:43 ET
Summary
- Synopsys is leveraging AI in three value streams: design participation and demand for AI chips, embedding AI in their EDA stack, and optimizing internal workflows.
- Synopsys.ai has seen success with 270 tapeouts and 9 out of the top 10 semiconductor vendors using it.
- The company's segments include Design Automation (65% of revenue), Design IP (25% of revenue), and Software Integrity (10% of revenue).
- We don't see room for further valuation multiple expansion, valuation is pretty stretched as is. While you pay for quality, the shares are priced for perfection.
- Writing OTM covered calls seems like a good option for those that have the shares, or writing OTM for those that like a lower entry point.
Synopsys ( SNPS ) is the market leader in EDA or electronic design automation which provides software, hardware and services to aid the design of semiconductors. They operate in three segments:
SNPS IR presentation
The Design Automation segment isn't only the largest, it's also the one producing the highest margins by far. Besides its technical acumen, the company is helped by some strong secular tailwinds that can be summed up with the catchphrase 'smart-everything.'
SNPS IR presentation
No surprise that AI is a rising part of this.
AI
Generative AI, while still only good for 10% of the company's revenues, is becoming a main driver with three levels of impact:
- AI chip designs. Third parties estimate that today's $20-$30B market for AI chips could very well exceed $100B by 2030 with Synopsys as the leading EDA provider to AI chip designers this is a huge secular tailwind for the company.
- 2) Synopsys.ai; AI assisted design
- 3) Increasing operational margin
Synopsys.ai
SNPS IR presentation
The company started with AI applications in 2017 in the design space. The company launched the industry's first AI-driven full EDA suite (see slide above).
Initially launched in 2020 for design optimization, this morphed into Synopsys.ai, a full suite of AI-driven solutions for the design, verification, testing, and manufacturing of the most advanced digital and analog chips, launched in 2023 .
Generative AI techniques augment the exploration, accelerate design choices, and automate some design generation.
The company went from a per-design subscription for AI tools to rolling into baseline license renewals to avoid having to use too many individual licenses. The results seem to be quite impressive ( Q3CC ):
In the last quarter, our customers have demonstrated up to 10x faster turnaround time and double-digit improvements in verification coverage. Customers are also reporting more than 20% silicon test cost reduction.
Recently, we engaged Synopsys.ai for analog and custom design. One of our top customers used our AI optimized Custom Compiler to achieve a 6% performance improvement over manually crafted custom circuits.
Synopsys.ai has driven more than 20% value increases in several recent digital implementation renewals, often leveraging significant growth for the underlying core tools used by Synopsys.ai.
This quarter, we saw multiple full-flow displacements to Synopsys.ai, driven by up to 10x productivity differentiation versus the competition, which brings me to generative AI.
It's therefore no surprise that adoption has been swift, with 9 out of the top 10 using it with 10th in testing. From 100 tapeouts (when chip designs are finalized and ready for production) in February there are already 270 tapeouts today (August 16, 2023). So it's no surprise that Synopsys.ai revenue is just starting to ramp.
At a time when there are resource shortages hampering industry growth (especially engineers), this kind of AI-driven automation produces additional benefits.
And very recently they launched a breakthrough generative artificial intelligence (GenAI) capability for accelerating chip design, Synopsys.ai Copilot, from the linked PR:
Now, working collaboratively with Microsoft, we're taking AI-driven design to the next level with generative capability such as conversational intelligence delivered in this first Synopsys.ai Copilot."
We have to say that this looks pretty interesting, investors might wonder whether others could replicate these capabilities as they have access to the same LLM capabilities.
We don't think that's an issue as we assume the Synopsis.ai Copilot is trained on Synopsys IP library, which is, of course, exclusive to Synopsys . It seems like a tool to speed up design choices, offering suggestions and solutions in a user-friendly way.
Segments
- Design Automation at roughly 65% of revenue
- Design IP 25% of revenue
- Software Integrity around 10% of revenue
Design Automation
SNPS IR presentation
Design Automation is their biggest segment good for 65% of revenue with Q3 revenue increasing 23% to $1B and it also produces the highest adj OpEx margin at 41.4%.
Design IP
SNPS IR presentation
Revenue grew 12% to $350M in Q3 with the adjusted OpEx margin at 24.7%. There is a considerable amount of q/q volatility in the margins for the IP business.
The company is building out an IP portfolio for each new node, for each different foundry, and for each different customer, basically constantly increasing the IP portfolio, which (Q3CC):
So we're confident in our long-term growth in that business because of the contracts we have signed with customers
SNPS IR presentation
3D stacked chips, automotive, IoT, and AI chips are big opportunities and the company bagged increased partnerships with Intel , Samsung , ARM , and TMCS ( here and here ) recently. Management expects a strong Q4.
Software integrity
SNPS IR presentation
Revenue was up 12% to $133M with adjusted OpEx margin of 16.9%, which is increasing on scale effects. However, some macro headwinds take growth below the long-term 15-20% target.
This segment has new relevance as a result of the risks of generative AI (Q3CC):
innovative new solutions like our AI code analysis API offering on our Polaris SaaS platform..
The company is building out its Polaris platform, an integrated SaaS solution with customers still transitioning onto Polaris. The company also engaged in strategic cooperation with Secure Code Warrior and NowSecure.
While the company has a strong position in this segment, it's still just 10% of revenue and the operational margin is well beyond the company average so progress isn't going to move the needle for quite some time to come.
Finances
Some info and metrics:
- The business is just strong across the board with AI as a main driver.
- Q3 non-GAAP operating margin of 35.3%.
- GAAP EPS at $2.17, non-GAAP EPS at $2.88.
- Bumper OpEx cash $560M.
- $300M share buyback.
- $7.1B in non-cancelable backlog.
- Cash $1.8B; Debt $18M.
Margins are quite variable quarter-to-quarter but there is a bit of a trend upwards with management arguing that since Ghazi became COO (August 2020), from the Q3CC:
Over that period of time, we're able to grow revenue 17% CAGR, 700 basis points in non-GAAP operating margin and 26% CAGR EPS
The company is also using AI to improve its own operational efficiency (Q3CC):
We see significant operational efficiency and automation potential and processes across the company so that our employees can focus on higher ROI tasks. Our experimentation is in full swing, and we are rapidly learning the strength and challenging of these new approaches.
Cash generation has been rising, although growth has tapered off over the past 12 months:
Management has increased the FY23 outlook (Q3CC):
For fiscal year 2023, the full year targets are: revenue of $5.81 billion to $5.84 billion, total GAAP costs and expenses between $4.544 billion and $4.564 billion; total non-GAAP costs and expenses between $3.78 billion and $3.79 billion, resulting in non-GAAP operating margin improvement of 200 basis points; non-GAAP tax rate of 16%; GAAP earnings of $7.85 to $7.96 per share; non-GAAP earnings of $11.04 to $11.09 per share. Cash flow from operations of approximately $1.65 billion.
The company also has longer-term financial objectives:
SNPS IR presentation
Valuation
The company's buyback program ($300M in Q3) neutralizes the dilution from share-based compensation and then some, but don't expect it to be a big driver of EPS, there is only a marginal decline in shares outstanding. From the 10-Q :
As of July 31, 2023, we had $1.1 billion of total unrecognized stock-based compensation expense relating to options, RSUs and restricted stock awards, which is expected to be recognized over a weighted-average period of 2.4 years. As of July 31, 2023, we had $48.5 million of unrecognized stock-based compensation expense relating to our Employee Stock Purchase Plan, which is expected to be recognized over a period of approximately 2.0 years.
So on top of the 152M shares outstanding, producing a market cap of $82B (at $540 a share), we have to add $1.15B in dilution from performance pay to arrive at a fully diluted market cap of $83.2B and an EV of $81.4B.
This means the shares are selling at 14x EV/S and on a steep 49 x P/E ratio. You pay for the quality, but a double-digit EV/S is pricing for perfection.
Upcoming Q4 Results
Now in a couple of days the company will produce Q4 results and from our perspective there are three things we'll be looking for:
- Does AI, that is, the AI chips design as well as the company's AI-aided design tools produce any acceleration in growth?
- We will also be looking for any increases in operating leverage, for instance from the application of AI.
- Cash flow has been relatively stagnant for about a year, any increase is also something we will be looking for.
Any significant increases in these three dimensions (which are at least in part related as an acceleration in growth is likely to boost operating leverage which is likely to produce more cash flow) will improve the margin of error in terms of valuation, although we have to say that we don't usually draw too firm conclusions from one quarter.
Conclusion
There are several things to like:
- A market-leading company with several secular tailwinds blowing in its back, not just AI with several benefits but also a proliferation of chips and software going into basically anything.
- While the stock seems fully valued and we see little room for valuation metrics expansion, the share price can nevertheless grow at the pace of earnings growth, which is likely to be faster than revenue growth due to considerable operating leverage and buybacks.
- We see an upside scenario from this which contains an AI-drive acceleration in revenue in combination with falling interest rates creating an environment where double digit EV/S multiples are more common again. Not impossible, but we think compared to betting on this there are better opportunities out there.
The upshot is that this is a world-class company where we see little threat to its position and boosted by several secular tailwinds, producing 15%-25% earnings growth and the likelihood of a similar stock price appreciation. This is of course an attractive proposition, but not one without some risks.
Given the high valuation, there are some risks should the world economy take a significant turn for the worse which could bump the growth down a notch and lead to some valuation metrics contraction and together these can lead to a considerable decline in the share price.
So far that hasn't happened and the stock is drifting higher on improving market sentiment, but as we see little room for valuation multiple expansion the best scenario is the stock rising with EPS growth in the order of 20% per year.
That's still an attractive scenario, provided nothing goes wrong as the stock is priced for perfection. However, we have seen periods when things did go wrong, with EPS and valuation growth contracting:
Our preferred strategy for this kind of situation is writing covered out-of-the-money calls, providing you have the shares, or waiting for a better entry point (which can, to some extent, be manufactured with writing out of the money puts).
For further details see:
Synopsys: You Pay For Quality