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A Promising Story Line for Synopsys

By Olga Kharif For years, Synopsys has been the runner-up to Cadence Design Systems (CDN) in the chip-design software business. In 2001, Synopsys (SNPS), based in Mountain View, Calif., appeared to slip even further behind, thanks to a change in its sales model. Instead of asking customers to pay the entire price of a product up-front, it began letting them pay in regular quarterly installments over a period of about three years. Revenues dropped 13% in 2001 as a result.

Two years later, Synopsys appears to have fully recovered from that setback -- and then some. According to preliminary data from market consultancy Gartner Group, it's on the verge of becoming the leader in the $2.76 billion market for software that's used in designing semiconductors.

HIGH-END NICHE. In part, that's because Synopsys' product line is concentrated in the market's most lucrative segment -- software for creating the smallest and the most complex chips. Sales of such software have held up even though chipmakers have cut their research and development spending, which usually precedes a decline in spending on Synopsys' software, says Gartner analyst Laurie Balch. An even bigger factor in its surge may be the 2002 acquisition of software concern Avanti, which helped fill holes in Synopsys' product portfolio.

The bottom line: While Synopsys held a 26.7% share of the electronic design automation (EDA) market to Cadence's 29.9% last year, this year could see the reverse, says Balch. Cadence execs disagree: "Speculating about market share at this juncture is like taking your eye off the ball to check out the scoreboard. It's simply the wrong thing to focus on," a Cadence spokesperson writes in an e-mail.

Try telling that to investors. Synopsys shares are up by more than 50% in the past 12 months, to $65, while Cadence's stock is at $13 and change, below its 52-week high of $15.58. Synopsys' second-quarter earnings report in May only fueled the buying enthusiasm. Its revenues rose 57%, to $292 million, while earnings grew 144% vs. the year-earlier quarter, to $61.2 million.

BETTER BOOKINGS. Analysts expect similar gains for its third fiscal quarter, which ended July 31, the results for which Synopsys will report on Aug. 20. Banc of America Securities analyst Sumit Dhanda on Aug. 7 upped his price target for the stock to $72 over the next 12 months.

Near term, the case for that seems strong: Despite the emerging consensus that Synopsys is the industry's leading player, it's trading at almost the same price-earnings ratio -- 18.5, on anticipated 2004 profits -- as Cadence, whose orders have been slipping at a double-digit rate this year. By contrast, Synopsys' bookings should increase by about 5% in fiscal 2003, ending in October, estimates Dhanda.

Still, risk-averse, long-term investors might want to wait before jumping into the stock. Much of Synopsys' performance in fiscal 2004 hinges on a semiconductor-industry recovery. And the timing and magnitude of that upturn remain uncertain.

INSTALLMENT PLANS. If the long-anticipated rebound doesn't materialize -- and if, as a consequence, Synopsys' bookings stay flat in fiscal 2004 -- its revenues will grow only 13% next year, to $1.3 billion, vs. their 30% increase in 2003, estimates Dhanda.

That may sound confusing, unless you understand how Synopsys books orders. Until three years ago, it recorded revenue at the time it made a sale. When the tech meltdown arrived, however, it switched to a so-called subscription model, which has since become an industry standard. Under this approach, customers pay for products -- and Synopsys records the revenue -- in installments over the software's useful life. So, orders from 2002 and 2003 will still keep on filling Synopsys' coffers in 2004. Even so, a fall from 30% to 13% sales growth would be quite painful.

Dhanda concedes that this assessment is overly conservative. Still, a broad-based chip recovery hasn't appeared so far, notes Peter Hofstra, senior investment analyst at the $113 million AIC Diversified Science & Technology fund. In fact, the EDA industry's sales typically pick up only after those of its customers climb, says Rita Glover, an analyst at market researcher EDA Today.

FADING BOOST? Gartner's Balch figures that after an innovation drought of the past few years, lots of chipmakers will shift their design work into high gear, pushing the EDA industry to grow 15% in 2004, compared to about 1% this year. Other analysts, however, are more skeptical. Merrill Lynch's Jay Vleeschhouwer expects only single-digit growth in industry revenues.

In addition, some analysts worry that a disproportionate share of Synopsys' revenue growth over the past year has come thanks to its Avanti acquisition -- and this effect might not last. When Synopsys salespeople renewed Avanti customers' contracts, they also managed to sell some Synopsys products, says Jennifer Jordan, an analyst with Wells Fargo Securities. But much of this upselling has already been completed, she estimates -- a sign to her that Synopsys' growth could slow.

Chief Financial Officer Steve Shevick disagrees. He says Synopsys is just starting to ramp up sales of some of Avanti's most important products, such as Astro, which helps designers figure out where to place transistors and wires on a chip. "These products have clearly not run out of steam," he asserts.

DILUTION ALERT. Another concern is that the design services Synopsys provides to chipmakers -- which accounted for about 32% of its sales in 2002 -- could continue to fizzle for a while. The engineering staff at most chipmakers are underutilized at this point, so design work isn't being outsourced as aggressively as it was before, explains Richard Tortoriello, an analyst with Standard & Poor's. He expects Synopsys to get only 23% of its total revenue from services this year, and he predicts that the slump could carry into part of 2004. S&P rates the stock 4 STARS, or accumulate.

Investors should also watch out for potential dilution in earnings per share if holders of Synopsys' 6.5 million exercisable stock options sell those shares: That would cut EPS by 6 cents to 10 cents for the final two quarters of 2003, Dhanda estimates -- which might affect the stock price.

Still, it seems likely that once the chipmaking recovery arrives, Synopsys -- and its investors -- will again prosper. "Synopsys is the highest-quality large EDA company," says Rich Valera, an analyst with Needham & Co. who once worked at Synopsys. After it finishes converting the majority of its clients to the subscription-payment model -- which should be within the next six months -- operating margins should rise from about 28% in 2003 to 30%-plus in 2004, says CFO Shevick.

A BROADER MARKET. Synopsys is increasing its R&D spending and should emerge stronger after the downturn. And it's already the leader in some of the most sophisticated varieties of chipmaking software -- for which demand should rise as chips become smaller and designing them becomes more difficult. Shevick says Synopsys is also pushing into the market for software used in manufacturing chips, in an effort to broaden its customer base to include chip-equipment makers.

Given this overal bright future, long-term investors might want to hold Synopsys. However, they may also want to wait for clearer signs of a chip-industry rebound -- or for dips in Synopsys' stock price -- before snapping up the shares. Kharif covers technology for BusinessWeek Online in Portland, Ore.

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