A Surprisingly Strong Software Niche
By Richard Tortoriello
Given the disappointing earnings reports from many companies and the market-rattling questions about accounting, investors are likely looking for something with a bit of stability these days. One place to look would be at the electronic design automation (EDA) software market. Positive market trends, increased demand, and steady earnings have helped the sector outperform the Nasdaq since September 11. Information-technology market research and consulting group Gartner Dataquest estimates that the EDA software market was worth about $3 billion in 2001.
EDA software is primarily used to design semiconductors, which are at the heart of products ranging from cell phones to cars. Growth in the EDA software market is being driven mainly by the increasing complexity of chips. Intel's (INTC ) Pentium 4, for example, boasts 42 million transistors. Chipmakers have to buy new EDA software to make leading-edge chips, with transistor sizes of only 0.13 microns or less, to stay at the forefront of production. Prices for EDA software range from several thousand dollars for a specific tool to millions of dollars for a site license or complete system.
EDA software makers are completing a conversion from a perpetual-license model to a subscription-license model. While the change to subscription licenses won't increase revenues, it makes earnings more predictable, thus making the stocks of these companies more stable investments. Also, the proliferation of products using analog and mixed-signal chips has led to a surge in demand for so-called custom design EDA software used for those chips.
A few large software designers, Cadence Design Systems (CDN ), Synopsys (SNPS ), Mentor Graphics (MENT ), and Avant (AVNT ), dominate this market, while a number of smaller players compete in specialized niches. Standard & Poor's two favorite companies in the EDA software sector are Cadence Design and Mentor. Both are ranked 4 STARS (accumulate). Synopsys, ranked 2 STARS (avoid), is in the process of acquiring Avant (not ranked).
Cadence is the field's largest player, with revenues of $1.43 billion in 2001. It's the leader in the "place-and-route" market (software that lays out transistors and wiring in the most efficient way), and it's neck-and-neck with Synopsys in so-called functional verification -- simulating the results of a system-level design to ensure it will function as expected. Cadence is second to Mentor in physical verification -- checking the design and placement of transistors to make sure that the circuit will function as expected -- with about a 30% market share. Its wide range of products allows Cadence to offer complete software packages to chipmakers.
Cadence's earnings per share increased from $0.46 in 2000, excluding goodwill amortization and special charges, to $0.84 in 2001. Much of the growth was driven by its advanced synthesis/place-and-route solutions and strength in its custom solutions for analog and mixed-signal design. Tality, CDN's design services business, which contributed 7% of fourth-quarter EPS, has been a drag on revenues as design services have fallen off during the downturn. However, S&P expects Tality to improve significantly as the economy and semiconductor markets strengthen.
Despite weakness in Tality, revenues increased 11% sequentially in the seasonally strong fourth quarter and 19% year-over-year. In addition, in the fourth quarter the average contract-renewal price rose 50%. S&P estimates EPS of $1.15 in 2002 and $1.40 in 2003. With a price-to-earnings ratio of 21 times our 2002 estimate, vs. our long-term projected growth rate of 20%, we think Cadence shares are attractive.
Mentor Graphics, the third-largest player in the EDA software industry, had revenues of $600 million in 2001 and about a 16% share of the worldwide market. Mentor has increased growth through a niche strategy of identifying markets not being served by its larger competitors and then focusing on the most difficult design challenges in those areas.
Recently, Mentor has enhanced its field programmable gate array (FPGA) design offerings. FPGA revenues grew 12% year-to-year in the fourth quarter and made up more than 35% of total revenues. Other areas of focus include systems design, deep-submicron design -- design of chips with the smallest electronic components -- and system-on-a-chip design.
In the fourth quarter, Mentor sold its first license for its new TestKompress design for test technology. As chip designs have increased in complexity, the amount of time needed to test them has exploded, significantly increasing testing expenses. The TestKompress program actually designs a small compressor/decompressor into the chip, resulting in a reduction of as much as 50% in total test time. The program is sold on a site-license basis for about $2 million.
Mentor has increased EPS, before goodwill and special charges, from $0.55 in 1999 to $1.01 in 2000 and to $1.13 in 2001. S&P estimates EPS of $1.24 in 2002 and $1.50 in 2003. Mentor also carries an attractive p-e-to-growth ratio, with a p-e on S&P's 2002 estimate of 20 vs. its long-term EPS growth projection of 21%.
Both Mentor and Cadence are reasonably priced and still offer decent earnings growth in this choppy market. Not bad considering so many of the alternatives.
Tortoriello is a technology industry analyst for Standard & Poor's