Synopsys, Inc. - A must-own and now trading at a discount
This is one of the best companies out there, particularly in the semiconductor industry, and I am now buying shares aggressively!
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It is about time I covered Synopsys again. The company was the first stock I covered in a deep dive on Rijnberk InvestInsights in January 2024. However, despite having a 6%+ weighting in my portfolio, making it a top-five position, I never updated my thesis again.
Luckily, now is the perfect time to revisit Synopsys. Last Wednesday, February 26, Synopsys released its fiscal Q1 earnings report, which was bang-on in line with estimates and shows the company is on a steady upward trajectory.
However, despite a generally strong 2024 performance with double-digit revenue and EPS growth, Synopsys shares have underperformed considerably over the last year.
For reference, SNPS shares are down 21% over the last twelve months and 6% so far this year, falling well short of the returns from the semiconductor sector and the broader market. However, the company is still delivering excellent financial results and is poised for another decade of strong growth, with multiple secular drivers working in its favor.
I remain as bullish as before – as I was a year ago.
Honestly, I will happily argue that Synopsys is still one of the highest-quality businesses you’ll find in the semiconductor industry. This is due to its extremely favorable positioning toward secular trends, the simple fact that this is an anti-cyclical pick in a highly cyclical industry, its subscription-based model, and the sheer necessity of its software for all semiconductor designers, including the likes of Nvidia, AMD, Broadcom, Intel, etc., no matter the cycle or state of the economy.
This is just a brilliant business and one of my highest-conviction picks for the decade ahead.
Yet, after the poor share price performance over the last year, Synopsys shares are now trading at multi-year low multiples and at quite a discount to historical multiples and my fair value estimate, even as the company continues to execute and seems to have its best years still ahead of it.
Therefore, today, I will take a close look at the company’s recent performance, financial health, medium-term growth prospects, and valuation. But first, let’s start by introducing this one-of-a-kind business once more since I bet most of you aren’t quite familiar with it.
This is Synopsys!
Synopsys is a leading technology company specializing in electronic design automation (EDA) and semiconductor intellectual property (IP). Founded in 1986 and headquartered in Sunnyvale, California, Synopsys plays a critical role in the design and verification of integrated circuits. It provides cutting-edge tools enabling chip manufacturers to develop increasingly complex, high-performance semiconductors.
Starting with IP, Synopsys has an industry-leading semiconductor IP portfolio. It provides pre-designed and pre-verified intellectual property blocks that semiconductor designers can integrate into their chip designs, including essential components such as processors, memory interfaces, and connectivity solutions. This portfolio allows companies to accelerate time to market while ensuring reliability and efficiency.
In this industry, it mainly competes with well-known IP provider ARM, with this one leading the industry. However, Synopsys has been making great strides in semiconductor IP, outpacing the market and ARM and rapidly gaining market share. For reference, Synopsys has a market share of about 20% but has been outgrowing ARM by a significant margin since 2016, closing the market share gap by 13.6 percentage points in just six years. Furthermore, its IP revenue growth rate sat 10.8 percentage points above that of ARM in the same period.
So, yes, Synopsys is doing rather well.
However, the more exciting part of this business is its EDA software, which accounts for about 70% of revenue.
EDA refers to the use of specialized software tools to design, verify, and simulate electronic systems, particularly integrated circuits (ICs). It is kind of like a productivity tool for chip developers.
Crucially, as modern semiconductors become increasingly complex, manual design methods are no longer feasible. Thus, EDA is essential for developing high-performance chips with billions of transistors. Furthermore, semiconductor technology is becoming exponentially more complicated and end-user-focused. This means there is not one successful way to design a chip; rather, it differs by end market, requiring much more complexity.
Synopsys’ EDA software not only allows customers to design their chips from a digital standpoint but also from a physics standpoint, as semiconductor technologies are increasingly pushing the boundaries of physics nowadays. This means this software is multi-dimensional and insanely complicated, as well as unmissable.
These tools assist engineers at every stage of the chip development process, from conceptualization and circuit design to verification and physical layout. They enable designers to create precise circuit schematics, simulate how a chip will function under different conditions, and detect potential flaws before fabrication. Advanced EDA software also optimizes power consumption, signal integrity, and overall performance, ensuring that the final product meets industry standards and specifications.
While working out of the spotlight, Synopsys is one of the most advanced engineering institutions, helping customers across the chain break boundaries.
Crucially, Synopsys is the largest provider of this crucial technology. It practically operates a duopoly with Cadence, and Synopsys is capturing a growing mid-30s percentage of the market.
And these both have a massive moat as well. Why? Well, the simple reason is that the amount of innovation and development to bring EDA software to market that matches that of these two players is so massive that startups have no chance of competing against Synopsys and Candence, who have decades of innovation under their belt.
Meanwhile, as is probably clear by now, Synopsys (and Cadence's) software is essential for semiconductor designers. Without it, modern semiconductor design would be impossible.
Highlighting this, Nvidia CEO and founder Jensen Huang even calls Synopsys’ EDA and IP products “mission-critical” to the company’s business and design process.
In other words, with today’s semiconductors becoming increasingly complex, there is no way these semiconductor designers can work without Synopsys’s EDA and IP products, which is exactly why its revenue stream is extremely stable and reliable through any cycle. Its customers simply cannot afford to cancel their EDA subscriptions, even for the shortest of periods. It would completely stagnate their design process.
The graph below says it all: Synopsys didn’t report a single quarter of negative growth between 2011 and 2024.
This is the result of a subscription-based revenue model, perfect positioning within customers’ R&D priorities, and a non-cancellable backlog of almost $10 billion. This translates into consistency, reliability, and great visibility.
Furthermore, this growing complexity and the growing necessity for its products also lead to a terrific long-term growth outlook for Synopsys, with the company potentially still having its best decade ahead of it.
With this exposure and leading positions in both the EDA and IP markets, Synopsys is exposed to two of the faster-growing verticals of the semiconductor industry, positioned well to benefit from the rise of AI, the increasing complexity of semiconductor designs, and the push for more affordable and standardized solutions.
As a result, management is confident that its subscription-based model will allow it to realize double-digit growth for the foreseeable future while maintaining incredible revenue stability.
On, yes, also worth pointing out is a great revenue diversification, further contributing to Synopsys’ revenue reliability. Notably, the company sees no single region accounting for over 50% of revenue. This means the company is not overly exposed to local headwinds. Also, unlike many semiconductor peers, the company has limited exposure to Asia, which I also view as positive as it means the company derives most of its revenues from stable economies. Synopsys derives about 46% of its revenues from the US and 10% from Europe. Meanwhile, China and Korea account for 26% of revenue, with the remainder being derived from “other.”
All this makes Synopsys one of the most compelling investments for the decade ahead, which is precisely why I have used recent share price weakness to grow my position further.
On that note, let’s delve into Synopsys’s most recent earnings report to get a better sense of its current performance and financial health.
Q1 performance + highlights
Q1 revenue was $1.46 billion, down 4% YoY and roughly in line with consensus estimates.
Q1 EDA revenue was $1.02 billion, up 4% YoY.
Q1 IP revenue was $435 million, down 17% YoY.
While maybe not great at first glance, these results were actually quite impressive. You see, the reason for the YoY decline in revenue was one less week of revenue generation compared to Q1 2024. Adjusting for this, revenue was actually up in the high single digits. Furthermore, the company beat consensus estimates and exceeded the midpoint of guidance.
Synopsys indicated that weakness in industrial, automotive, and consumer electronics remains pronounced, though it has not impacted the business too much. This is due to strength in AI and HPC demand and Synopsys being largely immune to these cyclical demand headwinds. Design activity, even in industries plagued by cyclical headwinds, remained strong as companies continued to invest in next-generation technology and products.
Even tough end-markets are down, Synopsys customers don’t stop designing products.
As a result, Synopsys remains an R&D priority for its customers. This is why EDA revenue, in particular, was strong, with one less operating week offset by broad-based strength. However, this strength was offset by a deeper decline in IP revenue, which was hit harder by one less operating week and a strong Q1 2024.
Nevertheless, the group performance was still better than expected. This strong (out)performance was enabled by continued innovation and product developments, which kept Synopsys software mission-critical to its customers and drove growth.
For example, the company keeps innovating its headline product – PrimeTime – which is used by virtually all key advanced node customers. Synopsys PrimeTime is a static timing analysis (STA) tool used in the semiconductor industry to verify and optimize the timing performance of digital circuits. It ensures that an integrated circuit (IC) meets its required timing constraints before fabrication, preventing issues like setup and hold time violations that could cause malfunctions.
This makes it critical in the semiconductor design process. With its most recent PrimeTime release, customers using the software achieve significantly faster turnaround times, up to 30% faster.
Also, the company’s IC Validator product family is delivering tremendous value. Recent improvements have led to far greater turnaround times for Synopsys customers, with leading-edge customers achieving greater than 2x turnaround time for full-chip physical verification sign-off at 3-nanometer and below. This allows design teams to finish more sign-off runs within the budget cycle time to improve the quality of results, making it incredibly valuable to Synopsys customers.
Meanwhile, the company is also fully benefitting from AI, not just through the growing demand for advanced nodes but also through the integration of AI into its own software stack to improve its products. According to Synopsys management, “generative AI capabilities are delivering significant productivity gains and cementing its leadership position.”
Synopsys is constantly increasing the presence of AI in its software offering, though it is still in the very early stages. Nevertheless, its early AI offering is already able to deliver 2-4x improvement across different processes, which is extremely promising. This cements Synopsys’s leadership and value to its customers.
This is what keeps growth as impressive as it is.
Meanwhile, this top-line growth pays off on the bottom line as well. Yes, the Q1 operating margin was down 220 bps year over year to 36.5% due to the aforementioned one-time headwinds, but the general margin trend is up. This is driven mainly by operating leverage, with Synopsys still heavily investing in R&D.
Further down the line, Q1 EPS was down 10% year over year to $3.03, but it still came in above the high end of management’s guided range and beat the consensus by $0.24, or a very solid 9% profit beat.
Furthermore, FCF turned negative in Q1 due to a temporary margin decline to a negative $108 million. Positively, Synopsys still maintained a healthy balance sheet with cash and short-term investments of $3.81 billion and minimal debt of $665 million.
When it comes to financial health, Synopsys also looks pretty great.
The Ansys acquisition
Before moving to the outlook and valuation part of this post, I want to briefly discuss the potential Ansys acquisition.
In January 2024, Synopsys announced the acquisition of Ansys, renowned for its engineering simulation software, in a cash-and-stock deal valued at approximately $35 billion. This strategic move aims to merge Synopsys's semiconductor electronic design automation (EDA) expertise with Ansys's comprehensive simulation and analysis portfolio, creating a leader in silicon-to-systems design solutions.
However, as expected, one year later, the deal hasn’t been closed due to regulatory hurdles. Positively, the company recently received approval from the European Commission and UK CMA after offering some remedies, including selling some of Ansys’ operations.
Meanwhile, the company is also making strong progress with other regulatory agencies, including China, which leads management to expect the deal to close in the first half of 2025.
In my eyes, this deal closing is a great positive for Synopsys shareholders. Ansys is a leader in analysis and simulation of semiconductor physics and multiphysics, both on a systems and silicon level, which is becoming increasingly important.
Whereas simulation was impossible or insanely slow before, thanks to the push for advanced computing, mostly by Nvidia, in combination with automation powered by AI, simulation is going to be a rapidly growing market. With Ansys the only real player in semiconductor design simulation, it is exceptionally well positioned to benefit.
More importantly, combining this with Synopsys’s strengths creates a one-stop platform for semiconductor companies to design, verify, and simulate entire chips and systems, strengthening its competitive position further and adding a solidly growing revenue stream.
Overall, the $35B price tag is steep, I have to admit, but the deal solidifies Synopsys’s leadership in AI-driven chip and system design, making it a strategic long-term win.
Personally, I hope the deal goes through later this year.
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Outlook & Valuation
FY25 revenue to be between $6.75 billion and $6.8 billion, up 10-11% YoY.
FY25 operating margin to be 40% at the midpoint.
FY25 EPS to be between $14.88 and $14.96, reflecting YoY growth of roughly 13% at the midpoint.
FCF to be roughly $1.6 billion, reflecting an expected FCF margin of roughly 33%.
Management reaffirmed its FY25 guidance, which aligns with consensus estimates. Despite a tough Q1 comparison, management’s guidance still reflects double-digit growth for the full fiscal year on both the top and bottom lines, with improving profitability and healthy cash flows, as we have gotten used to.
Furthermore, management also reaffirmed its long-term growth targets. Synopsys management believes that in the long term, it should be able to keep growing EDA revenue at a double-digit rate and IP revenue at a mid-teens rate. This should translate into consistent revenue growth at a low-to-mid-teens CAGR.
Furthermore, management targets a long-term operating margin in the mid-40s and an FCF margin in the mid-30s, which are really impressive numbers! This reflects the expectation for further margin expansion in the years ahead, and with revenue growth also likely remaining in the double digits, EPS is anticipated to keep growing at a high-teens rate.
This just remains a stellar outlook; it’s as simple as that.
Following these fiscal Q1 results and the reaffirmed guidance, there is no real need to massively change financial estimates either, which also explains why Synopsys shares showed little reaction post-earnings, apart from the broader market movement.
I continue to expect Synopsys to deliver revenue growth between 11% and 13% and EPS to grow slightly faster. Margins should continue to expand steadily, likely leading to EPS growth at a mid-teens rate. This is all reflected below.
It won’t surprise anyone that Synopsys shares tend to trade at a premium to the broader semiconductor sector, which I believe is more than warranted. As explained clearly throughout this post, Synopsys is by far the highest-quality and lowest-risk pick in the semiconductor sector, even beating ASML to the feat.
The company fully benefits from secular growth trends, which lead to a great growth outlook. At the same time, it has a de-risked revenue stream thanks to its subscription-based model, well-diversified exposure, and the sheer necessity of its products for its customers.
As an investor, this is all I can wish for, and I am, therefore, more than willing to pay the premium Synopsys shares consistently trade at.
However, this premium has come down quite a bit after the shares' underperformance over the last year. Over the last week, shares dropped to a new TTM low of $457 per share. This means shares now trade at “just” 30.5x the FY25 EPS consensus, a mighty 22% discount to the 5-year average multiple of 39x. Furthermore, this translates into a growth-adjusted PEG ratio of 2.2, which is a 10% discount to the 5-year average.
I know, these multiples are still rich and might seem expensive, but considering the quality, reliability, longevity, and predictability you get in return, I will argue this is a very compelling level to buy and a discount to fair value.
For reference, I believe a long-term 35x EPS multiple is well justified here, considering Synopsys should be able to keep up this growth well into the next decade. Using this multiple and my current fiscal FY27 EPS projection, I calculate a target price of $686 per share. This translates into potential returns of roughly 16% annually (CAGR) or a total 3-year upside of just over 50%.
These are excellent returns at a favorable risk-reward profile that should easily beat the market and the semiconductor index. Therefore, I will argue that Synopsys shares trade at very affordable levels right now, with share price pressure over recent months completely unjustified.
I am buying quite aggressively at these levels!
Hi Daan, I wasn't familiar with Synopsys before. It's always a pleasant surprise to get to know such top companies. I did know their biggest competitor, Cadence Design, a little better. I see that you have a lot of knowledge about this specific sector. That is why I would like to ask you some additional questions about your choice for Synopsys. If I look at the figures, both Cadence's ROE and ROIC are a lot higher. Actually, at first glance, most of the figures seem to be slightly better at Cadence. I also don't like the rather high SBC at Synopsys. But maybe I'm overlooking things? I would therefore like to hear your opinion.
Great write-up, Daan. I've heard this name pup up a few times on the BG^2 Pod and have meant to check it out. Would it be correct to compare the moat of the EDA software to Nvida's CUDA in terms of importance to the industry?