Synopsys Stock: A Leading Software Play (NASDAQ:SNPS)

As a “Silicon to Software” partner for companies that develop electronic products and software applications, Synopsys (NASDAQ:SNPS) plays a key role in electronic design automation (“EDA”). Now, whenever you come across words like “automation” in a high inflation environment where the wages of Engineers are going up, it makes sense to take a deeper look at the enabling company.

Then it comes as no surprise that Synopsys’ revenues have been increasing, suggesting that its solutions are gaining popularity among system-on-chip (SoC) designers creating advanced semiconductors or software developers writing applications that directly interact with the electronics.

More importantly, in the current market regime where investors now pay more credence to the bottom line even for high-growth software plays, the company exhibits positive earnings which are on an uptrend.

Now, with cost components becoming more expensive in the semiconductor space as a result of inflation and supply-chain constraints, it is important for software companies to deliver a lot more capabilities to designers than before, and this in an end-to-end fashion, in order to be competitive.

The competitive position

In this case, Synopsys with its Black Duck SCA (Software Composition Analytics) solution has been recognized as a leader for Q3-2021 among the top 10 vendors by the Forrester Wave. In addition to other categories as shown below, the company also received the highest scores in the vulnerability identification criterion. This is highly relevant in a context where organizations increasingly rely on external components and face more risks of being impacted by critical vulnerabilities. In addition, Synopsys’ solutions, in contrast to others also offer prioritization of vulnerability remediation in case problems are detected.

Synopsys received the highest score in the following categories:

• Strategy
• Vulnerability Identification
• Revenue
• Product Vision
• Market Approach
• Corporate Culture criterion

Consequently, equipped with the most advanced tools, the executives, during the fourth-quarter earnings call back on December 1, envisage that their company will play a predominant role in helping customers with chips design, IP (intellectual property) integration, software security, and quality testing through multi-year contracts.

Now, the prices of electronic components have increased as a result of shortages, and at this stage, it is impossible to say whether these are transitory. As a matter of fact, supply bottlenecks and cost inflation have already impacted the financial results of some semiconductor companies like Applied Materials (NASDAQ:AMAT) which missed analysts’ estimates for its fiscal fourth quarter. Thus, it is important to assess whether there are risks that can impact Synopsys’ growth and pricing opportunities.

Revenues and profitability

Synopsys delivered revenue growth of $4.2 billion for 2021 or a 14% increase over FY-2020. This was in turn made possible through double-digit growth in both of the two segments (as shown in the table below) spanning across all geographies. Additionally, the company significantly exceeded its original goals.

Diving into the bottom line, the company substantially expanded its non-GAAP operating margins, with more than 20% earnings growth. This achievement was made possible by the cost of revenues for both Products as well as Maintenance and Services being kept under control. As a result, the cost of revenue as a percentage of total sales decreased from 22% in 2020 to 20% in 2021.

There was also control for Sales and Marketing expenses which, despite increasing from 2020 to 2021, have remained constant when considered as a percentage of overall revenues. The same is the case for General and Administrative expenses which have been kept at 8% of total revenues.

Furthermore, as per the SEC filings, cash from operating increased to $1.49 billion, or an increase of $501.3 million over 2020. This is partly due to the fact that the company generally receives cash from upfront arrangements which is much sooner than from time-based products revenue.

Consequently, enjoying a record cash flow together with the fact that the software play has been able to grow at double-digit figures while keeping a hold on expenses makes it an attractive proposition for value-oriented investors who value profitability and cash metrics.

After the highly-profitable fiscal year 2021 (ending on October 30), it becomes important to consider prospects for the first quarter of 2022 with the financial results to be announced on February 17.

In this respect, Synopsys saw strong growth in run rate on the deals that were booked, together with several large significant renewals. This convergence of strong bookings and the large renewals resulted in $6.9 billion of backlog ending in Q4, which will be carried into fiscal 2022. For investors, this represents more than one and a half times FY-2021’s total sales, a considerable figure. Thus, Q1-2022’s expectations are for double-digit revenue growth together with continued operating margin expansion.

Valuations and the inflation-friendly rationale

Margin expansion should in turn translate into better earnings, and for this purpose, the market has already rewarded Synopsys with a forward non-GAAP Price to earnings ratio of 36.96x, which is already higher relative to the IT sector by over 65%.

Now, there are two ways to play the stock.

First, after more than a 20% drop since the beginning of 2022, value-oriented investors may wait for the price to fall further, maybe to the $250 level in order to initiate a buy.

Second, for investors looking more towards profitable growth, Synopsys constitutes a “disruptive innovation” play. This is made possible by products like EDA (Electronic Design Automation) and DSO.ai (AI-Driven Design Applications) can deliver results faster than human beings. These tools, by automating certain tasks, also help to reduce the number of man-hours required to do a design or engineering job, thereby enabling corporations to save on their R&D spending. Now, cost reduction, especially during a period of price increase is a strong argument, one which could take precedence over the valuation criterion in 2022 as wage inflation bites the labor market.

I am also optimistic about the stock due to its superior profitability and cash flow metrics as it scores an A on SA’s profitability grading. It also has a low debt level despite effecting acquisitions amounting to $98 million during its last fiscal year. Currently, with an RSI of less than 26, just a 10% upside based on its current share price of $290 would see the company flirt back with the $320-322 level in the event of an earnings beat on February 17.

On the other hand, in view of current market realities where even some stocks, especially those forming part of the IT sector with relatively good value metrics are being indiscriminately dumped by investors, it is possible for the shares to fall further. This is the reason why I consider the stock to be a hold.

Finally, in the race for increasing their market share for faster and lower-powered chips used in computing, networking, and mobility, companies have increased the dose of AI used in the design phase. Here, by proposing a differentiated and superior solution, Synopsys can significantly help its customers from the competition standpoint. At the same time, with software composition and supply chain risk now being high-priority issues for development and security teams, the company has the capacity to help them to be more frictionless while benefiting from cost savings.