A TOOLSET FOR TECHNOLOGY We are reinstating coverage of the electronic design automation (EDA) industry. EDA software is a toolset used by integrated circuit (IC) designers in designing and testing semiconductor chips. The EDA industry faced a challenging 2009 as semi customers hunkered down on opex, and we expect a modest 2010 recovery. Attention is turning more than ever to integrated EDA solutions, as shrinking IC architectures have yielded scaling challenges with respect to both physical and power limitations. Other key trends include: 1) increased focus on design for manufacturing, power, and verification; 2) further adoption of electronic system level design in select applications; 3) ramping use of standard-based IP; and 4) exploration for growth avenues beyond IC design.
SYNOPSYS IS OUR TOP PICK IN EDA Synopsys (Buy, PO $27) is our top pick based on its integrated product offering, cash flow generation capabilities, and strong balance sheet. We’ve taken a more cautious position on Cadence Design Systems (Underperform, PO $5.7) given limited upside potential to 2010 and near-term disruption due to ongoing corporate transitions. We are modestly positive on Mentor Graphics, as we see a viable best-in-breed IC strategy coupled with green field market expansion, but competitive headwinds in the IC design market could pressure long-term growth.
SEMI R&D TO GROW IN 2010; EDA INDUSTRY SHOULD FOLLOW The $5b EDA industry tends to lag the cyclical behavior of the $250b semiconductor market that it supports, and more closely tracks semiconductor R&D spending. Our bottom-up semiconductor R&D analysis indicates approximately 9% Y/Y growth in 2010 following 7% Y/Y decline in 2009. We are initiating our 2010 EDA market forecast at +4% and 2009 at -10%. Note that the subscription model transition underway at Cadence could cause a sharper 2009 decline and/or more muted 2010 recovery than the historical relationship would normally suggest – Q1 and Q2 have declined 11% and 16% y/y, respectively. We think low-single-digit growth remains a reasonable 2010 target, nonetheless.
VALUED IN A VACUUM; LONG-TERM UPSIDE TO EDA MULTIPLES We’re fascinated to see a sharp disparity between EDA valuations when stacked up against similar recurring revenue growth stories in our software universe. Company specific growth stories vary, but long-term growth for EDA is likely in the mid-single digit range. Comparable software stocks such as RightNow, Sybase, and Symantec trade at 2.3x 2010 EV/Revenue vs. EDA at 1.4x. Moreover, EDA is arguably a stronger industry than the software counterparts given the underlying $250b semiconductor industry it supports and the considerably high barriers to entry. We’re not calling for an immediate elimination of the valuation gap as we see no clear catalyst on the horizon, but we certainly believe there is an upward bias to EDA multiples over time.