One of the most important reasons to avoid investing in semiconductor stocks is because of industry cyclicity. As technology trends ebb and flow, spending on chips in the global economy can be highly volatile. A couple of years of boom time can be followed by sales droughts -- leading to some wild swings in stock prices.
Nevertheless, as volatile a space as it might be, it's also profitable -- global demand for chips is poised to rise over the next decade. That's why Synopsys (SNPS -1.73%) might be worth a look. It offers the growth of the chip industry, but with the more steady, predictable financial results of a software business. Here's why it's a top buy right now.
A critical industry partner you've never heard of
Synopsys specializes in what's known as electronic design automation (EDA). EDA is software that helps a semiconductor company design and test chips. Additionally, Synopsys also provides chip design templates that a company could license and incorporate into its own custom design. This helps simplify the process of engineering new chips and computing systems by utilizing a tried-and-true blueprint in areas not needing new work.
Synopsys and Cadence Design Systems (CDNS -1.98%) are the top two players in the EDA space, although Synopsys says there are other software companies that dabble in this area too. Many chip designers out there also have their own licensing and software businesses -- like Nvidia and Qualcomm, for example. Thus, some of Synopsys' customers are also competitors.
However, due to the subscription software-based nature of its business model, Synopsys offers investors far more steady, predictable returns than chip companies themselves that rely on final hardware sales. While Synopsys may not be the fastest-growing business in the semiconductor world, it hasn't been prone to some of the wild swings in sales other top chip companies have been over the last decade.
Data by YCharts.
Steady growth, highly profitable
Besides enjoying steady growth in revenue over time, Synopsys is also highly profitable. Over the last 12 months, the company has generated $1.58 billion in free cash flow, a very healthy free cash flow profit margin of nearly 32%. And as the company expanded over the last decade, free cash flow has grown at an even faster rate than revenue. That's exactly the kind of dynamic investors want to see: better operating efficiency as a company scales up.
The company's outlook for fiscal 2022 is solid as well, even as the overall chip industry begins to enter a cyclical downturn in some areas (most notably, in consumer electronics). Synopsys said it expects revenue to be at least $1.26 billion in its fiscal 2022 fourth quarter, up at least 10% year over year.
That expectation will cap off a stellar year for Synopsys. Thanks to a few tuck-in acquisitions and general chip industry growth, revenue should exceed $5 billion for the year, an increase of nearly 20% from 2021.
Also of note, Synopsys reported over $1.5 billion in cash and short-term investments on hand at the end of July, offset by minimal debt of just $22 million. In addition to free cash flow generation, that provides a nice cushion, from which the company can make other small acquisitions of software peers and repurchase stock. On that latter note, Synopsys has returned $717 million in excess cash to shareholders through the first nine months of fiscal 2022 in the form of share repurchases.
As of this writing, Synopsys trades for 33.6 times enterprise value to free cash flow. Despite chip industry headwinds, this software, design, and tech licensor is a great buy right now if you're looking for steady, profitable growth from the semiconductor industry over the next decade.
