Chip stocks were already hurting in 2022 when an expansion of U.S. restrictions on chip exports to China was announced on Oct. 7 and sent the semiconductor industry further into a slump. As measured by the iShares Semiconductor ETF (SOXX 1.86%), chip stocks are down some 44% so far in 2022 -- their worst performance since the Great Recession in 2008-09.
These new measures cast further doubts on how quickly the makers of the building blocks of tech will recover, since many of these companies rely heavily on sales to China. Governments around the world are doling out funding to promote domestic chip production (like the CHIPS and Science Act in the U.S.), but measures like this will take time to trickle through the industry and offset any loss of sales to China.
If this has you worried, you might consider giving electronic design automation (EDA) companies Synopsys (SNPS 0.49%) and Cadence Design Systems (CDNS -0.21%) a careful look.
The best of both computing technology worlds
Synopsys and Cadence Design are integral parts of the semiconductor industry. Both hold patents on circuitry designs that other companies can license and incorporate into their own work. Additionally, both companies provide chip simulation and testing. Synopsys also has a segment for software development and security services that integrates with the hardware the developer is working with. Cadence has a software development product that helps engineers validate software integration with chip systems.
There's a lot of overlap between what these two companies do, but both offer a similar investment benefit: They're semiconductor businesses but packaged up into a software-as-a-service (SaaS) business model. Chip sales can be highly cyclical. In fact, part of the reason chip stocks fell this year is that consumer spending on electronics is set for a big cool-off in the second half of 2022. But Synopsys and Cadence are steady-eddy businesses thanks to the subscription-based services they provide their customers.
Despite their stable-revenue models, it's worth noting that Synopsys and Cadence shares are both trading down big in recent weeks. Even EDA software is getting caught up in this latest round of the U.S.'s restrictions on tech exports to China. Back in August, EDA providers were told to stop providing design services to China for the most powerful chips used in AI and high-performance computing. An expansion of these restrictions to other companies that export these high-end chips to China could dampen overall demand for Synopsys and Cadence.
However, even after a recent tumble, Synopsys and Cadence are faring better than the semiconductor industry and the stock market overall. Why the outperformance?
Data by YCharts.
Minimal exposure to China at this juncture
It's no secret that China has been trying to foster its own domestic chip design and manufacturing industry. To do so, it relies heavily on U.S. technology companies, but it's no simple task to build. Infrastructure (like high-performance data centers) needs to be built, software licenses need to be obtained, and chip manufacturing equipment purchased and installed in a fab.
As a result, companies across the semiconductor supply chain saw rising sales from China. Some, like chip fab equipment companies, reported as much as one-third of revenue coming from across the Pacific. No wonder chip stocks were hammered. Bans on exports to China could represent a big chunk of revenue suddenly shorting out.
Synopsys and Cadence also derive revenue from China. However, it's a far smaller share of overall revenue than for most chip companies. Synopsys and Cadence reported a respective 15% and 13% of revenue attributable to China in their last reported quarters. Additionally, not all of the software they provide to Chinese companies is for the most advanced computing systems that are getting hit with export curbs. Synopsys and Cadence could thus take far smaller hits than their peers do.
Nearly half of sales for both Synosys and Cadence go to companies in North America, and government funding to bolster domestic research and manufacturing could help offset losses from trade restrictions. Granted, there could be some short-term pain if some EDA users get hit with export bans and subsequently reduce their EDA software and design licensing usage. Nevertheless, it would appear these two chip stocks are a bit more insulated from recent turmoil than most.
As of this writing, Synopsys stock trades for 28 times trailing 12-month free cash flow. Management expects full-year 2022 revenue to be up 21% year over year, and operating profit margin to be about 32%. As for Cadence Design, its stock trades for 38 times trailing 12-month free cash flow. Its outlook for 2022 calls for 17% revenue growth, and for operating profit margin to be nearly 30%.
I think Synopsys is the better buy right now given the slightly better growth outlook and the fact the company has only $22 million in debt (compared to $348 million at Cadence). But I expect both of these EDA stocks to perform in similar fashion in the years ahead, and they could fare better than the semiconductor industry overall as it works through new curbs on business in the Far East. If you're worried about this latest hurdle but still like chip stocks after the massive sell-off in 2022, Synopsys and Cadence Design Systems are worth second looks right now.
