Chip design software company Synopsys' (SNPS 0.94%) stock price heated up to kick off the new year. Until the recent quarterly earnings report, shares advanced nearly 20% in 2023 and rallied well over 30% from recent lows for the semiconductor space in October and November 2022.
The company met its growth expectations in the latest quarter and reiterated its rosy outlook for the rest of 2023. Nevertheless, investors were disappointed that the AI race heating up between big tech didn't result in a near-term financial upgrade from Synopsys. Synopsys shares gave back some of their recent run-ups following the quarterly update. Is this a buying opportunity for investors?
A supplier to nearly all parties involved in AI
Synopsys, along with its peers Cadence Design Systems and Mentor (now a subsidiary of German industrialist Siemens, sits at a critical choke point in the semiconductor industry. It's the leader in electronic design automation (EDA) software, used by semiconductor designers and manufacturers. This represents about 65% of Synopsys' revenue.
Additionally, a growing number of companies outside of the traditional semiconductor space (like big tech, data center providers, smartphone companies, etc.) are turning to Synopsys for its leading portfolio of chips that can be used as the basic building blocks of their own custom designs. This "chip IP" is another 25% of revenue. And finally is software verification and security, the last 10% of revenue. As software developers increasingly need to integrate their work with a custom chip and computing system, the lines are beginning to blur between strictly hardware and software.
Interestingly, the AI battle Microsoft kicked off with its investment in OpenAI is fantastic news for Synopsys. Looking at Synopsys' revenue breakdown another way, 45% of revenue is derived from computing system designers. That would include a company like Microsoft, which operates data centers that house the generative AI systems like OpenAI's ChatGPT that have suddenly gone viral. The same goes for Alphabet's Google, which has responded to Microsoft with a roadmap of new AI services of its own.
Basically, as new (and highly complex) computing demands rise, many of these systems companies are in need of their own customized silicon -- as well as computing system verification to make sure everything runs smoothly before deployment. And this is just one example of custom chips. The automotive industry is also in dire need of more computing hardware to support vehicle electrification and increasingly effective driver-assist functions (on the road to eventually, perhaps, fully autonomous vehicles). Again, more tech means more custom chips for autos.
Synopsys is a chip design and software verification supplier to them all. Thus, if you want to capture growth of the semiconductor industry (which is expected to go from about $580 billion in 2022 sales to over $1 trillion in annual sales by the end of this decade), Synopsys is a fantastic bet. Though the industry is growing, chip sales can be cyclical from year to year. However, Synopsys can be far more consistent, since its revenue follows semiconductor and tech industry research and development spending, not ultimate chip sales.
For example, take a look at all the bumpiness in Intel's sales over the last decade, which is Synopsys' largest customer. In comparison, Synopsys' revenue has been a much smoother up-and-to-the-right line over that span of time.
Data by YCharts.
Not just growth, but profitable growth
Since Synopsys is a mature software company that's been around for decades, it should come as no surprise that it's profitable. In the first quarter of Synopsys' 2023 fiscal year (the three months ended December 2022), generally accepted accounting principles (GAAP) net income was $272 million ($407 million on an adjusted basis) on revenue of $1.36 billion. Free cash flow -- which can be highly variable from one quarter to the next -- was $71.3 million.
The point is, no matter how you slice it, Synopsys is profitable. And in addition to forecasting 14% to 15% revenue growth in fiscal 2023, the company is focused on expanding profit margins. This will come primarily from the small software verification and security segment, but also (to a lesser extent) from chip IP and EDA. Adjusted operating profit margin should rise one percentage point this year and is projected to expand in the following years as Synopsys tries to get more efficient. The target is thus for average high-teens adjusted earnings-per-share growth (which includes stock buybacks) in the years ahead.
Given this outlook and the consistent growth advanced computing like AI is producing for Synopsys, shares trade for a premium of 60 times trailing-12-month earnings (or 37 times trailing-12-month free cash flow), and 37 times one-year-forward expected earnings.
Given the high price tag, I'd caution against buying a bunch of this stock all at once. Instead, this is a prime dollar-cost averaging candidate, which is how I've been buying as of late as I build Synopsys up into a larger position in my portfolio. Nevertheless, after a solid quarterly update and Synopsys reiterating its growth outlook for 2023 and beyond, this looks like a top way to bet on the coming decade's AI race that big tech just started.
