Riddle me this: Which came first, the chipmaker, or the chip-making equipment maker?

Answer: Neither. First came the company that made the software that let the chip-making equipment maker's equipment make chips. One such company, Synopsys (NASDAQ:SNPS), reports fiscal Q3 2006 earnings after close of market tomorrow.

What analysts say:

  • Buy, sell, or waffle? Eleven analysts boil Synopsys down to four buy ratings and seven holds.
  • Revenues. On average, they believe the company grew its Q3 sales 9% to $274.9 million.
  • Earnings. They also believe its earnings grew 90% to $0.19 per share.

What management says:
Synopsys trounced analysts' "pro forma" expectations in last quarter's earnings report. But even better, the company beat its own prediction of breakeven GAAP profits, reporting a whopping $0.04 per share in profits. That number also showed marked improvement over the firm's $0.03-per-share loss of Q2 2005, and provided a firm foundation for CEO Aart de Geus's statement that the firm "executed very well against our financial goals."

And the good times may be just beginning. Looking forward to tomorrow's results, and those for the full year, de Geus predicted that Synopsys will report $0.02 to $0.07 (yes, those "analyst earnings" you see above are of the pro forma variety, excluding certain items) in GAAP profits per share tomorrow, and rack up a total of $0.08 to $0.17 per share by year-end.

What management does:
Synopsys' rolling gross margins continue to hover in the mid-to-upper 82nd percentile, as they have for the past year. Meanwhile, all those picky little details that make the company's GAAP numbers look so much smaller than the pro forma variant are finally beginning to let up. Rolling operating margins finally turned positive again last quarter, and net profitability moved firmly into the black.

Margins %

1/05

4/05

7/05

10/05

1/06

4/06

Gross

84.7

83.7

82.8

82.6

82.5

82.7

Op.

5.3

(1.3)

(6.9)

(4.8)

(2.6)

3.2

Net

2.7

(0.6)

(3.1)

(1.6)

0.1

1.0
All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.

One Fool says:
In the last quarterly earnings report, de Geus predicted that Synopsys would generate $175 million in operating cash flow for the year. If we telescope out the past six months' worth of capital expenditures ($24.6 million) to get an annual run-rate on capex, shareholders could well be looking at better than $125 million in free cash flow generated by their company in fiscal 2006.

If that thesis proves out, the company is currently trading at 21 times its free cash flow for the year, while analysts project its profits will grow at about 12% long-term. Expensive? It sure looks that way today, but if Synopsys can continue to "execute very well," and get back to generating the $225 million or so in free cash flow that it generated in 2005 and 2004, today's price will look much more reasonable in retrospect.

Competitors:

  • Virage Logic (NASDAQ:VIRL)
  • Synplicity (NASDAQ:SYNP)
  • Rambus (NASDAQ:RMBS)
  • Mentor Graphics (NASDAQ:MENT)
  • Magma Design (NASDAQ:LAVA)
  • Cadence Design (NASDAQ:CDNS)

How does a cheap-looking stock start looking expensive in the first place? It helps (hurts?) to cut the cash profits and slash the growth rate. Revisit how cheap Synopsys was looking just nine months ago in "Synopsys: You Can't Win 'Em All."

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Fool contributor Rich Smith does not own shares of any company named above.