Cadence, Synopsys Designed to Bounce Back

The two companies will be early beneficiaries in the race to create souped-up info appliances.
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SAN FRANCISCO -- Software is in a slump, semiconductors are volatile and PCs look stagnant. Information appliances, the next generation of phones, TV sets, car radios and pocket organizers that run on high-powered chips, could revive any of these sectors in coming years, but that remains a vaporous vision for now.

However, there are a handful of companies already lined up to be early beneficiaries of the information-appliance trend. Unlike chipmakers, whose profits and share prices are prey to the vicissitudes of semiconductor cycles, these companies should enjoy a steady business. They work in a niche called "electronic design automation," or EDA, creating the chip designs that will drive the pumped-up appliances of tomorrow.

The budding leaders in this fertile arena are

Cadence Design

(CDN)

and

Synopsys

(SNPS) - Get Report

, which reported revenues of $1.2 billion and $718 million, respectively, in their recent fiscal years.

Chipmakers rely on software from Cadence and Synopsys to design ever-smaller chips with increasingly powerful functions. Richard Piotrowski, an analyst at

Everen Securities

, sees increased demand for single-chip information appliances and for design tools as well. Piotrowski has a "1:1" rating, the equivalent of a strong buy, on Synopsys and a slightly lower "2:1" rating on Cadence. Everen has not performed underwriting services for Synopsys or Cadence.

"This sector is showing smoother and faster growth than the equipment makers and the semiconductor industry," says Nick Moore, portfolio manager at

Jurika & Voyles

, one of the five biggest institutional shareholders in Synopsys, with a 4% stake. "These companies can still grow when the market for semiconductors is down because

chip companies tend to design their way out of a hole," which should translate to steady demand for EDA.

Semiconductor sales fell 6% last year compared with 14% growth in the EDA market.

Gartner Group's Dataquest

estimates the chip industry will rebound this year with growth of 11.8%, while EDA growth is expected to outperform again. Some analysts are predicting the EDA sector will grow 18% this year, boosted by the rebound in semiconductors as well as the expected expansion in information appliances.

That solid pace is even more attractive considering the valuations of the stocks. Dragged down by a broad-based slump in software issues, Cadence currently trades at 11 times earnings while Synopsys sports a multiple of 22. By contrast, the

S&P 500

is trading at more than 30 times earnings.

"These stocks are cheap and are growing," says one Boston-based buy-side analyst who has been considering a position in Synopsys. "If you're looking for an area of software that could be interesting, I think this could be it."

So why are the stocks so cheap? Cadence surprised Wall Street in late April by warning that growth would slow for the rest of this year. The company then followed with a management change, replacing CEO Jack Harding with the company's former CFO, Ray Bingham. The events sparked a wave of near-term downgrades from Everen and others.

Those developments came after Cadence moved to cut 12% of its workforce in November and restated its 1998 earnings to comply with

Securities and Exchange Commission

guidelines for in-process research and development charges for four acquisitions the company made that year.

But Jim Douglas, vice president and general manager of Cadence's embedded systems design group, says the recent management changes are "irrelevant" to the expected growth from the booming information-appliance market. He still expects that line of business to grow 50% to 70% annually from its fairly small base.

Meanwhile, Synopsys has tried to distinguish itself by taking a different tack. It has been pushing itself as a technology company that only wants to provide the best tools for chip designers fitting a chip into particular devices. The company has also advocated the idea of design reuse, which means building a portfolio of basic chip designs that companies can use and base new designs on.

Jurika & Voyles' Moore currently favors Synopsys in the EDA race, partly because the company can list chip gorilla

Intel

(INTC) - Get Report

as one of its largest customers and partly because Cadence has yet to prove its services business is a winning formula.

For others, however, it's still too early to pick an EDA winner because no one knows for certain how the information-appliance market will take shape. Cadence signed a three-year deal at the end of March to provide

IBM

(IBM) - Get Report

with EDA software, an event which one buy-side analyst in San Francisco says can't be ignored. "Cadence's deal with IBM is pretty big," the analyst says.

Besides, says Peter Lui of

PLT Investments

, after Cadence's recent share-price drop, the stock is starting to look cheap. Lui says if Cadence stabilizes in coming quarters as the new CEO focuses on operating margins and the business, investors may want to consider the stock for long-term growth. Because the market, he says, is definitely there.