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Mentor Could Lead Chip-Design Software

In the surging market, a few companies will likely see growth.

SAN FRANCISCO -- The market for electronic design automation software is in the midst of "the longest and highest surge of strength" since the late 1990s.

So says Gregory Hinckley, president of

Mentor Graphics

(MENT)

, one of the three primary public developers of software tools for semiconductor design.

"Almost every company in EDA reported revenue growth for the second quarter from high single digits" to upward of 30%, Hinckley told analysts recently.

But EDA suppliers have a mixed record of dropping that down to the bottom line. Research takes out a big bite, but failure to invest undermines future growth.

Each supplier has to weigh today's earnings against paying for tomorrow's tools. On that ground, Mentor Graphics may be the standout stock pick, though competitors have an ace or two up their sleeves.

Synopsys

(SNPS) - Get Report

recently got a strong vote of confidence from partner

Intel

(INTC) - Get Report

, which made the company Intel's primary EDA supplier in early August.

Market and industry perceptions seem to run counter to recent analyst ratings. Mentor and Synopsys scored downgrades in late August; rival

Cadence Design Systems

(CDNS) - Get Report

fared better, with an upgrade to hold in July.

Mentor shares, however, have gained $1.45, or 11.8%, to $13.96, since

issuing a strong earnings outlook on Aug. 23.

That company said it is not currently limited by bookings opportunities. "New accounts were up 3% in number, but a very robust 45% in value," Hinckley said recently.

Yet it's unclear whether the EDA surge has peaked. The industry has a one-year trailing growth rate of 15%, according to the EDA Consortium. Not only is the semiconductor industry still retooling, but also most EDA suppliers have been investing in new technologies.

And still more investment is needed.

Earlier this year, EDA consultant Gary Smith forecast 2007 to be the strongest year for the sector since 2001. After the tech bust, EDA suppliers cut back on R&D, he said. Semiconductor makers continued using tools developed during the 1990s, when the smallest features of chips were above 1 micron.

"That's over," Smith said. Now that features are down to 45 nanometers, and chips contain more than 100 million gates, or circuits, "the tools are breaking," he said.

Mentor is a leader in several of the newer model-based tools, according to Smith. One type is electronic system level (ESL) design, which lays out entire systems.

"For next year, we're in a transition period, moving up to ESL design," Smith said. "It's not a big revenue generator now. But it's where the design engineers are moving."

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EDA growth will come in computer aided design, as well as ESL, which "is a small category, but it's going to grow the fastest," Smith said. He projects a five-year growth rate of 47% for ESL.

Cadence has some ESL tools. "Cadence has been doing a turnaround since February." That's when the company bought two of the biggest start-ups in another EDA technology, Smith said.

Mentor is also strong in an aspect of computer-aided design, from its recent acquisition of Sierra Design Automation, according to Smith.

The Intel Factor

Computer-aided design, a $1.5 billion market, will grow to $2.25 billion by 2011, a growth rate of 7%, Smith estimated. Cadence and Synopsys are big players in that area.

Synopsys is just getting started in ESL tools, Smith said. "They are lagging a little behind, we think. ... They are driving their

clients' design engineers crazy right now."

"People might question

Synopsys's future. But today, they have the tools the power users use -- the Intels, the

IBMs

(IBM) - Get Report

-- who use the latest processes and who stretch everything they possibly can stretch," Smith said.

But not all is well for Synopsys on the stock valuation front.

Matrix CEO Dan Scalzi said that what drives ratings "is the cost of capital vs. the return on capital. When the cost of capital is greater than the return, you're not making any money."

And the greater the spread, the more likely a company is to be downgraded by the firm, which sells its research to institutional investors.

The cost of capital is also considered the opportunity cost of a firm's investments.

Synopsys was downgraded largely because the spread between the company's cost of capital at 11.5% far exceeded its return on capital of 2%, according to Matrix.

Synopsys has some good data behind it: Its free cash flow so far this year is around $222 million, according to figures in its

third-quarter earnings report.

That's a great improvement on its negative free cash flow this time last year. Synopsys' cash flow rate of 3.8% is better than 62% of companies listed in the Russell 3000 index, according to Matrix.

Synopsys closed Friday's regular session at $27.32.

Mentor's cash flow rate of 11.3% shines. That's better than 84% of the Russell 3000 and right up there with the software sector's rate of 12%, which makes Mentor a strong buy in that sector, despite of the broader hold rating, Scalzi said.

Although better than Synopsys', Mentor's ratio of cost of capital to return, 10.3% to 4.2%, is wide and a key factor in Mentor's downgrade to hold, Scalzi said.

But Mentor has redeeming value compared with the software sector. "If you have to buy into this sector, this is what you've got to buy," Scalzi said.

Mentor's trailing 12-month free cash flow of $199 million is attributable to a $130 million change in capital that includes the purchase of Sierra, Scalzi said. Mentor said it paid $90 million for Sierra, which has already showed $12 million in revenue in the quarter the deal closed.

Cadence's spread of 11% to 6.4% is comparable to Mentor's. "They have to get that fixed," Scalzi said. "It isn't as strong" as Mentor, but Matrix has a buy rating on Cadence within the sector.

Its stock closed Friday at $21.72.

Mentor is probably the standout stock in this subcategory of the software sector.