Synopsys, Inc. (SNPS) Earnings Call Transcript & Summary

Great. Hello, everyone. I'm Joe Vruwink, the vertical software analyst at Baird. Our next presentation comes from Synopsys. Synopsys is the global leader in EDA software used in the design of chips and a lot of electronic systems. I'm pleased to have joining us today, Trac Pham, he's CFO. I think Trac is going to give a brief overview of the company. And then afterwards, we can transition into a fireside chat. Thanks for joining.

Thanks, Joe. It's -- I'm glad to join you for the discussion. Appreciate you having me. It's been a great series of meetings with investors during this Baird conference so thank you for hosting us. Before I start, let me just make a comment. In today's discussion, I may make some references to forward-looking statements and refer to some non-GAAP financial measures. So I want to refer the audience to our website and 10-K, 10-Q disclosures for additional commentary on our risk factors and how we use non-GAAP financial measures. So I'll begin by highlighting that Synopsys is a technical software company. We've got 2 main lines of business. We've got the Semiconductor & System Design segment, which is roughly 90% of our business. And this is the EDA software and semiconductor IP business that Joe referred to, and we are the leader in that space. And then there's 10% of our business in the second segment, which we refer to as the Software Integrity business. And that -- in that space, we sell to software developers a set of products to help them assess the security and quality of their code base. And we also provide some security consulting services to them. Just 2 weeks ago, we wrapped up our second quarter and reported results. And it was a really outstanding quarter for us, record orders, revenue, non-GAAP earnings and cash flow and just really a record bookings for the company. And based on the strong results for the quarter and the start to the first half, we were able to have enough confidence and visibility into the business to reiterate our guidance for the full year. And with revenues in the range of $3.625 billion and operating margins in the 27% range, I think we actually, in fact, raised our EPS and cash flow guidance for the full year. The business is doing very well despite the current health and economic challenges. And a lot of that has to do with the business model. We have a generally 90% recurring revenue model. And as of the end of Q2, we have about $4.7 billion in noncancelable backlog. And so the combination of the fact that on the system and -- the Semi & Systems Design segment, because of the integral and essential nature of those tools to chip design, and the fact that we have a business model that is a 3-year license model, that really gives us a lot of cushion during downturns like what we're seeing right now. And when -- and the market's good and when the overall environment is healthy, we certainly participate well in the upside. So overall, the business is doing very well and a lot of it has to do with the customer environment, particularly on the Semi & Systems side. Despite the current challenges, our customers continue to keep their chip design projects on track, and we haven't seen a slowdown there. And that creates a strong environment for us to sell into. In addition to that, we have been making some significant investments in the business portfolio over the last 5, 6 years to continue to refresh and innovate on our products. So whether it's in EDA, IP or the new Software Integrity space, we have -- really have made a significant investment across the board. And as a result, we're able to really drive solid growth in the business. And through that investment and through the growth that we're generating and with a strong focus on driving operational efficiencies, we are on a path of driving now the strong margin improvements in the business. This year, we're -- as I mentioned, we're on track to deliver approximately 27% operating margin, which is 2 points higher than it was last year, and that was an improvement in the year prior. And our goal is to continue on that path, and we certainly feel like we've got the growth and the opportunity to drive margin expansion to the high 20s next year and then in the 30%-plus range over the long term. So overall, this is a very healthy situation for us, and we're incredibly pleased with the results so far and very optimistic about the outlook for the business ahead. Joe, I'll now turn it to you for any questions.

That's great. I wanted to dig in on some of the technologies and maybe it makes sense to start with EDA software. I have come to appreciate that EDA tools are handling some of the most complex design tasks that I can even imagine, oftentimes. And so I'm wondering, given you're not only participating, you're the leader in this category, can you maybe simplify what Synopsys does well, what the industry knows and recognizes Synopsys for, and we can take it from there?

Yes, sure. At a high level, we are often regarded as the technical leader in this space. And the -- and we also are recognized as having a complete set of solutions. So you can come to us and buy everything you would absolutely need in order to design a chip. Within the design environment, you have design tools, verification tools, and it could be focused on digital or analog. And we certainly have the full breadth of products. And from a scale perspective, we're the leader in this space. But to be fair, the environment is very healthy. And as I said earlier, our customers continue to focus on their design, and it's a good context for us and the competition. But I certainly like the position that we're in, in terms of having a very broad portfolio that is at the leading edge and that we have refreshed over the last 5-plus years.

Can you maybe go into the customer journey or, I guess, the total scope of the relationship you might have with a foundry or a semiconductor company? I think what's pretty unique about Synopsys is, if a foundry is using your TCAD tools, they might be engaging with you on a new advanced node, I don't know, 6 years ahead of time, 8 years ahead of time production. And then, obviously, companies are using your tools for design verification. You're getting paired with software -- with more software tools in the verification process. Maybe just -- there is no typical journey, but just to conceptualize the time line of Synopsys being involved in chip development.

That's a great way to pose the relationship and our position in the ecosystem. You're right. Given the breadth of capabilities and the technical capabilities of our products, we do have multiple ties to different companies and elements within this ecosystem. So let's start with the beginning with the foundries. I think you could see them both on the beginning and the end of it, right? So beginning, meaning the foundries are looking to make sure that they have the capabilities to manufacture and build products that are not just today's technology, but planning ahead to what might be 3 to 5 years down the line. So in that regard, there's a tremendous amount of research, meaning pure research in terms of thinking about how chip design will evolve and how they would actually manufacture that. So there's a manufacturing segment of our business that's focused on the software tools and the capabilities that are sold to the foundries to support chip manufacturing. And in that area, there's a deep, deep technical research, and they're looking at, for example, new materials. How do you think about new materials? How do they think about different methodologies to manufacture these chips? So from that beginning to the middle part where you're -- we're interfacing with the traditional semi companies or systems companies, companies that develop chips for their own end-product, to that middle part, where we're engaging with those customers to help them with their design. And from the early design and scoping of the architecture to the verification side and the simulation to ensure that what they hope -- what they set out to design and the capabilities that they're expecting from the chip, they're validating it through the verification process that the chip is going to do what it's designed to do. And even within that -- the simulations part of the process, we have both hardware and software tools to do that. Because right now, given how complex chip design has become, the code base for a chip has increased -- continue to increase over time. And their ability to do those simulations or those tests and validation that the chip design is accomplishing the right results, increasingly, they're finding it harder to do it in software. So we have hardware capabilities, so they could run those simulations. They can take that code base, load it to our hardware product, simulate the chip and then get an expected outcome from that and verify that, that's what they're expecting. And what that does is that allows the chip designers to move in their process so that software development begins earlier. So even within that middle space, working with our customers, we have a broad range of products through all the elements of design. And then you work on the back end, as I said, on the foundry, as they take that chip design to the foundries, we certainly can -- the partnerships with the foundries and the relationship with the customers at foundries, we're able to help them seamlessly go through that flow. So we touch the entire ecosystem. Well that's -- I mean, that's too strong. But we touch many elements of this ecosystem and are significantly impactful in the whole value chain.

That's great. I want to transition. There's maybe 2 broad categories where Synopsys can potentially accelerate growth. Before I get into that, I did want to touch on current events because I've gotten some questions. And really, the question is regarding export license restrictions, the ongoing tensions between the U.S. and China. Obviously, you've provided a recent guidance update where you have some assumptions for how the rest of the year continues. Maybe just your thoughts on the latest with some of these topics.

Sure. Let me try to make a few comments and then we can pull it together and integrate them into a more holistic view. First, keep in mind that the Entity List has been in effect -- existing Entity List has been in effect since May of last year. And so our results for last year and our numbers for this year and the guidance for this year reflect that those restrictions remain in effect. So you can see that despite that headwind, we did very well last year and year-to-date. We're doing very well. And the outlook is very optimistic. And so we've been able to adapt well despite that headwind. Over the last month plus or 1.5 months, there's been new updates to some of those restrictions. Overall, it's certainly a headwind for the business. But as you compose those new developments, they've added -- first one, there's been some additional companies that have been added to the Entity List. We've reviewed that list. We've looked at our outlook, and we don't feel like there's a material impact to the numbers. Two, there's some additional restrictions around how the Entity List companies can sell to one another or support one another, specifically Huawei as the end customer. Well the short answer there is we've already taken those -- that revenue of that business outside -- out of our business and out of our outlooks. So there's really virtually no impact there. The area where it's most complex and ambiguous is with regards to the [indiscernible] restrictions. And -- a few things. First of all, in terms of our initial review of this very complex update, we believe that we should be able to drive our guidance despite that -- those restrictions. And we don't think there's a material impact to FY '20 numbers. And further, if you think about the remaining business, we've got really 4 months left in the year, 4.5 months left in the year. So wherever the challenges are, we feel like we should have the wherewithal to manage it. But it is, as I said at the beginning, it's a complex situation that is -- we've tried to assess as well as we could. And I think that we -- our initial assessment is we can handle it. But just like many other companies are affected and trade groups that are affected, we're going back to commerce and asking for more clarifications. And as we get a better view on that, we'll certainly update investors. But at least for now, in the context of FY '20, we remain committed to our -- the numbers that we communicated just a couple of weeks ago.

Great. A few questions relating to maybe growth accelerators. The first would be some of the new products in your core EDA portfolio. Now part of why margins are set to improve, certainly, this year, next year, is Synopsys made very aggressive and proactive investments in a set of next-generation platforms. And so when thinking of the opportunity for something like Fusion Compiler, Custom Compiler, Verification Continuum, we should probably throw Polaris into this with Software Integrity. Maybe just talk about why those investments were necessary, important and kind of the opportunity that is now at hand.

Well you presented a very good description of a summary of the situation. You're right. We've made significant investments. And the basis for that was the business was healthy. The business was -- if you go back, rewind where we were 5, 6 years ago, the business is doing very well. We're very healthy. And that's exactly the time when you should invest. I mean, of course, over the course of our history, we've continued to invest in innovation. But we're doing well as a company. And we want to make sure that we could sustain that over time and not hit a cliff in terms of our growth. And so we were very deliberate in terms of investing and just the nature of where the business was, right? We were building out Software Integrity organically and through M&A. We were broadening our IP portfolio. And then we are very healthy and very strong in EDA, but we felt that we continue to need to invest in that business. And so there was just an unusual -- unusually high level of investment that just was made across the board. And our goal was not -- our intent was not to take the growth we had and the leadership position that we had in each of these areas, each of these markets. We don't take it for granted. And in the markets that we're in, innovation is so critical. And being considered the leaders in technology and innovation is so critical because what is happening in the space is so complex that they really need new tools and new capabilities to solve those problems. And so we continue to further bet on the business and continue to make those investments. And so far, the reaction -- the traction we're getting within new products have been very positive. And that's why we're optimistic about our growth prospects going forward as that's pretty broad-based across the business and pretty well further diversifies our business.

The other piece of maybe the new growth equation is there's a lot of customers that are outside of your traditional semiconductor audience. I think the number you provide in terms of systems companies, it's up to 40% of your business. I still track the automotive industry closely. You're starting to see a lot of Synopsys IP show up in automotive use cases. So that's one example. But I'm wondering if you could talk about kind of the applicability of the traditional core Synopsys products, how they're getting broadened and used by these other industries. And what sort of opportunity that provides to grow above and beyond kind of just the traditional way of thinking, where, if I'm tracking semi R&D budgets, I'll have a pretty good sense of what EDA spending is doing?

Well let me highlight a few growth opportunity. You've touched on it. Certainly, automotive as a vertical, the systems companies, particularly the hyperscalers, are good emerging customers with growth potential. AI is an opportunity for us, 5G, near-term and long term, I think are strong potentials. So there's a number of different opportunities for us. Let me highlight a couple of areas, specifically, and then -- just to give you an example. Hyperscalers -- increasingly, hyperscalers, those are grouped into our systems companies. Increasingly, they're doing more chip design because they want to take control of the capabilities of their hardware. They want to differentiate on their hardware rather than using commercial silicon. And what's unique about that space is that, while they have a tremendous amount of resources and capabilities, they're trying -- their goal is to get to market as fast as it's possible with a particular capability that is differentiated, right? So they're not trying to build a broad-based semiconductor design capability. So they're building the smaller teams that are really focused. They are really exceptional teams, but they're targeted in certain capabilities. And so of course, they will need our EDA software. But in addition to that, because they don't -- they're not trying to build out a semi company, and they want to narrow their focus on the places that they could differentiate, they are very open to buying IP from us. And so that's a great opportunity for us to broaden the amount of products that we're selling to these customer. And so they're buying more IP because they don't feel the need to develop it in-house. And then on top of that, because they are limited to the resources, they want to commit to that. They are much more open to buying consulting services and support services from us to help them with that chip design process. And so their needs and the strength of our portfolio, the fact that we're leaders in EDA, the fact that we've got the broadest portfolio in IP and the fact that we have these deep rich history of support capabilities, just allows us to bring tremendously strong capabilities to solve their problem. So that's why that's been a very positive growth driver for us, and we do see that -- the trend continuing. The other area where you highlighted as an opportunity for us is automotive. And what's unique about automotive -- now, chip design, same thing. Chip design for compute, chip design for automotive applications, I think they'll use same tools. But what's unique about automotive is just the regulatory and compliance requirements around automotive; and the fact that there's more chip in electronics being integrated in cars, and that trend will continue; and the fact that the supply chain within automotive is being -- is evolving because of that -- the content of electronics. And they are looking at these automotive OEMs and the supply chain. They're looking for vendors that can help them integrate those capabilities into their cars and similar to the integral role that we play within this semiconductor industry and that supply chain. And we're playing a similar role in automotive and being able to bring this chip experience, the design experience, the integration experience and a broad set of tools to it, right, as -- is one value. The other value is IP. The fact that we have been actively investing in certifying our IP for these very specific and highly regulated vertical positions us well to sell more IP into this product. And then on top of that, we can also sell our Software Integrity. Because if you think about it, there's been pretty well-publicized examples of cars getting hacked via their electronic system or software systems. And then -- so that's another area that we can sell into those verticals. So not only are we bringing deep domain expertise on the software -- on the semiconductor side and IP side, but we're also able to sell software security testing tools into this space. And so this is a very broad portfolio that we have, is getting very good traction in automotive. And I think while, near term, we may see some challenges economically, the long-term trends, I think, will stay intact. And we'll continue to see that evolve positively over time.

Just to go back to a question from the audience, and Lisa will laugh at this because I religiously read the Synopsys press releases. So there was one that came up about a month ago, and there's a question from the audience, just in terms of recent partnership with Broadcom. And it actually maybe ties into the conversation around the Fusion digital design platform and why that's important. But the question is, is this an important partnership or maybe more broadly because there seems to be a lot of announcements recently via -- with AMD on ZeBu or TSM (sic) [ TSMC ] or Samsung? Are these important to be keeping track of?

Yes, I guess, with a caveat. Yes, it's an important relationship and the fact that it's a well-run company that's -- has a strong reputation, and it's indicative of the traction they're getting with the new products, right? And it's highlights that we're not winning on -- that we're winning at a very strong level, right? And we try not to publish customer testimonials frequently because, in the end, we wanted the results speak for themselves. But this is just a customer announcement that highlights the traction that we're getting with the customer. And so it's important in the sense that it just validates what we've been saying over the last 3 to 4 quarters in terms of new product launches that the traction and the reaction that we're getting from our customers has been overwhelmingly positive. And the -- and it's been overwhelmingly positive because they are -- even they are surprised by the results that they're getting, right? There -- the performance space area and the density and the issues that they're trying to resolve. The results that we're getting has just been outstanding. And so the customer reaction has been positive. We've been winning benchmarks, and we're starting to see it gradually affect the financials. And over time, those customer testimonials and those customer indicators will eventually translate to positive financial momentum. So it's important in that regard. But the -- what you'll -- where it really matters is when it starts showing up in the financials, and we're very optimistic about that playing out over time.

Okay. Maybe the last topic. Just to touch on application security, why that was the chosen avenue, if I can call it that, to expand the Synopsys TAM? And then on Software Integrity itself, I think you've been pretty clear that 2020 may be a transition year, ultimately, in the journey of that business. Although I was pretty encouraged by the most recent guidance because it does imply the business has a nice acceleration into the second half of this year, so an overarching question on kind of the category and then your performance?

Yes. It's a much more detailed question, but I'll try to keep it short. I've a much more detailed answer, and I'll keep it short. Why Software Integrity? If we go back to where we were 6 years ago, we were really looking for a new market opportunity, TAM expansion opportunity for a number of years and experimented in different areas. And what we found is that it's always hard to find that sweet spot, right? Of -- you risk going -- staying too close to what you're doing, and therefore, you're not going to create a long-term growth opportunity. And if you go too far, you're not really bringing a lot of capabilities that you can leverage on that opportunity. And so it ends up being a path that's too far away from you. And what was unique about the Software Integrity space in terms of software testing and security testing was the original company that we acquired as the basis for this business, which is now 10% of Synopsys, that -- half of their business was to the traditional semi customers that we are already selling to, right? And the other half was to the enterprise. And so here is a chance for us to build out a new TAM in a market that could be significant to the overall results over time, both revenue growth and profitability. But we -- in the near term, we could derisk half that business because, effectively, what we would do, not only derisk it, but actually grow that existing business because we're taking it through our existing sales channel to the semi companies. And we could leverage our international footprint, a global footprint of this. And the reason why that the chip companies have embedded software in their chips, in their view was, "I'm not going to spend 12, 18 months developing this chip only to find out at the end that I can't manufacture it because I got this bug in the code." And so they were very early on -- quick to adopt quality and security testing in their embedded software. And our thesis was we could secure half that business and build a foundation on it and, over time, grow the enterprise half of the business in such a way that if we're successful, long-term, it's going to be a much larger part of that business. And it was going to open us up to a whole new set of customers. And so 6 years into it, that's exactly where we are. The enterprise side is a much larger space, opening us up to customers that we've never touched before. While simultaneously we've grown the semiconductor part but despite growing it, the opportunity in enterprise has been so much bigger and remains so much bigger. This year is certainly a transition year for us because 6 years in to it, we've done a really remarkable job getting it to scale and getting it to its level of profitability. But our ambitions for this is in the billions. And we're on a path to getting this to $0.5 billion. But we do see the market drivers and -- the market drivers and the portfolio that we have, this has potential to be a $1 billion-plus opportunity for us. And so last year, going into '20, we were really thinking about how to retool the business and -- retool the business and prepare us for the long term. And so that's sort of where we are.

That's great. I'm afraid we are out of time. I'd love to go longer, but I want to thank you, Trac, for joining us today. This has been great and helpful. So thank you.

Great. Thank you for inviting us.