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

Well, good afternoon, everyone. My name is Pradeep Ramani, and I cover EDA here at UBS as part of the semis team. We are delighted today to host Synopsys at our UBS Global TMT Conference. And we have with us Trac Pham, CFO of Synopsys with us today for a fireside chat. Welcome, Trac.

Thanks, Pradeep. I appreciate the chance to meet with you.

Great. Trac, first of all, congrats on a strong finish to fiscal '20 and a very solid fiscal '21 guidance. So maybe let's start with a fairly broad question on what you're seeing with respect to design activity globally. What is driving what looks to be, you could clearly say accelerating EDA software growth in 2021? And can you also speak to how 2021 might be different from 2020?

Okay. Well, thanks for the comment. It was a very strong year for us. And the environment continues to be very healthy. Despite the near-term challenges that our customers are facing as a result of the pandemic, they continue to invest very heavily and actively in their designs given the outlook that they see for end-user demand. And so when you move backwards from end-user demand to the activity at our customers, back to us, it's just been very healthy despite the near-term challenges. I would say that 2021 is really a continuation of what we saw in 2020. And frankly, over the last couple of years that the end-user demand for AI, for automotive, for machine learning and all those other applications are really putting a big, big demand on our customers. And so the design activity is continuing to be pretty healthy heading into 2021, and we do see it continuing for some time.

Okay. And IT has been doing great as well, driven by some of these end markets you talked about. And I guess, last year, for fiscal '20, IP grew roughly 20% year-over-year. Has the growth sort of being broad-based? Or is it coming from specific geographies or end markets? And do you sort of feel that IP continues to grow along this fairly strong 20% growth rate? Or does it sort of normalize at some point? Or are we in a new normal, so to speak, for IP?

Similar to the rest of the business, IP is doing very well, and I would describe it as more broad-based than anything. When you look at across geographies and the customer sets and the different use cases for IP, it has been driven by very broad-based strength, and that's what is so encouraging about that business today. And as we head into '21 and looking ahead for the next few years, I do think that we'll have a chance to continue to see very strong double-digit growth in this business. This year was extraordinarily strong for a variety of reasons. But when we talk about IP, we do see a long runway for this business to continue to grow very well. And over a multiyear period, we're very confident about our ability to drive this in the low double-digit growth. And that's what's going to be very positive about the outlook for the next few years is that, despite whatever happens in the macro environment or even the semiconductor industry, we think that we've got pieces that can continue to show pretty steady, consistent growth over the next few years.

I see. And the other piece of the puzzle, I guess, is hardware. Again, fiscal '19 was sort of a record year for hardware for Synopsys. And although you were slightly below that in fiscal 2020, when I look around, it feels like chips are just getting increasingly complex all the time. And do you feel like we're sort of in a, I want to say, a golden age for verification where it sort of grows at a sustained, maybe even a double-digit growth rate over a longer-term period. And granted, it's going to be lumpy, but what are your thoughts on how investors should be thinking about hardware itself?

I definitely appreciate the way that you're looking at it because it is a very positive environment for not only hardware, but the verification suite of tools we have today. We're seeing very good momentum on both the verification software and hardware. And as you described, 2019 was just an incredible year for hardware despite the -- what we described as a shift in some of the demand from our largest customer for hardware in 2019, it was still a record year for us. And despite it being down modestly this year by a few points, it was still a very strong a strong year for hardware, so that gives you a sense of the outlook for hardware and verification in general, that despite the challenges that we saw this year with our customers and the timing of schedules, it was a very -- demand for verification, both on the software and hardware side, is going to continue to be very healthy.

Okay. And I guess the other question I get a lot from investors is on China. So Synopsys' China revenues grew 31% year-over-year in fiscal 2020. And so when I go back and look at some of the local China semiconductor design companies, their revenues are growing at roughly 20% to 23% range on aggregate. Now I mean that's done easily with a pretty strong, big delta between how much Synopsys revenue -- China revenues have grown versus the semiconductor design revenues in China. Do you feel that maybe you're seeing some sort of a pull in? Or if not, how do we sort of explain this delta? And maybe can you speak to what a normalized China growth might look like in both EDA and IP?

I wouldn't characterize the business as pulling at all. In fact, we haven't seen any indication that, that's the case. The business in China, when I look at the customer diversification, the mix of product we're selling in there, we're doing well pretty much across the board. And so the trend that we saw in China in '20 is pretty much consistent with what we have been seeing in China over the last 15, 20 years and particularly over the last 5 years in China, in light of what the country is investing in -- in light of the investments that the country is making to build out their semiconductor capabilities. The -- I would point you to the fact that the demand for EDA and IP is much more correlated to semi R&D spend rather than semi revenues. And I think if you abstract it to the global environment, that would give you a really good sense because, on a global basis, the -- as reported, the semiconductor companies aren't posting the strongest results and yet, they continue to invest very heavily because they're looking ahead over the next year, 2 or 5 years in terms of what the the market opportunity is. And right now, what we're seeing as a function of the interactions that we're having with the customers in China and the demand that they have for our products and the interactions that they have with our support and our R&D group, there's a tremendous amount of investments that they're making. And in some days, it just doesn't feel like they could run fast enough or invest enough to accelerate their development. So that's a large part of why you're seeing the growth that we're posting in China today and how that doesn't quite reconcile with your model of looking at revenues because it's much more correlated to R&D spend.

Great. And on the supply side, I guess, from China, I mean, not a day goes by when you don't read about China's increasing desire to build out its own semiconductor and now, even more recently, EDA ecosystem. And it feels like they are beginning to attract increasing amounts of both financial and human capital. How are you thinking about competition in China for -- from an EDA perspective? And what are those names of those others companies you're sort of watching?

Well, the benefit of having been in this industry as a company, right, in this industry, for the last 3 decades, is the fact that we are used to competition, right? That the EDA environment is highly competitive. And in some ways, it's good because the competition forces each company and forces us to continue to be very focused on innovation and be very focused on delivering the best capabilities that we can provide to our customers in order for them to achieve their goals and their outcomes. And I would say that our ability to compete not only with the new emerging companies in China, but against our well-known competitors, is the fact that we continue to innovate. And when you look at the pipeline that we have delivered over the last couple of years, whether it's been in digital design or custom design or the verification platforms or in the new IP titles, we continue to keep pace with putting new products out there. And that, to us, is the best way to continue to compete with it. Now there's a number of start-ups that are certainly well-funded, and they're attracting quality talent. And they're, mostly on the smaller side and for the most part, they're competing on point tool capabilities. But no one really has the full suite of capabilities that we have, so that's the biggest disadvantage that they have. And on top of that, not only do we have a full suite of tools that you would need to design the chip, but we continue to introduce new products. And you're going to hear more from us in '21 and over the next few years with regards to our new products that we're bringing to market.

Okay. And on -- let's switch gears to your margin guidance, I guess, in fiscal '21. So your fiscal '21 guidance sort of calls for 100 to 200 bps of margin expansion.

Yes.

And can you walk us through the primary drivers behind that? And also, when you look at it relative to fiscal '20, where I think you gained 300 bps of margin points, can you help us sort of bridge why it is less than fiscal 2020?

Okay. Let's start with the first part of the question, which is what the driver of the improvements in March. I'm really encouraged by the outlook for 2021, coming off of a record year in so many ways for FY '20, we're going to show another year of solid revenue growth and margin expansion, and I think very healthy cash flow guidance. And when you look at the P&L, the key drivers of margin expansion is really going to start with the top line. The fact that we are providing an outlook of very healthy growth, that certainly is a key contributor to margin expansion. And as we continue to invest in the business to launch new products and scale up the business and make the necessary investments throughout the portfolio to position us for the next 5 or 10 years, we're going to do it in a very efficient and disciplined way to make sure that we are investing appropriately for innovation, but also investing for scale. And so but we're doing that in a way where we are certainly investing at less than the rate of revenue growth, and so you're going to see that drop to the bottom line. With regards to who's contributing, it will certainly be across the board. We are looking at various programs to drive R&D productivity. We will continue to drive more efficiency and productivity within SG&A group. And frankly, in light of what we've seen over this past year with the pandemic and the outcomes of that, particularly around the fact that most of this company has been operating from a remote working environment over the last 8 to 9 months, we don't look at new ways of collaborating and working together, while finding opportunities to do that in a more cost-effective way. Because certainly, what we've seen is that we can continue to be very productive while working remotely. And so what's the best way to create an environment that captures the best of being in person and collaborating in person, balancing that with the opportunity to perhaps do things in a different way in '21 and beyond. With regards to the comparison to '20 and the margin expansion, I'm actually very positive about that because if you look at it in terms of 1 to 2 points of margin improvement in '21, keep in mind, this is coming off of a just an incredible year in '20, you've mentioned that we increased margins by 3 points in '20, but that's only -- that was the second year of us having increased margins by 3 points to prior year. So certainly, we made a lot of progress and have been able to achieve our goal of high 20s operating margin, I would say, a year ahead of our plan. And so as we look at FY '21 and evaluate the opportunities ahead of us in terms of the opportunity to grow, we want to make sure that we're creating a plan that is balanced with regards to investing appropriately to sustain that growth, not only at '20, but potentially for the next decade, while at the same time, being able to deliver very solid margin expansion and continuing a multiyear trend of very solid double-digit earnings growth.

Right. And when you put your margin expansion plans in context of your 45% -- Rule of 45 rather longer-term ambitions, can you speak to the specifics around that? I mean if you -- for instance, if you assume that your core EDA business drives the bulk of the group going forward and your revenues grow at roughly 10%, that would imply that mid-30s sort of margins are attainable, especially for the semis business. So I'm wondering whether there's sort of a feeling here in terms of semi business margins? Or how you're thinking about the growth versus profitability sort of trade-off over a longer-term period?

Yes. Thanks, Pradeep. At this point, we're not prepared to provide more details of the breakdown between revenue growth and margin expansion. We are absolutely very committed to managing the company to a Rule of 45 given how strong we have done and how well we've done executing to the Rule of 40 in the last few years. You'll hear more from us in the coming year as we continue to refine and update our multiyear financial strategy and business strategy, and we'll share that with you as the year progresses. At this point, I would describe the achieving of Rule of 45 is really a combination of very solid revenue growth and margin expansion because that's going to be -- the combination of 2 is really going to be what is sustainable over time. Where if you end up going too extreme on one parameter, the other one, I don't think it's going to be sustainable over the long term. And then two, it's not going to be sustainable, but also, it really is the balance between 2, I think, is what is going to deliver the most value. And year-to-year, the mix may change, but we're very confident and very committed to delivering a very healthy combination of sustained revenue growth and margin expansion.

And when you speak about the longer term, does that mean fiscal 2022? Or does that -- I mean, when do you actually expect to get there in terms of getting closer to the Rule of 45, I guess?

It's going to be a progression. One, it's a progression. It's not going to be a step function increase, much like you see -- much like what you've seen in the business over the last few years, it's just a steady, methodical execution of the business and it's going to happen over the next few years. And what's great about where we sitting today with the portfolio that we have, one, clearly, there's confidence in the opportunity ahead. There's confidence in where we're positioned technology-wise and business-wise. There is confidence in our ability to execute to that. Hence, that's why we wanted to share our view of what the next few years might look like from that perspective. And then, two, when you think about managing to Rule of 45 and balancing growth versus profitability, it's really making the most and capitalizing in what is our strength, right? We have a, roughly, a $4 billion business that is a combination -- is a portfolio of multiple, very strong products and product categories. And as we think about driving for good growth and profitability at the corporate level, we're going to do it in a way that allows us to reinvest and continue to build a healthy business over a long term. And I'll give you an example of that. As we look at FY '21, we're committed to very solid growth and margin expansion, but we are also deliberately taking this opportunity to make the necessary changes in the software integrity business to scale it. We've done a really good job getting it to the revenue levels that we are today, and I would say we're ahead of our profitability goals. And in light of some of the operational changes that we're making in '21 to accelerate this on a next level, we want to make sure that we're investing appropriately, both on a product side and the go-to-market changes, to position this for the next 5 and 10 years. And so that's the beauty of having this portfolio because on one hand, we can still deliver what is a very good outlook for the coming year, but position a part of the business for future sustained growth and profitability that will, over time, contribute meaningfully to the overall business. And each of the portfolio, whether it's EDA software or hardware or IP and software integrity, are naturally going to go through its natural life cycles. And so as we are enthusiastic and as confident as we are in the business, we know that's a natural state of how the business will fluctuate. And so toggling between -- having the ability to toggle between investments versus driving for growth and dropping profitability to the bottom line. It's leveraging the portfolio to its full benefit.

Right. And that's a good segue because I wanted to shift gears into SIG. And maybe can we -- can you sort of remind us about how SIG actually fits into the strategic picture given that it is fairly different from the core EDA business that Synopsys is known more. And maybe, can you sort of start off by talking to us about the market opportunity that SIG enables you to pursue beyond EDA?

Okay. Let me answer that last question first, so I don't forget. The opportunity for SIG is just not a margin opportunity, Pradeep. It's both a long-term revenue growth contributor and margin. Right now, it's only about 10% of the business, but this is a potentially very big market, and we believe that there's an opportunity for us to continue to lead this market. So it's going to be a double benefit, double leverage in terms of how software integrity can contribute to the overall business. Let me go back 5 or 6 years and describe the strategic intent and the thesis that drove our investment in software integrity. It's really -- in simple terms, it's a thesis that's based on the convergence of hardware and software, right, and that the value that the systems companies and the chip companies could deliver over time, is going to be where they can improve that integration between hardware and software. Because you think about consumer products companies today or systems companies today that deliver the most value, taking Apple as example and Samsung to a lesser extent, where there is most value is that they're managing the full stack of their hardware and software and applications are on the top of that, the fully integrated stack. And the more that you see that integrated stack, you see how much the hardware and software have to work together. And so coming from the hardware side with chips and the compute because every single product you're dealing with is going to need some brains and if you're making a bet on the thesis, increasing those devices are going to run more software applications on top of them, and those software applications are really going to be the entry points or the risk points for security breaches, that was our thesis for us, is that we were clearly very strong from an EDA and semiconductor side. We saw -- I believe that the market was headed towards more software applications, and the increase in those software applications would create more security risk from that perspective. And the thesis was further validated by the fact that the original company that we acquired in the space, Coverity, had actually penetrated significantly the semi space or the embedded space because the half of the business was sold to semi companies, the other half to the enterprise. And the reason why they were so successful penetrating semi's side is that they got them. They got the value proposition. The semiconductors' companies understood that. It may take them 18 months to develop the chip, and the last thing they want to do is get to that point where they're ready to tape it out and it's a bug in the software, in the OS, that's going to blow this whole thing up and wreck that schedule. And so it was another validation of our thesis. And we knew that, over time, if we're successful in building this out, it's going to look less and less like the rest of the company. But there is a period of time where we do think there is significant synergies between the technical thesis, but also the operating benefits, right? Because if you think about what we're trying to do in the software integrity space, and in fact, we're trying to create a standardized process and create a set of -- standardized process for software development, right, and a standardized process for embedding security into the software development cycle. And on top of that, we're trying to create a standardized set of -- a full suite of tools to do that. That's not much different than where EDA was 30 years ago, right? Because 30 years ago, each semiconductor company had their own set of EDA tools, they had their own methodology. And their quality -- their approach as a quality, the outcome really dependent on the Head of Engineering. Today, the quality of software code, the security of software code really depends on the capabilities of the Head of Software Development at that company. And what we're trying to do is create a methodology and a set of tools that allows these software developers to standardize that process to increase their -- improve their time to market and improve the quality of their code. And so we definitely see a lot of synergies, both from a technology and also from an operating perspective.

And how is your customer mix sort of changed over time? I mean are you able to gain traction beyond the core semis space? Because I think, with security at least, it feels like a universal problem that a lot of enterprises are going to be confronting. And the other side of the coin is large markets attract a lot of competition. So maybe can you sort of speak to the competitive landscape as well for SIG from your perspective?

Yes. Yes, that's what's so remarkable. We actually have executed well against that thesis. And what was initially a mix of 50-50 of semi to enterprise, it's, in this past year, it grows up to 75%, right? And now that hasn't come at the expense of semis because it's -- both sides have grown. It's just that we've been very successful in terms of broadening the customer base beyond its original mix. So the semi customers -- semi opportunities continues to do very well, but we've expanded the enterprise side to levels where -- to a level to where is 75% of the mix. And I think over time, as we continue to really execute well on the go-to-market changes that we've -- that we're implementing, we should continue to see that percentage gradually increase. Now from a competitive perspective, we're actually very enthusiastic about the opportunity ahead of us because there are, frankly, no other companies that have the breadth of capabilities that we have, right? Because you can point to very few competitors that have both strength on the product side and security consulting. And when you -- then you drill down into both the strategic consulting capabilities and product offerings, no one has the breadth that we do, right, in terms of -- on the product side, the types of testing that you're running, right, the -- whether it's running the code, what's in its binary state or what's running or the type of test, whether it's proprietary code or open software, the breadth of language -- software languages that we cover, it's unmatched. The breadth of capabilities is unmatched. And even on the security consulting side, there is a wide range of capabilities. There is the strategic level, enterprise level-type security consulting where we can go in and help companies assess their development process and how to build security into that process. And we also have -- and you go to the extreme, it is as simple as managed services. You want us to take over some of the security test. The basic security testing and management for you, we can do that as well. So it's just a really strong portfolio of both product and services capabilities and then great breadth below that, and so we're very well-positioned. And the challenges that we're having now is really a function of us making the necessary changes to the scale. We've done a great job getting the business to where it is today. And -- but our ambitions are much greater than this. So the changes that we're making, the challenges that we're kind of working through right now really is a function of scale and not a failure and strategy or a failure in road maps. So we're really well positioned from that perspective. And if there's a bit that I love, which is a bit on our execution, so I'm very confident about our ability to make -- work through those transitional issues and really position this business for substantial growth over the next few years.

That's the interesting piece because as you start making changes to SIG and you push into consulting, both strategic and at the product level and managed services, I guess, how do you think margins at SIG's scale with revenue? Do they sort of scale linearly with revenue? Or is there sort of a tipping point around, let's say, $500 million of revenues, for example, that sort of drives margin acceleration? So the reason I'm asking, is there sort of -- how do investors sort of think about where margins for SIG can eventually go and how you sort of balance that growth versus profitability trade-off at SIG itself, independent of your sort of 45% -- Rule of 45.

When I look at that business and the opportunities ahead, there's nothing structural about that business that would prevent it from approaching the corporate average over time. It's a -- you think of that profile, it's a security software company selling mostly to enterprise and we're making investments to really scale that growth. And so I do think that this has very strong potential to deliver good profitability that convert just to the corporate average. Now the timing of that and to what extent it could potentially converge or exceed really depends on how well we can execute on growth. And so related to your earlier question, is it linear or is there an acceleration on it, I would say it's not linear, but it will depend on how we want to manage that trade-off between growth and profitability. We are in the early stages of this opportunity, right? And so the -- we are in the early stages of this opportunity, so the key for us is continue to run that business in a disciplined way to improve its profitability, but the bigger opportunity for us is scaling this business and helping driving very strong growth over time. And so the function of kind of the progression of profitability is less a function of what's inherently structural, but really the right management judgment to deliver the balance of growth, investments and profitability to deliver the greatest amount of value over the long term.

I see. And obviously, customers are looking at what you're doing to the organization and how you're thinking about penetration going forward. What is the customer feedback being with respect to SIG -- sorry, SIG, and especially around the changes you will be making?

Well, in 2020, frankly, the customer base is -- has been very much focused on how they're responding to the current macro environment, right? They frankly have more -- their own issues that they're working through, right? Because a lot of this financial service, a lot of the enterprise customers that we're selling to and the verticals that we're particularly strong in are under a lot of stress as a result of pandemic, and so that's been top of mind for them. Now that said, they continue to have to deliver on their security plans because that doesn't take a break. That risk doesn't take a break and delivering on their software road maps. And what's been very positive is that despite the kind of transitions that we're going through and the operational changes that we need to make, the feedback and the feedback from the dollar perspective, because that's what really matters, there's things that they tell us, because ultimately, they vote with their dollars. And they're voting with their dollars by continuing to buy into the platform, by continuing to choose us as their partners because of the breadth of the capabilities, right? That -- and we're not -- what's fantastic is that we're not competing as if we're a broad provider competing with best-in-class. We -- in some of the cases, we are the best-in-class in that particular capabilities, and we have quietly, over the last 6-plus years, assembled a platform of capabilities of best-in-class products. And so the customers continue to vote with confidence via their dollars. And so the deals that we've tracked this year, the feedback they're getting and why we won some of these larger enterprise deals, these multimillion dollar, multiyear deals, is a result of our vision for the Polaris platform and the breadth of capabilities that we're delivering and the fact that the breadth of capabilities is coming on top of what are very strong individual point tools.

And is there sort of a sense amongst customers that Synopsys is going to -- I mean with respect to the confidence in the product road map, is there a sense that you're seeing deeper engagement with existing customers in addition to sort of going and closing more deals with your customers? So for instance, in 2020, I mean, you could argue that the deal environment was tough. But what about existing customers sort of getting deeper into engagements with Synopsys?

Yes. We are definitely getting deeper. And one way that we track that, Pradeep, is the amount of cross-selling that we're seeing with the customers. And that's something we monitor very closely. We continue to expand the level of engagement, right? Are we moving up in the seniority and the level of senior leadership? Are we broadening our capabilities both on the product and consulting side and are we selling -- going back in and selling more tools or different tools to those customers or different projects? And we're seeing across all those metrics, we're seeing a very positive trend. Now for us, the challenge going forward is that there are customers who want to work with us because we really do have strong capabilities. So how do we make it easier for them to work with us? How do we streamline our processes? How do we educate them on the capabilities? And how do we bring those products to them in a way that fits with their needs? And so there's really a lot on our shoulders now to improve how we bring the not only inform of the value, but also deliver the value that we're committing to.

Great. I think we're almost out of time. So Trac, I really would like to thank you for sharing your time with us. And I look forward to many more conversations in the future. Thank you.

Great. Thanks, Pradeep. We really -- I really enjoyed the chance to catch up with you and share the progress that we're making as a company. Take care.

Great. Thank you. Goodbye.