Synopsys (NASDAQ: SNPS) is a company that provides electronic design automation software products used to design and test integrated circuits. We are currently neutral on the stock.
Competitive Advantage
There are a couple of ways to quantify a company’s competitive advantage using only its income statement. The first method involves calculating the earnings power value (EPV).
Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value can be measured using total asset value. If earnings power value is higher than reproduction value, then a company is considered to have a competitive advantage.
The calculation is as follows:
EPV = EPV adjusted earnings / WACC
$14.1 billion = $1.1 billion / 0.078
Since Synopsys has a total asset value of $8.8 billion, we can say that it does have a competitive advantage. In other words, assuming no growth for Synopsys, it would require $8.8 billion of assets to generate $14.1 billion in value over time.
The second method is by looking at a company’s gross margins because it represents the premium that consumers are willing to pay over the cost of a product or service.
An expanding gross margin indicates that a sustainable competitive advantage is present. If an existing company has no edge, then new entrants would gradually take away market share, leading to decreasing gross margins as pricing wars ensue to remain competitive.
Taking a look at Synopsys, we can see that gross margins have expanded in the past several years. As a result, its gross margins indicate that a competitive advantage is present in this regard as well.
Profitability
In the last 12 months, Synopsys has recorded $1.4 billion in free cash flow, making it profitable. This indicates that the company doesn’t have to rely on equity raises to continue funding its growth.
More importantly, its free cash flow has been trending up in recent years. To us, this means that the company’s free cash flows are reasonably predictable.
Risks
To measure Synopsys’s risk, we will first check to see if financial leverage is an issue. We do this by comparing its debt-to-free cash flow. Currently, this number stands at 0.1. In addition, when looking at historical trends, we can see that the debt-to-free cash flow ratio has been trending down.
Overall, we don’t believe that debt is currently a material risk for the company because its interest coverage ratio is 415.5 (calculated as free cash flow divided by interest expenses).
Another risk associated with SNPS stock is valuation. Currently, the company’s EV/FCF ratio is approximately 40.6x. With the Federal Reserve considering raising rates and offloading its balance sheet faster than expected, high multiple stocks such as SNPS could potentially be impacted the most.
This is because the Fed’s actions will push bond yields higher, resulting in higher discount rates and lower valuations.
Wall Street’s Take
Turning to Wall Street, Synopsys has a Strong Buy consensus rating, based on nine Buys and one Sell assigned in the past three months. The average Synopsys price target of $388.70 implies 17.8% upside potential.
Conclusion
Although the company has a strong underlying business, its current valuation leaves it vulnerable to macroeconomic forces such as rising interest rates.
In addition, the consensus price target is based on a low-interest-rate environment and does not provide a large enough margin of safety. Thus, we remain neutral on the stock.
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