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Is Intel About To Buy One Of These Companies?

Wednesday, November 27, 2013 2:30 PM

Imagine if Ford (NYSE: F) offered up its assembly lines to Chrysler. Or if Apple (Nasdaq: AAPL) started building computers for Microsoft (Nasdaq: MSFT).

Well, semiconductor giant Intel (Nasdaq: INTC) is pursuing just such a move. The chipmaker has built up so much excess manufacturing capacity that is now looking to make chips -- for other chipmakers.

The Wall Street Journal recently reported that "Intel's fabs would be open 'to any company able to utilize our leading-edge silicon.'" It's a painful but necessary move. Intel has spent billions on its various fabrication plants ("fabs," for short) and simply can't afford to let them sit idle.

Trouble is, it's a crowded field. Firms such as Taiwan Semiconductor Manufacturing (NYSE: TSM) and Samsung already operate chip foundries for firms such as Apple and Broadcom (Nasdaq: BRCM) that choose to go "fab"-less (that is, outsource their production).

To help snag customers, analysts think Intel will need to beef up its sales proposition by offering the ability to design and test chips -- a key series of steps before production can actually begin. And that has put the spotlight on the leading players in field known as electronic design automation (EDA).

These EDA firms can help speed the time to market, lower the device cost and enhance a chip's functionality. In the cutthroat world of chip design, their services have been in demand -- and that demand has been steadily strengthening since the recession.

Each of the firms is expected to boost sales 6% to 7% in 2014, and the subsequent years should provide solid growth as well. That's because chip firms tend to invest in new designs (and use EDA services) when business conditions are strengthening. A quick glance at the Philadelphia Semiconductor Index implies a sense of improving industry conditions.

Of course, Intel won't be pursuing these EDA firms solely on the basis of their near-term growth prospects. Instead, the chip giant will try to identify which of these EDA firms has the most well-respected product and service offerings. Here's a quick look at how what these firms do and how they distinguish themselves in the industry.

EDA firms are tasked with handling a number of discrete design aspects for a chip. They establish the basic architecture of a chip and help make decisions about which tasks will be controlled by hardware (the chip) and software. These firms then rely on their vast repository of software code to help establish how a chip will actually execute a set of functions. Placing the building blocks of code together, a process known as "synthesis," is an important middle step.

This whole process is known as the front-end design; the actual physical layout of the chip is known as the back-end design. Steps in this process entail "floor-planning" (that is, figuring out where the chip components such as the clock-timer and power supply will be placed) and routing of commands. These EDA firms constantly test the developing designs at each phase, using simulators that run thousands of cycles to try and expose any design flaws. Once the final design is in place, physical verification of the chip takes place.

Each of these three firms is known for expertise in specific areas. For example:

Mentor Graphics (Nasdaq: MENT) has strong expertise in the initial phase of system level design (and is also a key player in the final steps involving physical verification). Mentor has also built a considerable niche in support of printed circuit board (PCB) makers, which place a wide variety of chips onto a panel.

Synopsys (Nasdaq: SNPS) dominates the end of the front-end phase (synthesizing), along with back-end phases such as floor-planning and routing.

Cadence Design Systems (Nasdaq: CDNS) has good market share in functional verification, though this niche is dominated by Synopsys. Functional verification is the largest niche in the EDA industry. Cadence is also a leader in the development of analog chips, which have very different design requirements and are used in fields outside of telecom and computing.

These firms all offer the full range of services, and customers opt to give all of their business to one vendor, or instead use different vendors for various phases. Moreover, acquisitions in recent years have enabled each of these firms to bolster their strengths in areas that had been weaknesses.

Synopsys is considered to be the broadest provider, the closest thing to a "one-stop shop" in the EDA industry. Frankly, Intel would likely consider Synopsys or Mentor Graphics to be an appealing fit, depending on which way Intel wants to proceed with its foundry plans. Cadence, on the other hand, lacks the leadership in important areas that Intel would likely covet.

Should You Buy It?
As a long-standing rule of thumb, you should never buy a stock purely on the basis of buyout hopes, and instead focus on the most attractively priced stock. So which one of these firms stands out as a bargain?

Mentor Graphics holds the slight value edge, while Synopsys garners the industry's highest valuations, which is logical in light of the best-in-breed business model.

As a final test of value, I defer to D.A. Davidson's Thomas Diffely, who has been following these companies for a number of years. He says that "EDA spending continues to show signs of resiliency and is being driven by rapidly increasing chip complexity and designs that span multiple nodes." His take on these companies:

• Cadence is rated a "buy," with a $16 price target (24% upside). He actually boosted the stock from "neutral" in September, noting that a summer pullback had moved shares back into line with peers.

• Synopsys is rated a "buy" with a $45 target (23% upside), noting that the company's customers "continue to invest in next generation designs," and that these customers "continue their collaboration with SNPS on these leading edge designs."

• Mentor Graphics is rated a "buy" with a $26 target (16% upside), citing a recent 30% spike in bookings and a book-to-bill ratio that has exceeded 1.0 for four straight quarters.

Risks to Consider: Spending on chip designs always slumps when global economic trends weaken, and these stocks would likely slump along with a downturn in the chip sector.

Action to Take --> Based solely on the prospects of a buyout scenario, Synopsys is the most appealing investment in this group; Mentor Graphics, on the other hand, is the value play.

P.S. If the investment potential of EDA has you excited, wait until you see what StreetAuthority's Andy Obermueller has been working on. Andy has identified five "game-changing" trends with the potential to revolutionize the way we live our lives -- and make early investors a killing. To learn more about these developing technologies -- and the companies behind them -- follow this link.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of INTC in one or more of its “real money” portfolios.