Synopsys: Consensus Earnings Are Misleading

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However, intangibles are a vital part of the company's operations. This is because of two key facts.

  • The company deducts a large part of the amortization from the cost of revenue, which indicates that intangibles are closely related to revenue generating activity.

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SEC filing, 10-K 2015

The company acquires new businesses, mostly intangibles, frequently and accounts for them on the balance sheet. Therefore, adding back amortization to reach at non-GAAP earnings doesn't fairly reflect the earnings of the company.

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Source: Morningstar

As amortization of intangibles account for 6% of the company's revenue, using non-GAAP earnings for valuation purposes can lead to distortion of the price target. We can see this in the market as investors are basing their investment decisions on the company's consensus non-GAAP earnings.

Let's apply the EVA valuation technique to get a clearer picture of the valuation. Assumptions for the EVA valuation include:

  • Earnings growth of 10% is assumed during 2016-2020; 1% growth is assumed in perpetuity.
  • CAPM is used to calculate the required rate of return; NASDAQ return is used as a proxy for market return.
  • Invested capital is assumed to grow at the required rate of return during 2016-2020.

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Focus Equity estimates

The EVA model reveals a price target of $55.1 based on the non-GAAP earnings. This price target is close to the current market price indicating that the market is pricing Synopsys based on non-GAAP earnings.

This doesn't reflect the company's fair value given that the company is not registering the effect of amortization in non-GAAP earnings. In simple terms, by not accounting for amortization, the company isn't registering the effect of expense incurred in acquiring the intangibles. It's just putting the asset on the balance sheet without putting related expense on the income statement. Therefore, amortization shouldn't be added back to earnings in order to see the company's true value. Depreciation on tangible assets isn't ignored while calculating non-GAAP earnings. Same principle should be applied for amortization.

To arrive at the fair value, the EVA model is adjusted to reflect the effect of intangibles. As amortization is 6% of the revenue consistently, the same is used for the EVA model

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Amortization, SEC filings, 10-K 2015

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Focus Equity estimates

The valuation model adjusted for amortization tells a different story. The price target comes around $40, which is below the price for which the stock is trading. Note that valuation models are just a point of reference and don't reflect the exact price for which the stock should trade.

A cash-flow model is also used to value Synopsys. For the model, operating cash flow is expected to grow at 10% p.a. given the growth of the EDA and SIP segments of the company. Capital expenditures include the expenditure on PPE and the acquisitions. The average of the last three years' CAPEX is used as a starting point. CAPM is used for cost of equity.

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CAPEX extract, SEC filing 2015

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Focus Equity estimates

Cash flow-based valuation reveals a price target of $50, which is also below the current trading price. Note that cash flow-based valuation takes care of the amortization problem in EPS through CAPEX. As it directly records the CAPEX, there's no need for depreciation or amortization.

Final thoughts

To sum it up, non-GAAP-based valuation for Synopsys is misleading as it doesn't reflect the company's fair value amid exemption of amortization. There's growth in the industry and Synopsys is doing well as it managed to consistently beat earnings estimates. On the flip side, as consensus is based on non-GAAP; earnings management is easy using amortization.

Investors should focus on the GAAP earnings of the company. Note that on GAAP basis, Synopsys is trading at a forward PE of 34. This is lofty as earnings are expected to grow at 10% p.a. during the next five years. All in all, the market is mispricing Synopsys. It's a good pick at $40 given the cash-flow target of $50. But, above $50 there's not much value. At the current stock price, Synopsys is a sell.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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