As the artificial intelligence (AI) race heats up, investors have become increasingly aware of the powerful position of electronic design automation (EDA) software companies. That's because these companies deal with a type of design suite specifically for semiconductors that are so vital to AI's development. As a result, industry leaders Synopsys (NASDAQ: SNPS) and Cadence Design Systems (NASDAQ: CDNS) have been off to the races, sporting respective gains of 59% and 71% since the start of 2023.
Synopsys stock has fallen as of late, though, on rumors it would try to acquire Ansys (NASDAQ: ANSS), which produces software that analyzes and simulates engineered parts and systems before they're manufactured. Synopsys confirmed the rumor in late December and is offering to acquire Ansys for $35 billion. If successful, this will be one of the largest-ever tech mergers and acquisitions in a big bet on the future of AI. But investors should be aware of some important details before even considering buying right now.
Ansys will be a powerful tool in the AI era
On the surface, a tie-up between Synopsys and Ansys may look confusing. After all, Synopsys is a high-tech software business catering primarily to semiconductor companies and other businesses that design and assemble computing systems with chips. Ansys, by comparison, only counts about one-third of its revenue from semiconductor and computing customers. Its simulation software is primarily used for mechanical processes, not electrical ones.
But that isn't to say Ansys can't handle complex electrical design processes. In fact, as the companies said in the press release explaining the deal, all Ansys customers can benefit from having access to chip design software. That's because semiconductors are designed into products of all kinds these days, from cars to toothbrushes, and the trend isn't going to let up. On the contrary, with AI increasing the usefulness of embedded computing, many product companies are interested in putting AI to use but have limited AI and advanced software know-how.
That's the rationale for Synopsys-plus-Ansys. Together, the companies say their software suites have a total addressable market of $28 billion that's expected to grow at an average of 11% a year through 2028.
A premium price tag to pair with the AI rationale
All this sounds exciting, but Synopsys shareholders should give pause here. Intense scrutiny from regulators around the world, and the deal likely not going through until well into 2025, are but minor concerns.
After news of the acquisition broke, Ansys stock spiked. The company is now valued at about a $29 billion market cap (lower than the mid-December valuation, in part due to uncertainty around merger approval). But even now, that values Ansys at a hefty 60 times trailing-12-month earnings and 46 times free cash flow.
To pay the premium price tag to Ansys shareholders, Synopsys has secured $16 billion in debt financing. That will blow up what was a squeaky-clean balance sheet that had $1.59 billion in cash and short-term investments and just $18 million in debt as of the last quarterly update.
Paying down this debt will be a top priority for Synopsys should it be successful in taking over Ansys. The company's long-standing stock repurchase program to return excess cash to shareholders is now suspended until then.
For the time being, the pending purchase of Ansys could keep a lid on Synopsys stock, which itself also trades for a high premium (64 times trailing-12-month earnings and 52 times free cash flow). The promise of AI development over the next decade is exciting and will likely spawn more merger and acquisition deals like this one. But investors should pause before buying the hype. Synopsys' bid for Ansys is all about the long term, putting healthy shareholder returns at risk over the next few years.
As an alternative, also keep an eye on Synopsys' chip design peer Cadence Design Systems. It, too, trades for a premium price, so consider using a dollar-cost averaging plan if you decide to buy at all.
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Nicholas Rossolillo and his clients have positions in Cadence Design Systems and Synopsys. The Motley Fool has positions in and recommends Cadence Design Systems and Synopsys. The Motley Fool recommends Ansys. The Motley Fool has a disclosure policy.
