Synopsys (Nasdaq: SNPS), which sells software to the semiconductor industry, has been one of the bright spots in the tech space since releasing results last week. Investors are optimistic about the company’s future growth, and the stock price is now back in record-high territory.

Last week’s results included earnings growth among the highest Synopsys has achieved in the past. Third-quarter non-GAAP EPS were 8 cents ahead of consensus at $1.18, while GAAP EPS of $0.65 were slightly below consensus. This represented 25% growth from a year ago. Revenue of $853 million was 9.7% higher for the year and slightly higher than estimates. This growth was a little lower than the company’s long-term average.

Revenue guidance for the fourth quarter was between $830 million and $860 million. GAAP EPS are expected to be between $0.69 and $0.82 while non-GAAP EPS are projected at $1.10 to $1.15. The company will also buy back $100 million of its stock.

Excellent Long-term Prospects

It’s not surprising that investors are optimistic about this company’s future. Synopsys is one of only a handful of companies supplying software and IP to the companies building the components at the heart of the internet of things, 5G networks, and autonomous vehicles. In this sense investing in Synopsys is a smart way to get exposure to several significant tech trends, with one stock.

The company’s profitability is also impressive. The gross margin at 77% is excellent, though it is falling, and operating and profit margins at 12 and 17% respectively are fair, but somewhat volatile. These margins have all oscillated in a 5% range over the last ten years.

The ROE at 16.5% is also solid, and Synopsys has negligible debt. Moreover, a large percentage of the revenue is recurring, which adds to the quality of earnings.

Growth Needs to Continue to Justify the Valuation

Synopsys has driven growth by making over 40 acquisitions in the last ten years. This has worked out well so far, but it’s hard to say how sustainable it is.

While the long-term story is promising, the valuation is quite high when you consider that revenue growth hovers around 10% and earnings growth is somewhat lumpy.

Synopsys has driven growth by making over 40 acquisitions in the last ten years. This has worked out well so far, but it’s hard to say how sustainable it is. Organic growth is more predictable and justifies higher multiples.

Also, the slowdown in the semiconductor industry has lasted longer than most analysts expected, and some believe it may carry on for some time. This may not affect sales for Synopsys, but it could affect top-line growth.

There are therefore two risks to the company’s ability to continue the current growth trajectory; the sustainability of growth and the chip industry as a whole. The likelihood of one of the next few quarters producing substantially lower growth is relatively high. If that happens the market may not be happy to pay six times revenue as it is now.

There is a prominent trendline at $130, and lateral support at $125. This area should act as support and would offer an excellent reward to risk ratio. However, a move below that opens the possibility of a significant pullback – perhaps as low as $90 where the price-to-sales ratio would be more reasonable at 4X.

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