Magma to Cadence: Bring it On

I attended Magma Design Automation’s (LAVA) annual meeting on September 23, 2010. Over the past year, Magma stock has handily beaten the S&P 500. Since September 28, 2009, the S&P has struggled to break even while Magma's stock has increased around 70%.

Chairman and CEO Rajeev Madhavan handled the formal portion of the meeting, which was uneventful. After the meeting, he generously agreed to allow me to ask him questions one-on-one.

Mr. Madhavan’s energy is palpable. You can almost feel his lava-hot desire to succeed when you hear him speak and move. One gets a sense that Mr. Madhavan is bustling with ideas and can't wait to share them with you.

I expressed my concern that Magma’s general business was becoming commoditized, which usually causes margins to decline. However, Mr. Madhavan told me that Magma had “substantial leadership in the analog area” with several unique, brand-new tools. He said he was “extremely confident” about the new tools. He also indicated Magma’s biggest challenges were internal, i.e., to ensure execution without incurring more expenses.

When I pointed out that Magma was a smaller player in a market dominated by Cadence (CDNS) and Synopsys, Inc. (SNPS), Mr. Madhavan compared Magma to Google's Android, contending that if size mattered, Microsoft should have been able to outcompete Android--which has not proven to be the case. He also said that “Cadence is weakest in [its] technology” and doesn’t offer the “best of anything [in its market].” To put Cadence’s technological issues in context, Mr. Madhavan said that some of Cadence’s products were “three to four times slower” than anyone else’s. When I expressed surprise, Mr. Madhavan’s eyes lit up. He immediately issued a bold challenge to Cadence, saying,“You name it, I’ll take them on anyplace...every couple of weeks or so, we’re winning evaluations against Cadence, and we’re seven to fifteen times faster” in SPICE and several times faster in digital now.

What about Synopsys, I asked? Mr. Madhavan’s tone softened. He said Synopsys is “strongest in terms of numbers” and its balance sheet, and Magma “must continue to differentiate” its own products to compete with Synopsys’ products. [According to Magma, "In SPICE Magma has a tremendous differentiation and we expect to increase our digital differentiation with our upcoming product launches.”]

My impression was that Cadence was expanding in China, so I asked Mr. Madhavan about Magma’s Chinese footprint. Mr. Madhavan confirmed his company also had “sales and marketing in China” but indicated that the industry has yet to do as much business there as in the U.S.

I asked Mr. Madhavan about his biggest challenges going forward. He said that his primary goal was getting “engineers to try” Magma’s products. Once engineers try Magma products, they tend to view Magma as an attractive partner. But Mr. Madhavan admitted that existing business practices--specifically all-you-can-eat deals from other EDA suppliers--encouraged inertia. [Note: EDA is electronic design automation aka electronic computer-aided design.] Because the consequences of missing a deadline can be so severe, most engineers prefer to stay with the more established names rather than switch, even if Magma’s products are better and faster.

Regarding my contention that EDA was becoming more commoditized, Mr. Madhavan expressed disagreement: “The very fact that [other companies] think that their products are commodities is the anti-thesis of Magma...we strive to differentiate--that’s our culture.”

How about it, Cadence? Will you take on Magma in a head-to-head contest? Mr. Madhavan is waiting for you.

Bonus: a review of Magma’s 2009 shareholder meeting is here.

Disclosure: I own a small number of Magma (LAVA) shares. My holdings may change anytime. Also, a Magma employee had the opportunity to review this article and submitted some comments to me. I included some of his comments, including the references to SPICE.

Magma Design's Shareholder Meeting (2009)

I attended Magma Design Automation Inc.’s (LAVA) shareholder meeting on September 17, 2009. The company offered attending shareholders coffee, water, untoasted bagels with cream cheese, and assorted pastries. There was no prepared informal presentation.

CEO and Chairman Rajeev Madhavan handled most of the meeting. CFO Peter Teshima also answered several questions. Both CEO Madhavan and CFO Teshima responded to my questions with energy and confidence. I asked several tough questions, and I received good answers. Some quick points:

1. Some of the information provided in the 10K is now outdated. Although Magma’s 10K states, “There is substantial doubt about our ability to continue as a going concern,” (page 11) Magma recently secured financing and will be able to satisfy its May 2010 bond obligations. According to statements made at the meeting, management waived the original 70% voting requirement (page 59). About 54% of the 2010 bondholders participated in the 2010 note exchange offer. This new development allows Magma to avoid distributing all of its cash to the May 2010 creditors.

2. Magma derives a significant percentage of its revenue from outside North America. See 10K, page 24: “we generated 41% of our total revenue from sales outside North America.” Consequently, Magma’s future revenues may not entirely depend on the American consumer.

3. Magma may have patent infringement issues. See 10K, page 27: We believe the patent portfolios of our competitors are far larger than ours, and this may increase the risk that they may sue us for patent infringement...” (To be fair, many tech companies face the possibility of patent infringement litigation.)

4. Other bloggers have said they expect Cadence (CDNS) to buy out or merge with Magma; however, CEO Madhavan seemed mildly upset that his company wasn’t getting the same respect as Cadence and was somewhat dismissive of Cadence’s financial position. In contrast, he had high praise for Synopsys, Inc. (SNPS).

According to a Magma company employee, CEO Madhavan seems to admire Synopsys’ financial profile due to its 90/10 revenue model, where 90 percent of revenue during a given quarter stems from backlog and only 10 percent from same-period deals. On the other hand, according to the same internal Magma source, Cadence and Mentor Graphics (MENT) have not yet achieved this preferred 90/10 revenue model (Magma points out that it achieved this 90/10 ratio two quarters ago). To be clear, CEO Madhavan did not express an opinion of a possible or a preferred merger or acquisition scenario.

I asked CEO Madhavan my usual question: “What is your competitive advantage in the marketplace?” CEO Madhavan answered that Magma software offered a “value proposition.” Using Magma’s software, semiconductor companies could save one million dollars in the process of designing a single chip. My understanding is that Magma’s software streamlines various aspects of chip design, which allows semiconductor companies, especially analog chip companies like Maxim (MXIM) and Linear Tech (LLTC), to use fewer engineers. Obviously, fewer engineers means less overhead for a semiconductor company, and less overhead means more financial flexibility. That’s the short version of Magma’s purported advantage. The following is the long version, based on my conversation with an outside engineer:

Designing chips is expensive because designs usually go through several modifications before they actually work. Engineers first design a circuit on a computer (called schematics). Then, they run modeling/simulations to make sure the circuit runs properly on the computer. After computer testing, the engineers transfer their design from the software/abstract to a physical layout for fabrication. The final step is sending the layout to the fab to make the actual chip. However, even after the manufacturer/fab creates the chip, work is not done. Engineers still have to test the chip in their lab in real-life scenarios. Sometimes the chip doesn’t work to the proper performance specs. This gap in expected performance requires the engineers to go back and re-work the design. The company must go through all the design stages again prior to sending a new, improved design to the fab. Unfortunately, every iteration (i.e., modifying the schematics) costs the company money. Depending on the skill level of their engineers, a company may have to fund several more iterations. Magma is saying that its software reduces the number of iterations and therefore saves chip design companies money and resources.

I questioned the CFO’s reliance on non-GAAP accounting numbers, citing pro forma accounting gimmicks used by Enron. CFO Teshima countered by saying that only “one or two acquisitions were the primary difference between GAAP and non-GAAP numbers.” CEO Madhavan left the meeting saying that Magma was the “new kid on the block,” implying that it wasn’t getting the respect it deserved.

I enjoyed the energy Magma’s executive team brought to the table. The CEO seemed unafraid of his competitors and prepared to compete. Magma’s current share price, which is under two dollars, reflects the company’s recent financial problems. Magma indicates that such financial problems are behind it, and it is confident about the future. In my opinion, Magma has several high risk factors, but also the potential for major upside. Personally, I am going to wait until Magma’s balance sheet improves before making any major purchases, but I will be following the company more closely.

Disclosures: I own an insignificant number of LAVA shares. A Magma employee also had an opportunity to review this post prior to publication and submitted some comments to me. I incorporated a few of his comments, mainly relating to the 90/10 revenue model and paragraph 1, which starts, "Some of the information provided..."