Mentor's big decision

17 June 2008

There is clearly something in the water on the West Coast as hostile takeover fever is taking hold. Away from the Microsoft/Yahoo soap opera, another, somewhat smaller bid battle is gearing up. Mentor Graphics has rejected today's offer from Cadence Design Systems, citing antitrust issues among the reasons:

"As we recently indicated to Cadence, we reviewed Cadence's proposal and analyzed both the price proposed and the risks associated with obtaining antitrust approval for a combination between the companies,” said Walden C. Rhines, chairman and CEO of Mentor Graphics. "Following this review, we concluded that not only was the price insufficient to support a transaction but that the risks of not gaining regulatory approval were sufficiently high that the ability of the parties to consummate the transaction would be in jeopardy. For these and other reasons, our Board unanimously rejected the proposal."

On the conference call, Cadence did not distance itself from the idea that CEO Mike Fister could play the role of Steve Ballmer against who some analysts are setting up as the Jerry Yang in this battle, Mentor's CEO and chairman Wally Rhines. The script is similar: Mentor did not want to negotiate, and is not interested in providing value to shareholders.

However, Fister could equally be the loser in this particular contest as it's not entirely clear how much Cadence would gain from the $1.6bn deal against the risks of having to suffer scrutiny from either the Department of Justice or the Federal Trade Commission over antitrust issues. We are dealing here with two of the top three companies in the electronic design automation market. It's worth about $3bn, with almost all of the money going to just five companies.

Even if it succeeds, the risks to Cadence are huge. The deal is only 'accretive' — it boosts the earnings per share — if you assume pro-forma, non-GAAP accounting. The kind of accounting where the CFO decides which numbers are relevant rather than actual accounting standards. And it does not take into account the effect of having to report Mentor's numbers in a different way to which they are now.

Anyone who has followed EDA financials for any amount of time will curse the words 'ratable', 'revenue' and 'recognition'. These words define when the software companies decide to book the money they take for their tools. And they all do it differently. Not only that, every three or four years, they change the way they do it. This makes comparisons over any lengthy period of time a nightmare.

The upshot is that, if Mentor does succumb to a proxy war or decide to agree to a merger, the numbers will not quite be as good as everyone expects because Cadence will delay booking some of the money that the Mentor business units take in. Now, this is arguably a cleaner approach for a company that sells software licences, but it makes predictions of the value of the Mentor deal much harder to calculate.

Then you have the product risk, which is what most of the people watching this deal will care about. Gabe Moretti invokes the spectre of the Daisy/Cadnetix takeover from the early 1990s. This did not go well, although you could argue that these companies were on the way out anyway and they might as well have gone down together. This was the point where upstarts like Cadence and Synopsys — today's top two — were coming through. It's worth noting that Mentor stumbled at this point, reinventing itself under Rhines during the 1990s when he crossed over from chipmaker Texas Instruments.

Overlap is a big issue. On the Cadence conference call, Merrill Lynch senior analyst Jay Vleeschhouwer, who has covered EDA for some time, pointed out that Cadence has more than a little overlap with Mentor: "I can think of five areas where you and Mentor currently overlap, including verification and physical," he said and cited the example of Synopsys and Avant, where the two companies had comparatively complementary product lines. "It took Synopsys years to get the full benefit of Avant."

It's actually easier to count up the areas where Cadence and Mentor don't have competing product lines. It basically comes down to FPGA design and embedded software and, on the latter, Cadence has 'Project Sydney' coming up, which has a software verification component to it.

Here's Fister on the overlap problem raised by Vleeschhouwer: "I think the EDA market is full of subsegments. And certainly now many of the customers operate heterogeneous flows, a combination of points of light. That is where the extreme complement comes from. In my time I think we have demonstrated an ability to integrate not only the historic acquisitions but the ones we have embraced in the last four years. We developed a great capability to do that; the stucture of the holistic solutions engages in a collaborative fashion some of the rest of the industry and that is the muscle memory that we are going to use going forward." (Translations on a postcard please to...)

Bill Porter, chief administrative officer and formerly CFO, added: "Part of our strategy is to have a holistic solution, front and back. And part of Mentor's philosophy is to have very distinct points of technology throughout their product line. Our ability to integrate that will have benefit to our customers. We will be able to get on that very quickly....I think it has got some long-term benefits for our customers."

It's a fair point that Cadence has made acquisitions work for it: the company has a patchy history of turning internal R&D into top-notch tools. It has claimed, recently, that it is much better at it. However, the Mentor deal has demonstrated that Cadence believes Calibre is far superior to its own offering, Assura, which is a dramatic about-turn from a company that has busily been trying to push into the design-for-manufacturing (DFM) space. It is because of this that Cadence is now in the position that it cannot retreat from the takeover bid: it's signalled its weakness in certain key areas.

Is the deal worth it? For Cadence, the risks are huge and could turn out to be a 1+1=1 deal. Calibre will bring in the dough from day one but Cadence will have the issue of how it merges Assura with Mentor's tools. Mentor's PCB operation is a steady earner and the nature of that business means that Cadence would not have to spend much time merging tools. You just keep all of them that have a decent user base. Verification is far from clean-cut. It's hard to see the ModelSim team settling in well at Cadence. It took a while for them to settle in at Mentor and some of the other business units work because they have relative autonomy. That, historically, is not the way things have worked at Cadence.

I still need to do a full analysis of where the overlaps lie. But, trust me, the diagram is going to look messy. And, I believe that both Cadence and Synopsys are over-playing the concept of the one-stop-shop. The big chipmakers do want to buy a single design flow but there is a caveat: that flow has to have all the best tools in it. And none of the players can offer that. They won't be able to offer it even if Cadence succeeds in its purchase of Mentor. What they really want is some third-party to make the pain go away by taking the best tools around and glueing them together. This is not the same story that Fister is selling to Wall Street.

Mentor is also faced with a dilemma: a takeover might be bad for Cadence; it might be bad for EDA; but is it bad for shareholders? Let's face it, it's real money on the table. Last year, $16 was not a great offer. But, right now, it looks somewhat more attractive. Shareholders feeling a little rattled from the rollercoaster returns of the sector over the last ten years might feel like running, not walking, for the exit. Or, if they are feeling lucky, might want to take the cash and stick it in Synopsys, unless Aart de Geus has a rush of blood to the head and decides to bid for Magma Design Automation, while Cadence struggles to digest Mentor. A lot will depend on how Mentor's institutional shareholders fall on this deal.

4 Comments

Based on what I heard from the investment bankers, the shareholders might actually welcome this. Wall Street sees no upside in the near future or even further in the future for EDA investment. this might be a very good time for some investors to get out while the getting is good.

Is it good for the industry? Maybe not from an employment perspective, but it would simplify the field tremendously for the customer. And with one less major player, the value of the tools might actually increase. I've heard for some time that the industry is not big enough for more than two major players. This would leave us with three and Magma is just a couple of dollars away from an attractive acquisition.

I've seen the argument that taking out one of the big three would put an end to the price war. I am unconvinced on that point. You can quite cheerfully have a price war with just two players. It all depends on the strategy of those two. Right now, the companies seem to be engaged in a land-grab strategy where the game is to get major customers into wide-ranging deals in the hope that this will provide long-term business. But such all-or-nothing strategies tend to lead to lower, not higher prices because the value of individual tools gets discounted.

And yet, even with all of the Mentor tools absorbed, Cadentor still could not sell a complete flow: pretty much everyone is still going to buy DC from Synopsys.

Would it simplify things for the customer? Almost certainly not in the short, maybe even medium term. Some decisions by Cadentor would be simple. DRC's a no-brainer. Verification? Cadentor could argue that OVM solves all of the problems but most of the customers are not using that. Conversion from one simulator to another would be fairly painful.

"A lot will depend on how Mentor's institutional shareholders fall on this deal." Isn't it a shame that all the other important issues - tool usefulness, company innovation, benefit to the community, etc - almost always give way to greed. Yes, it's a naive statement, I know. But Mentor is an engineers company and I guess I'm still an engineer at heart.

"I still need to do a full analysis of where the overlaps lie. But, trust me, the diagram is going to look messy."

Here is Gary Smith's analysis of overlaps.

http://garysmitheda.com/thenumbers.html