Will Magma Die on the Vine?

Magma Design Automation, Inc. (LAVA) provides electronic design automation software products and related services, and is our fourth and final company in the EDA review. In February 2007 I reviewed Magma and noted they were a potential acquisition target given their legal problems in a losing patent fight with Synopsys. I pondered on the possibility of Synopsys taking over Magma and how that might restructure the industry.

Since then Magma won a re-examination of the involved patents, much to Synopsys’ chagrin in March, and gained leverage for a settlement in which Magma paid out $12.5 million and all other terms are settled and final. “For us, this case has always been about the return of Synopsys technology and the protection of our IP, and we have achieved this,” said Aart de Geus, chairman and CEO of Synopsys. And in response, Rajeev Madhavan, chairman and CEO of Magma noted, “I am pleased we found common ground for a resolution that makes business sense for both of us.”

Having put this dirty affair behind them, Magma in Q2 2008 posted record revenue of $53.5 million, a 27.5% increase YoY to $42 million a year ago and slightly higher than Q1 guidance. 76% of revenue came from backlog transactions and 24% from new orders (Q1 had only 14% in new orders). However, under GAAP rules Magma posted a net loss of $6.4 million (non-GAAP of $7 million positive net income), but this was almost 50% less than YoY results of $12.4 million in losses in 2006. And it was a surprise given Q1 guidance suggested Q2 net income would post at $0.26-0.28 loss/share. Compared to the previous quarter, Q2 was a bit better than Q1’s revenue total of $50.2 million and far better than the Q1 GAAP net loss of $11.3 million. The company also makes a point to note much of the difference in the GAAP rules is attributed to amortization, stock-based compensation, R&D charges, acquisition costs of Mojave, and related taxes, which it doesn’t believe is critically relevant to its core operations. Nonetheless, Magma’s management believes it had a good quarter.

The “success” was attributed specifically to products FineSim Pro and FineSim SPICE which grew in sales faster than expected and allowed entry into new markets Magma previously had no presence in, such as memory design. However, the spike in new orders was also attributed to clients under budget pressures to spend operating allocations. Then again, some would ask why punch a gift horse in the mouth. In short, Magma notes Q2 sales were a bit of an anomaly.

Magma also leverages operations costs with overseas facilities in three locations in India. Magma opened a facility in Noida in 2006 and gained a site in Mumbai with its November 2006 acquisition of Knights Technology. It March it expanded to Bangalore.

Company guidance for Q3 expected revenues of $53-55 million with a higher GAAP net loss of $0.19-$0.21 cents/share. Q2 was a loss of $0.16/share. The company strategy does not see the EDA market changing; in fact, despite regional differences, Magma instead sees clients trying to control and reduce the number of EDA vendors utilized, with market share changing among the players who survive to win the contract renewals. The company’s stock is currently priced at $12.36/share with a 52-week range of $8.13-15.70 and a market cap $436 million.

At this price Magma could be gobbled up just as easily as Mentor Graphics, but the question is, why? It might be a lot less expensive for Cadence and Synopsys to just win over market share in the next round of client contract renewals. More importantly, Rajeev Madhavan’s ego is unlikely to permit such a transaction, perhaps, causing the company to eventually die on the vine. In the meantime, investors should stay away from the company and the industry.