2HRS2GO: Simplex''s IPO success reflects its industry

COMMENTARY--The success of Simplex's initial public offering says a bit about the improving state of the stock market, but a lot more about the company's field.

Last week's debut for Simplex Solutions (Nasdaq: SPLX) resulted in the best first-day IPO gain since Transmeta (Nasdaq: TMTA) went public almost six months ago. Simplex stands out further when you consider that the first quarter of this year saw only three technology IPOs total--the driest pipeline since the 1980s, according to Richard Peterson, market strategist for Thomson Financial/Securities Data.

But Simplex told underwriter Credit Suisse First Boston to launch the offering as soon as the first window of opportunity opened, Simplex CEO Penny Herscher said during a telephone interview on Friday. Simplex registered its IPO in September, and as soon as it became clear that the Nasdaq had bottomed out in early April, CS First Boston didn't hesitate.

A profitable company if you exclude non-cash charges, Simplex came out with financials that probably were decent enough to uncork some pent-up sentiment for new offerings. Yet don't necessarily take this as a sign that we'll suddenly see a flood of new offerings. Simplex's entire sector has run against the Nasdaq grain for the last several months.

Don't be fooled by the company name. Simplex (Nasdaq: SPLX) specializes in an arcane field. Chip design software wouldn't be considered productivity applications or mission-critical products, unless you're a semiconductor engineer.

It's a narrow market by any definition, a fact reflected in the comparatively low value assigned to the field by Wall Street. The four companies cited as competitors in Simplex's IPO--Cadence Design Systems (NYSE: CDN), Synopsys (Nasdaq: SNPS), Avant (Nasdaq: AVNT) and Mentor Graphics (Nasdaq: MENT)--ended last week with a collective stock market value of slightly more than $11 billion.

That's a shade under 3 percent of the Wall Street capitalization of Microsoft (Nasdaq: MSFT), about 12 percent of Oracle (Nasdaq: ORCL), slightly more than a fifth of SAP (NYSE: SAP), a bit more than half of Siebel Systems (Nasdaq: SEBL) or just more than 60 percent of Computer Associates (NYSE: CA).

The four biggest names in chip design applications combined are scarcely worth more than Adobe Systems (Nasdaq: ADBE). Three of the four together are worth less than the leading maker of game software, Electronic Arts (Nasdaq: ERTS).

And that's after a period of relative strength for the stocks of chip design software:

Even as the tech-saturated Nasdaq composite index (represented by the "COMP" line) shed roughly 40 percent of its value over from November to April, all of Simplex's rivals save Cadence avoided heavy losses for the year. And Cadence, far and away the biggest company in design automation software, never dropped as much as the Nasdaq.

Viewed against that backdrop, it's little wonder that people flocked to Simplex.

Yet keep in mind that a big reason for the field's strength is because it was so weak during the bull market. While the Nasdaq soared in ྞ and ྟ, Wall Street savaged chip design applications as the industry shifted to subscription licenses, which give more predictable revenue at the expense of large, immediate sales.

Virtually all companies that sell software to corporations are moving to subscription models these days, but back in the go-go-go days, tech stocks suffered from anything that appeared to "slow" growth. Actually, subscriptions don't affect real growth rates; they merely shift money from up-front revenue to backlog, which is then recognized as revenue over several quarters.

Wall Street overlooked that long-term reality and bludgeoned the chip design software vendors because they weren't as bullish in the late ྖs as other software companies. The fact that Cadence and Avant were suing each other (and that Avant executives and directors faced criminal indictments as a result) didn't help the industry's image.

Only when the tech bubble burst did people realize that these companies aren't so bad. The industry leaders are solid businesses for the most part, so their stocks over the past few months have looked like a safe haven.

Herscher and other design automation executives like to point out that their products aren't fueled by technology capital spending budgets, the area hit hardest by the economic downturn.

Chip design software is used in research and development, an area that most semiconductor makers have protected even as their revenue has declined. A chipmaker might cut back on manufacturing, sales and marketing in tough times, but only a truly desperate technology firm drains the lifeblood from the R&D that spawns new products. As long as the economy looks weak, design automation looks great, especially with subscription sales already firmly in place.

But the market is diminutive, relative to other technology segments. Far fewer customers need chip design programs, compared with productivity applications, supply-chain management and sourcing software, databases, or system management products. Wall Street isn't making up those market capitalizations out of nothing.

Simplex's opportunity is even smaller than its competitors because Simplex concentrates on just one aspect of chip design and on only one part of the chip market. The company specializes in system-on-a-chip testing and verification; Simplex's software helps find flaws in designs. All its competitors are larger, with broader design portfolios.

That doesn't mean Simplex can't sell its products. Design automation vendors generally make sure their products can work with each other, so integration isn't an issue, and engineers are free to use whatever technology is best.

It does mean that you shouldn't expect Simplex to continue posting huge gains as a stock. Herscher admitted that her company's first-day performance already places enormous expectations on the company, which ended last week trading at a higher ratio of price-to-revenue than any of the leaders in its sector.

And when the economy recovers, you have to wonder if chip design stocks will trail the broader market again. After all, the same thing that insulates design automation from economic downturns also prevents it from taking full advantage of upswings. The field has solid businesses--but also unspectacular ones. 22GO>