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Forbes Column 08: How Chip Toolmakers Can Survive

Posted on Friday, Jun 20th 2008

My Forbes column on the Cadence-Mentor deal is here: How Chip Toolmakers Can Survive. It’s a controversial piece that challenges the semiconductor companies to do their part. Have a look, and feel free to discuss, either here or at Forbes.

A comprehensive discussion has also emerged with the my previous post, Cadence Takes a Page Out of Microsoft’s PlayBook.

This segment is a part in the series : Forbes Column 08


. Connecting With Your Intimate Bot
. The Gap in Google's Defenses
. A Recession-Proof Corner of the Tech Sector
. eBay's Bounce-Back Opportunity
. How To Dig Out Yahoo's Treasures
. The Microsoft-Yahoo! Battle Plan
. What Microsoft Should Do While Yahoo! Dithers
. The Next VMWare
. The Smartest Unknown Indian Entrepreneur
. The Coming Death of Indian Outsourcing
. India - Cash Rich, Product Poor
. How to Save the World's Back Office
. Latin America's eCommerce Leader
. The Next Indo-China War
. The Real VCs of Silicon Valley
. Fund Envy
. Bootstrap Yourself
. The Coming Convergence
. Lighting The Way In India
. Hydro-Alchemy
. How Amazon Could Change Publishing
. A Technological Fix For Education
. How Technology Can Save Retailers
. Mobile Microfinance
. How To Heat Up Solar
. How Chip Toolmakers Can Survive
. Kill The Business Trip
. Water Firm Enlivens IPO Market
. Web-Savvy Authors Reap Fame, Fortune
. Peeking Inside the iPhone
. Bootstrapping, Montana Style
. Entrepreneurs Flock To Online Travel
. Silicon Lazarus
. Carts Ahead Of Horses
. Weapon Of Mass Reconstruction
. Barack Obama' s Finance Lesson
. Stimulus Package For Entrepreneurs
. Building A Smarter Corporation
. Deconstructing The Cloud
. 'SaaS-ing' Back At The Economy
. Web 3.0
. My Adventure With Amazon
. An S.O.S. To Silicon Valley
. OLPC’s Last Billion
. Capitalism Revisited
. Bargains For Private Equity
. President Obama
. Perilous Protectionism
. Healing Health Care
. Stop The Fear Epidemic
. Obama
. 'Edutainment' Needs Entrepreneurs

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Let’s set aside any discussion of whether or not this marriage is a good one (it’s not, too much overlap in the wrong areas) and focus on the debt issue. Were Cadence to buy Mentor the combined debt of the two companies would be north of $1Billion. Given the current state of the credit markets, the interest rate on such a deal (since Cadence would have to borrow a lot of money to do the buy) would likely be quite high – more than 8%. Servicing that debt as revenues are flat to declining in a recessionary environment would eventually sink Cadentor. It would be a slow death spiral as budgets would be cut, R&D would be cut leading to less innovative product development and even more industry stagnation.

This kind of (dubious) deal may have made sense on some level in a more robust credit environment, say 2 or 3 years ago. Now the investment banks are understandably wary about underwriting deals like this. Several M&A deals have fallen apart over the last year and banks have been stuck with the “pier loans” (for example, the Delphi deal). The banks don’t have the appetite for underwriting deals like this now and if Fister insists on going forward the borrowing costs will be high. Let’s hope this deal doesn’t go through, otherwise the whole EDA industry could be at risk.

Concerned Friday, June 20, 2008 at 11:20 AM PT

What happens when there are too many products in a small industry? They consolidate. It’s just the way things evolve, whether you like it or not.

Your debt point is well-taken. I am curious about the financial engineering on this deal.

Sramana Mitra Friday, June 20, 2008 at 1:09 PM PT

“What happens when there are too many products in a small industry? They consolidate. It’s just the way things evolve, whether you like it or not.”

But there’s a problem with your thesis here. You don’t account for customer concerns about a particular product being killed. For example, simulators: EDA customers are pretty particular about which simulator they use for verification because they’ve invested a lot of man years incorporating their chosen simulator into their flow. Those who have been using ModelSim for years are not going to be happy about having to learn NCSim and the cost of changing all of their scripts. Because of this, I suspect that the merged “Cadentor” would still be supporting ModelSim for years to come. It’s not like they could kill one or the other simulator overnight to achieve some sort of perceived savings.

Still, I think its the state of the credit markets that will kill this deal…

Concerned Friday, June 20, 2008 at 2:06 PM PT

What is not good for the EDA industry, and it is our own fault, is agreeing to all you can eat deals. A customer says they want access to all your tools but they will only pay X dollars for the tool sets independent of usage. This means if they need more seats then initially purchased they get them at no charge. Additionally depending on their changing tool needs or peak requirements, they often want the right to mix and match for different tools even ones they have not purchased yet, at no additional charge. Finally they expect discounts from list price often >70%. And we often comply.

It is the old story software is free. COGs are high. Once you develop it, it is just a matter of electronic transfer of the tools and some support. This appears to be the mind set of EDA users. As a veteran of the ATE industry we could usually contain the discount demands since we could show the cost of the hardware but we could rarely charge for software. Also we were not faced with the mix and match problem. On the other hand ATE companies are not economically faring much better than the EDA companies.

From the customers view point the growing sophisticated of electronic systems demand the highest quality parts yet the price pressures on their components are enormous, the market windows are narrow and unforgiving, and their costs continue to escalate. So they demand more and more capability at lower and lower prices.

I agree the EDA business model is broke but I am not sure if royalties per se are the answer. Possibly some sort of sharing in the success of profitable products is a way to fix the problem. I do not think single vendor strategies are workable and I am not sure consolidation is the answer.

Jim Healy Friday, June 20, 2008 at 2:32 PM PT

Customer Concern: this is a concern in every single M&A deal that has overlapping products. Whether it was Oracle buying Siebel or Peoplesoft, or IBM buying Informix, or HP buying Compaq. I think, we both know, that while this is a valid concern, it will certainly not be the determining factor in deal/no deal. The market will not support 10 simulators, 5 place and route tools, etc.

Your debt issue, as I said, is well-taken, and I am trying to find out more about the financial engineering of the deal that the bankers have proposed to Cadence. I don’t, however, share your complete faith that the debt-structuring is not viable. Cadence is a solid company with a long history. Many banks would be falling over themselves to lend them money. This is not exactly sub-prime lending. Hence, I believe, you are over-blowing the issue.

Jim, royalties are a success-based model. For failed products, EDA vendors won’t get royalties either. But for successful products, if they get royalties, it would give them some skin in the game, and also profits with which to continue innovating.

Part of the precariousness of the situation being created is the lack of margins to innovate. No venture capital. It’s getting dangerous.

Sramana Mitra Friday, June 20, 2008 at 2:45 PM PT

Btw, at some level, I don’t care who merges with whom, but some consolidation is becoming essential.
Cadence’s move has forced the issue, and now the 4 CEOs will need to deal with it, and figure out who wants to marry whom.

I keep saying this, the other essential step is to bring innovation capital back into the system. And that needs to be in the form of corporate venture firms.

Both EDA and Semiconductor vendors need to pull together corporate venture funds to invest in chip and tool startups, both of which are segments that have become unpopular with the traditional venture investors.

Sramana Mitra Friday, June 20, 2008 at 3:14 PM PT

“Many banks would be falling over themselves to lend them money. This is not exactly sub-prime lending.”

In normal times you would be right. However, in the credit markets right now (and for the better part of the last year) things are anything but normal and conditions are once again deteriorating. What started out as a little subprime problem is now a full fledged credit crunch. Many of the large banks would be insolvent right now were it not for all the special “windows” the Fed has opened up allowing them to borrow without in secret.

The bottom line: Bankers are scared to lend right now preferring instead to preserve their dwindling capital. They have every reason to be concerned – as do we all.

Like I said, there have been plenty of M&A deals that have gone down in the last year leaving the underwriting banks holding the bag – they can’t afford anymore of that now as they need to take every possible step to remain solvent.

Concerned Friday, June 20, 2008 at 3:46 PM PT

EDA Duopoly: One too many?…

Ever since Sramana Mitra analyzed the Mendance deal as a necessity for consolidation as well to spur innovation, I have been keen in studying how this might play out. Not in the hypothetical, over-a-Heineken manner, but in a more Nash-equilibrium kind …

DAtum Friday, June 20, 2008 at 9:40 PM PT

The EDA industry has been using the same business model as the airline industry: we would rather lose money than lose a customer. For the industry to survive, there are only two real options available: raise prices significantly, or cut salaries and positions significantly. I’m betting on the second option; unfortunately this violates my first law of economics – you get what you pay for (aka free is worth what you paid for it)

EDA Insider Sunday, June 22, 2008 at 10:28 AM PT

Hi Ms. Mitra,
In the short term Cadence acquires Mentor. Stock goes up, shareholders are a happy lot, Fister takes home fistful of gold and EDA engineers leave. I won’t argue — you did mention this is market forces at play. Now will the same market forces ensure that the cycle of innovation which lead to Mentor DFT and DFM, both roaring successes and industry leaders be continued at Cadence? Cadence might have good financials but unfortunately I cannot say the same for it’s innovation quality. Tell me what was the last product in Cadence that amused you and when (when is important).
Personally, I think to clean this glut EDA biggies need to follow a model like Intel Capital and not necessarily spend money on outside startups but also intra company groups. Also, a google kind of 20% off on innovation time might not be a bad idea after all. Overall I am concerned since fast money is in everyone’s mind here and not a sustainable income source.

Regards

Arpan Sunday, June 22, 2008 at 9:41 PM PT

“Also, a google kind of 20% off on innovation time might not be a bad idea after all. “

Hmmm… I like it. Declare every Friday to be “Innovation Day” for EDA software engineers. Work on an interesting (hopefully) EDA related project. Actually, I think we’d have to set a few more ground rules than Google sets: It should be an EDA related project as opposed to the latest in social websites. Also, would open source projects be allowed? I suspect not. Collaboration with people outside the company?

It has worked pretty well for Google. It would be worth a try in EDA, however, the industry as a whole tends to be pretty stodgy compared to the likes of Google.

BusyBee Monday, June 23, 2008 at 9:54 PM PT