Synopsys: Growth by Design

We initially raised concerns around contract assets at Synopsys back in early 2024. Based on the most recent 10-Q filing, our system now rates Synopsys at our highest level of risk (‘10’). In the past 12 months the most concerning flag is the continued rise of contract assets, as seen in the extract from our report below. In absolute terms, contract assets have risen from $469m to $830m. Since contract assets represent revenue booked, but not yet invoiced to the customer, a sharp increase like this is often associated with aggressive revenue recognition.

Let’s take a look at the disclosure of contract balances in the notes to the accounts (see extract below), which shows us the change in the last 3 months. Below contract assets of $830m, we can see “Unbilled Receivables”, historically a very small balance in the accounts, increasing suddenly to over $100m.  Unbilled receivables is a close cousin of contract assets - it also represents revenue recognized but not yet billed, but unlike contract assets there are no further performance obligations to be met before the client can be invoiced (merely the passage of time).

Taking these two balances together, this amounts to nearly $1bn of revenue sitting on the balance sheet, waiting to be invoiced.

At the same time, deferred revenue (also shown in the extract) continues to unwind. Deferred revenue represents cash received where the revenue has not yet been earned, and can be thought of as the mirror image of contract assets.  As deferred revenue unwinds, revenue is released into the income statement. This pattern, the combination of rising contract assets and falling deferred revenue, represents a particularly high risk pattern in our system.

Now it’s possible this is due to a shift in the way services are provided and how clients are invoiced, but we find it strange that management hasn’t discussed this more openly given the size of the balances and how they’ve moved.

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The other major flag concerns inventory, where DSI has increased from 106 days to 140 days over the past 12 months (a level far higher than the historical average for this company). A question was raised on the Q1 2024 call 12 months ago by an analyst and the CFO gave this response at the time:

“We're anticipating another record hardware year and so we're building to ensure that we have proper supply to support our customers. And the reason that it's so important in our customer design is they're designing more and more complex chips, this allows them to help infuse into their design environment, the ability to model the software before they actually have the chips, so they can find issues and improve their essentially time to market. So it's an incredibly valuable capability for our customers.”

Shelagh Glasser, CFO, Q1 24 Earnings Call

We find it odd then that despite further growth in inventory since then, the question has not come up again, nor been mentioned by management. As discussed in our previous note, investors should tread with caution where there is a build up in inventory, particularly in the technology space where obsolescence is an ever-present risk. In addition, if the company finds it needs to adjust production downwards, it’s likely to have a knock-on impact to gross margins.

Taken together, the increase in contract assets and inventory have been partially responsible for a rapid expansion of the balance sheet. Over the past 12 months, total assets have risen from $10.3bn to $13.0bn.  One manifestation of this is that operating cash flow has been held back in FY24 and Q1 25.

As discussed in our previous note, management’s incentives are heavily weighted to revenue goals, which may place them in conflict with the long-term interests of shareholders. If revenue growth is prioritized over return on capital or cash flow, then expansion of the balance sheet matters little. While the market is currently relaxed about the balance sheet, we think it’s likely to attract more attention as and when sales growth comes off the boil.