I recently studied a method invented by Michael Porter, PhD, to evaluate the attractiveness of an industry and decided to apply the method to measure the “attractiveness” of the EDA industry.
Michael Porter is the Bishop William Lawrence University Professor at Harvard Business School and the director of the school’s Institute for Strategy and Competitiveness, which was founded in 2001 to further his work and research.
Porter's five forces analysis is a framework for analyzing the level of competition within an industry and business strategy development. It draws upon industrial organization economics to derive five forces that determine the competitive intensity and therefore the attractiveness of an industry. Attractiveness in this context refers to the overall industry profitability. An "unattractive" industry is one in which the combination of these five forces acts to drive down overall profitability. A very unattractive industry would be one approaching "pure competition", in which available profits for all firms are driven to normal profit. Normal profit is the profit that is necessary to cover the opportunity costs of the firm's investors. In the absence of this, investors would withdraw funds and use them to better advantage elsewhere.
The five forces are:
Competition in the industry
Potential of new entrants into the industry
Power of suppliers
Power of customers
Threat of substitute products
Competition in the Industry
EDA resembles an oligarchy. The industry is dominated by three companies: Cadence, Mentor, and Synopsys. All three of them have sales of over one billion, and Synopsys is by far the leader in annual revenue. Very recently Mentor has been acquired by Siemens and it is too early to foresee the impact the acquisition will have in Mentor approach to the EDA market.
Aart de Geus, founder and co-CEO of Synopsys coined the term “tecnonomics” to describe the fundamental driver of the EDA industry. A combination of technology and economics forces shapes the industry.
Competition among the three leaders is limited almost exclusively to very large customers, a subject that will be discussed in depth in the sections on power of suppliers and customers.
Competition exists among small suppliers of EDA tools. The revenue growth in EDA is determined by two major factors: advances in semiconductors technology, and advances in mathematics and engineering technology, especially in computer sciences. New semiconductors fabrication processes and structures demand new EDA tools that in turn require creativity to develop more efficient and effective tools for electronic designers.
Small EDA companies tend to focus on only one aspect of the market and very few have reached the revenue and market size to be able to go public. Their most frequent goal is to be acquired by one of the top three companies in the industry by developing a product that can be integrated in the existing product family of the purchaser, or, in rare occasion, replace an existing product with the one from the acquisition.
Two segments of the EDA industry demand special attention: Printed Circuit Board (PCB) design and manufacture, and Intellectual Property (IP).
Mentor is the leader in PCB revenue followed by Cadence. Synopsys does not participate in this market.
ARM is the revenue leader in the IP market, although it has also been acquired less than one year ago. Softbank, the large conglomerate headquartered in Japan, has a significant internal market for IP and it is conceivable that ARM’s development focus will be directed to satisfy that demand above all.
The result is that although from the outside the EDA industry appears very competitive, the technology based competition is mostly among small vendors, while the big three compete as much in price as in technology.
2. Potential of New Entrants in the Industry
Historically there have always been new entrants in EDA. They are generally small start-up businesses focusing on one specific application area. Only a very small percentage of new entrance will ever each the five years of life as an independent company. Many will go out of business because the cost of staying in business is higher than income, a few will remain active as “life style” companies where the company makes a small profit every year and the founder enjoy their active participation in the industry. Only less than ten percent will grow to become a trusted provider of engineering solutions, but their revenue will still remain too low to allow them to go public. About one third of start-up are purchased by a larger company. Either one of the big three, or, more often in the last couple of years, by corporations developing electronic systems. There are two major obstacles a new entrant must overcome: competitive installed tools and corporate reputation. A new tool must offer as a minimum a 10% increase in performance and quality of results (QOR). Ten percent sounds like a low number, but in engineering applications it is a difficult target to achieve. The performance and QOR are measured by using benchmark executions and the results very often depend on the characteristics of the designs used to run the benchmark. The incumbent vendor has a better position in choosing the designs to be used, so the challenger is already at a disadvantage even before the benchmark is executed.
3. Power of Suppliers
We must divide the industry into two parts: large companies with revenues above $250 million and the rest. Most of the power of large companies rests in relation with their installed base. It is very expensive for a user company to change supplier for a given tool. Doing so entails significant training expenses, possible development delays due to less than optimal tool utilization, or a less competitive product due to non-competitive functionality.
Therefore vendors have power over their installed base that stems from technology sources, but they also have financial power because they can construct business deals that involve not only pricing, but also length of licenses, and bundling other tools in the contract. Although these deals at first blush seem to be less lucrative due to discounts, in fact they assure a revenue flow, restrict competition, and provide for a stable relationship with the user company that results in development intelligence toward the next generation tool in the same technology area.
Smaller vendors have a much more difficult task when it comes to manage a business relationship. They either must compete against an installed vendor that is much larger than them, or they must convince the prospective customers of their financial staying power and of the superior technical capability of their tool. They also must obtain a license price that will provide them with enough funds to support the new customer, something that will be expensive in the first months of the relationship, both due to training and optimization of the tool to meet the specific requirements of the new customer.
4. Power of Customers
In EDA a customer can always find an alternative vendor for a given tool. The high cost of training engineers to use a new tool and the difficulties of integrating the tool in the existing development flow are the major obstacles to switch from a tool to another. But the opportunity still exists and it provides leverage to the customer in negotiating the price of the user license.
Since tools are licensed and not purchased the customer has a recurring opportunity to negotiate both the price and the length of a license. Customers can also negotiate the inclusion of new versions of the tool through a maintenance agreement that can be negotiate separately from the use license. The best time to negotiate new terms or to switch to a competitor offering is around the license renegotiation time. A customer can demand that in order to switch to a competitor product, the competitor compensate the customer for the cost of the remaining license span of the installed tool.
5. Threat of Substitute Products.
The EDA industry is driven by technology advances in a number of fields: mathematics, statistics, artificial intelligence, computing architecture, and semiconductors. New tools are constantly being developed, and new applications areas explored. Thus installed products are constantly liable to become obsolete as new versions or new similar products are released. The threat not only originates from established vendors, but from new startups. Starting capital to develop a new product is not high, since it mostly involves developing a new algorithm and the corresponding software. But releasing a new product requires the cooperation of a beta test customer who can allow the test of the new software against a real problem. Capital requirement grows significantly when the new company enters the marketing stage. Convincing a potential customer to use resources to allow for a beta test is expensive, due to the high volume of support required. Even assuming the beta customer is convinced of the benefits of using the new tool, growing the installed base takes time and financial resources. But a percentage of new companies are successful, thus substitute products make it to the market frequently enough to require significant development investments from established vendors.
The EDA industry is a highly competitive industry that must continuously stay at the leading edge of technology, both in computing and in understanding the requirements of the semiconductors industry and electronics industry. This is the primary reason that EDA vendors are mostly funded by venture capitalists and not by stock market activity. Venture capitalists can absorb relatively small losses and win large profits from a company either Initial Public Offering or an acquisition by a larger company. Very seldom, like in the case of Mentor Graphics both exit strategy occur. First Mentor went public and just recently was acquired by Siemens.
EDA companies that have gone public are few, like Synopsys and Cadence to name the most successful, and some, like Ansys have successfully expanded in the EDA market through acquisitions to the point that they are also publicly traded. These companies have attained a level of profitability that insure their financial survival, allows them to have cash reserves, and to execute narrow targeted acquisitions to expand their installed customers base. What is missing in the comparison with successful companies in other industries is the ability to pay and row dividends. Investors gain are produced by a growing stock price, thus limiting the profile oftheir investors.
Small EDA companies are in the “pure competition” stage with a run rate that does not allow them to contemplate a public stock offering. They either continue to look to be acquired, or they are “life style” companies whose principals love what they are doing, generate a reasonable income from the activity, and are satisfied with the life style.