Casablanca:Status Quo is Unacceptable at Mentor Graphics

(See earlier post on MENT dated April 4, 2011)
 
Letter dated April 25, 2011, from Casablanca Capital, LLC
to Shareholders of Mentor Graphics Corporation.
 
April 25, 2011
 
Casablanca Capital LLC
450 Park Avenue
Suite 1403
New York, NY 10022
 
Dear Fellow Mentor Graphics Shareholders:
As a 5.4% shareholder, we are disturbed that Mentor Graphics’ Board of Directors and management have not delivered shareholder value and are not acting in your best interests.  We believe the status quo at the company is unacceptable, and we intend to vote our shares at the May 12th Mentor Graphics annual meeting in support of the Icahn Group’s nominees, who we believe are well qualified and will work in the best interests of all shareholders.
 
While the Icahn Group has issued materials in support of its nominees, the following are our own, independent observations regarding Mentor Graphics’ long record of abysmal underperformance and poor governance practices:
§
Over the past 19 years under current management, Mentor’s share price is down 18%, with ZERO return for shareholders.  How can we as shareholders support a Board that is responsible for this underperformance?
Ø
Mentor’s share price is down 18% unaffected for Casablanca’s and the Icahn Group’s purchases1 versus gains for Synopsys of 112%, 292% for Cadence and 185% for the S&P 500
§
History of excessive shareholder dilution:
Mentor’s share count has increased 72% over the last 10 years, versus 10% and 23% for Cadence and Synopsys, respectively
Ø
Mentor’s issuance of $253mm of convertible bonds in March 2011 was another act of dilution while also increasing the costs for potential buyers and further entrenching the company’s leadership
§
Abysmal free cash flow generation:
Ø
Mentor has only delivered $113mm of free cash flow over the last 10 years versus over $2 billion each for Cadence and Synopsys
Ø
Meanwhile, Mr. Rhines has paid himself $65mm during his tenure2
§
Bloated cost structure:
Ø
For calendar year 2010, Mentor spent over 34% of revenues on selling & marketing expenses while Synopsys spent 24%3
 
Ø
Mentor spent almost $100mm on general & administrative expenses last year, similar to Synopsys (more than twice Mentor’s size) and over 25% more than Cadence
 

 
These higher expenses are egregious given the lower cost of living in the suburbs of Portland, Mentor’s headquarters, versus both Cadence and Synopsys located in Silicon Valley
 
Ø
Lowest revenue per employee compared with peers – 16% lower:
$195k for Mentor versus Synopsys’ $233k while Cadence’s revenue per employee was $233-$305k from 2003 to 20074
§
Obstructionist Board antagonistic to shareholder concerns:
Ø
Accelerated their 2011 shareholder meeting and rejected the Icahn Group’s $17 per share offer with little explanation
 
Ø
Publicly prejudged the feasibility of a third party combination despite strong strategic and financial rationale
Ø
Implemented a Poison Pill andissued a dilutive convertible bond despite non-dilutive alternatives
Ø
Entirely unaligned with shareholder interests as the Board and management collectively own less than 1% of the shares
§
Mentor’s directors, with a 15 year average tenure, have no relevant expertise aside from serving on Mentor’s Board:
Ø
None of the directors the Icahn Group has proposed to remove have been recently employed as other than an “industry consultant”, “private investor” or board director
§
By comparison, the Icahn Group’s director nominees are highly regarded professionals with a history of success in dealing with public companies:
Ø
Jose Maria Alapont – CEO of a $6 billion public auto parts supplier, which operates in a highly competitive cost conscious industry
Ø
Gary Meyers – EDA industry expertise as former CEO of a publicly listed company, Synplicity
Ø
David Schecter – proven asset manager and a direct representative of Mentor’s largest shareholder
§
There is no reason to believe in management’s ability to execute on its unimpressive strategic goals without historical precedent
Ø
Mentor has guided to 15% non-GAAP operating margins near term and 20% longer term versus 23% achieved by Synopsys and Cadence’s target of operating margins in the mid 20s
 
No detail on how management’s plan will be achieved
 
§
In summary, Mentor has been a persistent underperformer:
Ø
Negative share price returns
Ø
Poor operational performance
Ø
Dismissal of shareholder concerns
Based on these facts, we strongly believe it is time for a fresh perspective on the Board. While we are acting independently and are in no way connected with the Icahn Group, we believe voting in favor of the Icahn Group’s director nominees will ensure that Mentor’s Board will be held accountable and work on behalf of all shareholders.
Kind regards,
 
Donald G. Drapkin                           Douglas Taylor                                                      Francisco D’Agostino
Chairman                                           Chief Executive Officer                                         President

1 Unaffected share price represents the average share price of Casablanca’s and the Icahn Group’s purchases of $10.37
2 Per Icahn Group’s presentation filed with the SEC on April 12, 2011
3 Cadence spent 32% of revenues on selling & marketing expenses in 2010. Cadence underwent an accounting change in 2008 that altered its revenue recognition policy and depressed revenues throughout the life of their client contracts. Any comparison to Cadence from 2008-2010 should take this effect on revenues into account. We expect the revenue base to be normalized some time in 2012.  From 2005-2007 Cadence averaged 25% selling & marketing margins.
4 In 2010 Cadence had revenue per employee of $203k, although Cadence’s revenue is still affected from the accounting change


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