Cadence Design Systems (NASDAQ:CDNS) has emerged as a pivotal player in the realm of computational software, shaping a wide range of applications with its state-of-the-art tools. Over the years, it has crafted a diversified business model that underscores its resilience and sustainability, culminating in impressive financial performance. However, its path is not without challenges, with potential risks looming ahead. This article delves into an in-depth analysis of Cadence, shedding light on its operations, financial health, and the potential risks that investors need to consider.
In the intricate tapestry of the tech sector, Cadence Design Systems holds a unique position. Contrary to surface-level perceptions, Cadence is not solely a semiconductor firm. Rather, it leverages its core strengths as a computational software company, offering vital tools that are deeply integrated into a wide array of applications.
Recurring revenue constitutes 85% of Cadence’s total revenue, speaking volumes of its strong client relationships and business sustainability. The remaining 15% of its revenue arises from its involvement in hardware and Intellectual Property businesses. This diversification provides the company with a well-rounded business model, fostering resilience and facilitating growth.
With a deep-rooted understanding of the extensive capabilities of computational software, Cadence has managed to etch its footprint across a broad spectrum of sectors. This is evident from Electronic Design Automation (EDA), system design and analysis, to data-centric Artificial Intelligence (AI), all of which rely heavily on computational software. Cadence is, therefore, central to numerous technological advancements we’ve come to rely on in our everyday lives.
Since its inception 35 years ago, Cadence has been a pioneer in the tech sector, championing a culture of “servant leadership”. Founded by engineers for engineers, the company was established with the foresight of the growing demand for advanced tools to keep pace with Moore’s Law. This culture is still reflected in Cadence’s mission today: to help its customers perform their tasks more efficiently and effectively.
Cadence’s software and solutions are ingrained in the workflows of many top semiconductor companies, making it a trusted partner within the industry. The company’s collaborative approach with these partners signifies its commitment to mutual growth and success.
Visibility and Stability Driven by R&D and Complexity-Driven Growth
Cadence Design Systems has consistently displayed an impressive growth rate that outpaces semiconductor R&D spending. The company’s revenue originates predominantly from two sources, with system companies providing about 45% and the remaining 55% derived from semiconductors. However, it’s important to note that fluctuations in semiconductor revenue do not directly impact Cadence’s revenue stream.
Instead, the key performance indicator for Cadence’s revenue growth is the spending on semiconductor R&D, not the revenue from semiconductors. This perspective is significant when evaluating the financial stability of Cadence, given that it’s shielded from the direct impacts of potential downturns in semiconductor sales.
Interestingly, Cadence’s growth trend is slightly higher than that of semiconductor R&D spending. This can be attributed to the rapid acceleration in technological complexity, which outstrips population growth. As technology continues to advance at an exponential rate, Cadence’s customers increasingly rely on their tools to manage the complexity and deliver efficient results.
Over time, there has been a shift in R&D budget allocation within the semiconductor industry. At an industry conference, Cadence’s management stated that a few years back, approximately 92% of the R&D budget was allocated to personnel costs, while only 8% was spent on tools. This ratio has now shifted to 90% for personnel and 10% for tools. Given the limitations in scaling up the number of engineers to match the pace of technological complexity, this trend of increased tool expenditure is expected to continue.
Artificial Intelligence: The New Frontier
Artificial Intelligence is rapidly becoming indispensable in the realm of design, resulting in a progressive shift of R&D budgets from human resources to advanced tools. Cadence, with its longstanding expertise in computational software, is strategically poised to seize this AI opportunity and potentially outpace the broader industry growth.
As a well-established player in the AI domain, Cadence has been leveraging AI technology for years, with offerings such as the Cerebrus tool in its digital portfolio. Computational software, which is Cadence’s forte, combined with data, lies at the heart of AI, affirming Cadence’s potential to become a dynamic AI company. The company is thus excellently placed at the crossroads of EDA and AI, effectively straddling both these domains.
To highlight the company’s robust collaborations in the AI space, take, for instance, its long-standing partnership with Nvidia (NVDA). Cadence’s tools form the backbone of Nvidia’s operation, showcasing a mutually beneficial relationship. The Fidelity CFD product from Cadence serves as an exemplar of GPU acceleration, with remarkable performance metrics like 9x speed up, 9x cost savings, and 17x power efficiency.
Beyond Nvidia, Cadence’s AI-driven offerings are empowering a broad spectrum of major AI companies, including Marvell (MRVL), Broadcom (AVGO), and AMD (AMD). Cadence’s unique position in the ecosystem allows it to provide comprehensive support to its customers through its AI journey, leveraging both its hardware and software platforms. Furthermore, it’s playing a key role in specialized areas like HPC hyperscalers, where companies like Amazon (AMZN) AWS have achieved significant success with custom design chips.
In terms of AI integration, Cadence is pursuing a dual approach – external and internal. Externally, the company is delivering AI tools to customers, while internally, Cadence is incorporating AI in the development of its tools. An exemplary use case is the company’s Palladium hardware system, designed for emulation. This system represents Cadence’s commitment to its own solutions, with the custom silicon chip designed using Cadence’s tools. This ‘Cadence on Cadence’ approach provides the company with a formidable competitive advantage as it continues to innovate and utilize its own AI tools for future iterations.
Cadence’s extensive R&D investment, which accounts for 35% of its revenue, is effectively fueling its AI capabilities. With its existing partnerships, impressive AI offerings, and dedicated focus on internal AI integration, Cadence is well-positioned to capitalize on the burgeoning AI landscape, promising an exciting journey ahead for the company and its stakeholders.
The march towards technology independence led by China could potentially give rise to state-backed competitors that pose significant risks to Cadence. The company’s CEO confirmed at the recent Bernstein conference the presence of around 10-15 EDA firms in China that they are closely monitoring. Although these firms are currently small and highly focused, their growth fueled by state support could eventually lead to more considerable competition for Cadence. Nevertheless, in the short-to-midterm, this is unlikely to pose a substantial risk, as large Chinese clients still primarily engage with established players such as Cadence. Investors should, however, keep an eye on the rapidly evolving technology landscape in China as part of their risk assessment.
A separate yet vital area of potential risk for Cadence centers around investor skepticism over its Artificial Intelligence offerings. There’s a school of thought within the investment community questioning the uniqueness and, hence, the value of Cadence’s AI capabilities, especially compared to competitors such as Synopsys (SNPS). If customers do not believe there is differentiation between available AI offerings, it could potentially hinder Cadence’s ability to effectively monetize its AI solutions, which represent a considerable portion of the company’s current and future growth strategy.
In essence, while Cadence remains a robust player in the computational software and AI fields, potential competition from emerging Chinese firms and skepticism surrounding its AI capabilities do present notable risks. As with all investments, a comprehensive understanding of the industry landscape and close monitoring of evolving trends is paramount in navigating potential challenges.
Financial & Valuation
Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.
Our analysis of Cadence Design Systems’ recent earnings report from April 25, 2023, reveals several positive indicators for potential investors. Despite the stock trading down by 4.3% after the earnings announcement, we observed a robust y/y revenue growth of 13.3% to $1,022 million. This growth was perfectly in line with consensus estimates and reflected the company’s consistent performance. The gross margin was impressively high at 88.9%, while the operating margin did drop from 44.0% to 42.0% y/y. This slight dip in operating margin is not caused for immediate concern, but we’ll be keeping an eye on this in future quarters. It’s important to note that CDNS beat EPS consensus estimates by 2.7%, reporting $1.29 for the quarter, up 10% y/y, further underscoring the company’s profitability.
Over the last three fiscal years, CDNS demonstrated an impressive revenue CAGR of 15.1%, and consensus forecasts indicate a steady growth trajectory, with revenue growth predicted at 13.9% and 11.2% for the current and subsequent fiscal year, respectively. The trend of expanding EBIT margins, from 32.0% to 40.6% over the past three fiscal years, is particularly noteworthy, indicating improving operational efficiency.
Furthermore, the fact that CDNS spent 7.3% of its revenue on share-based compensation over the last three years and decreased its diluted outstanding common shares by 2.4% is a positive sign. It suggests that management is effectively utilizing share repurchases to offset shareholder dilution.
CDNS’s strong balance sheet, evidenced by a net cash position of $239 million, combined with strong ROIC of 25.2%, makes it an attractive prospect for investors. The lack of a dividend, though diverging from the S&P 500’s average dividend yield of 1.5%, is not necessarily a detractor; the company could be reinvesting profits back into the business to fuel further growth.
Turning to valuations, the current trading price of $227.21 per share implies a market value of $62.0 billion and an enterprise value of $61.7 billion. It’s worth noting that the stock has performed exceedingly well over the past year, returning 37% points more than the S&P 500, or 55.5% in absolute return. However, the stock is trading at significant premiums to the S&P 500 across all key multiples including EV/Sales, EV/EBIT, P/E, and FCF. The PEG ratio, too, is high at 2.3 compared to the S&P 500’s PEG of 1.5. This, combined with its current forward 12-month P/E of 42.2 compared to its 5-year mean of 37.1, suggests that the stock is on the higher end of its historical valuation range.
When compared to peers such as SNPS and KEYS, which trade at a forward 12-month P/E of 36.1 and 19.1, respectively, CDNS appears relatively expensive. Still, we believe that the stock’s premium valuation is justified given the company’s robust financial performance and strong growth trajectory.
In conclusion, while the valuation appears rich, we believe CDNS’s solid financial performance, coupled with consistent growth and a strong balance sheet, makes it an attractive proposition for long-term growth-oriented investors. However, investors should be mindful of the premium valuation and monitor upcoming quarterly reports for any changes in the company’s financial performance.
In sum, Cadence Design Systems embodies a robust blend of innovation, financial health, and forward-thinking strategy. Its formidable presence in the computational software and AI fields promises consistent growth, despite the challenges of potential competition and skepticism around its AI capabilities. Though the stock’s valuation may appear high, its robust financial performance and promising growth trajectory justify the premium. This makes Cadence a compelling proposition for long-term, growth-oriented investors. However, investors must maintain a keen eye on the evolving technological landscape and monitor trends closely to make informed decisions. Cadence’s journey exemplifies the essence of investing – balancing the potential of rewarding returns with a clear understanding of risks.