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Despite the macroeconomic uncertainties, Cadence Design Systems (NASDAQ:CDNS) continues to showcase its resilience and robustness in its Q3 earnings call. The company’s performance and outlook underscore its ability to navigate industry trends and harness the transformative power of technologies such as AI and 5G. This article delves into the company’s core strengths, the growth opportunities it faces, how geopolitical risks could impact its operations, and an analysis of its financial health and valuation.
Q3 Supports Bullish Thesis
Cadence hosted its Q3 earnings call detailing a very solid performance and outlook. In our view, the results demonstrate the strength of Cadence’s business model amid current industry trends. While macroeconomic uncertainties exist, as the CEO pointed out, long-term technology transformations around AI, 5G, and more appear to be fueling ongoing strong demand for Cadence’s core design and analysis solutions.
In our analysis, these generational trends are increasingly driving system complexity higher. From our perspective, this plays directly to Cadence’s strengths in providing tightly integrated, multi-domain design tools. What’s more, the growth of custom silicon and 3D/chiplet designs seems poised to benefit Cadence going forward. All told, we believe the trends underpinning Cadence’s business remain firmly positive.
Our assessment is that generative AI in particular stands to be a major driver of Cadence’s growth trajectory. The tripling of sales in this area over the past year, in our view, demonstrates the value customers are deriving from these solutions. Moving forward, we expect AI-enabled tools will be indispensable for managing rising design complexity. Cadence’s focus on incorporating AI throughout its software portfolio positions it well relative to competitors in our opinion.
Across the business, in our analysis, the quarterly results underline Cadence’s proven ability to execute. New adoption of tools like Cerebrus at leading-edge nodes reflects, we believe, Cadence’s technology leadership. Likewise, the continued uptake of hardware-accelerated verification speaks to the demand drivers in that domain. Overall, the strong growth achieved across CAD tools, IP, and system design gives us confidence in Cadence’s diversified portfolio.
Importantly, raising full-year guidance even amid macro uncertainties reflects management’s optimism in our view. Based on our review of earnings, Cadence appears well-positioned for continued success harnessing industry shifts through its design technologies and engineering expertise.
Generative AI
Generative AI represents a major growth opportunity and a strategic priority for Cadence that can help drive significant long-term value for shareholders. Management has rightly focused on incorporating powerful AI algorithms into core EDA tools from the ground up. This positions Cadence to be at the forefront of leveraging the transformative benefits of AI across the entire design flow.
Solutions like Cerebrus and the broader JedAI portfolio are already demonstrating the ability to substantially improve key customer metrics like power, performance, and design quality. Such impactful results highlight the disruptive influence AI will have on increasing the efficiency and outcomes of the design process. As customers accelerate adoption to stay ahead of Moore’s Law, recurring software sales should expand considerably.
Beyond the near-term financial benefits, generative AI is poised to be indispensable for managing the exponential growth in design complexity. This will increase Cadence’s strategic importance to customers innovating at the cutting edge across sectors like AI, 5G, and automotive. Sustaining leadership with AI-driven tools is critical for retaining major accounts and capturing new logos.
While still in the early innings, we believe AI adoption may scale as dramatically in EDA as in other domains. Even a fraction of this potential could fuel a step change in Cadence’s growth trajectory and margin profile over the coming years.
Cerebrus: A Deeper Look
Cadence’s Cerebrus AI tool for digital implementation appears to be a major growth driver and core strength for the company. Based on commentary from management, Cerebrus has seen tremendous proliferation across Cadence’s largest customers, now being deployed at all of their top 10 digital design clients. Its use has also led to over 300 tape-outs, underscoring the solution’s adoption in real production designs.
Customers are clearly deriving exceptional value from Cerebrus, with reports of up to 10% improvements in critical metrics like power consumption. Gains of this magnitude from an AI tool are enormously significant, rivaling or surpassing the usual benefits from moving to an advanced manufacturing node. This level of optimization could help customers stay ahead of Moore’s Law and sustain their leadership in performance-driven markets.
For Cadence shareholders, the proliferation of Cerebrus across major accounts bodes well for continued strong renewal activity and expansion of relationship value. As customers ramp their adoption, licensing requirements, and professional services are likely to grow substantially. Its ability to enhance customer outcomes also feeds increasing trust in Cadence’s innovative solutions overall.
Perhaps most exciting is the potential for Cerebrus and AI to revolutionize the design process itself. Automating significant portions of work that previously required tremendous human expertise and resources could reshape the paradigm. If adoption scales as rapidly in EDA as in other industries, the revenue growth opportunities for Cadence appear immense.
Risks: Geopolitics
The geopolitical risks facing Cadence Design are multifaceted, particularly in light of the ongoing US-China tech conflict and the rise of China’s domestic semiconductor industry.
The US government has imposed stringent technical restrictions on semiconductor exports to China, aiming to hinder China’s access to key chips and components, especially for supercomputers. These restrictions are part of broader efforts to curtail China’s technological advancements in critical areas like advanced computing and AI. The Biden administration’s recent measures further limit the export of advanced semiconductor technology to China, including restrictions on Nvidia’s AI chips, showcasing an intensified approach in this technological tug-of-war. These export controls, detailed in a 121-page document by the US Bureau of Industry and Security, intensify the restrictions on a range of equipment essential for key semiconductor manufacturing processes.
In response to these restrictions, China has been rapidly boosting its domestic semiconductor industry. The country’s share of domestic foundry purchases increased significantly from 8.5% in 2020 to 25% in the first ten months of 2022, reflecting a concerted effort to reduce dependency on foreign technology. Furthermore, China has significantly increased its subsidies for the semiconductor industry, with the Ministry of Finance upgrading the country’s tax credit for investments in this sector. The attendance at SEMICON China 2023 also underscored China’s growing influence in the global semiconductor industry, driven by flourishing domestic demand and the rise of local manufacturers.
The market forecast for China’s semiconductor industry is equally telling. It is projected to grow by 7.31% from 2023 to 2027, reaching a market volume of US$238.00 billion in 2027. This growth is indicative of China’s robust efforts to establish a self-reliant semiconductor industry, reducing its dependence on foreign technologies and potentially challenging established players like Cadence Design Systems in the global market.
These geopolitical developments present a complex risk landscape for Cadence. The US restrictions could limit Cadence’s market access in China, one of the largest markets for semiconductor products and services. On the other hand, the rise of China’s domestic semiconductor industry poses a competitive threat, as local companies may increasingly prefer homegrown alternatives to Cadence’s offerings. This shifting landscape necessitates a strategic reassessment for Cadence, balancing compliance with US export controls while navigating the increasingly competitive environment in China. The company must innovate and adapt to maintain its market position in this politically charged and rapidly evolving sector.
Financial & Valuation
Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.
Based on our analysis, CDNS’ strong financial performance and healthy growth outlook justify its slightly elevated valuation levels. While trading near the upper bound of its historical valuation range, the stock’s current P/E of 46.5 is still within two standard deviations of its 5-year mean of 38.7. Furthermore, CDNS’ consistent ability to outperform consensus expectations and expand margins suggests the potential for upside surprises going forward.
Over the past three years, CDNS has grown revenue at an impressive 15.1% CAGR with increasing revenue guidance from consensus analysts. Remarkably, this top-line growth has been met with expanding operating margins, as EBIT margin increased nearly nine percentage points to 40.6% through disciplined management of expenses such as share-based compensation, which averaged only 7.3% of revenue. As a result, EPS grew by an even faster 24.7% CAGR, clearly outpacing revenue. Looking ahead, consensus estimates call for another year of 14-15% revenue growth and a further 120-130 basis points of margin expansion. Such strong financial performance places CDNS among the elite performers in the sector.
We are also encouraged by CDNS’ consistent generation of free cash flow, which averaged a robust 32.0% of revenue over the past four years. Notably, consensus forecasts FCF will reach $1,288 million this fiscal year, translating to a healthy 31.5% margin. With an average capex spend of just 3.2% of revenue, we consider CDNS’ business to be modestly capital-intensive. Meanwhile, return on invested capital has remained solid at 25.2%, supporting the company’s efficiency.
Compared to its peer group, CDNS trades slightly higher based on forward earnings multiples, with a P/E of 46.5 versus Synopsys (SNPS) 41.9. However, given CDNS’ superior financial profile marked by faster revenue and EPS growth with expanding margins, we view this small premium as justified. Overall, CDNS appears well-positioned to sustain above-average performance, supported by key end markets like semiconductors that are expected to see ongoing strength. While monitoring valuation, we maintain a positive outlook given the company’s consistent execution and quality business model.
Conclusion
Cadence Design Systems demonstrates a compelling growth story. Its ability to tap into the transformative potential of AI, especially generative AI, positions it at the forefront of design efficiency and quality. The company’s products like Cerebrus are already gaining traction among top-tier clients and showing significant improvements in key metrics.
However, the geopolitical landscape presents a multi-layered risk for Cadence. The ongoing US-China tech conflict and China’s rapidly growing domestic semiconductor industry pose potential challenges. Cadence needs to balance its compliance with US export controls while maintaining its competitive edge in an evolving market.
From a financial perspective, Cadence’s solid financial performance and healthy growth outlook justify its slightly elevated valuation. While the company trades slightly higher based on forward earnings multiples, its superior financial profile, marked by faster revenue and EPS growth with expanding margins, makes it a worthy contender in the sector. Despite the potential geopolitical hurdles, the company’s strong execution, diversified portfolio, and innovative solutions give us confidence in Cadence’s continued success.
