Cadence Design Systems: Great Prospects, Mostly For The Operations

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Summary

Cadence Design Systems (CDNS) is a name with quite a good track record. It's a shame that I have not been covering this name before, although I briefly looked at the prospects for the firm in 2013 when it announced an interesting move at the time. The largest part of the strong share price advancement ever since has originated from higher valuation multiples, although accompanied by decent growth of the operations as well, yet the risk-reward does not look compelling here.

The Business

Cadence claims to be a leader of system design enablement solutions, including hardware, software and IP. This is so-called mission-critical technology for electronic systems. Its subscription software model results in high customer renewal rates, great loyalty and thus recurring revenues.

The addressable market of Cadence is just a fraction of the semiconductor sector, yet it is critical to these customers. Increasing demand for data, relating to for instance mobile, edge computing, machine learning, automotive and data centers, among others, makes this a real growth market. The company is truly a global business with great diversification between end markets. The great positioning to these growth, yet profitable segments means that Cadence has delivered on steady and impressive growth, combined with compelling margins.

This positioning and execution has paid off great for long-term investors, although the definition of the ''long-term'' section matters a lot in this respect. Shares traded between $10 and $40 between the dotcom bubble and 2008, only to collapse to $2 and change during the crisis. Ever since, shares have steadily risen to $40 by the end of last year, before returning more than 50% in 2019 to a current level of $67.

The Numbers

In October, Cadence reported results for the first nine months of the year with revenues up roughly 10% to little over $1.7 billion, making that sales will top $2.3 billion for the year. The company is immensely profitable as it reported GAAP operating earnings of $383 million for the first nine months of the year, for margins equal to 22%. Note that this is even the case as the company invested $700 million in R&D in the first nine months alone of this year already!

Aided by a low double-digit tax rate, the company reported net earnings of $1.17 per share so far this year, making a number of $1.50 per share for the year very realistic. Even at $67, multiples are very high at 44 times GAAP earnings at current levels, largely driven by the huge returns seen in 2019 already. While the company reported much higher adjusted earnings, that is largely the result of stock-based compensation. Pre-tax amortisation charges run at roughly twenty cents and might be adjusted for. Even if I do that, I still end up with earnings multiples around 40 times!

While the company operates with a net cash position of about a dollar, it is quite obvious that the valuation attached to the business is very large. After all, after backing out net cash, operating assets are still valued north of $18 billion, or nearly 8 times sales! While that is certainly a high multiple, it is noteworthy that sales are growing at double-digit rates at a time when the wider semi market is still seeing some struggles.

A Bolt-On Deal

The direct reason why I looked at Cadence was that of the $160 million acquisition of AWR Corp., a subsidiary of National Instruments Corp. (NATI). This software is used by microwave and RF engineers to design wireless and complex RF applications, used among others in the communication, aerospace, defense, semiconductor and related industries.

No revenue contribution was announced, yet with a deal tag just below 1% of the current market capitalisation of Cadence, this looks immaterial, although it it is interesting to see deal-making by the firm.

Concluding Remarks

When I told you at the start of this article that I wished that I would stumble upon this interesting business earlier, that statement is not really correct. In fact, I briefly checked out on the prospects for the firm in spring of 2013 when the company acquired Tensilica in a $380 million deal. In fact, shares traded at just $13 at the time, only to increase by a factor of 5 times in just about 6 years.

Valued at merely $4 billion at the time, Cadence was valued at 20 times earnings and 2.6 times sales. As such it seem very evident that most of the returns seen, with shares up a factor of 5 times in just six years, comes from higher multiples rather than actual sales and earnings growth.

Note that even as 2013 does not sound that long ago, typically valuations were less demanding than they are currently as mega trends from which Cadence is benefiting still were largely emerging at the time. While my neutral stance seems to have been too conservative at the time, I am much more confident in having a neutral to cautious stance at this point in time despite the current growth and rosy prospects, as valuations have risen too much to create a balanced risk-reward here.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.