Cadence Design Systems (CDNS)

Q4 Results Review

Introduction

Cadence Design Systems (CDNS) is in the Electronic Design Automation (EDA) space.  EDA is estimated to be a $15bn market.  Two players, Synopsys (SNPS) and CDNS have about a 70% combined market share.  

We have written in detail about SNPS, and this report can be found here. We have also written about CDNS, and this can be found here.

We are revisiting CDNS after the recent release of their latest quarterly results. 

Both CDSs and SNPS have been very successful investments and have given about 20X returns in the last twenty years.   

The companies are characterised by the following:

• Consistent Revenue & Earnings Growth.

• High Profitability and Margins.

• Strong Cash Flow Generation.

• Consistent stock repurchases.

• Technological Leadership

• Industry Tailwinds:

The tailwinds are the huge growth in the chip industry in the last two decades.  Chip design costs have risen sharply, and the software share of the total design cost has increased too.   

The two film clips below give a good introduction to the industry and CDNS. You can watch them at 1.25X to 1.5X speed to save time. 

The two companies provide software tools to electronic designers, particularly in the chip industry. The top 20 chip companies use CDNS’s products, and their clients include, Nvidia, Intel, ARM, Qualcomm, Samsung and Renesas of Japan. 

Between 85% and 90% of CDNS’s revenues are recurring, as customers roll over software licensing agreements every two or three years. 

You may think that exposure to a highly cyclical industry such as the chip industry may be a negative. However, CDNS and SNPS are paid out of the Chip makers’ R&D budgets which are more stable than their revenues.

CDNS revenues can divided as follows:

·       Digital Integrated circuit (IC) Design and Signoff; (27%)

·       Custom IC Design and Simulation; 23%

·       Functional Verification, including Emulation and Prototyping Hardware; (26%)

·       System Interconnect and Analysis (SDA); (10%)

·       Design IP (5%)

CDNS have been making their products available in a SaaS offering in the Cloud.  CDNS have been increasingly moving their products to the Cloud and, in the last few earnings calls, they have been talking about the use of AI in their products and services.

CDNS has 11,000 employees based in 26 Global development Centres.  Most of them are engineers:  6800 are R&D engineers and 2,200 are field engineers.  CDNS has been awarded 1,600 patents worldwide. 

The company believes its core competence in computational software, and this can be employed in many industries such as Communications, Automotive, Defence, Industrial and Life Sciences. 

The Results 

Cadence Design Systems, Inc. (Nasdaq: CDNS) recently announced results for the Q4 and FY 2023.

Q4 2023 Financial Highlights

• Revenue of $1.07bn compared to revenue of $900mn in Q4 2022

• GAAP operating margin of 31%, compared to 23% in Q4 2022

• GAAP diluted EPS of $1.19, compared to $0.88 in Q4 2022

FY 2023 Financial Highlights

• Revenue of $4.09bn compared with revenue of $3.56bn in 2022,

• GAAP operating margin of 31%, compared to 30% in 2022.

• GAAP diluted net income per share of $3.82, compared to $3.09 in 2022.

• Year-end backlog was $6.0bn and the current remaining performance obligations (“cRPO”), contract revenue expected to be recognized as revenue in the next 12 months, was $3.2bn.

Balance Sheet

Cash balance was $1.0 billion at year-end, while the principal value of debt outstanding was $650 million.  Net debt remains negative.

Cash Flow

Operating cash flow in the fourth quarter was $272mn and $1.35bn for the full year.

CDNS used $700 million to repurchase shares during 2023.

Business Outlook

For the first quarter of 2024, the company expects:

• Revenue in the range of $990mn to $1.01bn.

• GAAP operating margin in the range of 24.5% to 25.5%

For fiscal year 2024, the company expects:

• Revenue in the range of $4.55bn to $4.61bn

• GAAP operating margin in the range of 32% to 33%

Source: Long-term investing; CDNS

Y/Y growth in Revenue was 18.8% reflecting a strong upturn in Q4. Net profit growth was 35%.  Both these figures are higher than the long-term averages shown above in the last column and in the table below.

Source: Long-term investing; CDNS

Services are growing faster than Products but from a low base.  Products still account of 92% of total revenues. 

Source: Long-term investing; CDNS

Operating and Net Income Margins in Q4 were above average.

Source: Long-term investing; CDNS

The company remains a strong generator of free cash flow.

In summary, this was a strong quarter for the company and continued the trend of double-digit sales growth and ~30% margins.  The company expects lower, more normalised, numbers in the rest of 2023.

Conference Call Highlights 

Order Backlog

“We exited 2023 with a record backlog of US$ 6bn as customers increasingly committed to our chip to system integrated design and analysis platforms.” 

This $6bn compares with total projected revenue for FY 2025 of $4.6 bn so this points to good revenue visibility.  About $ 3.2 bn of the order backlog is cRPO, i.e. it will be recognised in the next twelve months.  

Demand drivers.

“Secular trends of digital transformation, hyperscale computing and autonomous driving, all bolstered by an AI super-cycle, continue to fuel strong broad-based design activity.”

Innovation

CDNS has stated that it has introduced 20+ significant products in the past thirty years. 

“Our multi-physics analysis portfolio couples our expertise in physics-based modelling with AI-driven optimization and is delivering superior results to customers across multiple vertical segments, especially aerospace and defence, and automotive.”

“We launched Celsius Studio, the industry's first complete AI thermal design and analysis solution for electronic systems, delivering up to a 10x performance benefit over legacy systems, with endorsements by Samsung and BAE Systems.”

AI

“Cadence is at the forefront of the AI revolution, closely partnering with marquee companies on their trailblazing AI designs for training and inference from cloud to the edge. NVIDIA and Cadence have collaborated closely over several years, and in Q4, we deepened our partnership through a meaningful expansion of our hardware solutions and EDA software.”

“We also pioneered bringing LLM capabilities to chip design, successfully helping Renesas (Tokyo listed semiconductor company) accelerate functional specification to final design.

“Accelerating momentum of our Cadence.ai portfolio has led to an almost tenfold increase in the number of customers adopting our GenAI solutions in 2023, as customers embrace the technology to develop optimized products much more efficiently.”

Chip Industry

Our digital software is proliferating in all top 20 semiconductor companies and our digital full flow was adopted by 34 additional customers during the year.

Cadence and Arm are closely collaborating to accelerate the development of custom SoCs (systems on chips) based on the Neoverse Compute Subsystem.

Hardware

The company sells hardware to clients for Emulation and Prototyping. Emulation is for getting the Chip design correct and Prototyping is for getting the software, that will drive the chip, developed and tested.   

CDNS Emulation product is called Palladium Z2 while the Prototyping Hardware is called Protium X2.  The two products are referred to as “the dynamic duo” by company management.

“all of the top (Cloud) hyperscalers are Palladium customers and the majority of them are also Dynamic Duo customers. Last month, we announced a new set of Palladium Z2 applications that included the industry's first four state emulation and mixed signal modelling capabilities, that will significantly accelerate SoC (system on Chip) verification.  Marquee customers including NVIDIA and Samsung supported the announcement.”

 “Our hardware family added 26 new and over 110 repeat customers during the year, with the top three deals being with a global marquee systems company, the leading AI systems company, and a leading communications services company.”

Valuation

The CDNS share price has doubled in the last two years and we have benefited from this growth. This advance has made CDNS our fourth largest holding (after MSFT, NVDA and BRK/B). 

However, the stock currently looks expensive:

·       The 12-month rolling forward P/E ratio is 48 times.

·       The two-year forward P/E Ratio is 41 times.

·       Price to Free Cash Flow Ratio is 63 times. This is a free cash flow yield of just 1.6%   

This looks expensive for a stock which is likely to grow earnings at 20% to 25% in the medium term at an operating margin and ROE of about 30%, even if one gives some leeway for the quality of the business.

Conclusions 

CDNS is a steady consistent performer. It is unlikely to be as profitable as a Microsoft or grow as fast an Nvidia. The market it serves many expand but will be much smaller than the markets that the tch titans serve. Nevertheless, CDNS has a rightful place in our tech portfolio as a balance to more high-flying names. 

We will continue to hold our position and continue to watch the performance of the company.  We would consider adding to it if the forward P/E ratio fell to 30 to 32 times.