2023-12-04 04:12:02 ET
Summary
- Cadence Design Systems has seen impressive growth of 69% in 2023, but caution is advised due to high valuations.
- The Company's business model focuses on providing tools for chip designers, making it less susceptible to cyclical market trends.
- While CDNS has a bright future and will benefit from industry growth, the current valuation is considered excessive.
Cadence Design Systems ( CDNS ) has shown a remarkable performance in the market in 2023, with an impressive growth of 69% so far this year. Currently, valuations are reaching 50 times the Free Cash Flow projected for the next year. It's important to note that this figure doesn't necessarily mean the stock is overpriced, as this analysis depends on various factors. However, caution is advised when considering buying stocks at such high multiples, avoiding decisions solely based on expectations of significant growth. As history has repeatedly shown, "Valuation matters."
Undoubtedly, Cadence appears to be a spectacular company with a bright future ahead. Despite operating in an inherently cyclical market, its business model isolates it from this cyclicality. Furthermore, it spares the company from engaging in fierce competition to create the most powerful chip every year, thereby significantly reducing the risk of disruption. Drawing a distant parallel, Cadence shares more similarities with ASML than Nvidia in the semiconductor market, making it a highly intriguing company for exposure to the anticipated substantial growth in this sector.
However, as I've mentioned before, the current valuation doesn't seem appealing to me for entry. Despite being a great company, the margin of safety at these levels doesn't appear sufficiently prudent to me. In this article, I'll attempt to explain these two concepts. First, I consider it a high-quality company, among the best in the semiconductor sector. Second, I believe the current valuation is excessive.
Business Model
If we think about semiconductor manufacturing, surely the Taiwanese company TSMC comes to mind, responsible for producing the majority of the world's most advanced chips. If you know more about the supply chain in this market, you've likely also considered ASML , which supplies a significant portion of the tools used by TSMC in its factories.
I believe that the relationship between TSMC and ASML is a good comparison to explain Cadence's business. Just as ASML supplies "picks and shovels" for chip manufacturing in the form of highly complex machinery, Cadence does the same for chip designers. It provides tools (mostly software in this case) to enable major chip design companies like Nvidia, Intel, or AMD to carry out their designs.
At the core of Cadence Design Systems' business is the offering of comprehensive tools and services for the design and verification of integrated circuits and electronic systems. Its suite of software tools covers the entire electronic design flow, providing a complete platform that spans from conceptualization to the physical implementation of the circuit. This wide range of tools facilitates key processes in the development of electronic devices for engineers and manufacturers.
In the initial phase of design, Cadence offers solutions for schematic creation, allowing engineers to visualize and plan the logical arrangement of components in the integrated circuit. This step is crucial for establishing the functionality and connection between different elements of the system.
Simulation is another crucial area that Cadence addresses. Its tools enable designers to conduct virtual tests of the circuit before moving to the physical implementation stage. This simulation helps identify potential issues and optimize circuit performance before manufacturing, significantly reducing the risk of costly errors in later stages of the process.
The physical design phase involves translating the logical representation of the circuit into a specific physical design. Cadence provides tools that allow engineers to efficiently make this transition, optimizing the arrangement of components to meet performance and space requirements.
Hardware verification is a critical step before mass production. Cadence offers solutions that allow designers to verify that the integrated circuit functions as intended and meets all necessary specifications. This verification phase helps ensure the reliability and functionality of the final product.
A concrete example of how these tools can be applied is in the design of a processor for mobile devices. Engineers would use Cadence's tools to create the logical scheme of the processor, simulate its performance in different scenarios, design the chip physically, and finally, verify that it complies with quality and performance standards before entering production.
Is Cadence "immune" to cycles and technological disruption?
My main concern when considering an investment in a semiconductor market company lies in the potential technological disruption and sensitivity to cycles. Examining the history of this sector reveals numerous examples of leading companies that, failing to keep pace with technological evolution, either disappeared or were relegated to secondary roles in the industry, as was the case with Fairchild Semiconductor. In this context, I consider it crucial to comprehend the specific role each company plays in this industry before contemplating it as an investment option.
As mentioned earlier, Cadence stands out by providing fundamental tools for chip design, distancing itself from the competition to produce the most powerful chip. Its focus is on supplying all designers with the necessary tools, strategically positioning itself in the market. Additionally, the company is unaffected by the cyclicality in semiconductor demand as it does not directly engage in the sale of these products.
Historically, during periods of low demand, both designers and semiconductor manufacturers cannot afford to halt their investments and research. Those who choose to do so risk falling behind when demand inevitably rebounds. This scenario directly benefits Cadence, as companies like Nvidia or Intel continue to invest in research and improvement of their designs, consequently continuing to use Cadence's software. Therefore, the inherent cycles in the sector would barely impact the company's revenues, providing predictable and secure future cash flows.
Considering that it is highly unlikely for Cadence to lag behind in any cycle since they do not need to heavily invest during periods of low demand, my primary fear or concern is technological disruption. Currently, Cadence is (alongside Synopsys ( SNPS )) the undisputed leader in this market, but will this remain the case in 10 years?
My major concern is that a design company might decide that Cadence's software is insufficient and opt to develop its own. For instance, Nvidia has both the technological capability and financial resources to create such software for internal use or, worse, for commercialization. It may seem improbable, but if our investment horizon extends beyond a decade, it is something to consider.
Some might think I am being paranoid, but we are already witnessing this trend in chip design itself. Companies like Google, Apple, Amazon, Tesla, and Microsoft have chosen to design their own chips rather than buying them from external suppliers like AMD or Nvidia. What prevents this from happening again, but with design software? I reiterate that it seems highly improbable since design software is not as critical as the chip design itself, but we must monitor this closely as it could potentially disrupt the entire investment thesis.
In ASML, which I have compared to Cadence, such an occurrence is much more complicated due to the significant investment in capex and an incredibly complex supply chain. However, replicating "just" software requires a group of skilled engineers, time, and money.
Cadence will benefit from AI career and semiconductor market growth
Something that is undeniable is that if the disruption risk I mentioned does not materialize, Cadence's future is undeniably bright. Alongside Synopsys, it is the best-positioned company in this market and will directly benefit from the increased investment in R&D in this industry. Globally, the semiconductor sector is expected to grow at a compounded annual rate of 7.42% until at least 2027, and likely beyond. However, I believe there are reasons to think that Cadence will outpace sector growth.
A significant tailwind is the clear trend of more companies beginning to develop their own chip designs, as mentioned earlier. The increasing number of design companies entering the market is an advantage for Cadence, as it will have more potential customers to whom it can sell its software and services. The surge in artificial intelligence has further accelerated this process, and the expenditure on research and design of more powerful chips will significantly boost Cadence's sales in the coming years.
As can be observed in the following chart, spending on R&D by the leading chip design companies in the United States has done nothing but increase in recent years. In fact, according to this study , 18% of the sector's revenues are allocated to Research and Development, making it one of the industries with the highest proportion dedicated to R&D.
As mentioned earlier, none of these companies can afford to forgo investing in innovation, even during the less favorable phases of the cycle. Competition in the coming years seems to be getting tougher as major American tech giants such as Google (GOOG), Amazon (AMZN), and Microsoft (MSFT) show a growing interest in designing their own chips .
Cadence in numbers
Cadence's financial performance since 2008 has been nothing short of spectacular. The top line has grown at a compounded annual rate of 9.15%, as mentioned earlier, without any significant downturn, highlighting the anti-cyclicality I explained earlier. It is challenging to find companies in this sector that exhibit such linear growth without being significantly affected by economic cycles.
Furthermore, Cadence has undergone spectacular operational leverage, driving the operating margins from -20% in 2008 to 30% this past year. The rest of the margins have also seen significant increases over the last decade. Particularly noteworthy is the gross margin, which has nearly reached 90%, underscoring that it essentially operates as a duopoly alongside Synopsys.
In terms of solvency, Cadence consistently operates with a net cash position and currently generates $1.24 billion in Free Cash Flow annually, so there is no cause for concern in this regard. One important factor to consider, which will be crucial in the valuation, is that being a software company, the Free Cash Flow tends to be higher than the Net Income. This is primarily due to two reasons: firstly, the negative working capital inherent in a subscription-based business, where revenue is collected before providing the service, and secondly, the amortization of intangibles that negatively impacts EPS despite not being a "real" amortization, as it does not need to be replenished through future capital expenditures.
Valuation
Having delved into the fundamental aspects of the business, identified potential risks, and considered long-term tailwinds, we can now attempt to derive a fair value for Cadence's shares. As mentioned at the beginning of the article, it's imperative not to overpay for a company, no matter how strong its fundamentals are, and currently, I believe the market is overvaluing Cadence.
To understand why I think the valuation is excessive, let's project its performance for the next five years. While the consensus among analysts on Seeking Alpha suggests a growth rate of 11-12% annually for the company's sales in the coming years, I am opting for a slightly more optimistic projection of 12%. Additionally, we'll assume that the Free Cash Flow margin will also expand, reaching 38% in 2028 from the current 31%. Lastly, even though the company hasn't been very active in share buybacks historically, let's consider a scenario where it repurchases 1% of its shares annually in anticipation of the substantial operating cash flow it is expected to generate.
Even with a highly optimistic outlook, surpassing the consensus of analysts, we arrive at a fair price of $271.5 in 2028. Currently, the company is trading at $270, resulting in a potential return of 0%.
Conclusion
In conclusion, I believe Cadence is one of the premier businesses globally and stands out in the semiconductor sector. However, the slight disruption risk I mentioned earlier, coupled with its exaggerated valuation, makes me exercise caution at the moment, leading me to refrain from including it in my personal stock portfolio.
While it's true that we could adopt a more optimistic outlook and project higher growth rates, considering the new tailwinds emerging in its business, I find this approach too risky for my investment philosophy. I always aim to invest in companies that are trading below their intrinsic value.
Therefore, taking all these factors into account, I am assigning a "Hold" rating to Cadence's stock. If you already hold shares in the company purchased at better prices, selling doesn't seem prudent as I generally avoid selling such strong companies solely due to temporary overvaluation. However, I do not have sufficient arguments to justify purchasing this stock at its current price.
For further details see:
Cadence Design Systems: Great Business But Too Risky At This Valuation