Michael Vi/iStock Editorial via Getty Images
Michael Vi/iStock Editorial via Getty Images
In the fall of 2022, I wondered if Cadence Design Systems (NASDAQ:CDNS) was performing too strongly, but this was of course ahead of the AI craze that followed soon thereafter, but most certainly in recent times.
Since that period in time, shares have essentially doubled, as investors recognize the growing importance of its role within the semiconductor sector (as well as other markets).
While the business is great, its future prospects are more than good, and margin expansion is delivered upon, I fear that the risk-reward here is really not skewed favorably in order to pursue an investment here.
Cadence provides computational technology for the design of electronic systems. Created by engineers for engineers, the company touts its strong focus and culture, as it develops cutting-edge computation software for such intelligent systems. The company does so through a workforce of over 10,000 workers, spread across 26 global development centers, the vast majority of which are R&D and field engineers.
This business offers a comprehensive set of offerings, including digital design, analog/custom design, debug and verifications, printed circuit board design and multi-physics optimization.
Benefiting from major megatrends such as data science, machine learning, autonomous vehicles, 5G, IOT, and AI, the company plays an important role in the sector at large. This comes as chip design and architecture become ever more important as the load on these, and expected performance, increases.
This is evident in the results, as a $2 billion business in 2017 has grown steadily to $3.5 billion in sales by 2022, accompanied by impressive non-GAAP operating margins of 40% of sales. Moreover, some 85% of sales are recurring, as the company has a >$5 billion backlog.
Cadence is known for its occasional M&A activity, which includes the purchase of the Rambus SerDes and memory interface PHY IP business from Rambus (RMBS) last summer. This was followed by another small acquisition in the form of a purchase of Intrinsix Corp, a subsidiary of CEVA (CEVA) in September of last year.
Early this year, Cadence announced the acquisition of Invecas, a Santa Clara-based firm. This deal was followed by the release of the fourth quarter results in February. 2023 sales were reported up 15% to $4.09 billion, indicating that the firm doubled in sales since 2017.
The company posted strong GAAP operating profits of $1.25 billion, resulting in GAAP earnings of $3.82 per share, with adjusted earnings reported at $5.15 per share. A big chunk of the gap between both earnings metrics comes from stock-based compensation expenses, so I am only really willing to place realistic earnings around $4 per share. The guidance for 2024 is strong, with the backlog standing at $6.0 billion, of which $3.2 billion is expected to be recognized in 2024.
For 2024, revenues are seen up to a midpoint of $4.58 billion, plus or minus $30 million, suggesting about 12% revenue growth. Adjusted earnings are expected to increase at a more impressive pace, seen at a midpoint of $5.92 per share. This makes that realistic earnings are likely seen close to $5 per share here, translating into very demanding multiples with shares trading at $317 per share, for a realistic forward multiple in excess of 60 times earnings.
This 272 million shares outstanding value equity of the firm at $86.2 billion at this point in time, and while it includes a modest net cash position of $350 million, that really does not alter the thesis. Based on the forward sales numbers, valuations are demanding as an 18 times sales multiple would look fair if it were an earnings multiple, but of course, there are the huge margins of the business and, moreover, the growth prospects of the firm.
Early in March, Cadence Design announced its next bolt-on deal, although, given the current market value, this is still a substantial deal in dollar terms. Cadence has reached a $1.24 billion deal to acquire BETA CAE Systems International AG, a leading system analysis platform provider of multi-domain engineering simulation solutions.
Some 60% of the deal is paid for in cash, about three-quarters of a billion, as pro forma net debt of $400 million is pretty manageable, while about half a billion in shares will be issued as well.
The transaction is set to close in the second quarter as BETA CAE Systems reports annual revenues of around $90 million, revealing that a nearly 14 times sales multiple has been paid. Dilution is seen at $0.12 per share on adjusted basis in 2024, but not that the deal only takes place during the year, with non-quantified earnings per share accretion seen to fiscal year 2025 earnings results.
Shares of Cadence, given its role in the industry, have fully participated in the rise of semiconductor markets; in fact, its share price performance has been better and certainly less volatile than many semiconductor firms themselves. This comes amidst a premium and more important role that companies like Cadence play in this environment, in which greater performance is the name of the game.
The question is how much of this good news has been priced in, yet it is a combination of ever-higher operating margins and higher sales multiples awarded to them, which makes me a bit cautious here.
While shares definitely deserve a big premium compared to a market multiple, the reality is that the risk-reward simply fees skewed here after shares have essentially doubled from the levels early in 2023. This means that while I like the business a great deal, I feel no need to get involved at current levels, until the risk-reward increases in a substantial way.