We Are
In June of this year, I concluded that Cadence Design Systems, Inc. (NASDAQ:CDNS) was a well-designed business, being well positioned to benefit from multiple long-term secular growth trends. This momentum was further fueled by shortages in the semiconductor industry, as a 50 times forward realistic earnings multiple was far too demanding in my opinion.
The Positioning
Cadence provides computational technology for the design of today’s electronic systems. The company has a very strong focus and culture, as it is created by engineers for engineers, standing at the forefront of computational software for such intelligent systems.
The company benefits from a couple of long-term trends which include the rise of data science, machine learning, hyperscale computing, autonomous vehicles, 5G, IOT and healthcare, among others.
With increased demands putting great strains on the entire architecture of such designs, it becomes ever more important to design chips well, and that is where Cadence comes in. The business has grown from $2 billion in sales in 2017 to $3 billion in 2021, all while non-GAAP operating margins have steadily risen to 37% of sales.
With many of these sales generated from recurring revenue streams, supported by a more than $5 billion backlog, the near- to medium-term visibility and growth were almost guaranteed. Despite all these positive attributes, there was a huge drawback and that was a great share price performance, with share price advancement outpacing the reported sales and earnings growth, to thereby push up valuation multiples meaningfully over time.
After hitting a high at $190 in 2021, Cadence Design Systems shares traded at $160 in June, marking a modest pullback (in relation to the market conditions at the time). The company grew 2021 sales by 11% to $2.99 billion as GAAP earnings rose 21% to $745 million, equal to $2.50 per share. While the company posted an adjusted earnings number of $3.29 per share, the vast majority of the difference stemmed from stock-based compensation charges, something I was not happy to adjust for. Pegging earnings power realistically at around $2.70 per share, valuations came in at 58 times realistic earnings, and that is in a rapidly rising interest rate environment!
Part of this high valuation is explained by a solid first quarter performance, as the company hiked the 2022 guidance, expecting sales this year at $3.41 billion on which adjusted earnings of $3.93 per share were anticipated. With realistic earnings seen around $3 per share, or a bit above that, valuations were still very demanding at more than 50 times earnings, even as interest rates have seen momentum higher at the time.
Perhaps this momentum comes amidst chip shortages which are driving the need for innovative solutions and designs. While this made for perhaps a good hedge on the chip shortages situation, a less than 2% earnings yield provided little protection in my eyes in this (rate) environment.
Steady As She Goes
Since June, shares have done quite alright, as in fact, shares have retested the highs in the $190s in August, to now settle at $170, actually marking modest gains from June. Part of the momentum is undoubtedly the result of an accelerated $100 million buyback program which was announced late in June, albeit that I am the first to admit that the size of this program is limited in the light of a near-$50 billion market capitalization here.
A month later, Cadence posted its second quarter results, as revenues rose by a healthy 17% to $858 million, as strong operating leverage was displayed with GAAP operating profits of $283 million being up nearly by a hundred million compared to the year before, all as a near-$700 million net cash position was preserved, although it is less than $3 per share.
The company raised the guidance to a midpoint of $3.49 billion in sales this year, with GAAP earnings seen around to $2.62 per share while adjusted earnings are seen topping the $4 per share mark now. With stock-based compensation responsible for about a $1 per share of the difference between both earnings metrics, the realistic earnings number close to $3 per share remains intact.
In September, Cadence closed on the $500 million deal for OpenEye Scientific Software, a deal which will largely deplete net cash holdings. While this is a meaningful result, the deal is equivalent to just over a percent of the value of the firm. Note that the deal was announced in July alongside the second quarter results.
OpenEye provides molecular designs in physics-based approach to improve health and is used by many large biopharmaceutical names as a $40 million revenue contribution in 2023 reveals that a 12.5 times sales multiple has been paid. This valuation is in line with the valuation of Cadence, which is valued around 13 times sales, although no growth or margin details have been announced on the deal.
Still Too Rich
Despite what appears to be a nice, yet truly bolt-on deal, and resilient second quarter results, I am still very cautious at 50 times earnings. This is even more the case than back in June, given where interest rates have moved.
After all, the earnings yield comes in at just half of short-term interest rates here, creating a dangerous set-up in case of slower growth and a valuation correction, which is seen in other areas of the market. This warrants a cautious tone despite great long-term prospects.
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