New Chip Designs Are Booming, and This Stock Stands to Benefit

With the early pandemic boom now in the rearview mirror, semiconductor stocks got bludgeoned this year by the bear market. The latest worry comes from new U.S. export curbs on sales to China, adding to jittery nerves over a big slump next year -- especially if a recession strikes. Despite the pessimism in 2022, massive amounts of money were spent this year on new chip design research.

Cadence Design Systems (CDNS -1.87%) offers a good example of this dichotomy. Despite various headwinds, Cadence just had an excellent quarter and provided a rosy outlook going forward. Is this chip stock a buy?

New technology requires a new type of engineer

Cadence design is what's known as an electronics design automation (EDA) company. Basically, it's software that helps design engineers streamline and accelerate their work on semiconductors and computing systems. Given the staggering complexity of designing modern chips, EDA is a powerful software suite that combines various elements like computer-aided design, physics-based simulation, and system verification. 

But new technologies are further increasing the complexity of problems for engineers. Things like data centers (supercomputers accessed via a network connection), 5G networks, robotics, and the like are beginning to be put to use across all sectors of the economy. Simply designing chips isn't good enough anymore. EDA has to account for these new technologies and help engineers work at all levels of tech design -- from the chip itself to the computer system it's a part of, and to the ultimate software that the computing system is being built for.

That's where Cadence (as well as industry peer Synopsys (SNPS -1.78%)) has started to make a name for itself among the financial community. Already deeply ingrained in the tech world, many investors have been attracted to Cadence and its EDA platform because it combines the long-term secular growth trend from semiconductors with the more stable business model of subscription software. This was on display when Cadence reported third-quarter 2022 earnings, which beat its own financial guidance in spite of the wall of worry the chip industry is facing right now. 

Data source: Cadence Design Systems. Note: The guidance was provided during the second-quarter earnings update

With just a quarter left to go, Cadence also upgraded its full-year 2022 guidance. Revenue is now expected to be $3.54 billion at the midpoint (previously $3.49 billion), and adjusted earnings per share to be $4.22 (previously $4.09). That outlook represents year-over-year growth of 16.7% and 28.3% for revenue and adjusted earnings per share, respectively.

China bans to be "limited and manageable"

But what of upcoming disruption to the semiconductor industry, especially if a recession hits next year? After all, chip companies are cyclical. After a big multiyear run-up in sales -- especially in consumer electronics -- a downturn is now here for many companies.

Whether ultimate chip sales are up or down, though, behind-the-scenes development on new chip technologies continues. Cadence (and Synopsys, too) is an incredibly stable business that keeps expanding as semiconductor technology deepens its roots in the global economy. Chip design companies keep spending with Cadence regardless of where they are in the sales cycle.

Data by YCharts.

And what about China? There was some concern that new U.S. export bans would hit EDA companies too. However, as expected, Cadence said on the earnings call that new curbs on China's ambitious semiconductor industry would be "limited and manageable" and that any impact on financials is included in the company's current outlook.

This "limited and manageable" impact from China is great news for the chip industry overall. Does that make Cadence Design Systems stock a buy? Shares currently trade for 38 times trailing-12-month free cash flow and 36 times expected full-year 2022 adjusted earnings per share. It's a premium price tag, but not unreasonable considering the solid long-term results this company has been putting up.

Nevertheless, with lots of quality and growing chip stocks getting battered by the bear market this year, Cadence doesn't top my list of top chip stocks to buy right now. But at the very least, this company deserves to be on your radar.