Big tech escalated the artificial intelligence (AI) arms race at the start of 2023. Microsoft invested in ChatGPT owner OpenAI, Alphabet's Google publicized a countermeasure with the soft launch of Bard, and Meta Platforms said it's revamping its data centers to favor more efficient computing use as it rolls out new AI of its own across its social media apps.
Behind all of this fancy new AI is an advanced kind of semiconductor system meant to be housed in a remote data center with its computation delivered to users via the internet. In the years to follow, more powerful -- and also more energy efficient -- chips will need to be designed and manufactured. This could make Cadence Design Systems (CDNS -0.21%) a fantastic buy today for this coming wave of AI.
An exceptional 2022
Cadence Design, as well as its peers Synopsys and Mentor (now owned by German industrialist Siemens), have staked a claim in a very important part of the semiconductor market. They provide electronic design automation (EDA) software. Think of it like CAD (computer-aided design), but for chips and computing systems instead of for buildings.
The proliferation of increasingly complex chips (for phones, laptops, cars, and data centers running AI services and apps) is great news for Cadence and friends. Hardware sales can ebb and flow, making the typical semiconductor stock highly cyclical. But since Cadence is primarily a subscription software business, it provides far more stability and consistency from the multi-decade secular growth trend that is semiconductors.
2022 was proof of that. Full-year revenue grew 19% to $3.56 billion. Operating profit margin was a very healthy 30% (up from 26% in 2021), or 40% on an adjusted basis (37% in 2021). Free cash flow on the year was $1.12 billion, $1.05 billion of which was used to repurchase stock (about 1.9% of the current market cap, if you're looking for an annualized dividend yield-equivalent to those stock buybacks).
2022 was a very volatile year for the semiconductor industry. Especially in the second half of the year, supply chains loosened up from their early-pandemic freeze just in time for consumer spending on electronics to falter. Many semiconductor companies have been dealing with contracting sales as a result.
Not Cadence. It closed out the final quarter of the year with 16% year-over-year growth and is forecasting 13% revenue growth (at the midpoint of guidance) and further profit margin expansion for 2023. This is because, regardless of the end demand for chips and computers, engineers remain at various stages of design for future projects.
Forget the battle itself, bet on the arms dealer
But what of this AI battle that's brewing among tech giants like Microsoft and Google? Cadence will be a top beneficiary. Besides providing designs for chips, Cadence's software is also used in entire computing system design and verification. In fact, management said on the earnings call that computing system companies (think big tech that operates data centers running AI services like ChatGPT, for example) comprise about 45% of Cadence's total revenue.
That overall systems design business is a key pillar to Cadence's overall growth profile. Systems revenue increased 27% in 2022 and is expected to continue expanding as a total percentage of revenue in the years ahead.
Why is Cadence so important to companies that are rolling out AI? It's not just optimizing chips to efficiently run an AI system (which consumes significant amounts of energy when generating a response to a user's request). Cadence's software helps automate repetitive tasks, and also generates ideas of its own to help smooth out the development process for engineers. Basically, Cadence offers generative AI that aids in the creation of new generative AI, like what Microsoft and Google are tripping over each other to roll out to the public right now.
If I can use a military analogy here, don't bet on the armies doing battle when you can bet on the arms dealers -- Cadence, as well as Synopsys.
Of course, Cadence stock trades at a high premium of 49 times trailing 12-month free cash flow after the final 2022 financial report. Profitability, and especially free cash flow, are expected to rebound in the next year. Cadence was shelling out a high amount of cash in 2022 to support its customers' demands, and as it dealt with industry supply chain restrictions. On an adjusted earnings per share basis (which will more closely follow the pace of free cash flow), Cadence stock trades for 40 times expected 2023 earnings.
By the way, there's upside to Cadence's guidance if management gets confirmation that the current chip slump will bottom by the middle of 2023 (something its semiconductor customers have been saying will happen).
In short, if chips and AI remain a growth trend for years to come, Cadence deserves the premium price tag. A premium-priced stock is going to include some bouts of turbulence, so I would caution against making one big purchase of the stock. Instead, employ dollar-cost averaging and build up a larger position over time. Nevertheless, Cadence is a wonderful way to invest long-term in the AI arms race.
