Artificial intelligence (AI) -- a computing system that attempts to imitate the way the human mind processes information and solves problems -- has been around for decades. But a new wave of AI is sweeping the tech world, driven by generative AI services like ChatGPT.
Companies across all industries see the potential to supercharge their performance if they put these new computing systems to work and are investing in new projects accordingly.
Behind every AI system is a powerful semiconductor, so chip stocks have rightly attracted a lot of attention in recent months. But before these building blocks of tech are manufactured and deployed into supercomputers that power generative AI, they need to be designed. That's why Cadence Design Systems (CDNS 1.70%) is worth getting acquainted with right now.
A top AI software stock for the AI era
Shares of Cadence Design have been hot, up over 30% so far in 2023 and largely bucking the bear market with a 54% return since the start of 2021 (versus a -5% return for the Nasdaq Composite Index over that same time). What's going on?
Cadence is a semiconductor company, but it's also a software business. Its electronic design automation (EDA) software suite is absolutely critical to designing semiconductors. Think of it like Autodesk's (NASDAQ: ADSK) AutoCAD but for chips and computing systems. And as the name EDA would imply (the "automation" in electronic design automation), this software provider has AI services embedded throughout its software portfolio. Just a few product examples are:
- Tensilica AI: chip designs for intelligent processing in Internet of Things (IoT) devices that a company can license from Cadence and customize to their needs. This is a similar business model to ARM Holdings.
- Allegro X AI: computing system design software featuring generative AI to assist an engineer with chip layout on a circuit board.
- Verisium: a suite of apps powered by AI to help with computing system debugging, verification of hardware and software integration, and managing software code.
The real beauty of a company like Cadence is its stable revenue growth. Its business model is primarily subscription based, which removes much of the booms and busts inherent with other semiconductor stocks. Booms and busts are common in a manufacturing industry, which is ultimately what the semiconductor space is.
The result isn't the fastest-growing chip stock out there, but a steady expansion of revenue and robust free cash flow generation are key features of this investment.
Data by YCharts.
A top AI stock, but at what price?
With AI chip and computing system design emerging as a top tech trend, Cadence obviously has a lot to gain in the years ahead.
But there is a drawback, and that comes in the form of a very high premium valuation. Shares of the design software company currently trade for 67 times trailing-12-month earnings per share or 55 times trailing-12-month free cash flow. Clearly, the market has caught on to Cadence's fantastic positioning for the AI era.
Cadence does expect to grow revenue by about 14% in 2023 ($4.03 billion to $4.07 billion is management's forecast range) and for a slight increase in profit margins (adjusted operating margin of 41% to 42%, compared to 40% in 2022). Still, it's a high premium.
EDA software peer Synopsys (NASDAQ: SNPS) trades for only 37 times trailing-12-month free cash flow, is growing sales at a similar pace, and is leaning into profit margin expansion as a top priority in the years ahead.
Even so, Cadence Design looks like a solid investment for the decade ahead as it could enjoy gradual expansion along with its myriad of chip design, computing systems, and big tech customers.
If you choose to buy, I'll caution against taking too large a position. As has been the case the last six months, this stock is a dollar-cost average position for me, as is Synopsys. I'm starting small, but with big potential going forward from the AI movement, Cadence is worth keeping tabs on after getting 2023 started on the right foot.
