Cadence Design Systems (CDNS 1.92%) may not be the first name you think of in the tech sector, but the semiconductor and computing systems design company is notching fast and steady growth from solid secular trends, especially generative AI.
Cadence -- along with its peer Synopsys -- are two of just a very small handful of companies in the electronic design automation (EDA) software space. Think of it like Autodesk's AutoCAD, but for chips, computers, and other electronic components.
As such, Cadence is a top stock that investors should consider for exposure to the long-term growth of the chips and AI systems industries. Let's dive in.
Forget chip sales, it's all about R&D
In this year's second quarter, revenue and adjusted earnings per share (EPS) grew 14% and 18% respectively year over year, and Cadence raised its guidance for the second half of the year. This certainly isn't the fastest-growing bet on the semiconductor and AI industry out there, but the results are impressive given that chip sales remained mostly in a slump during Q2.
Cadence's management said that robust customer activity for chip and computing system design has led it to raise its revenue guidance for 2023 to $4.05 billion-$4.09 billion (from $4.03 billion-$4.07 billion), representing a 15% year-over-year increase. Adjusted EPS should now be $5.05 to $5.11, or up 19% year-over-year.
This continues Cadence's long streak of steady growth in sales, and especially in profit margin and free cash flow expansion.
Data by YCharts.
Given that Cadence's core customers include highly cyclical chip designers and fabricators, computing system manufacturers, and data center constructors and operators, how is the company able to shake off the ups and downs and put up such consistent growth? It's more than just that Cadence focuses on subscription access to its electronic and system design automation (EDA and SDA) software for engineers.
In good times and bad, the semiconductor industry tends to keep its research and development (R&D) budgets at least fixed, if not steadily rising. That's because paring back too much on R&D during sales or economic downturns could lead to falling behind competitors in chip technology. It's a top reason that Cadence has been such a great investment over the years (along with Synopsys, the other leader in EDA and SDA software).
The AI revolution is lifting Cadence higher
More powerful and increasingly complex chips need a lot of computing power these days, and Cadence has been helping by launching some generative AI services of its own into its software suite -- like the ability for engineers to have an AI assistant automatically organize the layout of chips on a circuit board.
Cadence has also been deepening its ties to the industry, and has extended its software to handle the large systems that actually operate AI services. That includes none other than Nvidia, which heavily uses Cadence for chips, AI systems, networking, and more; and Tesla, which has been using Cadence to help build its Dojo supercomputer.
The company even used its strength to acquire Rambus's SerDes and memory interface PHY business, which is used in designing digital memory and data transfer into computing systems. The deal won't have a material impact on Cadence's earnings this year, but it should strengthen the portfolio of technology licensing it offers to customers.
Additionally, in 2022 Cadence acquired a small software company called OpenEye, which works in molecular modeling and simulation. Cadence is planning to add its own AI software capabilities to OpenEye to make a concerted push into the massive life sciences industry.
All this excitement has lifted Cadence's stock to new highs, and a very high premium valuation. Its shares currently trade for 41 times Wall Street analysts' expectations for 2024 EPS, or about 42 times 2024 expected free cash flow.
As promising as this company is as it powers new AI developments, investors should exercise caution. If you want to own it for the long haul, consider using a dollar-cost averaging plan, buying small amounts of Cadence Design stock, perhaps on a monthly or quarterly basis.
Nevertheless, if you believe chips and AI will remain the secular growth leaders for the five to 10 years, you need to keep tabs on Cadence Design Systems.
