Cadence Design Systems (CDNS, Financial) – a provider of electronic design automation (EDA) tools for semiconductor companies – reported results of its second quarter yesterday, topping revenue and earnings estimates.
The design automation company reported $518.4 million in revenue, ahead of analysts’ consensus of $514.9 million; revenue grew 8.2% year-over-year. Earnings grew 34% year-over-year to reach 45 cents a share during the quarter. The Street was modeling for earnings per share of 40 cents.
For the third quarter of 2018, the company is guiding for revenue of $515 million and non-GAAP earnings per share of 41 cents, in line with the consensus. For the full fiscal year of 2018, the San Jose-based design automation company expects revenue to reach $2.1 billion, translating into midpoint earnings per share of $1.74, beating the consensus by 12 cents. The result coincided with the market’s expectations as the stock was unmoved after earnings release.
What does Cadence exactly do?
The company is primarily involved in the provision of hardware and software for electronic design automation to system integrated circuit designers like Intel (INTC, Financial), Advanced Micro Devices (AMD, Financial) and other circuit and chip designers across industries. Cadence helps semiconductor companies in designing, configuring, analyzing and verifying ICs. Due to continuation of Moore’s law, i.e., miniaturizing of ICs and proliferation of connected devices, design automation companies like Cadence and Synopsys (SNPS, Financial) are gaining traction.
What drove performance?
During the second quarter of 2018, Cadence’s revenue growth was supported by “software and emulation and prototyping hardware business and an increase in IP revenue,” according to the company's earnings release. Digital IC design and signoff – solutions for creating IC representation for verification before actual silicon implementation – contributed the most towards the revenue of the company followed by custom IC design.
It’s worth mentioning that more than 20 customers adopted Cadence’s full digital flow in the first half of 2018. Moreover, the flagship DDR and PCIe products drove the revenue of the company during the quarter. Per Lip-Bu Tan, CEO of Cadence, on the earnings call yesterday:
“We prototyped the world’s first DDR5 test chip, achieving a data rate of 4400 megatransfers per second in TSMC’s 7-nanometer process. We had significant wins for DDR with a major semiconductor company, for PCIe with a leading storage company, and we are working with a mobile customer on a 7-nanometer sensor application.”Â
In short, the rise of data centers, networking, shrinking semiconductor manufacturing nodes and electrification of automobiles is driving the growth of Cadence. The growth is set remain intact going forward as no slow down is expected in the data-driven economy of today. But this raises the question, is Cadence a good investment opportunity?
What’s the investment case?
For starters, the market is already pricing the growth into the stock. Cadence is trading at a forward price-earnings ratio of more than 25. The trailing price-earnings ratio is also very high.
It can be seen that the stock is already trading at a very high price-earnings ratio. Although a high ratio can be justified with a high growth rate, Cadence’s earnings are expected to grow 12% per year during the next five years, which makes the stock a bit expensive even with growth.
Moreover, revenue is not very high in absolute terms to justify current valuation. Cadence is trading at a forward price-sales ratio of 6, which is quite high even for a growth stock.
Cadence is expensive as compared to its direct competitor Synopsys. In short, the stock is already trading on a high side.
What’s even more alarming, the Street is using non-GAAP numbers to ascertain the value of a company that is heavily reliant on software and intellectual property for its revenue. Ignoring amortization costs for a software company like Cadence might not reflect the true economic value of such a company. Furthermore, Cadence has a culture of using stock-based compensation; non-GAAP numbers ignore that expense also result in overstated earnings.
The table depicts Cadence has a very high proportion of stock-based compensation and amortization in its non-GAAP earnings. This means that the stock will be even more expensive using GAAP numbers, which are more relevant in the case of Cadence.
Takeaway
Although Cadence posted decent quarterly results and the company is set to beat full-year expectations in 2018, the stock is already priced for perfection given extreme relative valuation and the Street’s focus on non-GAAP numbers.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
