Cadence Design Systems (NASDAQ:CDNS) is a mainstay in the EDA (electronic design automation) software, which is used to design chips, ICs, and PCBs (printed circuit boards).
It is one of the top three companies together with Synopsys (SNPS) and Siemens, with Cadence and Synopsys each having about a third of the market and Siemens being considerably smaller.
Several much smaller players offer point solutions and given the trend towards more orchestrated solutions with the help of generative AI, we don't see these as a competitive threat.
We'll discuss how its core capabilities as a computational software company enable Cadence to venture out of its core EDA market and expand its TAM into ISD or Intelligent Systems Design, after which we'll provide a financial update.
Intelligent Systems Design
The company now defines itself as a computational software company, which basically amounts to mathematical processing, enabled by Generative AI and driven by (Q1CC):
Increasing system complexity and growing hyperconvergence between the electrical, mechanical, and physical domain is driving the need for tightly integrated co-design and analysis solutions.
It is using its core capabilities to expand its TAM in multiple directions:
- The Allegro System Design Platform and the OrCAD family of offerings for PBC systems design.
- Clarity 3D Solver for electromagnetic and power electronics analysis and simulation, as well as Celsius Thermal Solver, provide the foundation for multiphysics analysis technology, with complete electrical-thermal co-simulation for electronic systems from ICs to physical enclosures.
- Fidelity CFD Software is a physics-based analysis solution for mechanical design that complements the electronic system analysis portfolio, enabling multiphysics analysis workflows to address simulation and analysis challenges for applications including aerodynamics, hydrodynamics, propulsion, turbomachinery, heat transfer, and combustion.
- Millennium Multiphysics Enterprise Platform is an AI-enabled digital twin helping to overcome traditional computational fluid dynamics (CFD) speed/accuracy and compute resource limitations.
- Optimality Intelligent System Explorer is a generative AI-driven multiphysics optimization solution designed to produce the optimal system design solution.
- The Data Center Design and Insight Platform is an AI digital twin solution that brings physics-based design and analysis to the data center sector for performance-aware design and operational planning.
- OpenEye Scientific Software produce molecular modeling and simulation solutions
And it is arguing there is quite a bit of upside from doing so (Q4CC):
executing to our Intelligent System Design strategy, that triples our TAM opportunity while greatly expanding our portfolio.
Several market trends help the ISD strategy:
- Semiconductor companies are increasingly involved in designing the electrical systems that incorporate their chips.
- Systems companies, traditionally focused on system-level design are venturing into semiconductor design to achieve greater customization and optimization.
- The convergence between electrical and mechanical systems is blurring lines between electrical and mechanical aspects of system design, demanding integrated solutions that address both domains.
The main enabling factor is of course the transformative potential of generative AI in revolutionizing the design process as Cadence incorporates it into its strategy to automate and optimize design workflows (Q1CC):
And then the third part of AI proliferation is new markets that open up, which things like data center design with reality that we announced or Millennium, which is designing systems with acceleration or digital biology.
Let's look at some of the new capabilities.
Allegro X AI
The Allegro X AI PCB design platform is gaining traction, from the Q1CC:
Allegro X continued its momentum and is now deployed at well over 300 customers. While Allegro X AI, the industry's first fully automated PCB design engine, is enabling customers to realize significant 4x to 10x productivity gain.
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Reality Digital Twin platform
Cadence acquired Cascade Technologies in 2022 for its CFD (computational fluid dynamics) and LES (large eddy simulation) for high-fidelity multiphysics analysis.
Cascade's LES technology enables Cadence to deliver more accurate digital twins, leading to better product performance predictions and optimizations. These capabilities are used to create solutions for additional markets like designing entire data centers with the Reality Digital Twin platform, Q1CC:
virtualizes the entire data center and uses AI, high-performance computing (HPC) and physics-based simulation to significantly improve data center energy efficiency by up to 30%.
Celsius Studio
Celsius Studio was only launched this year, it's a unified platform that:
lets electrical and mechanical/thermal engineers concurrently design, analyze and optimize product performance without the need for geometry simplification, manipulation and/or translation.
But it has already been used by Samsung, which (Q1CC):
to uncover early design and analysis insights to precise and rapid thermal simulation for 2.5D and 3D packages, attaining up to a 30% improvement in product development time.
Millennium 1
Cadence acquired NUMECA International in 2021 to expand into the CFD (Computational Fluid Dynamics) market, a $2B market opportunity.
This has developed into a new AI-based physics simulation software that can be used to simulate how air flows over jets and other gear which is called Millennium 1 which was introduced just last February, from the Q4CC:
the other thing it does, hardware-based acceleration or emulation for CFD, is it will improve the market size of CFD as well. Like I was talking to one of these big aerospace companies and they said, current CFD, the current simulation is only done to 20% of the flight envelope, okay, which is unheard of in chip design, right? In chip design, we simulate 99-point-some percent of the use cases.. So, the potential with Millennium is one that 20% goes to much closer to much higher than 50%, and then a big portion of that can go to hardware-assisted emulation and verification... So, we had that at the heart of it, and then AI on top, and then accelerate compute at the bottom together with NVIDIA, and this completely changes the game in CFD. For the first time, we are able to simulate entire cars and planes in a few hours.
Clients are expanding (Q1CC):
In Q1, a leading automaker expanded its production deployment of Millennium to multiple groups after a successful early access program in which it realized tremendous performance benefits.
BETA CAE
The recent $1.24B acquisition of Beta CAE enables entry into the structural analysis segment, unlocking a multi-billion-dollar incremental TAM opportunity, from the PR:
Over the past few years, Cadence has expanded its system analysis portfolio to build out a comprehensive multiphysics platform including electromagnetics (EM), electrothermal (ET) and computational fluid dynamics (CFD) solutions, and with BETA CAE, Cadence will enter structural analysis, the largest system analysis segment.
BETA CAE is particularly strong in the automotive and aerospace industries.
OpenEye
OpenEye is a suite of molecular modeling and simulation solutions that Cadence acquired by acquiring OpenEye Scientific Software in 2022. Pharmaceutical and biotechnology companies use these solutions and services to accelerate drug discovery and make more informed decisions during the development of new therapeutics. But significant revenue generation is a few years out.
Orion
Orion is a cloud-native molecular design platform, from the Q1CC:
Additionally, Cadence's cloud native molecular design platform, Orion, will be supercharged with NVIDIA's BioNemo and NVIDIA microservices for drug discovery to broaden therapeutic design capabilities and shorten time to trusted results.
These additional SDA segments aren't yet a driver of revenue growth, but this is a gradual process, and the increase in the TAM is noteworthy:
It's also not terribly surprising, as many of the products described above are very new.
Q1/24 Update
Since our first article was published in March, the stock is actually down 7%, which (despite a 3 cents earnings beat) is due to a revenue miss:
Much of the growth decline is due to:
- Hardware revenue timing as the company is in the process of switching to its third-generation hardware systems - Palladium Z3 for emulation and Protium X3 for prototyping - and expects demand for these to boost H2 growth. Hardware revenue is upfront.
- Difficult comps, only 10% in Q1/24 was upfront revenue, compared to 20% in Q1/23 as the company prioritized filling backlog.
- Demand decline from China declined to 12% of revenue, again the result of strong comps in functional verification and hardware.
- Functional verification also had very difficult comps.
- From the Q1CC: "First of all in non-recurring, it's not just hardware, but it's also IP in terms of the second half because like we mentioned, we have new IP business driven by HPM and AI and also by Intel IFS."
Q1 saw the launch of Cadence's third-generation hardware platforms, Palladium Z3 for emulation and Protium X3 for prototyping, both of which are setting new benchmarks in performance, offering double the capacity and a 50% performance boost per rack compared to their predecessors, from the Q1CC:
But what is truly exciting about Z3 and X3 is this a big leap, it’s like Z3 is 4 times or 5 times more capacity than Z2. It's a much higher performance. So it sets us up nicely for next several years to be able to design the several generations of the world's largest chips. So that's the right thing to do. And the reason we can do it in three years versus six years is, we use our own design internally in Cadence for TSMC advanced node. So we're using all our latest tools, all the latest AI tools, we are using all our IP. There's a very good validation of our own capabilities that we can accelerate our design process, but really sets up hardware verification and overall verification flow for using the new systems... So even Z2, like NVIDIA talked about it last week, even Blackwell, which is the biggest chip in the world right now with 200 billion transistors, was emulated on few racks of Z2. Okay, so now with 16 rack of Z3, we can emulate chips which are like 5 times bigger than Blackwell, which is already the biggest chips in the world, right?... The Z3 X3 systems have been deployed at select customers and were endorsed by NVIDIA, Arm and AMD at launch.
So Cadence designed its own chips for the Z3 with the help of its AI tools.
However, the introduction will produce some transition costs and management expects growth to resume in H2, but longer-term this should bode well:
- They can put some of the older systems in the cloud and offer a ratable service.
- The new systems enable much larger AI chips from the likes of Nvidia, Qualcomm, Samsung and AMD as well as the hyperscalers like Meta, Microsoft, Amazon and Google that develop their own AI chips, and the complex accompanying software.
Despite these headwinds in H1, Q1/24 EPS came in 4 cents better than expected at $1.17, backlog was at a record $6B at the end of Q1 and recurring revenue is growing at double-digit rates.
Management raised its financial outlook for fiscal year 2024, projecting revenue between $4.56B and $4.62B, GAAP EPS in the range of $4.04 to $4.14, and non-GAAP EPS between $5.88 and $5.98.
There was strong growth in the IP business (Q1CC):
Our IP business continued to benefit from market opportunities offered by AI and multi-chiplet based architecture. We are seeing strong momentum in interface IPs that are essential to AI use cases, especially HBM, DDR, UCIe, and PCIe at leading edge nodes. In Q1, we partnered with Intel Foundry to provide design software and leading IP solutions at multiple Intel-advanced nodes.
The AI-driven solutions are getting significant traction as they produce design improvements (Q1CC):
So it is leading to deployment of our AI portfolio. And I think we mentioned like the AI run rate on a trailing 12 months basis is up 3x... Now, the second part of AI is applying AI to our own products, which is the Cadence.AI portfolio. And like you mentioned last week, we had several customers talking about success, you know, with that portfolio, including Intel, you know, like I mentioned Intel, Broadcom, Qualcomm, Juniper, Arm, and the results are significant. So we are no longer in kind of a trial phase of whether these things will work. Now we're getting pretty significant improvements. Like we mentioned, MediaTek got like 6% power improvement. And one of the hyperscale companies got 8% to 10% power improvement. These are significant numbers.
Margins were a little under pressure in Q1. The gross margin is a little seasonal with Q1 as the low while operating margin is expected to recover, from the CFO note:
Margins could fall a little this year on the acquisition of BETA CAE. Cash flow is still trending upwards, but only gradually:
Revenue is now projected to be between $4.56B and $4.62B, with EPS coming in between $5.88 and $5.98 and operating cash flow between $1.35B and $1.45B.
Valuation
Despite substantial stock-based compensation, the share count is actually declining through buybacks (with management committed to use at least half of free cash flow for buybacks):
And there is surprisingly little in the pipeline:
- Market cap at $300 per share is $81.6B
- $1.01B in cash and equivalents
- $650M in debt ($350M in 2024 notes and $300M in 2025 notes)
- EV $81.25B
- FY24 EV/S at 17.7x
- FY24 p/e at 50.6x
Needless to say, the valuation is at nosebleed levels but the shares have been very richly valued for quite some time:
Conclusion
This is a market-leading stock at market-leading valuations and although these valuations are close to or at historic highs, there are some reasons to argue that the share price has some room to run:
- H2 is going to be stronger than H1 due to a recovery in upfront revenue.
- Interest rates might very well decline.
- The company has embarked on multiple new initiatives under the umbrella of Intelligent Systems Design, which greatly increase its TAM.
So we think the shares are still a buy at $300, but from a valuation perspective, we don't see much room for valuation multiple expansion, if any.
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