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Cadence Design Systems: Further Customer Wins Boosted By Strong Products

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About: Cadence Design Systems, Inc. (CDNS)
by: Himalayas Research
Himalayas Research
Long/short equity, research analyst, tech, gaming
Summary

Strong 3Q results with beats on the top and bottom line.

Breakthrough deal in IP with a marquee US semiconductor company.

Further wins in hardware orders.

3D EM solver gaining traction with customers already.

Upside still present with positive optionality if trade uncertainty resolves.

Cadence Design Systems (CDNS) reported strong 3Q results all round with an IP win with a marquee US semiconductor company. The company reported 3Q19 revenue of $580m, roughly 1% higher than Street and non-GAAP EPS of $0.54 which was about 6% better than Street. The stock is roughly down 10% from its recent highs, and I believe it is an attractive buy given its strong fundamental momentum.

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Marquee semi client drives revenue upside

The marquee semiconductor company which the management has boasted earlier this year has started to pay dividends. On the call, it was mentioned that the customer made a large IP order in 3Q, pushing IP segment revenue to a record high of $86.9mn.

Year-over-year revenue growth rates have slowed slightly in the past few quarters due to tough comparisons for its hardware segment. Still, huge IP deals helped offset the softer hardware segment. Further, the management is optimistic on the pipeline of hardware deals as inventories rise heading into the final quarter and the company still expects to see 0-5% YoY growth in its functional verification segment, implying 25%+ qoq growth in the segment.

We see the Street penciling in stronger next few quarters as shown in the chart below. This would put both the YoY and 2-year revenue growth rate back in acceleration mode.

Source: Bloomberg

Gross margins up slightly to about 90%

3Q19 gross margin was stronger than expected at 91.6% due to hardware contribution from hardware emulation and Protium X1 FPGA-based prototyping which I believe carry higher margins than functional verification that slowed due to tough comparisons.

More customer wins

As mentioned before, the marquee U.S. semiconductor company placed its largest IP order with the company due to its strong ongoing partnership, and the deal included its Tensilica processor family and design IP portfolio, and ultra-high-speed SerDes. Benefiting from the continuing IP outsourcing trend, Cadence had additional wins in audio, imaging, computer vision, and machine learning in its Tensilica products.

A different global marquee customer purchased one of the largest hardware orders for Cadence in order for the customer to expand additional Palladium Z1 and Protium X1 capacity. In Q3, the Z1 product added eight new customers and had eight key expansions. Management believes the Protium X1 is a great complement to its Z1 and is upbeat about the robust customer interest in X1.

Full verification suite wins in Q3 included a major customer in Asia and an automotive semiconductor company in EMEA.

For security, its 3D EM Solver gained 4 competitive wins and more than 30 active customer engagements going forward. The product was launched in spring earlier this year and has gained traction.

Updated guidance assumes export limitations

The company provided an updated guidance for Q4 which they expect revenue of $590-$600m, non-GAAP operating margin of about 30%, and non-GAAP EPS in the range of $0.52-0.54. Further buyback of $75 million shares is planned.

I believe the outlook is still quite solid but export controls from the United States Department of Commerce on the customers on the entity list would continue to be a headwind. Now, it's hard to speculate what might actually happen next year, and as a point of reference, in 3Q, 10% of revenue came from China compared to 12% in 2Q and 10% in 1Q.

Valuation

Cadence shares have begun to trade back above its 2-year historical mean if we look at the forward P/E ratio. I expect revenue growth of about 7% in FY20E, which is conservative given the relatively low volatility of Cadence's top-line compared with semiconductors, and net margin to expand slightly. This puts expected EPS in FY20E to be about $2.4 and assuming ~31x PE, we arrive at $74.4, implying upside from current levels.

I believe Cadence's products are addressing fast-growing challenges that its customers face in simulation and testing which is driven strongly by growth in AI, 5G, Cloud, and IoT.

There is uncertainty regarding export controls to customers in China on the entity list, but I believe the company's guidance has already factored that in, at least for the time being. I don't believe sales to China will go to zero abruptly (currently ~10% of revenue), but there is a risk. However, on the flip side, should it get resolved, there is positive optionality which I think is not embedded in the stock price.

Source: Bloomberg

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: All research, figures, and interpretation are provided on a best-effort basis only and may be subject to error. Any view, opinion, or analysis do not constitute as investment or trading advice, please do your own due diligence.