Why The Market Is Mispricing Cadence Design Systems

Today is an age of unparalleled advances in technology. Driven by a revolution in semiconductor chip design and manufacturing capabilities, electronics today are integrated into everything from your car to your home and offer incredible computing power coupled with the ability to be connected anywhere. The design of these chips and systems is only possible through advanced electronic design automation ("EDA") tools that enable everything from design of individual transistors to the development and testing of critical software before the actual hardware is built.

Cadence Design Systems (CDNS) ("Cadence" or "the Company") is one of the largest providers of electronic design automation tools and systems, with roughly 18% share of the $5 billion EDA market. This small cap industry leader operates a high-margin, asset-light business which benefits from an attractive recurring revenue model. However, misunderstood short-term headwinds this year have sparked a sell-off in shares, which are now trading at multi-year lows in valuation.

In my opinion, shares of CDNS are undervalued relative to the broader industry and do not properly reflect the company's leadership position in an essential niche market. Trading at a big discount to historic earnings multiples, the market seems to be mispricing the company's steady and predictable cash flows. A conservative five-year DCF analysis, confirmed by relative EBITDA multiples, implies shares are undervalued by 25-30%.

Company Overview

Cadence, founded in 1988, is the world's second largest provider of electronic design automation software. Headquartered in San Jose, California, the Company offers software, hardware IP and expertise that its customers use to design and verify today's mobile, cloud, and connectivity applications. Each new electronics device today is a unique combination of silicon, SoC (System on Chip), software and system technology - all of which drives demand for Cadence design tools and intellectual property. The Company combines its products and technologies into categories related to major design activities:

Custom IC Design, Digital IC Design

Integrated chip design and verification offerings are used by customers to create schematic and physical representations of circuits down to the transistor level. Cadence offers leading solutions for mixed-signal and low-power integrated chip design that serve high growth markets such as mobile, consumer, and network devices. Its major design platforms are Virtuoso custom IC design, Encounter digital IC design and Allegro system interconnect design. The Company's Virtuoso platform is an industry leader in analog design, and the Encounter and Incisive platforms are also gaining traction in digital design and verification, respectively.

Functional Verification, Hardware and IP

Functional Verification products are used by customers to efficiently and effectively verify that the circuitry they have designed will perform as intended. Verification takes place before implementing or manufacturing circuitry, reducing the risk of discovering an error in the completed product. SoC Realization, which includes design and verification IP, is a high-growth business for Cadence - revenue for these products increased 30% in 2012. The Company offers differentiated, high-performance IP to the mobile, video and network markets.

System Interconnect Design

System Interconnect Design offerings are used to develop printed circuit board and integrated chip packages. In 2012, the Company acquired Sigrity, greatly increasing its capabilities in this area through integration of Sigrity analysis tools with the company's existing Allegro platform. System design tools enable customers to design highly complex and functional electronics while reducing cost and time-to-market.

Design for Manufacturing

One of the challenges that semiconductor companies face is ensuring that the integrity of the chips they design can be maintained while manufacturing in massive volumes. Cadence's DFM capabilities help customers address manufacturing effects as early in the development process as possible.

Recent Financial Performance

In its most recent earnings release, Cadence offered current year guidance of $1.45 to $1.46 billion in revenues, with EPS of $0.85 to $0.86 per share. The Company is on track to generate between $430-$440 million in EBITDA. The Company currently has a backlog of $1.7 billion in revenues; the new Palladium offering seems to be well received, and bookings are solid across the core product line.

Strong Recurring Revenue Business Model

One very attractive aspect of Cadence's business is that it employs a recurring revenue model, which allows for a highly visible and predictable revenue stream. According to company filings, the firm generates roughly 90% of projected quarterly earnings from its backlog, which stood at $1.7 billion as of December 2012. Its average contract term is slightly under 3 years. Cadence has consistently generated operating margins and return on equity in the mid-to-high 20% range with strong free cash flow yield (currently around 6%).

Earnings Outlook

After several years of double-digit revenue growth, Cadence still seems poised to grow revenues in the mid single digits in absence of further accretive acquisitions. The semiconductor industry has gone through an extended period of weakness in conjunction with slumping PC sales; should the industry experience a rebound or enter a meaningful cyclical recovery it would be possible to see sustainable revenue growth of 10% or greater over the coming years

Even assuming a modest slowing in sales momentum from 10% to ~7% year over year, revenues should top $1.5 billion in 2014 with EBITDA in the area of $500 million. Bloomberg consensus is for EPS of $0.97 per share in 2014.

Recent Deal Renegotiations Were An Exception, Not The Rule

On its October earnings call , Cadence disclosed that several customers had negotiated their existing licensing agreements, resulting in fewer licenses per contract. This resulted in a sharp sell-off in shares, as investors worried that these renegotiations were either a sign of weakness in the overall EDA market or in the Cadence offering suite specifically.

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Commenting on the renegotiations, Chief Financial Officer Geoffrey Ribar stated, "There's a small number of customers doing that... I don't want to overstate it. We don't believe it's a long-term trend." Management went on to describe that many of its customers are going through restructurings, citing Japan specifically. While this presents a short-term headwind, leadership is encouraged that these few customers are refocusing their efforts on the consumer and making intelligent business decisions for long-term viability and success.

CEO Lip-Bu Tan Accumulates Shares

In October, following the earnings miss and subsequent sell-off, the Company's CEO purchased 20,000 shares of CDNS at an average cost of $12.82 per share, investing $256,500 of his personal savings in the Company. This brings Mr. Tan's total direct ownership to 190,831 shares (worth ~$2.6 million) and, along with his indirect holdings through options and incentive compensation, his total holdings to over 790,000 shares (worth over $13.5 million). While I'm not going to comment on Mr. Tan's investing expertise, it's quite a vote of confidence from senior management to make an open market purchase of this size considering his holdings are already substantial.

A Note on Convertible Bonds

It is also important to mention that Cadence has two convertible bond issuances outstanding. The first one will mature this month, while the second comes due in 2015. The covenants in these bonds have prevented CDNS from paying dividends or engaging in a share repurchase; however, as these obligations are met, the company may begin to return cash to shareholders in the coming years.

Valuation

Prior to the 2008 financial crisis, Cadence traded with a trailing 12-month P/E ratio in the mid 20's. As earnings have normalized following the recession, EPS has almost quadrupled from $0.20 in 2010 to the $0.86 expected in 2013. Surprisingly, Cadence has seen its multiple contract from the high 20's to 16 times current year earnings today, a two-year valuation low despite strong earnings growth.

Today's share price implies a valuation of 8.5X EV/EBITDA, compared to the broader software industry, which trades between 12-13X EV/EBITDA. The publicly traded EDA firms, which include Cadence, Synopsys (SNPS) and Mentor Graphics (MENT) have historically traded around 10-11X EV/EBITDA. I view the main reasons behind today's discount to be the customer contract renegotiations previously discussed, as well as the high level of spending by Cadence on acquiring IP this year. However, I feel that the renegotiations are customer-specific "one offs" and the IP purchases this year should be accretive to EPS in 2014 (they were mildly dilutive this year).

When looking at fair value for CDNS shares, I used both an EV/EBITDA approach as well as a five-year DCF analysis, giving equal weighting to each.

Applying a 10.5X EV/EBITDA multiple to $500 million in 2014 EBITDA yields a per-share value of $17.22, a 25% premium to today's price. This assumes no debt prepayment, and no reduction or issuance in outstanding shares.

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For the five year DCF analysis, I modeled EBITDA increasing to $500 million in 2014 and $560 million in 2015, with growth slowing to 6% by 2017 where EBITDA reaches $635 million. Assuming an 11% weighted average cost of capital and a 2% terminal growth rate, my PV calculation for Cadence is $5.4 billion or $17.79 per share - a 30% premium to today's closing price. This implies a terminal EBITDA multiple of 10.4X which is roughly in line with where the sector has traded historically.

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Source: Company financials, author estimates

Blending the results of both analysis yields my intrinsic value estimate of $17.50 per share. At today's closing price of $13.77, this represents 27% upside over the next 12-18 months.

The Bottom Line

While EDA may not be a "sexy" business, it is an attractive niche market that serves an essential role in the design of today's electronics. Cadence is a major player with 18% market share, and enjoys a cash generative, high-margin recurring revenue model that has proven resilient over time. Short-term concerns around spending and customer contracts have left shares at a two-year low in valuation, which I believe mis-prices the company's earnings potential over the coming years. I view shares as oversold today, and should the stock trade back to levels consistent with historic norms, upside should be 25-30% over the coming year.

Safe investing...

Source: Why The Market Is Mispricing Cadence Design Systems

Disclosure: I am long CDNS. 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. (More...)

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