Top semiconductor and electronic design automation (EDA) software company Cadence Design Systems (CDNS -1.19%) has been on a tear this year, up nearly 50% so far in 2023 and near its all-time highs. The company just released a stellar earnings update, providing at least some validation for the stock's run so far and its rich valuation today.
But given market turbulence exacerbated by ongoing fears of a weakening global economy due to high interest rates, some may wonder why Cadence's run-up hasn't slowed. In a word, it's because of AI.
A top bet on the long-term advance of AI?
EDA software is an oligopoly, dominated by Cadence and peers Synopsys and Siemens EDA (formerly known as Mentor). Cadence and the EDA oligopoly control the gateway into the semiconductor world. Think of EDA as a type of computer-aided drafting service purpose-built for the mind-bogglingly complex chip manufacturing and computing systems industry. Just about everyone involved in semiconductors, computing systems, data center operators, and the like rely heavily on this software.
It all makes for a steady-growth software bet on the advancement of computing and related hardware technology. Unlike some of the wild cyclical swings some chip stocks experience, Cadence and the EDA market follow their customers' research and development (R&D) spending -- which tends to rise in good times and bad since tech companies can't stop developing for risk of falling behind rivals.
As an illustration, let's look at revenue trends for Intel and Micron compared to their more stable R&D spending, and how those R&D budgets compare to Cadence's long-term sales trajectory.
Data by YCharts.
You can see the spike in Cadence's growth rate the last few years even as some big customers like Intel and Micron have had to pare back some spending. That's because of a nasty downturn in PC and smartphone sales, the worst since at least the dot-com bubble popped in 2000. But Cadence keeps rising as more advanced computing needs get more difficult to solve.
That's where generative AI, and other big tech trends like industrial automation, electrification, and self-driving features of cars, play a role in Cadence's rise.
Cadence has AI throughout its operations
Cadence started announcing new AI features in its software a couple years ago, and it's in the midst of a big upgrade cycle as its customers' contracts get renewed and Cadence upsells new AI products to its EDA core. As a result, Q3 2023 revenue was up 13% year-over-year to $1.02 billion. Earnings per share (EPS) increased 37% to $0.93, up 19% to $1.26 on an adjusted EPS basis.
The fourth quarter of this year will feature numerous renewals of contracts with customers, and Cadence is optimistic about this cycle as customers throughout the tech universe gear up for the era of generative AI. Cadence is ready, having already infused many of its products with high-end computational power from Nvidia's GPUs. These GPUs help run Cadence applications like generative AI used to aid in the layout of circuit boards (where chips are packaged before being installed in a computer).
Management said it expects Q4 revenue to advance as much as 20% from last year to as much as $1.079 billion, and for EPS to be up as much as 3% to $0.91 (or up 42% to $1.36 on an adjusted EPS basis).
How to handle a stock like this
As might be expected for a company in position to benefit from secular growth trends like AI, Cadence stock fetches a high premium. Shares trade for 66 times expected full-year EPS, or 45 times full-year expected adjusted EPS.
Cadence has a shot at continuing to grow revenue at a low-teens percentage for years to come thanks to AI and other design challenges as customers' R&D keeps steadily increasing. And thanks to its cost discipline and shareholder returns via stock buybacks, profit margins and earnings per share should also tick higher in the coming years.
Data by YCharts.
Nevertheless, that premium on the stock price should be noted. It can cause wild volatility in the share price if growth should ever come in below expectations. If you want to bet on Cadence and the long-term growth of the EDA software space, consider taking small bits at a time, or using a dollar-cost average plan, to build a position. Cadence looks like a top way to play the advance of new AI technologies in the decade ahead.
