Semiconductor Stock Giant Beats on EPS, Faces Large Backlog

Key Points

• Cadence Systems beat earnings per share expectations but provided a guidance downgrade.
• The firm is dealing with declining margins and a hardware backlog.
• It expects margins to recover and needs to ramp up manufacturing to meet demand.

Cadence Design Systems NASDAQ: CDNS is a software company that makes programs essential to semiconductor design. The firm announced Q2 2024 earnings on July 22, 2024. Let’s break down Cadence's operations and products to get a better understanding of the business. We’ll then review the earnings report. We’ll finish off with what to look out for next about Cadence, as well as what Wall Street analysts expect.

Cadence Systems: Leading the Charge in Electronic System Design Software

Cadence is a provider of electronic system design software. This software is based on Electronic Design Automation (EDA), which Cadence has iterated new versions of. The goal of this software is to help create semiconductors through simulation, design, and verification.

Before implementing a proposed circuit, engineers model it in a simulation to predict its behavior. The design takes the proposed chip and explains how all the different components will be connected. Verification then tests this layout to determine if the design will result in sought-after performance. Cadence has different software that addresses all these steps in the semiconductor design process. Cadence generally monetizes its software through licenses that last two to three years.

IP cores make up 12% of Cadence's business. IP cores are basic chip designs that help create more complex chips. When it comes to verification, Cadence also provides hardware known as its Palladium and Protium systems. This specifically designed hardware allows associated verification software to run much more efficiently than otherwise, which is necessary to keep up with advancements in chip design. The verification segment of Cadence's business makes up 25% of revenue.

An important note about EDA software is that it is essentially impossible to create cutting-edge chips without it. This is one reason that the United States banned the export of certain EDA software that can be used to create chips with 3-nanometer node sizes, the most advanced chips currently available. Still, Cadence has found workarounds to continue selling to Chinese customers. In 2023, 41% of Cadence’s revenue came from the United States and 17% from China.

Cadence's competitors include Synopsys NASDAQ: SNPS and Siemens OTCMKTS: SMAWF, which together control about 70% of the EDA market. Overall, IP cores and EDA represent 2% to 3% of total value added in the semiconductor ecosystem. Experts expect the software design market to grow by 15% to 20% annually through 2030. In 2023, 84% of Cadence’s revenue came from recurring, obligated streams, and 16% came from upfront payments.

Cadence Systems' Robust Q2 Performance, Disappointing Guidance

Cadence reports adjusted earnings per share (EPS) of $1.28, beating consensus estimates by 5 cents and up 5% from the previous year. It also beat revenue by $20 million, coming in at $1.06 billion, an increase of 8.6% from the previous year.

The company raised its guidance for Q3 but lowered it for fiscal 2024. It now projects a midpoint adjusted EPS of $5.87 vs. $5.93 previously.

Operating margin dropped 200 basis points from the previous year to 40%. However, the firm sees this recovery occurring throughout the year, with a midpoint forecast of 42.5% operating margin in 2024. The firm is getting less revenue from China. It dropped to 12% of overall revenue in the first quarter of 2024 and stayed at that level in Q2.

With its hardware segment, the company is currently facing a backlog of $6 billion. This backlog has been increasing over the years, up from $4.4 billion in 2021. This increase has largely been due to the firm’s release of its next-generation hardware products, for which it is working to build inventory.

What to Watch For and Analyst Price Targets for Cadence Systems

Seeing such a large and growing backlog is a blessing and a curse. It shows that the firm’s products are in high demand; however, it doesn’t have the manufacturing capability to meet that level of demand. It is essential to increase its capacity in a cost-efficient way.

The company predicts stronger hardware revenue in the second half of the year. Therefore, it is important to monitor any news about Cadence’s ability to build up its hardware inventory and reduce its backlog.

Three analysts have updated their price targets for the firm over the past month, increasing them by an average of $8. Those analysts see an average price target of $338, implying an upside of 18%. No analysts have given an update since the earnings release.