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Cadence Design Systems: Worth Keeping an Eye On
Stock Analysis & Ideas

Cadence Design Systems: Worth Keeping an Eye On

Cadence Design Systems (CDNS) provides computation software for intelligent system design. It services many high-tech industries, such as aerospace and semiconductors, to name just a few. We are neutral on the stock.

Cadence Design Systems’ Competitive Advantage

There are a couple of ways to quantify a company’s competitive advantage using only its income statement. The first method involves calculating the earnings power value (EPV).

Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value can be measured using total asset value. If earnings power value is higher than reproduction value, then a company is considered to have a competitive advantage.

The calculation is as follows:

EPV = EPV adjusted earnings / WACC

$11.8 billion = $886 million / 0.068

Since Cadence Design Systems has a total asset value of $4.2 billion, we can say that it does have a competitive advantage. In other words, assuming no growth for Cadence Design Systems, it would require $4.2 billion of assets to generate $11.8 billion in value over time.

The second method is by looking at a company’s gross margins, because it represents the premium that consumers are willing to pay over the cost of a product or service.

An expanding gross margin indicates that a sustainable competitive advantage is present. If an existing company has no edge, then new entrants would gradually take away market share, leading to decreasing gross margins as pricing wars ensue to remain competitive.

Taking a look at Cadence Design Systems, we can see that gross margins have expanded in the past several years. As a result, its gross margins also imply that it has a competitive advantage.

Profitability

In the last 12 months, Cadence Design Systems has recorded $940 million in free cash flow. More importantly, its free cash flow has been trending up in recent years. To us, this means that the company’s free cash flows are reasonably predictable.

Risks

To measure Cadence Design Systems’ risk, we will first check if financial leverage is an issue. We do this by comparing its debt-to-free cash flow. Currently, this number stands at 0.37. In addition, when looking at historical trends, the debt-to-free cash flow ratio has been trending down.

Overall, we don’t believe that debt is currently a material risk for the company because its interest coverage ratio is 44.2x (calculated as EBIT divided by interest expense).

However, there are other risks associated with Cadence Design Systems. According to Tipranks’ Risk Analysis, CDNS has disclosed 40 risks in its most recent earnings report. The highest amount of risk came from the Finance & Corporate category.

Overall, the company’s risk profile is essentially in line with the sector average, suggesting that it’s not riskier than most of its peers.

Wall Street’s Take

Turning to Wall Street, Cadence Design Systems has a Moderate Buy consensus rating, based on three Buys, one Hold, and one Sell assigned in the past three months. The average Cadence Design Systems price target of $197 implies 38.3% upside potential.

Final Thoughts

Cadence has a strong underlying business that generates cash with a measurable competitive advantage. Nonetheless, we remain neutral because we want to wait for its next earnings report, scheduled on February 22, to see how CDNS has performed during the fourth quarter.

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