Cadence (CDNS)

Semiconductor design software provider Cadence Design Systems (NASDAQ:CDNS) met Wall Street’s revenue expectations in Q1 CY2025, with sales up 23.1% year on year to $1.24 billion. The company’s outlook for the full year was close to analysts’ estimates with revenue guided to $5.19 billion at the midpoint. Its GAAP profit of $1 per share was 1.9% above analysts’ consensus estimates.

Company Overview

With the name chosen to reflect the idea of a repeating pattern or rhythm in electronic design, Cadence Design Systems (NASDAQ:CDNS) offers a software-as-a-service platform for semiconductor engineering and design.

The demand for rich, interactive 2D, 3D, VR and AR experiences is growing, and while the ubiquitous metaverse might still be more of a buzzword than a real thing, what is real is the demand for the tools to create these experiences, whether they are games, 3D tours or interactive movies.

Competitors in engineering and design software include Ansys (NASDAQ:ANSS), Synopsys (NASDAQ:SNPS), and Siemens EDA (subsidiary of XTRA:SIE).

Examining a company’s long-term performance can provide clues about its quality. Any business can put up a good quarter or two, but many enduring ones grow for years. Over the last three years, Cadence grew its sales at a 15.6% compounded annual growth rate. Although this growth is acceptable on an absolute basis, it fell slightly short of our standards for the software sector, which enjoys a number of secular tailwinds. Luckily, there are other things to like about Cadence.

This quarter, Cadence’s year-on-year revenue growth of 23.1% was excellent, and its $1.24 billion of revenue was in line with Wall Street’s estimates.

Looking ahead, sell-side analysts expect revenue to grow 9% over the next 12 months, a deceleration versus the last three years. This projection doesn't excite us and indicates its products and services will face some demand challenges. At least the company is tracking well in other measures of financial health.

Billings is a non-GAAP metric that is often called “cash revenue” because it shows how much money the company has collected from customers in a certain period. This is different from revenue, which must be recognized in pieces over the length of a contract.

Cadence’s billings punched in at $1.23 billion in Q1, and over the last four quarters, its growth was impressive as it averaged 24% year-on-year increases. This alternate topline metric grew faster than total sales, meaning the company collects cash upfront and then recognizes the revenue over the length of its contracts - a boost for its liquidity and future revenue prospects.

The customer acquisition cost (CAC) payback period represents the months required to recover the cost of acquiring a new customer. Essentially, it’s the break-even point for sales and marketing investments. A shorter CAC payback period is ideal, as it implies better returns on investment and business scalability.

Cadence is extremely efficient at acquiring new customers, and its CAC payback period checked in at 3.7 months this quarter. The company’s rapid recovery of its customer acquisition costs means it can attempt to spur growth by increasing its sales and marketing investments.

Software is eating the world. It’s one of our favorite business models because once you develop the product, it usually doesn’t cost much to provide it as an ongoing service. These minimal costs can include servers, licenses, and certain personnel.

Cadence’s gross margin is one of the highest in the software sector, an output of its asset-lite business model and strong pricing power. It also enables the company to fund large investments in new products and sales during periods of rapid growth to achieve higher profits in the future. As you can see below, it averaged an elite 85.9% gross margin over the last year. Said differently, roughly $85.86 was left to spend on selling, marketing, and R&D for every $100 in revenue.

Cadence’s gross profit margin came in at 86.5% this quarter, marking a 1 percentage point decrease from 87.6% in the same quarter last year. Cadence’s full-year margin has also been trending down over the past 12 months, decreasing by 3.5 percentage points. If this move continues, it could suggest a more competitive environment with some pressure to lower prices and higher input costs.

While many software businesses point investors to their adjusted profits, which exclude stock-based compensation (SBC), we prefer GAAP operating margin because SBC is a legitimate expense used to attract and retain talent. This is one of the best measures of profitability because it shows how much money a company takes home after developing, marketing, and selling its products.

Cadence has been a well-oiled machine over the last year. It demonstrated elite profitability for a software business, boasting an average operating margin of 30%. This result isn’t surprising as its high gross margin gives it a favorable starting point.

Looking at the trend in its profitability, Cadence’s operating margin rose by 1.1 percentage points over the last year, as its sales growth gave it operating leverage.

In Q1, Cadence generated an operating profit margin of 29.1%, up 4.3 percentage points year on year. The increase was encouraging, and because its gross margin actually decreased, we can assume it was more efficient because its operating expenses like marketing, R&D, and administrative overhead grew slower than its revenue.

Free cash flow isn't a prominently featured metric in company financials and earnings releases, but we think it's telling because it accounts for all operating and capital expenses, making it tough to manipulate. Cash is king.

Cadence has shown terrific cash profitability, driven by its lucrative business model and cost-effective customer acquisition strategy that enable it to stay ahead of the competition through investments in new products rather than sales and marketing. The company’s free cash flow margin was among the best in the software sector, averaging 28.3% over the last year.

Cadence’s free cash flow clocked in at $464 million in Q1, equivalent to a 37.3% margin. This result was good as its margin was 17.2 percentage points higher than in the same quarter last year. Its cash profitability was also above its one-year level, and we hope the company can build on this trend.

Over the next year, analysts predict Cadence’s cash conversion will improve. Their consensus estimates imply its free cash flow margin of 28.3% for the last 12 months will increase to 31.6%, it options for capital deployment (investments, share buybacks, etc.).

One of the best ways to mitigate bankruptcy risk is to hold more cash than debt.

Cadence is a profitable, well-capitalized company with $2.78 billion of cash and $2.48 billion of debt on its balance sheet. This $300.5 million net cash position gives it the freedom to borrow money, return capital to shareholders, or invest in growth initiatives. Leverage is not an issue here.

This was an unexciting quarter that seemed to not be good enough to convince the market. Revenue was just in line and EPS beat by a small amount. The stock traded down 1.8% to $280.52 immediately following the results.

Updated: May 16, 2025 at 10:21 PM EDT

When considering an investment in Cadence, investors should account for its valuation and business qualities as well as what’s happened in the latest quarter.

There’s plenty to admire about Cadence. Although its revenue growth was a little slower over the last three years and analysts expect growth to slow over the next 12 months, its admirable gross margin indicates excellent unit economics. Plus, Cadence’s efficient sales strategy allows it to target and onboard new users at scale.

Cadence’s price-to-sales ratio based on the next 12 months is 16.5x. Looking at the software space right now, Cadence trades at a compelling valuation. If you’re a fan of the business and management team, now is a good time to scoop up some shares.

Wall Street analysts have a consensus one-year price target of $320.19 on the company (compared to the current share price of $317).

Want to invest in a High Quality big tech company? We’d point you in the direction of Microsoft and Google, which have durable competitive moats and strong fundamentals, factors that are large determinants of long-term market outperformance.

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