H & Q report on Cadence:
June 14, 1999 - 9:
CREDIT SUISSE FIRST BOSTON CORPORATION
Equity Research
Americas
U.S./Technical Software/Electronic Design Automation
HOLD
LARGE CAP
Cadence Design Systems (CDN, NYSE)
Analyst Meeting Reveals Credible Product Roadmap; Near-Term
Revenue Targets Likely at Risk; Retain Hold
Summary
Positive Developments: 1) Appointment of Alberto Sangiovanni-
Vincentelli as chief technical advisor fills "visionary" gap
; 2) Next-generation place & route development ("Nano Project
") looks credible; 3) Overly-aggressive product price
discounting will not continue.
Incremental Concerns: 1) Management willing to choose
pricing discipline over near-term revenue target achievement,
implying uncertainty about 2Q and 3Q; 2) Will components of
Nano Project roll out in time to stave off startup competition
? 3) Increased employee turnover during past 2 months partly
being checked by additional option grants.
Investment Outlook: Recent stock price rally likely to give
some back due to higher near-term uncertainty. Retain hold
rating.
Price Target Mkt.Value 52-Week
06/11/991 (12mo.) Div. Yield (MM) Price Range
USD 13.81 $15.00 $0 None $3,231.5 $39.00-10.63
Annual Prev. Abs. Rel. EV/ EBITDA/
EPS EPS P/E P/E EBITDA Share
12/00E $1.40 9.9X 35% $0
12/99E $1.15 12.0 50%
12/98A $1.20 11.5 58%
March June Sept. Dec. FY End
2000E Dec.
1999E $0.31 $0.23 $0.26 $0.35
1998A 0.25 0.28 0.30 0.37
ROIC (12/98) NA
Total Debt (12/98) $138mm
Book Value/Share (12/98) $3.13
WACC (12/98) NA
Debt/Total Capital (12/98) NA
Common Shares 234
EP Trend2
Est. 5-Yr. EPS Growth 13%
Est. 5-Yr. Div. Growth NA
1On 0611/99 DJIA closed at 10654.67 and S&P 500 at 1306.60.
2Economic profit trend.
Cadence Design Systems is the leading, broad-line, electronic
design automation (EDA) software and services provider, with
CY98 revenues exceeding $1.2b. Cadence dominates the
physical design market segment, while maintaining a top-three
market share across all product segments. With design
services, Cadence is targeting the broader and larger "
electronics product implementation" opportunity.
Investment Summary
Analyst Meeting Backdrop: Cadence's management held an all-
day analyst meeting last Friday (June 11th). Faced with
increasing questions about the company's technology portfolio
, the well-attended meeting was squarely targeted on
profiling Cadence's technology roadmap. A brief overview of the
format for color:
Introduction and corporate strategy by Ray Bingham (CEO)
Technology roadmap by Shane Robison (President, Design
Productivity Group)
Competitive overview by Jim Hogan (VP, DSM Group)
Technology Q&A panel
Business Q&A (Bingham, Robison, & Bill Porter, CFO)
Product demonstrations
In our recent analysis of Cadence, we have suggested that we
will continue to monitor our stance on the following three,
company-specific issues, while acknowledging that the product
roadmap is the primary concern:
Services execution: Significant margin improvement and more
realistic growth expectations. We would like to see Cadence
continuing to establish a track record of successful
execution with the electronics experts, before getting overly
excited about the electronics "wannabes".
Too much FAM: We believe FAMs (flexible access model deals)
front-load revenue recognition ahead of customer budget
allocations, and have incorporated overly-aggressive product
price discounting.
Exhausted product cycles?: Our primary concern is that
Cadence needs next-generation physical design tools for new
product cycles.
In the interest of focusing on incremental analysis rather
than reporting, we will spare the blow-by-blow details on
identify positive developments vs. issues of concern.
Positive Developments: We were pleasantly surprised by a
number of developments/announcements. While none of these
translate into near-term revenue upside, each is critical for
how Cadence emerges in CY00:
Cadence announced that long-standing board member and
renowned technologist Professor Alberto Sangiovanni-
Vincentelli had been appointed to the additional role of
Chief Technology Advisor. Recall our commentary upon the
appointment of Ray Bingham to CEO just over a month ago .
that Ray is a strong operations executive who would be well
suited as chief executive of a relatively mature and sizable
technology enterprise. We had felt that the challenge, for
Ray, would be in providing/driving the technology vision for
Cadence. In this newly-formed, part-time role Alberto is the
perfect solution. He is very familiar with the company and
the management team. More importantly, we believe Alberto
will be critical in holding together Cadence's technology
experts who are intimately familiar with his work. This is a
good practical move. Alberto was at hand during the course of
the analyst meeting.
In response to recent competitive developments in the IC (
integrated circuit) physical design place & route arena,
Cadence has been talking about the "Nano Project" with some
trade press editors. On Friday, we got some more details
about the Nano Project (will be rolled out in phases through
CY00) and sat through a product concept demonstration.
Before Friday, we were under the cynical impression that the
Nano Project was essentially a "powerpoint presentation" in
response to the startups. In reality, Nano appears to be a
well-conceptualized place & route roadmap technology with
some key near-term deliverables. Separately, we are also
impressed with Cadence's launch of the Affirma Verification
Cockpit (which combines event, cycle, formal, and static
logic verification under an integrated environment). If
there is an EDA sub-segment in need of an integrated "flow"
. logic verification, with its fragmented point tools, is an
obvious candidate. Bottom-line: while there is work to be
done, Cadence is neither asleep at the wheel nor are they
lacking the technology expertise . like the current New
York Knicks, Cadence likes to fall behind in critical games
before staging a comeback (this concession from a diehard Celtics
fan).
Both during formal Q&A and during one-on-one discussion, Ray
Bingham acknowledged that Cadence does "not want to see price
erosion continue". While this does not suggest that Cadence
will wean themselves off FAM (flexible access model) deals,
we believe that executive management has recognized the
extent of overly-aggressive price discounting that has been
taking place in the field (we have had independent reports of
>60% off list price). For an industry that has very little
price elasticity of demand (customers cannot and do not hire
more engineers because the tools are cheaper), we have been
extremely concerned about the overall health of the industry
due to this aggressive pricing behavior. Management has
asserted that all large, end-of-quarter deals will be
carefully scrutinized for discounts. Great news for the health
of the EDA sector.
CREDIT SUISSE FIRST BOSTON CORPORATION
Equity Research
Americas
U.S./Technical Software/Electronic Design Automation
HOLD
LARGE CAP
Cadence Design Systems (CDN, NYSE)
Analyst Meeting Reveals Credible Product Roadmap; Near-Term
Revenue Targets Likely at Risk; Retain Hold
Incremental Concerns: In general, we walked away from the
meeting with a more positive disposition towards Cadence's
prospects for CY00. However, the discussion also raised some
issues of concern:
Uncertain revenue outlook: We believe that the move towards
better pricing discipline benefits the overall industry and
Cadence. When asked to choose between pricing discipline
over near-term revenue target achievement, management was
unequivocal in stating that "getting the business model right
is key". Given the anecdotal data about discounting, it is
difficult to estimate the degree of potential impact. We
could broadly speculate that about $30mm of product revenues (
out of our $132.0mm product estimate) for 2Q could be
vulnerable. The sheer uncertainty comes from having to
predict individual customer behavior: will they continue to
insist of past levels of discounts and refuse to ink a
particular deal, or will they sign a smaller deal at a higher
ASP?
While incrementally impressed by the Nano Project roadmap, we
remain somewhat concerned about the rollout timeframe. As
design flows for 0.18-micron processes get established at
leading-edge user sites, it is unclear whether Cadence may
miss out on part of the 0.18-micron cycle. The problem stems
from the fact that Cadence currently has the leading market
share in place & route (about 50-60%), with every startup (as
well as Synopsys) eyeing a piece of the market. One startup
in particular, Magma Design, was prominently discussed during
the technology Q&A and demo sessions . perhaps suggesting
that Cadence is indeed worried. Magma has had a product in
the works for about two years, by our estimate, whereas the "
core" of the Nano Project has likely been worked on for about a
year.
Management was quite forthcoming in acknowledging that
employee turnover (especially in sales, applications, and
marketing) has accelerated over the past two months. Cadence
is partly addressing this by granting additional options to
key employees. We have no particular beef about the
company's response, although it does imply additional share
dilution through CY00. We would be more concerned about
attrition and the company's ability to retain key employees.
Quickturn Acquisition: With the Quickturn acquisition
recently completed, management indicated that deal with be
about 11-13 cents dilutive for CY99. This is nearly twice as
much as earlier indications of about 7 cents dilution, driven
off more conservative revenue estimation and higher legal
expenses (as the trial with Mentor gets underway). Given
that Cadence announced the Quickturn deal when their stock
was ~$28 and closed the deal with the stock ~$13, we are not
surprised to see some dilution, nor are we surprised by
management's extra-cautious stance. When we have worked
through the historical restatements for Quickturn, we are
likely to build in about 12 cents of dilution in CY99.
Investment Outlook: Cadence's stock has been rallying
recently with more longer-term value-oriented investors
likely establishing positions. With higher uncertainty about
near-term revenue estimates (based on the company's assertion
of better pricing discpline), the stock is likely to
experience some pullback. On the margin we are more
optimistic about Cadence's future, but recognize the
pragmatism of having to work through the uncertainty
associated with near-term revenue estimates. Maintain our hold
investment rating.
Model Note 1: At this point, we are not including Quickturn
in our forward estimates (nor have we restated history).
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