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Cadence: Buyout Rumors Persist

Posted on Wednesday, Dec 26th 2007

I have regularly commented on the EDA industry and discussed specific companies in the past, including Cadence, Mentor, Magma, and Synopsys. Today I come back to look at Cadence again, and examine what has changed since.

During the summer Cadence (CDNS) was rumored to be in buyout discussions with Blackstone and KKR, which I said were preposterous. The only company in the EDA industry that warrants a buyout is Mentor Graphics. Nonetheless, rumors seem to be persisting in the industry, telling of how clueless people are about how buyouts work, and what investors’ motivations are in such deals.

Anyway, Cadence announced Q3 earnings on October 24, 2007 with results posted being better than analysts were expecting. Cadence Q3 revenue totaled $401 million with net income resulting in $97.4 million, versus $81.4 million YoY for the same quarter.

For guidance, Cadence predicted it would meet analysts’ expectations in Q4, and revenue will be in the range of $465 million to $475 million.

Regardless of beating analyst expectations, the market has not been kind to the stock. With a market cap of $4.9 billion and 268.8 million shares outstanding, CDNS closed at $21.69/share prior to announcing earnings on October 24, 2007. The following day the stock was downgraded and closed at $19.32/share. The downgrading was due to a lack of faith in a new licensing model that will affect Cadence’s pipeline. They committed in earnings discussions to keep focused efforts on making sure to have strong technology offerings, keeping a management eye on the product pipeline, which in turn would keep the company successful. Analysts seem to (rightly) disagree with that conclusion.

Two acquisitions have provided Cadence key ammunition in growth segments of the EDA business. Clear Shape and Invarium, both in the DFM segment, bring technologies that would have been difficult to develop internally. I am glad to see the infamous Mike Fister NIH (Not Invented Here) syndrome, a direct import from Intel, has not hindered Cadence in DFM, as it would have been absolutely fatal. [You can read more about DFM here.]

Cadence’s direction is to envelope the client and cover as many areas as possible under umbrella all-you-can-eat contracts. The company is placing a lot of bets on the introduction of a draw-down license, or EDA Card, in which Cadence found its customers buying more software through an umbrella license than through traditional product-specific ordering. Started two years ago, this approach has continued to grow revenues significantly, they claim.

The hope is to capitalize on what Cadence dubs “spontaneous demand,” and have the flexibility to meet the variety of needs as they occur at the moment they occur, and Cadence believes the company can generate more sales as a result.

The fallacy in the argument is that Cadence continues to sell its future short. These multi-year all-you-can-eat contracts, while introducing predictability into revenue streams, also take the punch out of technology breakthroughs, disruptive innovations, and associated upsides. The sales force, now incentivized with a commission structure to sell more of the very large all-you-can-eat deals, no longer pay any attention to point products. Yet, the irony of EDA is that any disruption, should it happen, would happen in the point products.

It is not an easy equation to balance – between umbrella deals and point products – since each have their pluses. However, the industry, as a whole, is still spinning in place, and nothing important has happened since I first wrote my piece Future of EDA pointing out the dysfunctions.

Meanwhile, the rumor of a buyout is back, with a share price considerably cheaper at $17/share than the $23/share price of the summer. I still maintain, there is no upside in Cadence for a Private Equity firm, and not much for any investor, unless Cadence makes some very drastic steps to re-engineer the industry. That would mean mergers like ARM or KLA Tencor, which would consolidate adjacencies of a significantly different scale. Should such deals be in the realm of possibilities, then a private equity buy-out may be a very interesting proposition.

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Tech companies in general are not good buyout candidates. They are conservatively financed with little debt on the books, so there is definitely room to lever up the company. Their maintenance revenues provide the necessary funds to service debt. But, the problem is that LBO firms don’t like to invest in R&D. Once you run the company in this lean mode without any R&D spending for a couple of years, you have a dog on your hands with outdated technology when the rest of the market will have moved on with competitors continuing their rapid pace of innovation. So short-term prospects definitely look attractive with the opportunity for creating value through financial engineering, but the long-term prospects become bleak when you disrupt the innovation engine.

Sudarshan Dharmapuri Wednesday, December 26, 2007 at 12:52 PM PT

I think some tech companies are GREAT buy-out candidates. Especially certain turnarounds, as we have seen this year and in the past (Palm, 3Com, Seagate).

You will see in my Mentor Graphics piece later in the week, that companies that can be chopped off also often make good buy-out candidates.

Sramana Mitra Wednesday, December 26, 2007 at 1:40 PM PT

[…] In our EDA review, Synopsys (Nasdaq: SNPS) is the second major player, always going neck-to-neck with Cadence. […]

Synopsys Looks Healthy, But - Sramana Mitra on Strategy Thursday, December 27, 2007 at 3:41 AM PT

[…] third company in the EDA review is Mentor Graphics (MENT). As I said in the Cadence piece, if any company in the EDA industry is perfect for an LBO, it is Mentor Graphics. It has at least […]

Mentor Graphics: LBO Recommended - Sramana Mitra on Strategy Friday, December 28, 2007 at 3:30 AM PT

I worked in the EDA industry for 15 years. It is a relatively fixed market driven by the number of EEs in the world and the number of designs being started at any given time. As you’ve noted in your Cadence article, big EDA companies don’t pay much attention to developing innovative and disruptive point tools. They let startups do that heavy lifting and then acquire them pre- or post-IPO and glue the tools together into platforms, some better integrated than others depending upon the level of customer involvement.

The only way an LBO of a large commercial EDA vendor makes any sense is to roll it up with a state of the art fab, equipment company, and embedded software company to create a powerhouse semiconductor player to challenge Intel and other SOC leaders. In effect, this would be making the EDA vendor captive and signal a return to the days of proprietary tool design. My guess is that it might cause an implosion of the remainder of the commercial EDA industry due to lack of faith in those participants to move the technology boundaries forward in service of Moore’s Law. Someday, we may end up with a very polarized chip industry–those that build complex, multi-core SOCs and those that build programmable logic devices. Everything in between, including commercial tools, may fall away.

Scott Seiden Friday, December 28, 2007 at 5:59 PM PT

[…] is playing in, and the resultant “deal practices”, please read my prior EDA series: “Cadence: Buyout Rumors Persist”, “Synopsys Looks Healthy, But”, “Mentor Graphics: LBO Recommended”, and […]

Cadence Crashes. Now What? - Sramana Mitra on Strategy Friday, February 8, 2008 at 11:04 AM PT

Nice set of EDA related articles-very insightful.

david healy Tuesday, February 19, 2008 at 7:36 PM PT