Fitch Ratings has affirmed Cadence Design Systems, Inc.'s Long-Term Issuer Default Rating (IDR) at 'A-'.

The Rating Outlook is Stable. Fitch's actions affect $1.05 billion of total debt, including the $700 million revolving credit facility (RCF, $550 million available as of 3Q FY22). The $300 million term loan is not being rated.

The ratings and Outlook reflect Fitch's expectations for solid operating performance and significant financial flexibility. Fitch expects Cadence will maintain conservative financial policies and that credit protection measures will remain strong for the rating, with EBITDA leverage below 1x. At the end of 3Q22, Cadence had $1 billion of readily available cash and cash equivalents on its balance sheet. The company expects to use approximately 50% of its FCF for share repurchase. Fitch assumes Cadence would slow or suspend share repurchases for large acquisitions.

Key Rating Drivers

Increasing Focus on Intelligent System Design: Cadence is leveraging its leadership in the EDA and IP businesses to expand into more sophisticated Intelligent System Design that integrate hardware, software, and AI that are grounded in computational engineering. Such offerings effectively extend Cadence's position in the value chain from semiconductor component designs to system designs deepening integration into customers' design process. Fitch believes the system focus would expand Cadence's addressable market and increase entry barriers and switching cost.

Strong Leadership in the EDA Industry: The EDA industry is characterized by high entry barriers as both the depth and breadth of technologies require high level of R&D investments over extended period of time. Cadence has maintained cash R&D to revenue ratios of near 35% (GAAP near 40%) in recent years. The level of R&D investments has been higher than Synopsys, Inc., the largest competitor, at approximately 33% (GAAP). The investments have enabled Cadence to maintain a leading position in Analog segment, and a top-three player in Verification, PCB & Packaging, and Digital & Signoff.

Extending Analog Strengths into Digital: Cadence has traditionally been a strong player in analog products, with an estimated market share near 60% within the sector, followed by Synopsys. Cadence has historically lagged behind Synopsys in the digital segment market share. In recent quarters, Cadence has closed the gap with Synopsys with approximately one-third share each. Given the high entry barriers, Fitch expects the EDA industry to be dominated by the two major players, Cadence and Synopsys, accounting for the majority of the market followed by Siemens EDA as a distant third.

Resiliency Through Industry Cycles: Cadence's semiconductor products are primarily utilized in the front-end design process that is relatively insulated from normal industry cyclicality. While the industry faces occasional supply/demand imbalance that affects semiconductor manufacturers, the front-end design activities are less sensitive to cyclical end-market demand fluctuations and manufacturing activities given the long design cycle. Fitch assumes moderated growth for Cadence in periods of semiconductor down-cycle as its customers could become more sensitive to costs.

Diversifying Outside of Semiconductor: Leveraging its strong computational simulation capabilities, Cadence has been extending into new industry verticals through acquisitions. During 2021-2022, Cadence acquired Pointwise, NUMECA, and Future Facilities. These companies collectively specialize in computational fluid dynamics (CFD) with applications in aerospace, electronics cooling, and energy performance optimization. In 2022, Cadence also acquired OpenEye Scientific Software that specializes in molecular modelling and simulation with applications in life sciences. The newly acquired technologies provide foundation for future growth opportunities while leveraging Cadence's core technical capabilities.

High Level of Recurring Revenue: In recent years, Cadence has transitioned its revenue structure to a primarily subscription-based model. This model provides a high level of revenue visibility as approximately 85%-90% of total revenue is backed by contracts with well over 95% renewal rate. Fitch views the high level of revenue predictability favorably.

Highly Diversified End-Product Exposure: While Cadence's direct customers are focused around electronics and semiconductor systems companies, it is well diversified across all electronics end-products as EDA systems are utilized for all complex electronics system design and manufacturing. Fitch believes the aggregate demand from emerging applications, including AI, data analytics, cloud, automotive and IoT, could provide further tailwinds for continuing growth for the EDA industry, despite the fragmented nature of the individual subsectors.

Strong Cash Flow Generation: Cadence's EBITDA and FCF margins are consistent for software companies in the rating category. Between 2013 and 2021, the company generated EBITDA margins of 26%-39% and FCF margins of 17.5%-34%. Fitch estimates Cadence's FCF margin remaining above 30% to generate FCF in excess of $1 billion through our forecast period. Fitch expects Cadence's FCF to increase gradually, in-line with revenue growth.

M&A and Share Repurchases: Fitch expects Cadence to be opportunistic with acquisitions primarily targeting complementary IP that enhances the company's technology capabilities. In the absence of attractive acquisition targets, Fitch expects Cadence to return excess cash to shareholders through share buybacks. As of Oct. 1, 2022, $1.4 billion of share repurchases remain under current authorization approved by the board and increased in August 2022. Fitch expects shareholder return to remain a continuing theme in the near term.

Derivation Summary

The ratings and Outlook reflect Fitch's expectations for solid operating performance. Fitch anticipates low-teens growth over the intermediate term in a normal industry environment, driven in part by new product introductions (NPI), including new areas in Intelligent System Design that build on Cadence's core EDA and IP products. Fitch expects these capabilities to position Cadence for new applications in emerging technologies. System design enablement, digital and signoff, as well as design IP businesses should continue growing, driven by increasing design complexity and shortened NPI cycles. Fitch expects applications in aerospace and life sciences to have minimal contribution to Cadence's operating profile in the near term.

Fitch views Microsoft Corporation (AAA/Stable), Constellation Software (BBB+/Stable) and Broadcom Inc. (BBB-/Stable) as close peers to Cadence. Microsoft is a large-scale technology company. It is well positioned in the rapidly growing cloud segment with its Azure platform and cloud-based applications. Microsoft is significantly larger than Cadence in terms of scale and margins, but it operates with slightly higher leverage. Similar to Cadence, Broadcom addresses the technology product development environment across a wide range of industry verticals through its acquisition of CA, Inc. Broadcom has greater scale and margins than Cadence but maintains a lower rating due to its higher leverage and appetite for acquisitions. Constellation Software is also comparable in revenue scale to Cadence with FCF margin in the mid-teens. Cadence compares well against these two software peers in the 'BBB' rating category. Fitch also views Synopsys as a close peer with similar business profile and market exposure, with Cadence relatively stronger in analog systems and Synopsys stronger in digital systems. Synopsys's LTM EBITDA and FCF margins are slightly below those of Cadence.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Revenue growth in 2023 weakens to high-single digits due to semiconductor industry headwinds followed by normalized growth rates in high-single digits to low-teens through our forecast period;

Stable operating EBITDA margins of approximately 40%;

$1.5 billion in aggregate acquisitions for 2023-2025; deals would likely bring only minimal revenue (more IP based);

$600 million-$700 million in annual share repurchases for 2023-2025 as cash accumulates;

$150 million outstanding RCF fully repaid in 2023;

$350 million unsecured notes due in 2024 is fully refinanced;

$300 million unsecured term loan due in 2025 fully repaid at or before maturity.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Well balanced exposure to at least three business lines or markets with different sensitivity to the economic cycle;

Sufficient capacity and financial flexibility to execute M&A strategy and capital allocation priorities enabling the company to pursue large acquisitions to continuously upgrade technology capabilities and maintain competitiveness without significant degradation to credit metrics.

In addition to the above, Cadence would need to provide a publicly articulated financial framework or a demonstrated record of maintaining a consistent credit profile, yielding increased confidence in EBITDA leverage sustaining under 1x combined with operating performance that is in line with Fitch's current expectations.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Structurally lower revenue from material share losses resulting in Fitch's expectations for sustained FCF below $500 million;

Lower base line operating profitability from increasing price competition or a shifting product mix resulting in Fitch's expectations for sustained EBITDA leverage above 1.5x.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Strong Liquidity Position and Financial Flexibility: Cadence's financial flexibility and liquidity position are solid considering its ability to generate consistent levels of FCF of over $1 billion annually. Fitch expects Cadence to generate more than $750 million of FCF through the semiconductor cycle. The company's liquidity position is further supported by its $1 billion of readily available cash and cash equivalents and $700 billion of RCF of which $550 million was available at 3Q22. Fitch expects the RCF to be fully repaid during 2023.

Manageable Maturity Profile: Cadence's maturity schedule is manageable and Fitch believes the company has sufficient financial flexibility through expected FCF generation, cash on balance sheet, and access to the capital markets to address maturities. The next scheduled maturity is in 2024, when the senior unsecured notes are due. Cadence generates sufficient FCF to service its debt maturity while continuing its share repurchase program.

Debt Structure:

$700 million ($150 million outstanding) senior unsecured revolving credit facility due January 2026;

$350 million senior unsecured notes due 2024;

$300 million senior unsecured term loan due 2025.

Issuer Profile

Cadence Design Systems, Inc. (CDNS) is a provider of mission critical system design enablement (SDE) software, hardware, and IP solutions for the semiconductor industry and electronic systems business. Its SDE provides the technologies necessary for its customers to develop a complete and functional electronic product.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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