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Stock Strategist

A Little-Known Technology Firm with Big Upside

We think this software firm offers a 25%-plus return.

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Following is a sampling of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

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Cadence Design Systems
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.68 | Three-Year Expected Annual Return*: 25.4%

What It Does:  Cadence Design Systems (CDNS) is the largest developer of electronic design automation (EDA) software in terms of market share. EDA software is used by semiconductor companies to design and verify chips. Cadence is by far the leader in analog design and it has recently diversified into digital and mixed-signal design.

What Gives It an Edge: Morningstar analyst Amol Shelat credits Cadence with a narrow economic moat, as its existing customers are effectively locked in by the high cost of switching to a competitor's suite of products. According to Shelat, Cadence's EDA software is integral to the design process of its semiconductor customers, so these firms mostly avoid changing suppliers for fear of a costly disruption to their operations. Also, Cadence's platform is an industry standard, and comparable substitutes may not exist. As chip designers continue their march toward miniaturization and more complex instruments, Shelat believes Cadence's software will play an even more central role to the success of the semiconductor industry.

What the Risks Are: Cadence is taking steps to change its business model through the introduction of EDA cards, which allow customers to buy software platforms and tools as they need them. Consequently, customers are shying away from long-term "subscription" contracts in favor of more short-run "term" contracts. Over the years, its share of revenue coming from backlog has decreased to 60% from 75% in this last quarter. We expect this to fall further to 50%, thereby increasing revenue volatility.

What the Market Is Missing: Shelat blames a recent string of negative earnings surprises for the weakness in Cadence's stock price. These results probably looked even worse to investors after its next major competitor, Synopsys (SNPS), painted a rosy picture for its coming year. While the market has become skittish about Cadence's future prospects, Shelat believes the astute investor can profit by digging deeper into the firm's reported numbers. According to Shelat, Cadence has recently transitioned to a new contract strategy that makes its stated earnings more volatile, but benefits customers with more flexibility in setting and forecasting their own EDA spending. As a result of the change, Cadence now books and bills a much greater portion of its revenues in the same quarter compared with Synopsys, which relies more heavily on backlogs. While this has worked against Cadence in the short run as recent macroeconomic weakness has caused semiconductor firms to delay their spending on R&D and EDA software, Shelat does not believe that the fundamental economics of the firm or industry have changed. Rather, Cadence is simply more susceptible to the current economic climate than its competitors, and when industry R&D spending bounces back, the firm is just as likely to post above-industry revenues. While Cadence is expected to suffer from a general economic slowdown, Shelat urges investors to stay focused on the firm's bright long-run prospects and pick up shares cheaply before industry spending rebounds.

One More New 5-Star Stock
Murphy Oil Corporation (MUR)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, May 30, 2008.

Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.