Morgan Stanley Earnings Preview: Cadence Design Systems (CDNS.US) Q3 Results Poised for Steady Growth, Commercialization of AI Design Tools a Key Focus

Morgan Stanley noted in its latest research report published on October 20 that as the complexity of artificial intelligence (AI) chip design continues to increase and the application of AI tools in semiconductor R&D processes gradually expands, electronic design automation (EDA) software giant Cadence Design Systems (CDNS.US) is expected to usher in a new round of growth opportunities. The bank believes that AI-driven design tools and agent workflows will become important growth drivers for the company in the future, and maintains its "Overweight" rating and $400 price target. Based on the closing price of $319.51 on October 16, the target price was about 25% above the stock price at that time. Cadence Design Systems will report its third-quarter 2026 results on October 26. Morgan Stanley expects the company to continue its steady growth momentum since the beginning of the year, but because the market has already formed high expectations for its consecutive earnings beats, simply delivering strong financial results may not be enough to drive a significant increase in the share price. Investors are more focused on whether management can clearly explain how the adoption of AI technology will incremental revenue and profit. Morgan Stanley expects Cadence Design Systems' third-quarter revenue to be approximately $1.612 billion, up about 20% year over year, broadly in line with the company's previous guidance range of $1.595 billion to $1.625 billion and the market consensus estimate of $1.615 billion. Non-GAAP diluted earnings per share are expected to be $2.07, slightly above the market expectation of $2.05 and at the upper end of the company's previous guidance range of $2.01 to $2.07. The bank also expects backlog at the end of the third quarter to increase further to $8.2 billion from a record $8.1 billion in the second quarter. The continuously growing order backlog reflects continued activity in advanced chip design and provides high visibility for future revenue. From a business structure perspective, Morgan Stanley expects all three major business areas of Cadence Design SystemsEDA software, intellectual property (IP) licensing, and system design and analysisto maintain strong performance, with the IP business expected to continue growing faster than the company overall. In the previous quarter, Cadence Design Systems' IP business revenue grew about 40% year over year, becoming an important force driving performance growth. Morgan Stanley believes that continued expansion of demand for advanced-process chip development will continue to drive customers to purchase related design IP, especially against the backdrop of increasingly complex chip architectures and increased custom chip development activity, and the IP business still has strong growth potential. At the same time, major semiconductor manufacturers such as Intel Corporation (INTC.US), Samsung, and Taiwan Semiconductor Manufacturing Co., Ltd. Sponsored ADR (TSM.US) continue to advance advanced-process R&D, which is also expected to support Cadence Design Systems' EDA business. Morgan Stanley expects management to further introduce the company's progress in design technology co-optimization (DTCO) and the application of related technologies in advanced chip manufacturing in the earnings report. However, compared with the steady growth of the traditional EDA business, Morgan Stanley believes that the commercialization prospects of AI design tools are the most noteworthy topic of this earnings report. As AI model developers and large technology companies increase investment in custom chip R&D, the scope and complexity of semiconductor design activities are expanding. This not only increases demand for traditional EDA tools but also creates new market space for AI-driven automated design platforms. Cadence Design Systems has continued to expand its ChipStack product portfolio in recent years, including AI-related design tools such as ViraStack and Aura Stack. According to information previously disclosed by the company, ChipStack has obtained more than 20 customer collaborations or application projects. Morgan Stanley expects management to further introduce customer adoption and practical application progress of related products in this earnings report. The bank believes that the revenue contribution of these new products may become more evident in 2027. As AI tools gradually participate in chip design, verification, and optimization, Cadence Design Systems is expected to explore new commercialization models beyond traditional software licensing. Among them, usage-based charging may become an important direction. Cadence Design Systems previously stated that usage-based pricing models can serve as a supplement to traditional software licensing models. Morgan Stanley believes that as AI agents capable of autonomously performing some design tasks gradually become widespread, this charging method may allow the company to benefit more directly from increases in customer design activity and tool usage. For example, when AI agents can automatically perform more chip design and verification tasks, customers' frequency of using EDA tools and consumption of computing resources may increase accordingly. If Cadence Design Systems can convert this incremental usage demand into revenue, its long-term profitability is expected to be further enhanced. However, Morgan Stanley emphasized that a clearer link still needs to be established between the adoption of AI tools and commercialization revenue. Investors want to know not only how many customers have begun using related products, but also how these tools increase customers' willingness to pay and ultimately how much additional profit they can bring to Cadence Design Systems. It is worth noting that after competitor Synopsys, Inc. (SNPS.US) recently held its investor day, the market is paying more attention to cooperation between EDA companies and large AI model developers. However, Morgan Stanley does not expect Cadence Design Systems to announce a major AI cooperation agreement similar to Synopsys, Inc.'s in this earnings report. The bank believes that Cadence Design Systems is more likely to emphasize that its design tools have been widely adopted by multiple AI model developers rather than highlight a single partner. In terms of financial outlook, Morgan Stanley expects Cadence Design Systems' full-year 2026 revenue to reach $6.324 billion, up about 19.4% year over year; further grow to $7.366 billion in 2027, up about 16.5% year over year; and reach $8.323 billion in 2028. On profitability, the bank expects the company's non-GAAP diluted earnings per share to be $8.35 in 2026, increase to $9.82 in 2027, and further reach $11.43 in 2028. With revenue expansion and improved operating efficiency, the non-GAAP operating margin is expected to rise to 46.1% in 2027 from 44.6% in 2026. Morgan Stanley believes that Cadence Design Systems' long-term competitive advantages come not only from its leading position in analog and mixed-signal chip design, but also from system analysis and simulation capabilities, deep customer relationships, and an expanding portfolio of AI-driven EDA products. On valuation, the bank noted that Cadence Design Systems' current forward price-to-earnings ratio for fiscal 2027 is below its historical average, reflecting market doubts about whether large AI models may replace some traditional EDA functions. However, Morgan Stanley believes that AI is more likely to be a factor driving growth in demand for EDA tools rather than simply replacing existing design software. As AI-assisted chip design gradually becomes widespread, Cadence Design Systems is expected to benefit from this trend through its existing technology and customer base. Based on expected earnings per share of $9.82 in 2027 and a price-to-earnings ratio of about 41x, Morgan Stanley maintains its $400 price target for Cadence Design Systems. In a bull case, if chip design activity and commercialization of AI tools progress faster than expected, the bank believes the share price could reach $600; in a bear case with weak macroeconomic conditions and a significant decline in semiconductor R&D spending, the share price could fall to $200.