Cadence Design Systems Inc (CDNS) — Q3 2016 Earnings Call Transcript

Thank you, Mike, and welcome everyone to our third quarter 2016 earnings conference call. With me today are Lip-Bu Tan, President and CEO, and Geoff Ribar, Senior Vice President and CFO. The webcast of this call can be accessed through our website, cadence.com, and will be archived through December 16, 2016. A copy of today's prepared remarks will also be available on our website at the conclusion of today's call. Next please note that today's discussion will contain forward-looking statements that our actual results may differ materially from those expectations. For information on the factors that could cause a difference in our results, please refer to our filings with the Securities and Exchange Commission. These include Cadence's most recent reports on Form 10-K and Form 10-Q including the company's future filings and the cautionary comments regarding forward-looking statements in the earnings press release issued today. In addition to the financial results prepared in accordance with Generally Accepted Accounting Principles, or GAAP, we will also present certain non-GAAP financial measures today. Cadence management believes that in addition to using GAAP results in evaluating our business, it can also be useful to measure results using certain non-GAAP financial measures. Investors and potential investors are encouraged to review the reconciliation of non-GAAP financial measures with their most direct comparable GAAP financial results, which can be found in the quarterly earnings section of the Investor Relations portion of our website. Additionally, a copy of today's press release dated October 24, 2016 for the quarter ended October 1, 2016 and related financial tables can also be found in the Investor Relations portion of our website. Now, I'll turn the call over to Lip-Bu.

Good afternoon, everyone, and thank you for joining us today. We were pleased by our results for the third quarter, as Cadence continues to execute on our $84 million. Let me start with the environment today. Semiconductor business conditions continue to be mixed with some sectors performing better than others. Favorable trends include cloud and datacenter, automotive, artificial intelligence, and video. While semiconductor consolidation has not had a material impact on our business this year, it may present challenges over the next few years. At the same time, our relentless focus on innovation, execution, and helping our customers succeed is driving our momentum in the marketplace and our opportunity continues to grow with system companies. This leads me to our System Design Enablement or SDE strategy. SDE opens up additional growth opportunities as it takes us beyond a horizontal focus on semiconductors and moves us to a system company focus on end-market products and vertical market segments, thus increasing our customer base. One important SDE trend is the adoption of our market-leading IC packaging solutions for applications in which the IC package is becoming a primary system integration platform. In Q3, we expanded our business with BAE Systems, including system-level integration using our IC packaging solution and with significant adoption of our Innovus and Genus Digital IC design flow for SoC design. We delivered a comprehensive system design solution for TSMC advanced wafer-level Integrated Fan-Out packaging technology known as InFO. TSMC awarded Cadence with a Partner of the Year award for development of this solution. Our System Design and Verification group delivers a holistic verification suite of connected solutions based on strong core engines optimized for total verification throughput, which includes Palladium for emulation, Incisive for simulation, and JasperGold for formal verification. In Q3, Palladium Z1 continued its strong momentum, adding nine new customers. Continuing with the SDE theme, five of the new Palladium customers were system companies, including a major aerospace company. Mobileye adopted the Palladium Z1 for the development of automotive vision technology for ADAS applications. Fujitsu adopted Palladium Z1 for the development of its ARM v8-based Post-K supercomputer, the next-generation flagship supercomputer in Japan. Overall, verification is especially critical in automotive applications, and to that end in Q3, we expanded our business with Infineon in the area of automotive functional safety. Our digital and signoff products continue to gain momentum with the top 20 semiconductor companies. Overall, we had six full digital flow wins in Q3. A global system company is deploying our Innovus implementation solution for advanced node designs. A market-shaping semiconductor company, pleased with the performance of our digital solutions, exercised the growth option in its contract to begin proliferation across its design groups. Tempus, our timing signoff solution, now has nearly 150 customers with rapid growth in mixed-signal timing signoff. The number of 10-nanometer tape-outs with our solutions is growing rapidly. We work closely with TSMC to certify our implementation and signoff tools, and integrated flow for 7-nanometer designs. Next, I will move on to IP, which is a strategic business for us, a key component for our SDE strategy. First, I will discuss our strategy, and then provide highlights for the quarter. During the quarter, we completed our review of our IP business strategy. The result of the review is that we significantly increased our focus on standardized, off-the-shelf IP; certain strategic vertical markets; and most advanced process nodes, while deemphasizing more customized IP. IP remains an important business for us, and the IP market opportunity is strong as the outsourcing trend continues, thus creating opportunities for future growth. We are confident that these refinements will drive sustainable and scalable growth, and we expect our IP business to return to modest sequential growth for Q4. We have some great IP product highlights for Q3. Virtual and augmented reality are exciting new technologies that I'm watching closely. The Tensilica architecture provides unmatched performance and power efficiency for this type of application. I'm thrilled that our Tensilica processors are at the heart of the holographic processing unit in Microsoft's HoloLens AR headset, using 24 Tensilica Xtensa cores. Cadence has worked closely with TSMC to develop some of the first design IP offerings for the 7-nanometer process, offering earlier access to protocols that are optimized for mobile and high-performance computing applications. We have already delivered 7-nanometer DDR IP to a top-tier Asia-Pacific customer. We also introduced a broad portfolio of interface and memory design IP solutions for automotive applications using TSMC's 16-nanometer FinFET Compact process. Cadence delivered the first design IP for MIPI SoundWire Version 1.1 for high-quality audio solutions and demonstrated interoperability with Realtek. So, now, in summary, we are executing on our strategies, and Cadence delivered good operating results for Q3. Interest in the Palladium Z1 remains strong with adoption by nine new customers in Q3. Our digital and sign-off solutions maintained momentum with market-shaping customers. We completed the review of our IP business strategy, and with our new focus, we expect the business to return to modest sequential growth in Q4. Our IC packaging solutions are growing in importance as a key component of System Design Enablement. We won four TSMC Partner of The Year awards for collaboration on both 7-nanometer mobile and high-performance computing design flows; InFO IC packaging solution; and our analog and mixed-signal IP. Now, I will turn the call over to Geoff to review the financial results and provide our outlook.

Thanks, Lip-Bu, and good afternoon, everyone. Execution was good in Q3 with key operating metrics meeting or beating our expectations. Total revenue was $446 million, in line with our expectations. Non-GAAP operating margin was 26%. GAAP net income per share was $0.23, and non-GAAP net income per share was $0.30. Operating cash flow was $84 million, and we repurchased 9.6 million shares of stock for $240 million, over 3% of the shares outstanding at the end of the prior quarter. Also note that the weighted average contract life was 2.5 years. Recurring booking and revenue mix have remained approximately 90% for the past year. DSO was 34 days, down 1 day from Q2. Due to an increase in hardware leases driven by strong hardware sales, DSO has increased by 6 days, and long-term receivable has increased by $13 million compared to Q3 of 2015. Now let's turn to our outlook. There are no changes to our fiscal 2016 outlook for the midpoints of bookings, revenue, operating margin, EPS, or cash flow. We have narrowed the ranges on bookings, revenue, and EPS. We expect bookings in the range of $2.03 billion to $2.07 billion, which equates to 8% growth at the midpoint; revenue in the range of $1.81 billion to $1.82 billion, which would be a 7% growth at the midpoint; non-GAAP operating margin of approximately 26%; GAAP EPS in the range of $0.74 to $0.76; non-GAAP EPS of $1.19 to $1.21; and operating cash flow in the range of $380 million to $420 million. For Q4, we expect revenue in the range of $463 million to $473 million; non-GAAP operating margin of approximately 27%; GAAP EPS in the range of $0.18 to $0.20; and non-GAAP EPS in the range of $0.32 to $0.34; approximately 90% of the revenue is expected to come from beginning backlog. Also note that we are launching a voluntary retirement program in Q4, and we've included the estimated cost of $12 million in our GAAP outlook. You can find guidance for additional items in the CFO Commentary. Now with that, operator, we'll take your questions.

Yeah. Thank you. Good evening. Lip-Bu, let me start with you with a couple of related market questions. You noted in your prepared remarks that you've so far been able to avoid the anticipated adverse effects of semiconductor customer consolidation. Perhaps, remind us why you've been able to avoid that so far? And relatedly, it would seem that EDA, as a percentage of semiconductor R&D, has remained fairly steady. That relationship has held more or less the same. But could you talk about other current or leading indicators that you're relying upon now to forecast or anticipate your business? What else would you be looking at besides semi R&D to gauge the environment?

So, thank you, Jay, for good questions. So, a couple of things. One, first of all, I think, let me touch on a little bit about the environment. So, I think we all know that the semiconductor business is challenging and quite mixed. Some of the statistics show that this year will not have growth for semiconductor overall in the sector. Meanwhile, I think there are some great opportunities in terms of longer term, and I mentioned mobile video related machine learning, deep learning, artificial intelligence automotive and it will significantly increase some of the design opportunities, especially in the system company and also in the IP core area. To get back to your question about consolidation, clearly, I think this year is slower than last year in terms of large consolidation. We are very mindful; we pay a lot of attention to the consolidation activity. We do not expect any material impact on our business in 2016, but the next couple of years are challenging for us to forecast and it's too early to estimate some of the impacts. In terms of how we avoid that, clearly, we're engaging with our customers, collaborate deeply with them to ensure that in whatever new designs, new product developments, we are heavily engaged, especially as they embark on either the 10-nanometer or 7-nanometer new product development. Those are the areas we try to engage steadily with the customers, and that's the best way to avoid some of the impacts of consolidation. Other indications can be viewed legally with our customers. They see our new technology, new development and new product, and they are excited about opportunities like machine learning and deep learning which will have a huge impact in our overall industry across all different verticals in automotive, search engines, and some genomic sequencing developments. We are actively engaging with our customers in R&D development, and we see that they're enthusiastic about our new technology and their need for differentiating solutions.

Alright. Thanks. Let me finish up with just a couple of related product questions. When we look at the industry data over the last number of years, we see a number of product categories each of which you participate in that have had fairly steady growth on a trailing 12-month basis, and in some cases for a couple of years or more. For example, custom layout has been consistently a good category for a number of years, place and route, parts of physical verification have been doing pretty well on a steady basis. On the other hand, analog/mixed signal has been flat to down; RTL simulation, important category, flat to down; and synthesis as well. So, you participate in each of these categories to varying degrees. My question is, what headwinds or impediments would you anticipate for those categories that had been consistently good so far? On the other hand, what possible tailwinds would you anticipate for those categories like AMS and RTL and so forth that have otherwise been lagging for the last couple of years?

Yeah. Very good question. So let me touch on some of the topics that you mentioned earlier about the category of products. We are very focused on customer engagement in new product development, and that’s where our tools come in. Clearly, the complexity of some designs and the opportunities become very clear to us. For example, in machine deep learning, our Tensilica and a lot of customers are very interested in this area. In terms of some of this aggressive either in machine learning or graphics or CPU-related structures, place and route, synthesis, and verification become critical for them in terms of getting to market quicker and addressing complexity in design and layout. They worry about power and signal integrity issues in terms of the end-to-end. Our IC packaging that I highlighted has become very critical, and in terms of security, power and signal integrity are compelling arguments for engagement. Overall, across the board, we are excited about the opportunity, and the customer feedback supports our efforts. Across the portfolio, even the custom analog side, we see continued growth, especially in the mixed-signal side, as we are the de facto standard for the last decade. Many customers are moving into the advanced node space. So, I see continual growth because mixed-signal requirements and automotive concerns are starting to embrace our solutions to meet their low-power envelopes.

Thanks very much.

Thank you.

Yeah. Hi. Thanks for taking my question. Actually I have a few of them. Lip-Bu, just to follow up on the semi R&D impacting the EDA industry down the road, is the voluntary retirement program you announced tied to that where you expect the growth to slow? Along the same path, you've done about, in the last couple of years – this year, you're going to grow about 7%, in the last couple of years between 8% to 10%. On a go-forward basis, what do you think is the right growth rate for the industry? Then I had a few other questions to follow up. Thank you.

Yeah. Good question. You mentioned the R&D impact and the retirement program that Geoff will be able to highlight for you. But clearly, we continue to drive innovation in solutions, performance for our tools, and productivity for customers. For example, Palladium is a very good one that we can drive some of the verification requirements. So, I think all in all, not just helping our customers drive efficiency, we also look at driving efficiency within our own organization to enhance quality and performance.

So, on the voluntary retirement, it is something that we've done from time to time in the past for our employees. It does allow us to, of course, focus on our return to our shareholders. I think it's a win-win solution.

Got you. Got you. All right. And then I had a couple of other quick questions. One is, for Lip-Bu, you guys are gaining traction on the emulation market. Curious to know your view on physical prototyping, would the HAPS business be something of interest to you? It looks like a lot of the customers are beginning to outsource; would that be of interest for your emulation hardware platform or is it too small a market? And then along the same type for Geoff, you guys have done about $240 million a quarter share buyback pretty consistently, that's going to get done by Q4 this current quarter. So, I want to know your thoughts on capital returns when you look into 2017, buybacks, any dividend or plan to take on any more leverage. Thank you.

Yeah. Good question. So, let me address the first question you have about emulation and prototyping. Our Palladium Z1 is the most successful launch for our emulation business. We continue to see a lot of growth with it. We are also doubling down on the prototyping side. We have the Protium series of product family and we're adding our FPGA prototyping scale and capacity.

So, on the buyback, we remain committed to the $1.2 billion repurchase program, which ends in Q4. So far we've repurchased over 45 million shares for $916 million. That's approximately 15% of the shares outstanding when the program began in July of 2015. As always, we look at how our program balances our need for investment in our business, the appropriate level of risk for our business model and operating environment, and opportunities to return cash to shareholders. We regularly review our capital structure along those lines and will continue to do so. At this time, we're not commenting on 2017.

Thanks, guys.

Thank you.

Thanks for taking my question. My question is regarding your revenues, the breakup between semi versus systems. You've noted in the past that about 40% of the revenues for you guys come from systems. I was wondering if you can provide some color on your overall growth. How is the growth for semi versus systems tracking this year? And is one portion of the business growing faster than the other?

Hi, Farhan. So, welcome to the call. Our ratable model means that we don't see large swings in revenue-based metrics from quarter to quarter, period to period. Our system business was strong in Q3, as Lip-Bu pointed out in some of the prepared remarks and is growing nicely, but also our semi businesses are growing. The differential isn't as great as you would expect. We remain approximately 40% of our businesses in systems business, and we'll let you know when that changes materially.

Got it. Thank you. And then one question on your IP. Lip-Bu noted in the prepared comments that Tensilica, the HoloLens was pretty significant. I was wondering if you could provide some color on what's the long-term opportunity of DSP cores and high performance computing or like in visual processing if you guys have done any kind of market sizing related to that, that would be helpful.

Sure. Tensilica, as you know, is a DSP programmable processor engine, very low power. This is really suitable for all kinds of vertical computing. Something that really excites me is the whole machine learning, deep learning, and vision processing related area for ADAS, genomic sequencing and search engines. I think this will open up a lot of opportunity for us. Clearly, not just the hardware itself, but also the software, the algorithm, and the library can play a very important role providing a solution. Overall, we are excited about it, and this Tensilica area is where we are doubling down in investment.

Thank you. That's all I have.

Sure. Thank you.

Hey, guys. Thanks for taking my question. Just two quick ones. So, first on the semiconductor IP, can you talk about when you expect that piece to start showing some growth and maybe some share change that's happening in that segment?

Your question is when? So, I think, clearly, with the refinement of our strategy and our more focus on the standard off-the-shelf IP, some strategic vertical markets for us, and most advanced processes, we believe this is going to return to moderate sequential growth for Q4.

Hey, Mitch, and welcome to the call. So, as we always do, we provide our 2017 outlook when we do our Q4 earnings. So, stay tuned for January-February timeframe.

Got it. And then just one small one on the cash flow. If we were to look out kind of in the, I guess, 2017, is there any reason why you guys can't continue to grow that line? I know it wasn't really uptick for the full year, and just maybe talk about the dynamics there.

Yeah. Stay tuned for our 2017 guidance in January-February. We'll let you know then.

Hi. Thanks for taking my question. First, on the R&D line. Geoff, if we look R&D's percentage of revenue is like 38.4% this quarter. Year-over-year definitely, it used to be 33% to 34% of revenue. So, do you see it normalizing from here or is it a new normal and what factors are leading to such high revenue, especially in 2016?

So, a couple of points. In Q3, revenue stepped down from Q2, which changed the denominator of the equation. We’ve focused from the beginning of this year on investments for our innovative solutions, and I think you're seeing that show up in R&D expense. We'll comment on the future in the future.

Got it. Then if I look at acquisitions, Cadence has historically made more tuck-in smaller acquisitions. Going forward, could you comment on the scale of acquisitions you would be interested in? Is it similar to what we should think about or could it be much larger than previously?

Yeah, Monika, let me address that issue. Clearly, we have been very disciplined in our approach to M&A. The acquisitions have to align with our key strategies. We're looking for products that have differentiating technology and top talent, both managerial and technical. Our executives work as one team, and we hold ourselves accountable for ROI and synergy. With that in mind, either it's a big or small acquisition, we apply the same criteria.

Got it. Thanks. Then just as a follow-up on the IP question. If we look year-to-date IP revenue, year-over-year is down high single digits, 7%, 8%. Is that in line with your expectations? And then, IP is a secular growth market, as you also highlighted. Do you see it going back to the industry growth rate over the next couple of years?

Yeah. As I mentioned, the IP business is very important to us. There's a lot of growth opportunity thanks to the outsourcing trend. Our top customers are interested in outsourcing some of their needs, focusing on standard off-the-shelf IP and advanced node processes. We are very good at meeting customer requirements, and I believe with our refined strategy, the IP business should be on a growth trajectory.

Thank you so much.

Thank you.

Thank you. Lip-Bu, you mentioned the term System Design Enablement several times in your prepared remarks. I understand this is part of your focus on system customers. But is there anything more to that than just a marketing statement? Are there actual products or channels or infrastructure within the company that you're developing incrementally to pursue this System Design Enablement strategy?

Yeah. Very good question, Rich. It's not just a marketing campaign. For the last eight years, we've been focused on execution. System Design Enablement means providing solutions that system companies can optimize for their differentiations, taking the end product into account. We have unique offerings, including tools, IP, PCB, and IC packaging. Customers are looking for a software-hardware co-design approach, and our solution meets their requirement.

Yeah, and I think positive audi feedback has helped our audio business, right? We need that too. We want to provide solutions that meet our customer needs.

Got it. Thank you for that, Lip-Bu. And then, Geoff, I think, this one's for you. You mentioned you're seeing more leasing of emulators. Can you talk about how that will impact your model, revenue and otherwise, if that continues to grow as being a bigger piece of your business?

Yeah. We've had a lot of strength in our hardware business this year. It's been very good, and Z1 has been successful. As you would expect, DSO will go up, and our long-term receivables will increase as we sell more hardware and lease more hardware.

Got it. Okay. Thank you. That's it for me, gentlemen.

Thank you.

Yeah. Thanks, guys. I had a couple of questions. Hopefully, it's not a repeat of the prepared remarks. But Lip-Bu, you were very difficult to hear. I couldn't catch much of what you were saying in the beginning.

Yeah. We're sorry. We understand that we've had audio problems today. Our prepared remarks will be posted on our website after the call.

Great. Thank you. We appreciate it. So just following on what Rich was talking about in terms of functional verification, specifically, I think the functional verification revenue line only grew 7% year-over-year as compared to 40% last quarter, 23% the quarter before that. How much of that was something that was happening in emulation versus the rest of it? Can you give us some more color on what's driving that significant deceleration?

Yeah. We expected a lower revenue than Q2, and functional verification and emulation was a large piece of that. We anticipate a little bit of downturn, and that's what happened in Q3.

What goes into that? Is that lease versus sales? Is it lead times on emulators?

It's the fact that we're taking our business as it occurs. Right? We don't want to change our dynamics or our value calculations in any way. We want to take it when our customers want the product. That came after two record quarters in both Q1 and Q2.

And on the lease idea, can you give us a sense of what portion of that emulation business is leased? Is that recognized ratably when you're leasing the equipment?

Leasing is recognized upfront because it's a lease, but we collect cash over time. That said, leasing remains a small portion of the business.

Okay. And what percentage of that emulation business is leased?

It remains a small portion. We don't break out the details, but it remains a small portion of it.

Got it. And then last question. Since it is a public forum and I know you can't answer directly around Mentor Graphics and some thoughts on acquisition et cetera. I wouldn't expect you to say yes, you're interested in buying the whole company, but wondering if I could ask the question this way. Is Caliber technology today as interesting and complementary to Cadence as it was, say, in 2007?

Yeah, I think Caliber is an important industry player, but we don’t comment on such topics. We respect their products and their leadership in the industry.

Okay. Thank you, guys.

Thank you.

Yes. Good afternoon. One more IP question. Could you quantify how your change in focus affects the served market that you're going after in IP directly?

Yeah. As you know, IP is a newer business for us, and we have grown to 10%-12% of our revenue. It's strategic for our overall SDE strategy. The recent review of our IP business shows we are focusing on standard off-the-shelf IP, pursuing certain vertical markets, and the most advanced nodes, while deemphasizing more customized efforts. That outsourcing trend will further drive our growth.

From a strategic point of view, that makes a lot of sense. But what percentage of your IP business has historically been in the customized part that you're moving away from?

We don't break out that segment of our IP business.

Okay. I was just wondering if you're expecting another leg down in that business and then growth from that point on.

Now, we expect sequential growth moving forward based on our refined strategy and customer engagement.

In terms of geographical performance, Asia ticked up, and we continue to see strong performance there. We anticipate that trend to continue.

Okay. And, I guess, just finally here then, when you look at the end markets, Lip-Bu, you talked a lot about semis not seeing growth this year. But what are you seeing in the key areas like logic and overall design activity with your customers?

Yeah. In terms of growth in the semiconductor and system company area, the cloud data center and IoT are clear opportunities. We see significant design engagement, and the complexity of designs indicate good engagement with our customers around these opportunities.

Great. Thank you for your time.

Thank you.

Hi. Thanks for taking my follow-up. I have two of them. One is, Geoff, you mentioned systems is about 40% of revenues. Can you help us understand how much is auto as a percentage of total revenues or systems? And the second question is, is there any update on the whole ratable accounting issue that you guys have been working on with KPMG and the SEC? It appears that things are looking fine for 2017. Is the ratable revenue model at risk for Cadence or the EDA industry in 2018 and beyond?

We don't break out auto. We stay with systems at 40% but do believe it's growing as a portion. On the revenue recognition, we are still working through details with our advisors to determine implementation and impact. We expect to retain recurring revenue treatment.

Thanks, Geoff.

In closing, we are continuing to innovate and deliver System Design Enablement solutions to our customers. We look forward to continuing to execute our strategies and create value for our shareholders. I want to take this opportunity to thank all our hardworking employees, shareholders, customers, and partners for their continued support that made this possible. Thank you all for joining us this afternoon.