Cadence Design Systems Inc (CDNS) — Q1 2017 Earnings Call Transcript

Thank you, Mike, and welcome, everyone, to our first quarter 2017 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 June 16, 2017. A copy of today's prepared remarks will also be available on our website at the conclusion of today's call. Before I start, I want to call your attention to our CFO Commentary, which was included in our 8-K filing today and is available on our Investor Relations website at cadence.com. The commentary should be referenced with both today's conference call remarks and the earnings press release issued today. Please note that today's discussion will contain forward-looking statements and 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 April 24, 2017 for the quarter ended April 1, 2017 and related financial tables can also be found in the Investor Relations portion of our website. And now I'll turn the call over to Lip-Bu.

Good afternoon, everyone, and thank you for joining us today. We are pleased with our first quarter results. Consistent execution drove solid operating results, and it was a great quarter for innovation with several new product introductions. I will address the environment and strategy before turning to the first quarter customer and product highlights. Starting with the environment, semiconductor business conditions appear to have stabilized with expectations of low-single-digit growth for 2017. However, expected improvements are sector-specific, and macro uncertainty remains. We have successfully managed through some customer consolidation and expect just a minimal impact on revenue in 2017. Turning next to strategy, we are steadily executing our System Design Enablement or SDE strategy. SDE offers additional growth opportunities as we expand beyond semiconductors and tap into a significantly larger market with system companies and new vertical market segments. Cadence is pursuing opportunities in higher growth areas, including automotive, cloud infrastructure, machine learning, and aerospace and defense. In Q1, we expanded our engagement with Renesas for the design of their industry-leading ADAS, autonomous driving, and IoT semiconductor solutions using Innovus, Virtuoso Advanced-Node, and the Cadence verification suite. Let me now turn to some of our product highlights and customer successes for the first quarter. Innovation is the engine of our success, and we have introduced more than 20 significant internally-developed products in the last three years. In Q1, we launched Xcelium, the industry's first parallel simulator for production use, and the Protium S1 FPGA-Based Prototyping Platform for early software development. Xcelium and Protium S1 joined JasperGold for formal verification and Palladium Z1 for emulation as the four core connected engines of our verification suite. Xcelium incorporates innovative multi-core parallel computing technology from last year's acquisition of Rocketick, and it has been deployed at several customers across multiple domains, including ARM and STMicroelectronics. Protium S1, with its new architecture, increases scalability and speed and reduces design bring-up time due to a common compiler with the Palladium Z1. A number of new customers have purchased the Protium S1, including Xilinx and Mellanox Technologies. After a successful 2016, the Palladium Z1 continues to do well with seven new customers, six of them being system companies, and an additional seven customers making repeat orders. We also introduced a new product within digital and sign-off in early April called Pegasus. The Pegasus Verification System is massively parallel, cloud-ready, physical verification sign-off solution that can deliver up to 10x improved performance across hundreds of CPUs. Early adopters include Texas Instruments and Microsemi. Our focus on innovation and market-shaping customers is paying off as place and route revenue was up over 20% with the top 20 semiconductor companies year-over-year. Also, our integration of our leading custom-analog and new digital products provides customers with the best solution for their mixed-signal designs. Several top-tier customers are now using the full Cadence mixed-signal flow from IP block characterizations through implementation to full chip verification. Next, I would like to talk about our IP business, which is a key component of our SDE strategy. The IP market opportunity is strong as the outsourcing trend keeps growing. We see the result of our strategic refinement of our IP business with strong year-over-year revenue growth. We booked our largest design IP contract ever with a major customer in the automotive semiconductor sector. Also, a major Asian semiconductor company is using Tensilica Vision P5 processor to improve image quality in its mobile products. Looking to the future, I am most excited about the opportunity for our Tensilica processors in artificial intelligence, automotive, and vision applications. Before turning it over to Geoff, let me quickly summarize my comments. Consistent execution drove solid financial results for Q1. System Design Enablement is expanding our opportunity beyond EDA and extending our customer reach. Innovation is the engine of our success. And so far this year, we have introduced three significant new products. Our digital and sign-off tools are proliferating for advanced-node design with market-shaping customers. Our refined IP strategy set us up to drive scalable, profitable growth, as evidenced by Q1 results. Now I will turn the call over to Geoff to review financial results and provide our outlook.

Thanks, Lip-Bu, and good afternoon, everyone. Consistent execution led to strong operating results for Q1. Key results for the quarter were total revenue was $477 million; non-GAAP operating margin was 26%; GAAP net income per share was $0.25; non-GAAP net income per share was $0.32; and operating cash flow was $92 million. Also note that the recurring revenue mix was approximately 90%, but Cadence did not repurchase any stock in the first quarter. DSOs were 37 days, up 4 days from Q4 due to the delays in collecting several large payments. Most of these payments have already been collected in Q2. We now expect DSO to be approximately 35 days for 2017. Service revenue was down $11 million year-over-year. Service revenue that is recognized on a completed contract basis can lead to variability from quarter to quarter. Service revenue was down year-over-year, primarily because in Q1 of 2016 we recognized a large amount on a completed contract. Tensilica had a strong revenue quarter and a one-time benefit to royalties. The one-time benefit was a result of beginning to recognize royalties on a current-quarter basis. Excluding this one-time benefit, our IP business still had strong growth. Now let's turn to outlook. There is no change in our outlook for the year for revenue, non-GAAP operating margin, non-GAAP EPS, and operating cash flow. For fiscal 2017, we expect revenue in the range of $1.9 billion to $1.95 billion, which would be a 6% growth at the midpoint; non-GAAP operating margin of approximately 27%; GAAP EPS in the range of $0.93 to $1.03; non-GAAP EPS of $1.32 to $1.42; and operating cash flow in the range of $430 million to $470 million. And for Q2, we expect revenue in the range of $470 million to $480 million; non-GAAP operating margin of approximately 26%; GAAP EPS in the range of $0.20 to $0.22; and non-GAAP EPS in the range of $0.31 to $0.33. Approximately 90% of revenue is expected to come from beginning backlog. You will find guidance for additional items in the CFO Commentary. I also want to provide a few additional comments before we take questions. As a reminder, hardware and IP have become a larger portion of our business, which may lead to more variability in results from quarter to quarter. Only about 5% of our revenue is in currencies other than the U.S. dollar, primarily the Japanese yen, but about 30% of our costs are in currencies other than the dollar. So a weakening dollar would generally be a headwind to operating profits, and conversely, a strengthening dollar would be a tailwind. The dollar has weakened since the beginning of the year, and we are taking steps to manage our costs accordingly. As you know, we've been reviewing the new revenue accounting standard that we will implement for 2018, and we are confident that we will substantially maintain recurring revenue treatment. Now in closing, we had a strong first quarter, delivering both financial results that met or exceeded our expectations and introducing new innovative products. Looking to the future, I like the opportunities created by our SDE strategy, innovative new products, and trends such as autonomous driving, cloud infrastructure, industrial IoT, and machine learning, just to name a few. So with that, operator, we'll now take questions.

Hey, guys. Thanks for taking my question. Overall a good quarter. I just had one question starting on kind of the digital side. It looks like that's seeing some lumpiness. It's up double digits last quarter and now it's kind of up singles. And on conversely as well, the IP business, it looks like it's now growing at double digits again. So could you maybe walk me through how we should expect that to shape out for the rest of the year in both of these segments?

Yes. So on the digital side, Mitch, the actual revenue growth was close to 6% compared to Q1 of 2016. You're right, the apparent growth was lower than recent results. This was because in Q1 of 2016, it included a large completed service contract, which was included in our digital and sign-off product line. But we're seeing a lot of success in our digital and sign-off products proliferating with market-shaping customers, and new customers are adopting these products. We expect good growth for 2017.

Got it. Yeah. And then secondly on the IP side, seeing that growing at double-digits apparently, do you expect that to continue in 2017?

Yes. We did have a one-time benefit from our IP business as we started recognizing royalties on a current quarter basis. But excluding that one-time benefit, our IP business still had strong growth in the mid-teens in Q1 over Q1.

Okay. Got it. Thank you very much.

Great.

Thank you. Good evening. Lip-Bu, let me start with you and ask about opportunities you may have for incremental revenue and share in a number of respects. First of all, let's ask about geography. When we look at 2016 EDA industry results, there was a very substantial increase in China. We know how much of that was due to Mentor from the numbers in their 10-K, but that still left well over $200 million in revenues from China for everybody else. So perhaps you could talk about how you're doing there and what share progress you're making in China. Secondly, you highlighted a number of new products including Pegasus and Protium. Could you talk about how you think about the share opportunity with Pegasus? It's an enormous category that you're addressing, but by the same token, it's historically proven to be very, very sticky for incumbent products. And then lastly on new products line, with respect to Protium, your revenues in FPGA prototyping to date have been immaterial relative to what Synopsys is doing there, for example, with their HAPS products. So, again, similarly maybe you could talk about how you're thinking about the revenue or the share opportunity in that hardware category, then a couple for Geoff. Thanks.

Yeah, Chris, thank you so much for the question. So a couple of things. One, I think you mentioned about the geographical. Clearly, China is a great opportunity. We are well-positioned in China and we are very confident to continue to drive success and growth not only on the tool side but also the IP side. And China, as you know, the government is very committed to build up their domestic semiconductor industry with heavy investment. And we've done well in China. So we're going to continue. It's going to be a growth opportunity for us in China. And then regarding the new products, so a couple of things that you highlight. Thank you for bringing it up. Pegasus, and this is very important for us to complete our digital and sign-off flow. And as you will recall, we are building up quite a lot of the digital success with Innovus. I mentioned about 20% growth with a top 20 customer. And then we have Genus on the synthesis side, and we have Sign-off on Tempus and Voltus on Power. And then now, this physical verification has become the missing piece, we are delighted to completely build up this product, massively parallel and cloud-ready and can scale up to 1,000 CPUs, and then drive 10x in terms of turnaround time. This is very, very significant. We are delighted a couple of customers already support us, and we mentioned that in our script. And so this should be as exciting so that we have a complete full flow opportunity for our customer to drive from the Innovus and the place and route, all the way to physical verification. And, of course, working closely with our foundry partners is critical for the success. And then the other two new products we also have a successful launch, and that is on the verification part of our business. And then clearly, it's very exciting for us to complete our whole verification suite. As you'll recall, we have the JasperGold, which is a very strong position in the formal verification. We have hardware, Z1 which has been very strong for emulation. And what we like to do is basically to really complete that with the FPGA prototyping. And this is something that can scale up to 600 million gates. And then using the same compiler as the Z1 hardware emulation, so the customer can really go from prototyping all the way to massive scaling in terms of emulation. And then the other part is in our simulation tool with the acquisition of Rocketick. They provide very, very strong parallel simulator, and that engine can be very fully integrated with what we call Xcelium. This is a first production-ready parallel simulator, very well-received with the customer. And we're delighted so that we can complete the whole verification suite to provide to our customer. On the Protium FPGA side, we have Xilinx and Mellanox with us and plus a few others. So it's in a very early state, but people are really excited about it. We are very positive about that.

You highlighted a number of end markets that you're focusing on like auto, aero, and defense and so forth. Could you again remind us how you're organizing yourselves to address those markets in terms of teams or sales or anything out that kind? And then one of the persistent issues for you and for EDA historically has always been, particularly when you've had active new product periods, is having sufficient AE capacity. And maybe you could address that issue, how you're doing there, and having the requisite support in AEs and so forth that you think you're going to need, given the multiple new product ramps that you now have to manage?

Yeah. Thank you so much for the question. This is very much related to our strategy of System Design Enablement. And this is really providing not just the core EDA strength of our increased adoption and not only the IP strategy for scalable growth, but more importantly right now, we are moving into some of the emerging new growth areas. We've highlighted a couple of them. This is automotive, the massive data center, and then the machine learning-related, and then applied into some of this vertical market that we are going after. Thank you for bringing it up. We have been very, very focused on the aerospace and defense. Over the last few quarters, we have highlighted Northrop Grumman, BAE Systems, and also GE Aviation that we are very deeply engaged with them. And then same thing with automotive, and we've mentioned Mobileye using our Palladium Z1 for automotive vision and also Infineon for automotive function safety. Stay tuned, we do right now have a dedicated team to focus on automotive and a dedicated team to focus on aviation and defense. So some of these verticals, besides providing the tool, the IP, the emulation, but more importantly, we're going to learn what their new requirements are, and then we're going to be starting to pick up the area that we need to either organically grow or through acquisition to provide the total solution to our customer in the system and then somewhat the vertical market that we are pursuing.

All right. But again, just to pick on this point. You're saying in effect that field support, AEs, all that sort of thing that historically has been a constraint for EDA when ramping new products is not an issue for you right now or a manageable one?

Yeah. So what we did is basically continue the AE support. It's very important for someone's success. But we relocate and then we rearrange and then recruit some talent on the AE side for some of defense, aerospace, and automotive, and then continue to drive efficiency. So in some way we are driving the efficiency of the AE support to our current customers and put more resources in some of these vertical markets and to support their success.

Yeah, hi. Thanks for taking my question. I had a few of them. First one, Geoff, just wanted to find out why no buybacks this quarter? Like you guys have been doing it at a very consistent pace for the last three years. So I'm kind of surprised why there was no buyback. And is there any reasoning behind it?

Yeah. So when we announced the program in the Q1 or the Q4 earnings call in February timeframe, we said we're going to be more flexible with this most recent authorization. We're sticking to that. Don't take any other messages besides we're being more flexible.

Got you. So it's not like you are constrained by certain events or something. It's just more your own choice?

We're just going to be more flexible moving forward.

Got you. All right. And then a follow-up on the ASC 606 rev rec, so you guys are still confident that you can maintain the 90% ratable revenue that you have. I'm kind of curious, A, is that still the case? And if there is a risk of that ratable revenue going away, how much of the 90% do you think would be at risk?

Yes. So we are going to implement a new standard, as you know, ASC 606 in 2018. We are confident that we will substantially maintain recurring revenue treatment for the language or in a language of the new standard revenue over time treatment. We're not committing to a particular percentage right now.

Got you. But a significant portion of the 90% can be...

Or substantially maintain, I think, is the keyword, substantially maintain.

Just to add on to what Geoff is talking about, clearly we have this refinement of the IP business to drive profitability and scalability. And we are very much on track of that, and then so double-digit growth. And then the outsourcing trend continues. And that creates opportunity for us. And then clearly we are focused on standardized, off-the-shelf IP, strategic vertical market, and most advanced process node and top customers. So we really drive quality revenue with the top customers. That is our focus.

Thanks for taking my question. My first question, Lip-Bu, is like if I look at your growth and your year-over-year growth the last few years, every year it has been decelerating. And it's now at about 6% this year. I just wanted to understand how do you think about the long-term growth of the business? Is it more like a 5% growth business over the next few years? And what is really needed to make it more like a 10% growth?

Okay. Good question, Farhan. A couple of points. First of all, we are confident with our strategy and direction of the business and the future opportunity. We are pleased with the revenue growth for this year, 6%, with the order mix environment that we are operating in. I think a couple of things that are good drivers for us. Our core EDA software is doing well, growing with all the new products we came out with. Our IPs rebound to 10% growth rate. The hardware continues to be a good year this year for us. So I think overall, we are pleased with what we see in the marketplace, and that's why we guided 6%. And in terms of the trend going down, clearly, we are mission-critical solutions to our customers. I think we continue to drive value and be very disciplined in what we provide to our customers. I strongly believe collaborating deeply with the customer, delivering innovative products to meet their challenges in design. And then the other part, I think they are going to help us to grow the business in terms of revenue growth will be the system design enablement. And that's where we are moving into some of the vertical areas and then the vertical market. Addressing some of the higher growth opportunities in automotive, data center, and then the aerospace and defense-related area. Again, the chip design is getting more and more complex. We are very mission-critical, and the design and verification are getting a lot more complex. We can drive a lot more value. That's why we want to be disciplined and drive value, and that is our motto going forward.

Got it. One question I have for you is regarding the buyback. You mentioned wanting to maintain flexibility. Should I interpret that as you looking at some mergers and acquisitions? Also, is there a MIPS asset that's currently for sale that you might be interested in?

Yes. We do not want to engage in speculation, but we maintain a very disciplined approach to mergers and acquisitions. We are not focused on acquiring revenue. It is crucial for us to refine and advance our strategy, emphasizing the development of innovative products that attract customers. Additionally, we aim to hire top talent, whether in management or technical roles. We are strict about our return on investment. Thus far, our focus has been on internally developing and innovating products, as demonstrated by the introduction of 20 new products over the last three years. In the first quarter, we launched three new products and will continue this trend. We will only consider mergers and acquisitions if they provide value and align with our strategic objectives.

Got it. And then one question on China. Can you talk about software piracy in China? Have you seen any effect of software piracy within semiconductor or in the systems design?

Yes. So I think clearly piracy, not just in China, but across the world, is happening. We are very focused on getting the value and protecting our IP. So that makes sure that our tools and IP, our customers properly pay for it and then for the full value. That's something we believe in and we are very disciplined on that. So if there's anything in piracy, we will definitely approach the customers to make sure that they come clean and then pay up not just the past but going forward. We want to ensure that we enforce that.

Got it. And my last question on Mentor Graphics acquisition by Siemens, have you seen any business impact where you've seen like divestitures or small businesses where Siemens has decided to get out of business? I just want to understand like if there's been any noticeable change that you have seen in regards to the acquisition of Mentor by Siemens?

Yeah. So far, I think we expect Mentor products continue to be competitive under the even bigger umbrella in Siemens ownership. We don't take it lightly. We continue to compete with them in the marketplace. Clearly it's a $100 billion big giant. We want to not take it lightly. There are some good products we are competing with. So far we continue to pay a lot of attention to them.

Yeah. Good afternoon. I was hoping that you could look at your three new products and maybe rank, if you could, what the relative revenue opportunity is for each of them going forward, maybe both on a near-term and a long-term basis?

Yeah. Tom, this is Geoff. We don't give specifics on our different businesses at that level of detail. We don't give guidance on that. They're all going to be important products.

All right. Okay. So I guess, Geoff, moving on to the margins, it looks like from your guidance here that the margins have to step up nicely in the second half of the year. Is that just stronger revenues? Is it going to be a mix issue? What drives the stronger margin profile?

Yeah. Generally, if you look at, Tom, our trends over the past couple of years, the second half of the year has been stronger than the first half of the year. Some of that is just what I'll call the normal ebb and flow of seasonality in the business. We have Social Security and Medicare taxes kick in at the beginning of the year. As people reach those limits, those go away. We have more vacations tend to be in Q3 and in Q4 than they have early in the year. Those things contribute to keeping expenses down in the second half of the year or relatively flat. As our revenue has consistently grown, traditionally we drop more to the bottom line.

Okay. Makes sense. And then I noticed – I look at some of the GAAP to non-GAAP adjustments, there's about $0.14 and then there was about a $0.07 tax on that $0.14. I'm curious, why is there such a kind of a heavy tax rate on those adjustments?

Yeah. Again for non-GAAP, we use a 23% non-GAAP tax rate when we give guidance and actually for our actuals. We look at that every couple of years and take a look at where we would expect to be if we didn't have any tax attribute and our company was operating in a normal tax environment. Traditionally, our cash taxes have been materially under that. Our GAAP tax rate will fluctuate materially based on all kinds of things, based on where income is earned, various different discrete items and tax. Those things will fluctuate. I tend to focus on two things, the 23% that we use for non-GAAP and the cash tax rate.

Okay. That makes sense. And then Lip-Bu, in your comments, you talked about the customer consolidation having minimal impact on 2017. Was that a comment that you expect minimal impact going forward, or is that perhaps just 2017 and 2018 is perhaps a different story?

Yeah. I don't think we are going to comment on 2018. We just stick to 2017. So far we see minimal impact.

Thanks for taking my question. My first question, Lip-Bu, is like if I look at your growth and your year-over-year growth the last few years, every year it has been decelerating. And it's now at about 6% this year. I just wanted to understand how do you think about the long-term growth of the business? Is it more like a 5% growth business over the next few years? And what is really needed to make it more like a 10% growth?

Okay. Good question, Farhan. A couple of points. First of all, we are confident with our strategy and direction of the business and the future opportunity. We are pleased with the revenue growth for this year, 6%, with the order mix environment that we are operating in. I think a couple of things that are good drivers for us. Our core EDA software is doing well, growing with all the new products we came out with. Our IPs rebound to 10% growth rate. The hardware continues to be a good year this year for us. So I think overall, we are pleased with what we see in the marketplace, and that's why we guided 6%. And in terms of the trend going down, clearly, we are mission-critical solutions to our customers. I think we continue to drive value and be very disciplined in what we provide to our customers. I strongly believe collaborating deeply with the customer, delivering innovative products to meet their challenges in design. And then the other part, I think they are going to help us to grow the business in terms of revenue growth will be the system design enablement. That's where we are moving into some of the vertical areas and then the vertical market. Addressing some of the higher growth opportunities in automotive, data center, and then the aerospace and defense-related area. And again, the chip design is getting more and more complex. We are very mission-critical, and the design and verification is getting a lot more complex. We can drive a lot more value. That is why we want to be disciplined and drive value, and that is our motto going forward. In closing, there are macro challenges ahead but also opportunities specific to Cadence. Through innovation and execution, we are well-positioned to build on our success, and to continue proliferating our solutions with market-shaping customers. I'm pleased to note that for the third consecutive year, Cadence was named by Fortune Magazine as one of the top 100 companies to work for. I would like to thank all our shareholders, customers and partners, Board of Directors, and hardworking employees globally for their continued support. Thank you all for joining us this afternoon.