Cadence Design Systems Inc (CDNS) — Q2 2017 Earnings Call Transcript

Thank you, Devon, and welcome everyone to our second quarter 2017 earnings conference call. With me today are Lip-Bu Tan, President and CEO; Geoff Ribar, Senior Vice President and CFO; and John Wall, Corporate Vice President Finance and Controller. The webcast of this call can be accessed through our website, cadence.com, and will be archived through September 15, 2017. A copy of today's prepared remarks will also be available on our website at the conclusion of today's call. Before we 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 CFO commentary should be referenced with both today's conference call remarks and the earnings press release issued today. Next, 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. Also note that this afternoon we filed our 10-Q for the quarter ended July 1, 2017. 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 review 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 July 24, 2017 for the quarter ended July 1, 2017 and related financial tables can also be found in the Investor Relations portion of our website. Today, following Lip-Bu's remarks, John Wall will present the financial results and outlook. Then Lip-Bu, John, and Geoff will all be available during the question-and-answer session. Now I'll turn it over to Lip-Bu.

Good afternoon everyone and thank you for joining us today. We are steadily executing our system design enablement or SDE strategy. SDE offers additional growth opportunities as we expand beyond semiconductors and tap into significantly larger markets with system companies and vertical market segments, such as automotive, aerospace, and defense. In Q1, we booked our largest design IP contract ever with a major customer in the automotive semiconductor sector. In Q2, this momentum continued with an ADAS system company licensing our PCIe Express gen-IV IP on the new 7 nanometer SoC; and another major customer licensing Tensilica for automotive radar application. Also in the automotive space, Rohm adopted our ISO 26262 compliant functional safety verification solution, and we received ISO-26262 certification for our PCB flow. Overall, four of the top five automotive semiconductor companies are now using Cadence IP. In aerospace and defense, adoption of our Palladium Z1 emulation system increased with purchases by several significant system customers; providing integrated system-level solutions is also a key goal of our SDE strategy. In Q2, we released the Virtuoso system design platform, which optimizes design integration between our chip, package, and board flows. We also expanded our partnership with MathWorks through a new integration between Virtuoso ADE and MATLAB, which will enable customers to accelerate analysis of large data sets when modifying custom RF and mixed signal design. Digital and sign-off revenue grew 14% year-over-year, driven by growing proliferation with market-shaping customers. Innovus is rapidly becoming the implementation solution of choice for CPU, GPU, and SoC designs for networking, wireless, consumer, automotive, and IoT. In addition to the momentum on the digital products, there is increasing traction on the adoption of the full flow by digital and mixed signal customers. Our full digital flow is now used by over 70 customers performing advanced node design, including more than 20 full flow customers designing at the 7 nanometer nodes. Next, I want to talk about our IP business, which is the key element of our SDE strategy. As we have stated, the IP market opportunity remains strong due to growing demand trends. IP revenue grew 15% year-over-year as our refined strategy gains momentum. Multiple smart speakers are using Tensilica processor for AI, audio, and Wi-Fi. In Q2, we had multiple Tensilica Vision processor wins for drone, handset, and industrial applications; and we introduced the Tensilica Vision C5, which is the first dedicated rural network DSP IP. Now for system design and verification; while overall, hardware revenue was less than anticipated for the first half, we expect hardware revenue to be a little stronger for the second half. Palladium Z1 remains the most advanced emulator on the market. In Q2, we expanded our partnership with HiSilicon on Palladium Z1 with a significant add-on to the emulation capacity. We are pleased with the earlier customer reception of Protium S1 FPGA-Based prototyping system. Momentum continued, as we received an important endorsement of our technology and integrated hardware approach, with a competitive win at a leading North American semiconductor company, which is one of the largest users of the Palladium Z1. Overall, we have several repeat orders and five new logos. Before turning over to John, let me quickly summarize my comments. Consistent execution drove excellent financial results for Q2. System design enablement is expanding our opportunity and expanding our customer reach. Software and IP were particularly strong, and the proliferation of our digital and sign-off solutions is growing with market-shaping customers. We continue to innovate and introduce new products like Tensilica Vision C5 DSP targeted at neural network applications. Now I will turn the call over to John to review the financial results and provide our outlook.

Thanks, Lip-Bu, and good afternoon everyone. Consistent execution drove excellent financial results for the second quarter, highlighted by revenue near the high end of our guidance range and operating margin, EPS, and operating cash flow, all exceeding expectations. Specifically, here are some key results for the quarter; total revenue of $479 million; non-GAAP operating margin was 27%; GAAP net income per share was $0.25; non-GAAP net income per share was $0.34; and operating cash flow was $162 million. Also, please note that the recurring revenue mix was approximately 90%; DSOs were 31 days, down six days from Q1 on strong collections. Our DSO target remains approximately 35 days. For geographies and products, Asia continued as our fastest-growing region, with revenue up 18% year-over-year. As Lip-Bu mentioned, digital and sign-off revenue was up 14% year-over-year, as we benefit from proliferation with market-shaping customers, and IP continued to rebound from 2016, with revenue up 15%. Functional verification revenue was down from last year, as overall hardware revenue was less than anticipated for the first half. However, we expect hardware revenue to be a little stronger for the second half. Now let's turn to our outlook. We are increasing our revenue and EPS outlook. For fiscal 2017, we now expect revenue in the range of $1.91 billion to $1.95 billion; non-GAAP operating margin of approximately 27%; GAAP EPS in the range of $0.98 to $1.04; non-GAAP EPS of $1.36 to $1.42; and operating cash flow in the range of $430 million to $470 million. For Q3, we expect revenue in the range of $475 million to $485 million; non-GAAP operating margin of 26% to 27%; GAAP EPS in the range of $0.24 to $0.26; and non-GAAP EPS in the range of $0.33 to $0.35. Approximately 90% of revenue is expected to come from beginning backlog. You will find guidance for additional items in the CFO commentary. Next, I will take a moment to review our capital allocation priorities. As we have said before, the company regularly reviews its capital structure, balancing our needs for investment, the appropriate level of risk for our business model and operating environment; maintaining adequate liquidity and the opportunity to return cash to shareholders. In January of this year, the board authorized the repurchase of $525 million of our common stock. We did not repurchase shares in the first half of the year, but we do expect to repurchase some shares in Q3. 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 our 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 further weakened in Q2, but so far, we have been able to manage through this challenge. As you know, we have been reviewing the new revenue recognition standard that we will implement for 2018, and we are confident that we will substantially maintain recurring revenue or revenue over time treatment. To conclude, we are pleased with our second quarter results, including strong financial performance, software and IP growth, and growing proliferation of our digital and sign-off solutions with market shaping customers. Looking forward, we are excited about the new opportunities resulting from our system-design enablement strategy, and we are confident that we will continue to drive strong financial and operating results. And with that operator, we will now take questions.

Thank you. First question, it relates to the decision to start buying back stock. I think as recently as a few weeks ago, in public appearances, some management were saying that you guys were going to be doing a five-year strategic plan, and sort of at the conclusion of that, you would decide whether you'd be starting to buy back stock or not. So I am taking based on your decision, that you have actually kind of concluded that plan. So I am wondering if there is anything you can share with us about that plan, as it relates to opportunities for M&A on your side, presumably that you are buying back stock. I guess you might conclude that you don't see much opportunity for M&A. But just wondering if you can share anything about that five-year strategic plan and how it relates to your decision to start buying back stock? Thank you.

Rich, this is Lip-Bu. First of all, I wanted to highlight that last year, we completed our $1.2 billion repurchase program, and then the board has approved and authorized a $525 million buyback in 2017. And clearly, our approach usually focuses on business requirements and also the appropriate risk management along with our business model and operating environment, and we also want to provide the flexibility for us to continue executing our plan. Clearly, returning capital to shareholders is a top priority from my point of view. So overall, I think we continue to review that with our board. The board just approved our new purchase, starting in Q3.

Okay. And I guess I would like to move on to hardware/emulation. You mentioned it was a little lighter in the first half than you had expected. If you could just comment on why it was lighter, and if there have been any competitive changes in the markets particularly, as it relates to competitors and their platforms? And then presumably, something came in stronger than you expected in the first half, I am wondering if that's IP or digital, that sort of backfilled for that slightly lighter hardware revenue? Please comment on that. Thank you.

Sure, thank you, Rich. On the hardware side, clearly, we didn't perform as well as we had anticipated in the first half. As you know, this is a very lumpy business, and we expect to do a bit stronger in the second half. Having said that, I think clearly, we are still the most advanced emulator on the market, and our capacity can scale up to 9.2 billion gigahertz with over 2,300 concurrent users. So clearly, it's still very well received; 16 out of the top 20 semiconductor companies are using our hardware emulation. Nine out of ten smartphone companies are utilizing the Palladium Z1. Overall, I think we are satisfied with our product offerings, and now we have the S1, which is the FPGA prototyping version, and that has received very good and encouraging reception from our customers. We mentioned repeat orders, and also we have five new logos, and they appreciate the flexibility from FPGA to our very scalable hardware platform. Overall, we are pleased with our product line and continue to execute. It’s a very lumpy business. Saying that, I think Q2 is a good quarter for us. On the software side, we have done quite well. To highlight a few points, the digital side grew year-over-year by 14%. IP with a renewed focus grew by 15% year-over-year, custom analog sales grew by 9% year-over-year, and overall we had a 7% growth for our SPB. So overall, our software and IP are performing very strongly, and hardware has just been a very lumpy business, which we are focusing on customer requirements and insights. So stay tuned, we expect a slightly stronger performance in the second half.

Okay. Thank you, Lip-Bu. Appreciate it.

Hey guys. Yeah, it's Jackson on for Sterling tonight. If we can just circle back to the buyback that you're anticipating to start in the third quarter. So what exactly is different about the third quarter, the second half of 2017 versus the first half when you were not expected to repurchase any shares?

Yeah. As I mentioned earlier, last year, we completed a significant $1.2 billion of buyback. The board even approved the $525 million for this year. Clearly, we want to maintain flexibility. The timing has to reflect business market conditions, corporate and regulatory requirements, and also look at acquisition opportunities and other factors. So I think we put that into the total picture. We discussed at length in every quarter with our board. We decided that Q3 is when we would start the buyback.

Okay. And then just a quick follow-up; within functional verification and hardware which you just mentioned, were there any deals that maybe you expected to close from the first half that slipped into the second half, or do you just see more demand building in the second half of the year?

Yeah. I think clearly, as I mentioned, it's a very lumpy business. However, we still have the most advanced emulator. We continue to work closely with customers to drive value and meet their needs. Meanwhile, we don’t want to overly push sales just to meet numbers; we aim to satisfy customer needs over being overly aggressive. Hardware remains a long-term business.

Hey, thanks guys. Just two quick questions for me. So actually first on the strategic side; I know you guys are looking for a new CFO. Do you mind just providing a quick update on the process there?

Sure. First off, Geoff committed to March 2018. So we have enough time to get the best CFO on board. And in saying that, we have strong internal talent and also continue looking at highly qualified external talent. Geoff committed to me that he will ensure a smooth transition, so we continue to work on that as part of our game plan.

Got it. And then secondly, I am going to circle back to the hardware side of it. I think that just generally speaking, Mentor should be losing share it seems like to both you guys and Synopsys. My basic understanding is that you guys are actually more comparable in terms of the emulator and what products you compete against, particularly in the smartphone side. So I guess, why would that slow down, I guess this quarter and then re-accelerate next quarter?

Yeah, as I mentioned, it's a very lumpy business, and we continue to focus on customer requirements. Our strategy is to drive value in the market rather than just pushing for sales aggressively. We still have a robust plan, and I'm confident in our direction.

Hi. Thanks for taking my question. My first question is on the hardware side. On the emulation, your first half sales are coming in a little bit stronger, and then I look at Synopsys; their hardware sales are actually coming in quite a bit stronger. So is there some market shift going on firstly between you and Synopsys? And secondly, can you talk about what are the end markets that you saw weakness in, and what gives you the confidence that it comes back in the back half of the year?

Yeah. So I think first of all, the hardware emulation side, we have a lot of respect for our competitors, especially Synopsys and Mentor. On the hardware emulation side, we compete more with Mentor. Clearly, we continue to be the most advanced emulator in the marketplace. It's more about the timing of the customer requirements. On the Synopsys side, we respect their approach, and they have FPGA versions; however, we have our own S1 FPGA. I would say that the earlier reception from our customers is very encouraging. As I mentioned, we have repeat orders and also five new logos, which we are proud of. It’s noteworthy that we received a significant endorsement from a leading North American semiconductor company, which is among the largest users of Palladium Z1; they endorsed us on the FPGA S1, which is crucial for building momentum. Overall, we aim to sustain healthy growth in our emulation business.

And Farhan, this is John Wall here. I'd just like to add and remind you that Q2 2016 was a record year for hardware, and we continue to see a secular trend of increasing customer need for emulation and acceleration products. But just wanted to point that out.

Got it. Thank you. And then for the emulation business, do you still expect it to be growth for you this year? Because if I recollect correctly, at the beginning of the year, you were expecting that the business will grow?

Yeah. As I mentioned, the first half didn't perform as well as we had anticipated. However, we expect it to strengthen in the second half.

Got it. And then in terms of the growth that we are seeing in digital and then system interconnect, you have pretty impressive growth there, more than 15% year-on-year. How sustainable is that, and how should we think about that portion of the business in the second half of the year?

Yeah, very good question. We are very proud of our innovation approach to our digital flow. As I mentioned in my remarks and the Innovus, it has become the platform of choice for placement and route for multiple applications, which is very powerful. We are optimistic about that performance. The performance, area, and power optimizations are delivering impressive results, and customer adoption is rapidly increasing with market-shaping customers. The 70 customers endorsing us and using our improved rating on the full flow gives us confidence. We anticipate strong continued growth in digital flows, especially within the custom analog side.

Thank you. That's all I had.

Good evening. A couple of short term questions to start; first for Geoff and John, then a question for Lip-Bu. For Geoff and for John, you reiterated your cash flow guidance for the year. Yet, through the first half of the year, you have already done about 60% of the low end of your guidance range for cash flow, and I am wondering what you are seeing in the second half of the year, that perhaps cash flow might be less than in the first half, hence the reiteration of the current range? And then secondly, back to the emulation question, just to clarify what you mean by stronger; is that an increase in absolute terms, first half to second half, or are you talking about a year-over-year increase in the second half versus a pretty easy comp from the second half of last year? In order for you to grow your emulation business for the year, it looks like your second half would have to be up by about a third in total or more; if you could comment on that?

So Jay, this is John, I will take that first question on the cash flow. I'd just point you to the DSOs that we had a six-day decrease in DSO from Q1. A number of large payments came in after the end of the first quarter, driving a more favorable comparison between the quarters. So Q2 ended up being a very strong quarter for us regarding collections. You will see a little bit of a shift to the first half for cash collections. But our guidance reflects our confidence in the business and takes into account everything we know at this time. So we reiterated the cash flow guidance.

Yeah. And Jay, on the hardware side, as I mentioned, the first half is lower than anticipated. As I stated earlier, it's a very lumpy business, and we expect to be a little stronger in the second half. That’s our expectation, and again, we want to preserve the value and make sure that we are meeting customer requirements.

For you Lip-Bu, a couple of market and customer questions. Number one, is about the length of your current product cycles or adoption cycles. We have seen now, for the past roughly two years, that the implementation business, both yours and Synopsys, have done well, and I am wondering how long you think this cycle might last? The reason I ask is, when we look at the last big product cycle for you in PCB, that lasted for about three years, 2012 to 2015? And I know it's not the same technology or the same customers necessarily, but do you think that perhaps there is another year or so to go, to fulfill this adoption or upgrade cycle and implementation, and then are you going to have to see some other category pick up?

Yeah. It's a good question, Jay, and clearly, as you know, the complexity of design has increased substantially as the industry moves down the geometry to 10 to 7 to 5. We are aggressively positioned with leading companies in the 10 to 7 and beyond processes. This transition period has seen significant innovation. I don't see any slowdown with the new exciting applications around machine learning, deep learning, cloud infrastructures changes, and the automotive industry related to autonomous driving. Overall, the complexity of chip design will continue to drive growth opportunities for our business. I am optimistic about the future.

Yeah hi. Thanks for taking my question and congrats on a good quarter. I had a few of them, first one either for Lip-Bu or John; I mean, I don't want to ask the same question on buyback, but I am trying to figure out a different way. Your capital allocation or capital return policy; in the last six months you didn't do any buyback, and there is always speculation whether there's a takeover or M&A happening or something. So from your standpoint, why weren't you considering a dividend, so that you don't have to worry about timing the buyback?

Yeah, so Krish, I think clearly, capital allocation is a topic that we discuss at every board meeting. Geoff and I, along with John, review it quarterly. In terms of buybacks, dividends, it's all part of our discussions with the board. So far, the board has authorized a $525 million buyback, and we will review that to provide the flexibility we require.

Got it. And then on your hardware business, can you roughly say the split between emulation and FPGA prototyping; is it like an 80-20 split or am I in the ballpark?

Yeah, we don't provide the breakdown. As you can expect, we don't want to give that information to our competitors. But clearly, hardware emulation remains our current volume production. The S1 FPGA was just announced recently, and we are excited about the early reception from our customers with repeat orders and five new logos, including one very strong competitive win. That endorsement will carry our momentum going forward.

And Krish, this is John here. I want to just add that we have great products in the hardware space. Note that we delivered excellent financial results for Q2, both in software and IP being strong, and we increased our outlook for the year. So the first half is only part of a really good story.

Got it. And then a final question for Lip-Bu; looking at the market, you have all these exciting technologies like AI and deep learning, autonomous driving. Can you quantify the opportunity for EDA or Cadence? Either as a percentage of the market size for AI or as a dollar value corresponding to what the chip market could be for those? Can you help us quantify the EDA opportunity in this trend?

Yeah. It's a good question. But it will be difficult for us to quantify it at this moment. What I can share is my excitement. Machine learning, deep learning, and AI could transform our semiconductor industry with a broad application area. For instance, autonomous driving is just one application. Machine learning could have a substantial effect on datacenters and cloud infrastructures and will require a lot of compute resources to analyze that data effectively. There is significant potential for our EDA solutions to provide that support. We are very excited about the future, but quantifying that potential specifically is challenging as of now. Stay tuned as we gain more insights.

Yeah, good afternoon. Just following up on that last question, when we get into an environment, and guys like NVIDIA are building these huge chips, is the bigger opportunity for you on the hardware side, or do you think the EDA software side is a bigger opportunity on an incremental basis?

Very good question, and clearly, we have a lot of respect for NVIDIA, and what they have done is fabulous for the industry as they continue that innovation engine. In general, the machine learning and deep learning have tremendous impacts on the semiconductor sector. Besides memory operations, we see significant implications with cloud infrastructure too. The overall growth opportunities presented in that market are compelling, but it's hard to specify which side provides greater incremental value as they are closely interlinked in increasingly complex solutions. So I think it's both sides presenting big potential and we need to remain agile.

Okay. And I know we have spent a lot of time talking about the leading edge, but as we look into things like IoT and the pervasiveness of sensors and the like on the low end, how are you positioned to benefit from that versus the unit growth and design growth at the low end?

Yeah, very good question. In the IoT and lower-end devices that collect data, we have a unique offering because Tensilica processors are low-power and programmable. Additionally, our expertise in low power within processes is a strong asset. As you noted, low power is critical for IoT solutions where long-lasting battery life is a necessity, and we have solid techniques in addressing those challenges effectively.

Okay. So when you put this all together, is your expectation that as these opportunities develop over the next few years, the growth in your served market will actually accelerate from where it is today?

Yeah, I think we are hopeful for that. One thing I want to highlight is our strength in analog mixed-signal domains, which is critical for data collection in many IoT products. We are successfully building a strong pipeline for customer throughput in these areas, which gives us confidence in our offerings.

Okay. And just finally, going forward, do you think the FPGA prototyping product will be sold or packaged with emulation or are those separate sales?

Yeah. It depends on customer requirements. Hardware emulation has the scale and high capacity of 9.2 billion gigahertz, which attracts leading large companies. Emulation offers the most accurate results for designs. Meanwhile, FPGA prototyping is an efficient way for customers; and we offer both services using the same compiler. This flexibility meets a variety of customer applications, so we are prepared to deliver excellence.

Hi. Thanks for taking my question. The first is on R&D; if I look at R&D as a percentage of revenue. The first half of this year is somewhere around 37.3%, which is higher than previous year. So is this a normalized R&D level to think about going forward, or how should we think about what is the R&D level?

Yeah, I think let me start and then John can chip in. First off, there is not much out there to buy for EDA tools. A lot of customers are shifting towards us, with expectations that we will significantly increase our R&D investments to support their needs. Thus, we have maintained funding, particularly in R&D, given our focus on leading-edge technologies. We decided that we need to continue investing in innovation as we tackle challenges of the most complex chip designs. We remain focused on driving returns from our investments and ensuring that our R&D commitments yield positive impacts for our clients.

Monika, this is John. I would just like to add that, the R&D investment we are making now is for future years. Our priority is to develop innovative products and help our customers be successful so we can capture market share and deliver value. But we continue to build on innovation and take action to drive growth while delivering results to our customers and value to our stakeholders. Geoff, I don't know if you want to add anything?

Just from an expense perspective, in the first half of the year, we had higher social security payments, both for the employees and on the company's behalf, and less vacations compared to more vacations in the second half. So usually, the expense moderates in the second half.

Got it. And then, you talked about the $525 million share repurchase authorization from the Board. Maybe, can you discuss how you are thinking about share repurchase for the second half of this year?

Yes. As we said, we like to maintain more flexibility with the most recent authorization. The company regularly reviews its capital structure, balancing our needs for investments with maintaining adequate liquidity and returning cash to shareholders. Board and management make their decisions through the lens of shareholder value. We did not purchase shares in the first half, but we obviously expect to repurchase shares in Q3.

And we are not specifying the amount of time nor the method at this time.

Okay. Then just the last one, eight-nine months since Siemens announced the acquisition on Mentor closed almost four months. Have you seen any change in competitive dynamics in the market? Thank you so much.

Sure, Monika. First of all, I think the Mentor product is going to remain competitive under Siemens ownership. Siemens is a very large company, $100 billion company; they have tremendous resources, and we have a lot of respect for them. So we continue monitoring the competitive landscape and pursuing our strategies.

In closing, through innovation and execution, we are well positioned to build on our success and to further proliferate our solutions with market-shaping customers. I would like to thank all our shareholders, customers and partners, board of directors, and our hardworking employees for the continued support. Thank you for joining us this afternoon.