Cadence Design Systems Inc (CDNS) — Q1 2019 Earnings Call Transcript

Thank you, Chanelle. And I would like to welcome everyone to our first quarter 2019 earnings conference call. I am joined by Lip-Bu Tan, CEO; and John Wall, Senior VP and CFO. The webcast of this call is available through our website, cadence.com and will be archived through June 14, 2019. A copy of today’s prepared remarks will also be made available on our website at the conclusion of today’s call. Please note that today’s discussion will contain forward-looking statements and that 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 we issued today. And by the way, we just filed our first quarter Q a few minutes ago. So, it's now available. In addition to 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. The reconciliations are available at the Investor Relations section of cadence.com. Copies of today's press release dated April 22, 2019 for the quarter ended March 30, 2019, related financial tables and the CFO Commentary are also available on our website. And now, I will turn the call over to Lip-Bu.

Good afternoon, everyone, and thank you for joining us today. Cadence achieved excellent operating results for the first quarter of 2019, delivering 11% year-over-year revenue growth and 32% non-GAAP operating margin with broad-based strength across our product line. As a result, we are increasing our outlook for the year, and John will provide more details shortly. While there is some uncertainty in the overall macro environment, we are confident about the multiple trends that are continuing to drive strong design activity. In addition to technology trends, like AI and 5G, design activity is being fueled by workload-specific computing, system companies building custom silicon, new silicon startups and digital transformation of industries such as automotive, aerospace, medical, and other industrial applications. Our business is mission-critical to silicon development, which is the cornerstone of our design activity. As we have stated, our system design enablement or SDE strategy drives growth in our core EDA and IP business, broadens our reach in system companies and targeted verticals, and guides our expansion into newer adjacent areas. We executed well on this strategy, and today I want to highlight its next phase, which we’re calling Intelligent System Design. The foundation of this strategy continues to be delivering design excellence via our core EDA and IP business. In addition, we are building upon our core competency in computational software to expand into two new areas, system innovation where we are expanding into new system domains; and pervasive intelligence where we will apply AI and our algorithm know-how to our core business and specific verticals. Our Intelligent System Design strategy will enable us to provide more capabilities and value to our customers, while also expanding our current total addressable market from about $10 billion to an estimated $30 billion over the next five years. To highlight some of our recent activities in the system innovation space, in Q1 we announced a strategic partnership with Green Hills Software, which opens new opportunities in the estimated more than $3 billion embedded system, safety and security space. And earlier this month, we entered the system analysis market, an estimated $4.5 billion total addressable market opportunity by introducing our first product Clarity3D Solver, a next-generation solution for electromagnetic field simulation. Clarity is a true 3D Solver, which delivers up to 10 times faster simulation performance while providing virtually unlimited capacity without compromising accuracy. Clarity uses state-of-the-art distributed multiprocessing technology, making it uniquely optimized for the cloud and on-premise distributed computing and has been endorsed by Teradyne and HiSilicon. Turning to our core business, our Digital and Signoff business achieved 12% year-over-year revenue growth, driven by strong adoption by new customers, and proliferation among existing customers at advanced nodes. To date, more than 100 7-nanometer designs have taped out using our digital solutions, and multiple 5-nanometer designs are underway using our solutions as well. Our hardware-assisted verification products, an important part of our verification suite, had another good quarter. Palladium Z1, our flagship emulation platform, added two new customers that are doing machine learning designs, including SambaNova Systems. We also had 13 repeat orders, including three significant expansions, one of which was at Annapurna Labs, an Amazon Company. Our Protium S1 prototyping platform, which enables early software development, also added two new customers, and received seven repeat orders. Palladium Cloud continued its steady momentum and now has more than 10 customers, several of which have made repeat orders. Our IP business also showed double-digit growth year-over-year. Tensilica continued to win sockets for machine learning, vision, and audio applications in the automotive, consumer, and surveillance segments, adding eight new customers in the quarter. In the design IP space, our new 112-gig long-reach SerDes IP was adopted by a marquee semiconductor company, and we launched the industry’s first complete silicon-proven LPDDR5 solution. As I said earlier, our strategy broadens our reach in system companies and targeted verticals. One of our most successful targeted verticals is aerospace and defense, where we recently announced that we are working with Northrop Grumman, where our EDA and IP solutions have supported a shortened product development cycle and advanced node tape-outs. Lastly, I want to highlight the new Cadence CloudBurst Platform, the latest addition to our Cloud portfolio, which extends our cloud leadership in EDA and provides customers with compelling productivity, flexibility, and scalability benefits. CloudBurst enables hybrid cloud environments and is ideal for serving peak demand. It provides fast and easy access to pre-installed Cadence design tools in either AWS or Azure cloud environments. It was used by Barefoot Networks to achieve a 10x productivity improvement running Cadence Tempus Timing Signoff Solution on their 7-nanometer networking chips. With that, I will now turn the call over to John to review the financial results and provide our updated outlook.

Thanks, Lip-Bu, and good afternoon everyone. Cadence achieved broad-based growth across all lines of our business during Q1 with demand for hardware and IP exceeding our original expectations. Revenue, operating margin, and cash from operations were all strong in Q1, and as hardware and IP have become a larger part of our overall business, our recurring revenue mix percentage is now in the high 80s. Now let’s go through the key results for the first quarter starting with the P&L. Total revenue was $577 million. Non-GAAP operating margin was 32%. GAAP EPS was $0.43, and non-GAAP EPS was $0.54. Turning to the balance sheet and cash flow. At quarter-end, cash totaled $539 million while the principal value of debt outstanding was $400 million. Operating cash flow for Q1 was $185 million. DSOs were 42 days. And during Q1, we repurchased $81 million of Cadence shares. Now, I will provide our updated guidance. For Q2, we expect the following results: Revenue in the range of $575 to $585 million; non-GAAP operating margin in the range of 31% to 32%; GAAP EPS in the range of $0.34 to $0.36; and non-GAAP EPS in the range of $0.52 to $0.54. Our updated guidance for fiscal 2019 is as follows: Revenue in the range of $2.305 billion to $2.335 billion; non-GAAP operating margin of approximately 31%; GAAP EPS in the range of $1.39 to $1.47; non-GAAP EPS in the range of $2.04 to $2.12; operating cash flow in the range of $665 million to $705 million; and for the year, we expect to use approximately 50% of free cash flow to repurchase Cadence stock. You will find guidance for additional items as well as further analysis in the CFO Commentary available on our website. In summary, I’m pleased with our performance in Q1. We achieved strong operating results, highlighted by 11% year-over-year revenue growth, 32% operating margin on a non-GAAP basis, and the generation of $185 million of operating cash in the quarter. And looking at our revised outlook for the year, I’m pleased to see improvements in operating income consistently flowing through to cash as illustrated by the increase in our operating cash flow guidance for the year. We’d like to thank our customers, partners, and of course our employees, for a solid start to 2019 and we look forward to updating you on our progress throughout the year. And with that, operator, we’ll now take questions.

Comments on your foray into the system analysis market. And obviously you started there with I guess, an electromagnetic-based solver. But there are obviously many solvers that you could potentially roll out there to have a complete portfolio for that market. So, just wondering how aggressively you plan to go after that market. Will you go after the mechanical and static side of it, as well as sort of the more electronic-centric solvers? Just any sort of sense of your real aspirations in that market? Thanks.

Yes. Rich, Lip-Bu here. And we did not hear the first portion of your question, but I guess it’s about the 3D Solver that we announced. And we're delighted. And this first product, Clarity, is a truly 3D Solver and is a next-generation solution that is for the electromagnetic field simulations. And this is our first entry into the system analysis. And clearly, we have other products we’re working on developing. We're excited because a couple of things. One, clearly, we look at our core competency that we have in the computational software, and that's what our EDA background comes from, and then also our 3D, some of our packaging technology that we have. That combination gives us a very unique opportunity to really drive in the next-generation disruptive; that's why we can claim up to 10 times the performance. And this is very cloud enabled, so that we can really provide a truly next-generation, uniquely optimized for cloud and on-premise distributed computing, and so that we have something unique to offer. And stay tuned, we’re going to have more products coming up. This is our first entry into the system analysis market.

Great. Thank you for that. And if I could just circle back to your last earnings call where you referenced a major win with a marquee semiconductor customer, you mentioned that you were pretty aggressively ramping up your AE hiring to support this customer. So, given that you've kind of given us some hints on the expense side for that customer, is there anything you’re willing to say about your revenue expectations, like when you might expect to generate incremental revenue from this customer, whether it’d be this year, next year or any color at all you could give on that? Thank you.

Yes. I think we're excited about this marquee U.S. semiconductor company. As I mentioned at the last earnings call, it’s a breakthrough and wide-ranging win. And we are very excited; it’s the early days of partnering with this customer to expand the breadth of our engagement. It’s across all our different tools. And we are excited about it. And clearly, everything we know is already built into our guidance for the year. But overall, to support a very important customer we have to build out our AE and R&D support and to really proliferate across the requirements.

Lip-Bu, maybe first to you. In your prepared comments you did talk about some pockets of uncertainty out there in the environment which makes sense, given what some of your traditional semiconductor customers were putting up. I'm just kind of curious, to the extent that you guys continue to do better than expected in beat-and-raise, what do you think it is about your business that's allowing you to buck these trends? Is this just your ability to address nontraditional customers? Is it the new large win that's offsetting this? Maybe you can just help us give us a sense as to why you seem to be bucking some of the uncertainty trends out there?

John, that’s a great question. Let me address this uncertainty. We are aware of the challenges in the marketplace, including geopolitical factors and slowdowns in certain sectors like automotive. However, we are optimistic about several drivers, particularly AI, 5G, autonomous driving, and the industrial edge, which I am very passionate about. As we transition into a big data environment, the focus on data and data analytics is critical. This shift is creating new demands for semiconductors, especially in terms of workload-specific or domain-specific processing and general-purpose CPUs and GPUs. Currently, workloads have evolved to be more application-related, which drives not only computing needs but also innovations in memory and storage. For instance, advancements like NVME controllers and the disaggregation of storage are significant due to the enormous amount of data that requires this disaggregation in storage and networking. Additionally, there is a need for high-speed connectivity to scale, particularly in hyperscale environments. All of this is leading to substantial design activity, and we are strategically positioned to take advantage of these developments. This is why we are seeing a significant increase in design activity, and we are excited to support our customers as they explore these opportunities.

That's helpful. And then, John, just maybe as a follow-up on the op margin guidance, both for the fiscal second quarter and the full fiscal year. It’s a slight downtick from what you just put up in the fiscal first quarter. Is that nothing more than the expense of onboarding the new large North American customer? Can you talk about some of the other points and takes that might have op margins going down throughout the fiscal year on what's going to be rising revenue?

Sure, John, great question. I mean, for the year, looking at the year, our annual merit increase is going to take effect in July. So that impacts the second half of the year. And of course, over the course of the year, we're investing in R&D and field resources to support proliferation of our solutions with market-shaping customers. And I say customers plural, it's not all for one, one customer.

Hey, guys. Thanks for taking the question. I have two. So, the first one is kind of on the operating margin long-term target. I know you guys historically talked to 30%. But you guys are above that for three quarters in a row. And I'm wondering if you guys may provide sort of high-level commentary on where you think that could go in three to five years? And then, secondly, I noticed in your prepared commentary you guys are now breaking out China as a separate geography. And it seems like the numbers there have a lot more volatility. I mean, there used to be kind of 8% of revenue but then it was 13%; in December, now it’s back down to 10%. So, maybe you could talk about why you guys are disclosing China now as a separate geography.

Hi, Mitch. I'll address the second part of your question first. Yes, you'll find China listed separately in the revenue by geography table in the CFO Commentary and our 10-Q. The fluctuations in revenue percentages are likely due to our IP and hardware businesses, which tend to have more variability than other segments. Regarding your first question, we're not currently prepared to set long-term targets. We're continually looking for ways to enhance operating performance. If you examine a longer timeframe and compare our current guidance for 2019 to our results from 2016, you'll see how we've successfully scaled the business in recent years.

Yes. Just to add to what John is talking about on the China side. If you look at historical 2016, above 8%; and then, 2017, about 9%; and last year is about under 10%; and this year is 10%. So overall, we have done well in China. And clearly, China is very committed to build its domestic semiconductor industry. And they're making great progress. And we are well-positioned to support not just China, I mean globally in Asia and other places. And we want to be the trusted partner for them.

Thank you. Good evening. Lip-Bu, a technology question first for you regarding what you called now, your Intelligent System Design strategy. And the question is, over the last number of years, perhaps the most important thing you've done, particularly in digital, is to pursue your parallel architecture with a common data model across the portfolio, and that's obviously helped you on the digital tool side. The question is, with respect to the new Intelligent System Design target, how extensible or leverageable is that platform or architecture the last number of years for that new strategy or is there some additional rework or new technology you have to insert into the portfolio to pursue that? And in any case in the meantime, what additional opportunity do you have to further integrate the tools? For example, you’ve read some work you’re doing to better integrate Innovus and Genus, is that something you could continue on as well?

Yes. Good question, Jay. Let me try to address your inquiries. Intelligent System Design can be divided into three main areas. The first is design excellence, which encompasses our core EDA and IP. We are dedicated to ensuring that our foundations are strong and that we offer the best tools in every category, which is our goal. We are pleased with our growth in the digital and signoff sector, achieving a 12% increase last quarter. We are successfully attracting new customers and expanding with existing ones in advanced nodes, specifically in the seven to five, and now moving on to 3-nanometer technology. We are excited about this progress. The second area is system innovation, which involves moving into system domains. As previously mentioned, we engaged in a thorough evaluation and discovered that our core competencies in computational software and digital implementation can be scaled to the system level, which is why we are optimistic. We are entering the embedded system, safety, and security space through our strategic partnership with Green Hills, and we see a $3 billion market opportunity there. Next, we are exploring the analysis area, valued at about $4.5 billion, where there is a need for innovative cloud-enabled and scalable solutions. Our strengths in PCB business and 3D technology will support our efforts in the 3D Solver for electromagnetic field simulations. We are actively developing and investing in this area, and initial feedback from potential customers has been positive, emphasizing the performance benefits. Lastly, we plan to leverage AI and machine learning for pervasive intelligence, applying these technologies internally to enhance performance and productivity across all EDA product lines, where we've seen substantial improvements. Additionally, we are collaborating with leading customers to use AI to optimize workflows and methodologies, allowing them to enhance their performance using machine learning and deep learning applications. This outlines our approach.

Lastly, geographically. There's been some interesting trends in Japan, which for years, as you know, was quite weak and lost share in terms of total EDA. But for you, you've now seen a few quarters in a row of sequential improvement in Japan and year-over-year improvement in Japan on both the quarterly and trailing 12 basis. The question therefore is, are you beginning to redirect or grow your investments in Japan and sustain that growth either with sales or AE or anything else?

Yes. Good question. I think Japan is an important market for us. A couple areas Japan is very strong, and I’ll just name a few. Now, automotive, they are very, very strong. And also, I mentioned earlier the edge industrial IoT, the microcontroller. And there are a lot of controllers collecting data, and then, couple of key players in Japan that we're very excited to team up with. And also, the whole video surveillance, consumer-related areas, and that AI machine learning can really play a role in it. And so, I think this is a very important market, and they are recovering very nicely. And then, right now, we’re engaging heavily with a couple of key customers that we want to be that trusted partner going forward.

Hey, guys. This is Jackson Ader on for Sterling tonight. A couple of questions from our side. The first would be, so looking at the outperformance here in the quarter, it seems like it's coming from the two areas that you called out, IP and hardware, which are typically the two more volatile areas for revenue. So, what is giving you the confidence then to raise the full-year guide above just this quarter's upside? Is there something in time-based licenses that came in ahead of what you thought or is the pipeline building better than what you thought?

I think, Jackson, I'll begin, and then John can add on. Firstly, I want to emphasize that we are seeing strong performance across our product lines. While we noted the hardware and IP contributions, we also experienced a 12% growth in digital. Additionally, we are very pleased with the custom and system connect sectors, which are both showing over 8% growth. This excites us, and it's why we are investing in system analysis as part of our analog custom interconnect system level, which has been performing well. Overall, I would say this growth is consistent across the board, including some of the new products we have integrated into our guidance for the year.

Yes, we had very pleasing Q1 performance for IP, but of course, IP is lumpy and probably benefits against a better compare versus Q1 2018. On the hardware side, if you recall, our functional verification revenue grew in the high teens in 2018. And the last time we spoke to you, we were expecting functional verification revenue in 2019 to be approximately flat year-over-year. With Q1 behind us and with better visibility into the hardware pipeline, we are now expecting modest growth in our functional verification segments, despite the difficult compare. We saw a pickup in demand in Q1 for our hardware products and we expect that to continue into Q2.

Okay, great. That's helpful. Follow-up question is kind of a two-parter. So, the first being, you've mentioned, Lip-Bu, the $30 billion TAM over the next few years, and expansion from the $10 billion that you've seen in the past. What would you say you currently I guess address of the incremental 20? And then, secondly, obviously part of this is going to be the Clarity 3D Solver that was announced a couple of weeks ago. What do you see as the main or who I guess, would you see as the main competitors for this Clarity 3D Solver? Thank you.

Good question. We are excited about the expansion of this total addressable market. This is a key focus for Cadence, which is why we have our Intelligent System Design strategy. Our foundation continues to grow in terms of design excellence, and all our EDA tools are driving growth with semiconductor and system companies to enhance differentiation. We are also starting to address system innovation, particularly in embedded systems, safety, and security. Our partnership with Green Hills is an important part of this strategy. We are now moving into the system analysis space, which represents a $3 billion opportunity, while market analysis is above $4.5 billion. Overall, we are making progress, and we will share some of our successes with you. On the competition side in system analysis, there are a few well-known players with legacy solutions. Customers require increasingly complex systems and prefer to ship less while conducting more simulations. This trend, along with the need for larger designs, demands solutions that offer more capacity and higher performance, which align with our strengths in algorithms, expertise, and multi-processing capabilities. These factors present a unique opportunity for us in this market.

Hey, guys, thanks for taking my questions. Can you hear me all right?

Yes, very well.

Yes. So, good raise to the full. First half of 2019 guidance assumes kind of 11.7% growth, and then decelerates kind of to the 6.7% for the second half. I appreciate your comments on kind of the updated hardware outlook. But how conservative is guidance still for 2019?

Hi, Jason. This is John. Everything we know is in our guidance. You're right, the first half does look kind of flat compared to the second half. And that's mainly because of functional verification, which includes both software and hardware products. But, that's quite lumpy, and our visibility into demand for Q2 looks good. Q4 is a very tough comparable.

Okay. And then as far as IP revenue for the quarter, I mean, you guys did post a strong quarter. I mean, how should we think about IP as a whole growth wise for the full year?

We're very pleased with our IP results in Q1. But IP in Q1 benefits from a relatively easy compare versus Q1 2018. We're not guiding the individual product groups, but we're very pleased with our IP results for the first quarter.

Yes, a couple of things we’re kind of positive about is a Tensilica, the proliferation adoption for the machine learning, vision, audio, and also automotive consumer surveillance. We added eight new customers. On the design IP side, clearly, we have the 112 gig long-reach SerDes IP, and this is a must-have for the hyperscale infrastructure. And we are just at the beginning of it and we are delighted, marquee semiconductor companies adopted it, and more to come and stay tuned, and we'll have more updates for you.

Hi, guys, thanks for taking my question. The first one is just, John maybe to clarify in terms of the guidance, one thing that has kind of changed is the recognized revenue that’s kind of estimated come over time. That ratable revenue is saying that it’s the new guidance, it’s 85% to 90% versus previous around 90%. Is the main delta in the hardware products a way that you’ve seen Q2 demand kind of turn out? Is that the reasons perhaps?

Yes, Gal. Our upfront revenue comes predominantly from two main sources, IP and the hardware part of our functional verification group. The expectation for better functional verification growth leads directly to that revision of our outlook for the recurring revenue mix. We're now expecting high-80s for 2019.

And then, the second question is just linked to your cloud offering. And in the past, your customers kind of liked to mix and match different parts of the processes. And when you move to the cloud, especially when you start doing design in the cloud, my question is, can tools still be matched as easily as previously requirements? And if not, does that mean that potentially tools can be more sticky or do you not expect any change into workflows, the way they're being managed in terms of vendors side?

So Cadence Cloud does not change our business model; it just offers our customers another way to optimize their investment in Cadence tools. We're not really expecting any difference in how our customers use our tools.

In some way, we try to drive the performance and productivity for our customers by moving to the cloud, so that you can address the peak load and you can parallel the distributed to the unlimited server that the cloud infrastructure provides and that is tremendous value to our customers.

And just as a follow-up on that. Would you say that when you are seeing the adoption of the cloud in the future, would you expect the majority of it coming from adverse capacity, like you mentioned from existing customers who potentially will invest less in their own infrastructure, or do you think that the new customer, the system companies, or even the startups will account for a larger portion of that adoption in the future?

It really depends on the customers. And they can use hybrid, using the on-premise, and address peak load with the cloud or they want to from scratch, some of the startup, they want to be all cloud, we are also open to that. So I think there are a lot of different models. And we basically want to make it available to our customers, whatever they chose and make sure that it is secure and can drive performance and productivity for them, and that is our main driver for using the cloud and then basically we are supporting them, and they have options, either customer-managed, using the Cadence managed or Palladium Cloud.

Thank you all for joining us this afternoon. In summary, our business is mission-critical to silicon development, which is the cornerstone of all design activity. Through our strategy, we are capitalizing on multiple technology waves and further proliferating our solutions with a broader base of customers. Next phase of our strategy, Intelligent System Design, brings new opportunities in design excellence, system innovation and pervasive intelligence, and an expanded total addressable market. In closing, I would like to thank all our shareholders, customers and partners, the Board of Directors, and our hardworking employees for their continued support.