Cadence Design Systems, Inc.
Q4 2016 Earnings Call Transcript

Published: 2 Feb 2017

[Operator:]

Good afternoon. My name is Shannon, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Design Systems Fourth Quarter 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you. I will now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence Design Systems. Please go ahead.

[Alan Lindstrom:]

Thank you, Shannon, and welcome everyone to our fourth 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 March 17, 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. 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 February 1, 2017 for the quarter ended December 31, 2016 and related financial tables can also be found in the Investor Relations portion of our website. Now, I will turn the call over to Lip-Bu.

[Lip-Bu Tan:]

Good afternoon, everyone, and thank you for joining us today. 2016 was another great year for Cadence, and I am pleased to talk to you about our results, accomplishments, and strategic direction. We delivered strong financial results in the fourth quarter and for the full year; revenues of $469 million in Q4 and $1.816 billion for the year, representing growth of 6.7% over 2015. Non-GAAP operating margin was 27% for the quarter and 26% for the year. Non-GAAP EPS was $0.34 in Q4 and $1.21 for the year, up 11% over 2015. Now I will address the environment and strategy before turning to the 2016 product highlights. Starting with the environment, semiconductor business conditions appear to have improved slightly with the expectations of low single-digit growth for 2017. Expected improvements are sector specific though and macro uncertainty remains. We are focused on key emerging and high-growth areas including automotive, virtual and augmented reality, cloud infrastructure, IoT, machine learning, and aerospace and defense. We have successfully managed through the ongoing customer consolidation to date. We expect just a minimum impact on revenue from consolidation in 2017 and believe we are successfully positioned for larger opportunities in the future. At the same time, our relentless focus on innovation, execution and customer success is driving momentum in the marketplace for us. The opportunities continue to grow with system companies. Turning now to our strategy, we are steadily executing our System Design Enablement or SDE strategy, the key points of which are to drive increased adoption of our core EDA portfolio, leverage our refined IP strategy for scalable growth, maximize the market opportunity of our system solutions, invest in emerging and new growth areas, and develop partnerships with an expanded ecosystem. SDE offers additional growth opportunities as we expand beyond a horizontal focus on semiconductors and tap into significantly larger markets through addressing systems companies and new vertical market segments. In 2016, we made measurable progress executing our SDE strategy. Expanding our ecosystem is important to developing opportunities outside our traditional markets. We announced several important partnerships for our SDE ecosystem in 2016. For example, Cadence and Arrow Electronics launched an integrated, cloud-based version of our OrCAD Capture. We partnered with MathWorks to streamline system level design and circuit level implementation for mixed signal IoT and automotive applications. We grew our system business in aerospace and defense, with expanded partnerships with Northrop Grumman and BAE Systems. Let me now turn to some of our product highlights and customer successes in Q4 and 2016. Innovation is at the heart of our success and we have introduced nearly 20 significant products over the past three years. Several of our products won awards in 2016, including Palladium Z1 and Virtuoso Analog Design Environment, and we have a robust product pipeline planned for 2017. Investments in our digital, signoff products are beginning to pay off as we gained even more momentum with the top 20 semiconductor companies. Revenue was up nearly 20% for the year with these customers. Overall, digital and signoff growth was 9% for the year. We are setup for additional proliferations in 2017. We added 60 Genus customers, 30 Innovus customers, and more than 20 new customers using our full digital and signoff flow. 16 of the top 20 semiconductor companies are now using Innovus, including four of the five top mobile chip makers. Innovus was used to tape-out a large GPU design, which helped a customer realize 15% power savings over the previous design. We are currently working with over 45 customers on advanced node design, with more than 12 7-nanometer engagements. In Q4, Qualcomm entered into an agreement with Cadence that represent an expanded commitment to Cadence products, including hardware and IP. Our Verification Suite provide complementary connected solutions that are based on strong core engines. It includes Incisive for simulation, JasperGold for formal verification, Palladium for emulation, and Protium for FPGA prototyping. We are pleased to report that Palladium Z1 had a phenomenal full year on the market. Total hardware revenue surged to a record high. We gained 29 new Palladium Z1 logos in 2016, 11 of which were system companies, and this is the fastest adoption of a new emulation system in Cadence history. In Q4, several leading semiconductor companies adopted Palladium Z1, including Cavium and Innovium. Customer demand for the Palladium Z1 remains strong due to its enterprise-class capabilities, which are ideally suited for large emulation firms (11

[Geoffrey G. Ribar:]

Thanks, Lip-Bu, and good afternoon, everyone. 2016 was a great year for Cadence all-around. We delivered strong innovation, customer successes, execution, and robust financial results. Overall, we are in a good position as we start 2017. Key results for Q4 and 2016 were

[Operator:]

Your first question comes from the line of Farhan Ahmad from Credit Suisse. Your line is open. Please go ahead.

[Farhan Ahmad:]

Hi, thanks for taking my question. Lip-Bu, can you provide some color on growth by different end market segments that you expect between your Functional Verification and Digital IC in this year?

[Lip-Bu Tan:]

Yeah. Farhan, I think your question is the growth on the Functional Verification and the Digital side. So overall, I think, I will give you the high level and then Geoff can provide you more detail. So far in term of our verification side, we are doing well and this is the fastest-growing for our customers and our Verification Suite, that as I mentioned in my script, and now (24

[Geoffrey G. Ribar:]

So a little bit of color. We don't guide specific questions, but a little bit of color perhaps. We do expect good growth across our core software business, especially in digital and signoff. We expect IP to rebound and have at least 10% growth. And we expect another strong year for our hardware, but wanted you to recognize we're coming off a phenomenal year with record revenue, meaning that the year-over-year comps may be difficult in hardware.

[Farhan Ahmad:]

Got it. And, Lip-Bu, can you talk about maybe VR and AR and the role that your IP is playing in HoloLens and how big of an opportunity do you see that growing for you over time?

[Lip-Bu Tan:]

Yeah. We are excited about this whole AR/VR. I mentioned a couple of areas that we are double, triple down on it (27

[Farhan Ahmad:]

Thank you. That's all I have.

[Lip-Bu Tan:]

Thank you.

[Operator:]

Your next question comes from the line of Monika Garg from Pacific Crest. Your line is open. Please go ahead.

[Monika Garg:]

Yes. Hi. Thanks for taking my question. Geoff, first, this new revenue recognition model, maybe can you talk about when do you expect to implement it and any impact to your current revenue recognition model?

[Geoffrey G. Ribar:]

Yes. So I'll start. We do expect to retain a recurring revenue treatment. We're currently working through the details of the new standard with our advisors to determine how we will implement it and what impact, if any, it'll have. There's still a lot of work to do. So stay tuned.

[Monika Garg:]

Any initial assessment? Do you think it could impact your model or not?

[Geoffrey G. Ribar:]

Yeah, again, we expect to retain recurring revenue treatment, Monika.

[Monika Garg:]

Got it. Okay. Then a couple of months back Siemens announced acquisition of Mentor. Maybe could you talk about how do you see that impacting the EDA industry and Cadence.

[Lip-Bu Tan:]

Sure. This is Lip-Bu, Monika, and I think, clearly, Mentor is a good competitor and it will remain an important competitor. And we are not in the place to comment or speculate as they are pending for transaction. One thing that highlights the importance of SDE and then the EDA part of that SDE, System Design Enablement, we are excited about that in that it tie in (30

[Monika Garg:]

Got it. Just last one. Customized design for two consecutive years has grown less than 5%. Anything particular there or do you think customized design is a lower growth market than digital? Thank you.

[Lip-Bu Tan:]

Yeah, custom/analog, as you know, we are the leader and clearly when you have the position, sometimes the growth is not going to be higher, but we continue to drive the leadership and then we drive the most advanced set of custom and analog. And in fact right now, we also tried to tie in with our strength in the digital side to provide the mixed-signal solution to our customers. And in fact, we have couple of new encouragement points in our adoption of our next-generation product, the new Virtuoso suite. Actually it's ahead of expectation and we are very pleased with that and also adopt by over 100 customers. And then the other part is that the Spectre XPS, our new FastSPICE simulator and now have over 70 customers on the SRAM side, and now we're starting to apply and expand into the mixed-signal side. So I think all I can highlight is that we have a strong position. We continue to drive the leadership on that. And then the other part is, we also drive some of the new, emerging opportunities like IoT, automotive and then the mixed-signal application that we can really drive continued leadership.

[Monika Garg:]

Got it. Thank you so much.

[Lip-Bu Tan:]

Thank you.

[Operator:]

Your next question comes from the line of Mitch Steves from RBC Capital Markets. Your line is open. Please go ahead.

[Mitch Steves:]

Hey, guys. Thanks for taking my question. I just had one, kind of on the actual system side of the business. So, so far just based on your comments, I think R&D spending hasn't really been impacted by consolidation, so the semiconductor piece should be fine. But how do we think about the systems piece in terms of how that growth rate is comparing at a relative basis to overall semiconductor R&D spend?

[Lip-Bu Tan:]

Yeah, so, Mitch, let me try to answer that. That's why I think it's important to understanding our System Design Enablement strategy and this is expanding beyond our EDA towards – expanding to also the system company and some of the new verticals that we are pursuing. And then just like we did in the semiconductor side, the ecosystem partnership becomes very important like, for example, in the semiconductor side in the early days, we're very focused on TSMC, same thing, we are starting to really focus on networks that we announced on the system-level design and circuit-level implementation, Arrow Electronics and then somewhat this packaging become very important with TSMC. And then some of the vertical we are pursuing, couple of them we highlight, is aerospace and the defense and then with our expanded partnership with Northrop Grumman and BAE and then stay tuned. We will tell you more. And then also our expanded partnership with the GE Aviation side. And then on the automotive side, we highlight a couple of pointers to you. Mobileye is engaging with us on the Palladium Z1, Infineon engaging with us on the automotive function safety, and then some of this enablement in terms of automotive application on the TSMC 60-nanometer FinFET. And also, we have a dedicated team right now on the automotive and aerospace and defense. And then, we also highlight some of the IP engagement with a Japanese customer on automotive application, and also our data center is another area that we are focusing on. And beside our data center, IP, our hardware with Cavium, Innovium and the engagement, and I think stay tuned. So I think over time, we're going to like kind of show you how we're going to expand that strategy. And then some of that strategy, I think we highlight, not just new area, actually it's enhanced our Core EDA to drive even more adoptions, and then leverage on some of the refined IP strategy that we focus on and then to drive some of the success in the expanded ecosystem.

[Geoffrey G. Ribar:]

And just a little bit, Mitch, on the numbers. The systems business is approximately 40% of our business. It has expanded our TAM and it's growing nicely.

[Mitch Steves:]

Okay. Got it. Thank you very much.

[Lip-Bu Tan:]

Thank you.

[Operator:]

Your next question comes from the line of Krish Sankar from BoA Merrill Lynch. Your line is open. Please go ahead.

[Krish Sankar:]

Yeah. Yeah. Thanks for taking my question. I had a few of them. First one either Lip-Bu or Geoff. I'm just trying to understand on your guidance, is there a way you can quantify the negative impact from the semiconductor customer consolidation and the positive from your share gains in product traction, or is the impact of semi consolidation overblown that it's really de minimis? Then I had a few follow-up.

[Geoffrey G. Ribar:]

Yeah, Krish, it's really de minimis, had minimum impact on the revenue from consolidation. And, again, I think there's also opportunities that come from consolidation to us that are harder to track for 2017, right? It's de minimis for 2017.

[Krish Sankar:]

Got it, got it. And then, a couple of other questions. One is, your hardware business, I'm guessing that includes emulation and FPGA prototyping. Is there a way to quantify the market size in 2017 for each of those two categories?

[Geoffrey G. Ribar:]

I think it's kind of hard. I think what we've generally said is both of these businesses are growing because of a secular trend, which is benefiting the whole industry and certainly, as you saw, we had a record year last year in hardware, particularly driven by the Z1.

[Lip-Bu Tan:]

And in some way, for the advanced node complex silicon and system design, hardware emulation is very critical, so that they can – shipping their product faster, because whatever their design, they can verify much closer. And then this hardware/software co-design, co-verification is really the bottleneck. And so, we're going to see continued growth and demand. And Palladium Z1 is really enterprise class, people love it. And then the customers, when they're starting to use Palladium – and they just find they want to buy more, because the capacity requirement, the benefit they receive and then time to market improvement is tremendous value to them and that's why we see very good growth for us.

[Krish Sankar:]

Got it, got it. And then the final question, the operating margin is expanding about 100 basis points this year. Is it primarily a function of some of your digital investments winding down now that you're getting the traction or is there something else going on that actually high 20s, 30% Op margin in the future is probably a reality?

[Geoffrey G. Ribar:]

So glad you noticed that our operating margin improved by 100 basis points. I think it's less that we're continuing to make investment. But I think we're seeing the results of investment show up with extremely strong digital growth last year and particularly in Q4 and we expect that growth to continue into the next year, plus the results from all the rest of our businesses rolling in.

[Lip-Bu Tan:]

And in some ways, Geoff and I will continue to drive the productivity efficiency to drive success and then scale the business.

[Geoffrey G. Ribar:]

Yeah.

[Krish Sankar:]

Got it. Thanks, guys. Thank you.

[Lip-Bu Tan:]

Thank you.

[Operator:]

Your next question comes from the line of Jay Vleeschhouwer from Griffin Securities. Your line is open. Please go ahead.

[Jay Vleeschhouwer:]

Thank you. Good evening. Lip-Bu and Geoff, you noted a couple of times that semi consolidation had had a minimal impact and that in itself is not too terribly surprising. But the question really is when we consider actual levels of semi R&D, is there some rate of growth that you think you do need to see to sustain your growth in EDA? The reason I ask is, when we look at a composite of semi R&D, at least for the third quarter of last year, the latest data available, semi R&D does appear to have somewhat declined sequentially Q1 through Q3 of last year, was flat to slightly down year-over-year, not too terribly much. But that helps you keep a minimal impact. But at what level of growth, if any, do you think you really need to see in semi R&D setting aside systems customers to sustain your core EDA growth?

[Lip-Bu Tan:]

Yeah, Jay, let me start first. I think now clearly our focus on the leading company, the top 20 and when they do more and more consolidation, actually it's very interesting. They actually spend more money in R&D, because they want to continue their leadership. And so, by focusing on the right customer and then really drive efficiency, drive the most innovating products to help them, and I think we're going to see that opportunity for us. So that's why I think the impact is minimum. And then secondly, we are very well positioned to getting greater opportunity going forward, and also I think I mentioned earlier the system company, the SDE strategy that we are pursuing. We get that. And also, I think that China, the semiconductor company are (41

[Jay Vleeschhouwer:]

Okay. The follow-up question is how you're thinking about some of your internal investment priorities for 2017 and beyond. When we consider your need to hire people or bring people on, one thing we noticed recently was an unusually large increase in job openings that you're looking to fill in Asia, much more pronounced than we'd seen before. And again, that in itself is also logical given the importance of that market to EDA, but how are you thinking about your head count expansion plans, at least in that part of the world from a geo (42

[Lip-Bu Tan:]

So I think, Jay, let me try to answer the R&D side, and then Geoff can talk about the other portion in terms of internal priority. From the R&D point of view, I think clearly we will continue investing in digital and in signoff, because we are proliferating with our customers, the leading customer. And then secondly, we're going to continue double down on some of the verification side, because that's where the bottleneck on some of the customer shipment. And then, in terms of the digital front, I'll just go a little bit deeper and we are right now very focused on the full-flow. And so, not just the place and route, the signoff. Synthesis is very important. We have a new product came out, very well received and right now our priority focus is full-flow. And the customer looking for full-flow optimization productivity gain in terms of the PPA, performance, power, and area and the runtime so that they can drive their efficiency. So I think that part, we're going to continue to double down. And then the other part, we are (43

[Jay Vleeschhouwer:]

All right. And then lastly for, Geoff, on emulation. Your cost of revenue for product and maintenance increased sequentially by about $19 million from the third quarter. So just to be clear, $13 million of that was due to the write-down for XP II, which perhaps has reached end-of-life now. And therefore the remaining $6 million or so would have been largely tied to a sequential increase in hardware from Q3, and therefore there would have been a strong, by inference sequential increase in emulation revenue for the quarter, possibly leading to a record quarter for hardware in Q4.

[Geoffrey G. Ribar:]

Yeah. So on the reserves, yes, we took a $13 million charge in Q4 for XP, not just XP II, but XP, right, as we're reaching the end-of-life for that product. That was on top of the $5 million in Q3. And so, that was the major thing. We're not breaking out hardware beyond that in Q4. But as we said, hardware was a record year last year, mostly driven by Z1.

[Jay Vleeschhouwer:]

Okay. Thank you.

[Operator:]

Your next question comes from the line of Rich Valera from Needham & Company. Your line is open. Please go ahead.

[Richard Valera:]

Thank you. Lip-Bu, I was wondering how you would characterize the macro environment for your customers entering 2017 versus 2016. I know you mentioned that semis look a little bit better this year with at least some growth expected, but can you just put in your own words how you think about the environment this year versus last year?

[Lip-Bu Tan:]

Yeah. As I mentioned, the environment from what I see has improved slightly and I think it's not in general. I think it's more sector specific from my point of view. And I think that I like what I see and engage with the customer. I think automotive, as you all know, the ADAS, the self-driving is a lot of excitement going on right now. And AR/VR, that's a lot, a whole suite of new players coming up. And then the cloud infrastructure, that's something that I'm – very dear to my heart. And clearly, the scalability of the hyperscale web services, they're driving the new changes, and then in terms of more programmability and more scalability, in terms of the storage requirement. And then of course the IoT, not just the consumer IoT, a lot of industrial IoT to drive productivity and to drive efficiency and more intelligent and machine learning, deep learning on the cloud and on the edge. And then there's a lot of new changing landscape and, of course, the whole aerospace and defense application and their requirements. So those, I think, drive the 2017 semiconductor growth and I'm excited about it. And I think Cadence, well-positioned to capture some of this and then clearly they are driving some of the most advanced nodes and design and also they are looking at holistic approach from just design all the way to verification to the PCB board, packaging, design and then all the way to the system hardware, software design and verification and then I like what we have in that – in our (48

[Richard Valera:]

All right. Thank you for that, Lip-Bu. A question for Geoff, and first I'm glad to hear you'll be staying on for another year, Geoff. The question, just want to revisit the operating margin. It is nice to see that you're guiding for about a percentage increase this year. Just wondering, going back a ways, there was a point when you guys talked about kind of a target incremental operating margin. And I know you kind of got away from that as you got into the investment mode here. Is there any thought of getting back to that sort of target as you move forward, some kind of target for leverage in the model or are we going to kind of play this year-by-year?

[Geoffrey G. Ribar:]

Yeah, so our strategic priority, Rich, remains to develop innovative products and to drive customer value, customer success. And so that remains our concentration. But as you noted, we started guiding 2015 at 25%, 2016 at 26% and this year at 27%. So we are seeing the impact of those investments working out. So I think that's the positive, but we're not guiding – we're concentrating on strategic priority, which is innovative products.

[Richard Valera:]

Got it. And then, just with respect to the written down emulation product, if you sell that product you guys are going to kind of call that out in your COGS, I mean, essentially you have sort of zero cost inventory, I guess, now?

[Geoffrey G. Ribar:]

Yeah. If we happen to sell stuff, it would be largely at zero cost. We also have maintenance requirements going forward on XPs (49

[Richard Valera:]

Okay. Very good. Thanks very much, gentlemen.

[Lip-Bu Tan:]

Thank you.

[Operator:]

And our final question comes from the line of Sterling Auty from JPMorgan. Your line is open. Please go ahead.

[Sterling Auty:]

Yeah. Thanks. Hi, guys. I wanted to drill into, first, the 20% growth with the top-20 semi companies. Is there additional color you can give us in terms of how much of that was expanding usage by more design teams versus taking down additional tools versus selling to new maybe top-20 that you weren't doing as much or maybe any business with previously?

[Lip-Bu Tan:]

Sterling, let me start first. Clearly, we are excited. Our investment is starting to pay-off now and I think, clearly, in some of our – entire new suite of tool that we develop and clearly customer see the benefit in term of the performance, power, area, and runtime and it can help them to drive these complex designs. So the top-20 semiconductor company plus several top-tier system companies are really adopting the Innovus. And then right now we are working closely with them in terms of full-flow design, and that is very important so that they can really count on us to design their most complex chip and can be fabricated in the most advanced node, the 10-nanometer to 7-nanometer and towards later on to the 5-nanometer. So I think overall, they basically start with – work with us and then adopting some of our tool and then now we are starting to not just a couple of projects, now there are some group and their (51

[Sterling Auty:]

Got you. And then one follow-up would be, Geoff, I think the non-GAAP R&D expenses dropped sequentially more than I have seen in my memory anyway. Was that just the timing of the restructuring or what other items drove that and is there any snapback that we should expect in that R&D spend in the first half of 2017?

[Geoffrey G. Ribar:]

Yeah. So a couple things always happen in the latter half of the year for us, Q3 and in Q4. First is, the Social Security goes down and frequently to zero as people go over the Social Security cap. Second is the vacation time goes up in the second half of the year, both in Q3 for the summer and in Q4 for the holidays. So those two obviously are the biggest drivers and you should expect some snapback in R&D in Q1 as a result.

[Sterling Auty:]

Got it. Thank you, guys.

[Lip-Bu Tan:]

Thank you.

[Operator:]

I would now like to turn the call back to Mr. Lip-Bu Tan for closing remarks.

[Lip-Bu Tan:]

In closing, 2016 was a year of great success and 2017 present us with exciting opportunities. I would like to thank all our shareholders, customers and partners, board of directors and hardworking employees for their continued support. Thank you all for joining us this afternoon.

[Operator:]

Thank you for participating in today's Cadence Design Systems fourth quarter and fiscal year 2016 earnings conference call. This concludes today's call. You may now disconnect.