Cadence Design Systems, Inc. (CDNS) Earnings Call Transcript & Summary

Hello, everyone. Good afternoon. This is Krish Sankar from Cowen. I'm the semi equipment and hardware analyst here. And the next company presenting is Cadence, and we are fortunate enough to have John Wall, the CFO. John, very nice to see you virtually.

And good to see you Krish.

Thanks, John. And I think John is going to give a few minutes, a high-level overview, and then we'll jump into Q&A. With that, John, the floor is yours.

That will be great. Thanks, Krish and before I start, I should read the safe harbor statement. Keep me in with my legal team. So today's discussion will contain forward-looking statements and we'll make use of certain non-GAAP financial measures. Please see our most recent 10-K, 10-Q and website for a discussion of risk factors and our use of non-GAAP financial measures. But yes, thanks for the introduction, Krish. Yes, as you know, Cadence is a company that was created by engineers, basically created by engineers for engineers, where it's technical vertical software company, largely in the EDA space. We provide software tools, intellectual property, hardware verification platforms and services to semi and electronic system companies. Our customers are across multiple verticals, including mobile, consumer, cloud, data center, mil/aero, automotive and upcoming in industrial and Medical. We have a very strong culture of innovation, and we spend close to 40% of our revenue in R&D. Over the last 3 years, we've developed and introduced more than 20 significant products. And the other aspect is that we've had a relentless focus on ensuring customer success, and we've partnered very closely with them at the very early stages to understand their needs, which in turn drives our road map. In our earnings call a couple of weeks ago, we reported pretty decent financial results and reaffirmed our guidance for approximately 10% revenue growth for the year.

Got it. Thanks, John. Let me start at something very topical. I'm sure you've gotten this question a million times about the whole commerce department ruling. And looks like there are 2 aspects to it. One is the civil military fusion, which impacts the Chinese customers directly. And then the other one is the direct product rule which impacts Huawei through TSM. And if you look at the landscape, these are all customers of yours. So I'm kind of curious, how do you look at it from Cadence vantage point? Do you think this is a management risk? Is it in a de minimis issue? Or how do you look at it? And then I have a couple of follow-ups on that.

Sure, yes. So the export restriction situation is still very fluid. Many of these things are largely a bureaucratic or red tape exercise for us. We're a large international organization and we have our import/export compliance group and we operate in dozens of countries around the world. But -- so we have to comply with import/export regulations everywhere. And when new rules are introduced, our team work with the legal team to understand how we can implement those. We're a U.S. based company so we'll continue to comply with all government regulations, while at the same time, we're supporting all of our global customers as best we can. But Asia Pacific is a strong growth region for us. We've done very well in China. And that presents -- that represents a very good growing opportunity for us. We grew our revenue, what was it, 10% in 2018, 10% in 2019. And we got off to a really strong start this year with 13% in Q1. China is committed to growing out its semiconductor ecosystem. And we're doing all we can to support our global customers, including in China, while we comply with those export regulations. I should point out this -- what is it, the 55% to 60% of our revenue comes from our top 40 customers. We have a very diversified global customer base with no heavy concentration in any one single customer. That's -- although China is investing heavily in the semi industry, and there's many exciting startups and opportunities for us out there in China, the guidance that we gave in the most recent earnings call, the same as we always do, we assume that the export restrictions that exist at the time will remain in place for the rest of the year. And since then, as you said, there's been some new rules again, it's largely a bureaucratic exercise for us. We're reviewing the new rules. In some cases, we have to wait for additional clarification because the more subjective the rules, the more difficult it is for us to try and implement it. So people have to do a whole lot more documentation, in terms of how to apply the rules, probably a bit premature to size any impact right now. But generally, any increase in restrictions is a bit of a headwind for us. Any decrease in restrictions as a bit of a tailwind. But like you said, most of these things tend to be a bureaucratic red tape exercises.

Got it. Then on -- in your last quarter, Q1, you can say that on a year-over-year basis grew almost 42%, which is kind of impressive and the fact that actually, Huawei was in last year's number, but not in the most recent quarter. So I'm kind of curious what's going on there. And how should we think of your overall China sales exposure for the full year? And is this all mainly coming from domestics? Or do you think there are some multinationals also in it, although I really find it hard to think there's multinational are being designed in China?

Right. So let me unpack it a little bit. But so I particularly don't like talking about any individual or single customers. So let me talk about the region as a whole. But in terms of the quality of our results in China in Q1 were excellent. But that's not unusual. I mean, our China revenue over the last 9 quarters has fluctuated between a low of 8%, I think, of our revenue in Q2 '18 to a high of 13% both last quarter and back in Q4 2018. But some of our revenue is lumpy in nature. Most of our revenue is recurring and it's almost daily revenue. But the recurring revenue percentage is in a range of 85% to 90%, which means that there's 10% to 15% in each quarter that you're recognizing upfront revenue, and that typically comes from our hardware and IP business. That's -- in those businesses, that -- you get revenue upfront on delivery of the IP or delivery of the hardware. And as a result, it's kind of lumpy in nature. It's that we benefit from diversification across -- we have 5 different businesses, and we operate across so many different geographies. The company benefits from that diversification at a very high level. But once you start drilling into geographies or into individual business groups, that lumpiness can skew the numbers in any one quarter. So in Q1 2020, we had more IP -- a lot of our IP and hardware revenue for upfront revenue fell into China in Q1 2020, whereas back in Q1 2019, the comparative quarter we probably had more upfront revenue for hardware and IP in places like Japan and the Americas. But generally, we encourage people to not just look at any one quarter, but kind of, look at maybe a rolling 4-quarter look at the year, look at a rolling 4-quarter view to take out some of that volatility that comes from individual upfront revenue falling into one quarter.

Got it.

We're very pleased with the start that we got off to in China for this year.

Yes. That's very helpful, John. And then this is my last question on the China topic. One of the things that's kind of interesting is over the last few years, you've seen I guess, the growth of some of your competition in China, there's like Empyrean, Avatar and all these folks. So how do you segment them? Where they are relative to the more, what I call is the well-established players like yourself and Synopsys?

Of course, I mean we're -- naturally, we're respectful of all competitors. But -- and there are a number of China-based EDA companies, as you highlighted, that offer a few point tools. There are 3 major providers in EDA tools and platforms worldwide. And those have been in business for 30 years, that's ourselves, Synopsys and Venture, and that's built on a foundation of writing millions of lines of code over that 30-year period. There's only 2 companies in the world that provide a complete end-to-end chip design flow for analog, digital and mixed signal. But -- and Cadence staying on top of that also has complete those for RF Board and IC package design. Collectively, our expertise, I think, is unparalleled. And we'll certainly take time, and it will certainly take time and major investment for anyone to match it. But -- and I know it's been reported many times that China is committed to semiconductor self-sufficiency. And presumably, that means EDA too. But we don't see it as either a near or medium-term threat right now.

That's helpful. And then on the earnings call, John, you spoke about baking in some credit deterioration in your full-year forecast. However your smaller customers, where I think the bigger impact would be, have been over the last couple of months, have they been more or less resilient in this COVID environment?

Yes, yes. Our expectation -- I mean we're blessed in that. I mentioned earlier that's like 55% to 60% of our revenue comes from our top 40 customers. And it reads like a who's who of the strongest balance sheets in the world. That's -- but we're concerned about the long tail because we figured that it's the smaller mom-and-pop shops, just the smaller businesses that are most impacted by the coronavirus. And the impact this coronavirus has had on people taking care of normal day-to-day business. So what we did, and we naturally have a failure rate of start-ups in the business. That's a recurring theme anyway. There's people -- you're not trying to innovate if you don't fail sometimes, right? This -- so we often have a number of customers that we know will fail from time to time. So we're prepared to deal with situations like that. What we do is we look back through the history, and we thought, just for the purposes of providing guidance that will -- with the current environment, what if we saw the same failure rate that we had suffered from like Q1, 2017 right through to Q1, 2020. What if all of that happened again in a condensed 3-quarter period. And then I topped that up by 10% to 15%. And we said, okay, we just embedded that into the guidance. And then we thought, let's work with our customers, try to help them. Where that impact shows up is it's the actual perception of credit deterioration can impact your results. But it doesn't matter. I mean, if everybody kept paying on time, the fact that you think you may not be paid can throw you into what they call variable consideration from an accounting perspective. And if you doubt that you're going to be able to collect on the revenue, you shouldn't take the revenue, you should defer the revenue until later, but until you have more certainty about collections. So we factor all of that in, and we embedded that into our guidance. So we're anticipating some natural credit deterioration in the longer tail of customers. But it's like I say, it's all in the guidance, and we feel very, very comfortable about being prepared to support for our customers through this.

Got it. And I understand a majority of your revenue is recurring, so obviously, it's a more durable and resilient business. But let's just say, hypothetically speaking, if over the next few quarters, there's a macro or an end demand slowdown. Which segment of your business will see it first? Would it be like hardware, IP systems, where do you think you it first?

That's a great question. I guess the fundamental resiliency of EDA stems from the fact that our customers use us to design products that won't come to market for 1.5 years or more. But I know I'm the envy of my peers when I talk to them. And because our customers spend with us is coming out of their R&D budgets. And I talked to many of my peers, and they tell me that their customer spend is coming out of their IT budgets or their G&A budgets. And in a downturn, it's G&A, you'll go to cut first before you ever touch R&D. So we have some protection from that. We very rarely see our customers send engineers home. If anything, in times like this, a lot of our customers will double down on R&D to design their way out of this. In the past also, I would have answered your question and said -- I mean, for me, personally, the first thing I look at is I want to cut CapEx. And you probably saw that in our Q1 results because we were guiding $90 million in CapEx for the year. And we immediately scrubbed that and cut that back to $80 million. But -- and I thought that would impact our hardware demand. And similarly, from a strategic standpoint, we've been building a palladium cloud to make sure that we have an OpEx model to fit customers. So if customers are worried about CapEx, we have that alternative. But I'm not so sure that's necessarily the case anymore in terms of EDA hardware is kind of -- it's a mission-critical priority of chip software and system design that -- I guess where it will show up first is because of the nature of those hardware and IP revenue -- some IP revenue being upfront, that's, I guess, any slowdown, even a proportional slowdown is probably going to hit your -- you'll see it first in your upfront revenue numbers. But yes, I guess that's where you'd see it.

Got it. And then, John, last year, your IT business grew, I think it was like 16% year-over-year. How much do you expect it to grow? Or how much of it is embedded in your full year guidance for FY '20?

Yes, we feel good about our IP business. I mean, typically, we're aiming for double-digit growth or low-teen growth there. And we found that that's quite the sweet spot. But we could grow faster there, but we turn away some business because we're focused on like we typically guide ourselves with the rule of 40 metric. Just as a concept, it's -- we're looking to optimize for revenue growth and profitability, maximize profitability for -- we worry about your take-home pay, not your gross pay, right? But -- and so from an IP perspective, we like to focus on off-the-shelf IP, IP that generates royalty revenue is really sweet. I love that because it's 100% margin. But when you look at -- on the IP business, we've focused on having a differentiated portfolio of top-class IP ideally off the shelf, and then we try to do as little customization as possible. But because we find the more we customize, that's the less resale value you get later because you're narrow down your audience to an audience of one, if it's highly customized for reuse opportunities. But generally on IP, I think the sweet spot is kind of in that double-digit to low teens for us from a profitability perspective.

And are you guys doing any more -- I mean, any of more custom IP? Or is it all like -- I mean, I thought that was again a customer-specific request, right?

Well, a lot of IP, I mean, even the IP that you're selling off the shelf, a lot of customers will want you to tweak it to some extent to customize it for their use. So yes, there's always some level of customization. And if you recall, on our earnings call, we highlighted that some of our uncertainty in relation to Q2 was because our guys had to go into the lab to complete customization on the customer -- on the IP that the customer was buying. And it's just the timing and access of the lab to get through all that work. We created some uncertainty between Q2 and Q3, but no answer for the year.

Got it. Then what percentage of your sales are you say, system sales? And what percentage of your total sales is recharacterized as driven by auto customers?

So I guess, yes, I mean, typically, we look at like systems versus, say, semis. But -- and over the last 5 years or so, the systems percentage of our revenue has been approximately 40%. It's always been slightly growing because by nature, we're growing into -- with our intelligence system design strategy, we're growing more into that system space anyway. And as we grow the long tail of customers that we will see that systems percentage rise. I think it's trending already -- I'm rounding down to 40% now. It's already trending higher. But I think it's only a matter of time before we hit the mid-40s, and then maybe you get to 50-50 at some stage. That's the trend that we're on. But right now, kind of 40s, trending towards the mid-40s is kind of the systems percentage of the business.

Yes. And what about...

I was just going to say automotive because you mentioned auto customers. Our automotive is a bit harder to track. That's -- there are some startups and Tier 1 suppliers and chip design activity by auto manufacturers hasn't really taken off yet. But most automotive-related revenue probably comes from the semi companies.

Then I think, John, I think on the last earnings call, you mentioned how your systems customers has grown to over 30 and I think it was like 20-or-so a quarter earlier. So clearly, growing at a pretty high clip. Is this mainly share gains? Or is it actually the systems customers realizing that EDA is more valuable for us and the SAM is essentially expanding?

Well, I think so it's all of the above, right? In terms of -- I definitely think it's a space that's growing. Its system and chip design is more complex. And so as system design becomes more and system simulation becomes more complex. But that whole area, that whole market is going to grow. And we feel that, that's a fast-growing market. That's particularly one of the things that attracted us to is that -- I mean, Cadence's core expertise is in computational or technical software that were our core EDA business, probably 1 -- I know we break our business down into 5 different platforms. So maybe 1/3 of all of our revenue is probably coming from simulation -- simulation activity. So we have a lot of simulation expertise internally in the company. And then we supplemented that simulation -- those simulation internal experts with some domain expertise in system analysis to create our new products for -- with the Clarity 3D electromagnetic solver and the Celsius thermal solver that by nature of the fact that we're coming off a very small base in system analysis, and we're already entering, but we're naturally any business we're doing there, we're taking share because we're starting from zero, right? That's -- so we're taking shape. But I do think that it's a big enough space and it's growing fast that's going to accommodate -- is going to accommodate multiple players. And I think it's a really good opportunity for us. And it's a natural place for us to go.

Got it. And then, over the last few years, I should say, what has kind of struck me as very interesting as our operating margin expansion. So what do you think is a long-term operating -- right operating margin for this business?

Right. So basically, our focus has been on driving profitability, increased profitability, revenue growth, but not just revenue growth for the sake of revenue growth, profitable revenue growth. But -- so we adopted the rule of 40 to fairly allocate investment dollars amongst the groups because like you say, you've got like 5 businesses under the umbrella of Cadence, and you've got an investment pool, and you have to fairly allocate it to the different groups. When we were doing that, we thought rule of 40 was a good way to size these businesses up against each other in terms of where was a good place to allocate the investment dollars. In terms of like from back end -- we started doing that back in, I think, 2017. So 2016, the year before we started that, you had -- I mean, Cadence had just less than 26% operating margin. Last year, we finished with 32% operating margin. The reason it grew so quickly from 26% to 32% over that 3-year period was that in 2017, 2018 and 2019, we dropped more than $0.50 of every additional revenue growth dollar through to operating income. And that's what we're focused on. But again, in our guidance for this year, it's slightly skewed by the fact that we are including -- we have the AWR and Integrand acquisitions, we had to take a purchase accounting haircut on deferred revenue there. But -- and of course, we have the extra week, a 53rd week this year. But if you back those things out, you similarly see now full year running, we have more than $0.50 of every dollar flowing through to operating margins. So there's no near-term ceiling on operating margin for us while we continue to do that. But 1 thing that's interesting is that, when you look, while we went from, say, 26% to 32% over that 3-year period, you had, say, ANSYS, a beautiful company that had 47% operating margin, it went to 45% because they're growing incremental margin at 40%. You look at the likes of a Synopsis that I think Synopsis went from 23.5% to 25% over that period of time because incremental margins were coming through at 28%. So we naturally look at everything, we look at everybody else's data to see what we should be doing. We try to take the best of all worlds. But our focus on incremental margin has -- is really what's driving the operating leverage that -- and it's all neatly tied in together because you're basically trying to allocate your own investment to the areas where you have the highest opportunities for growth, and we're a very, very data-driven company, and we use oceans of data to make sure that we do that properly.

Got it. I mean, one of the reasons I asked this question was because if I take a very long-term view, 10 years ago, Cadence Synopsis, they were like 20% op margin companies, mentor used to be more like 12% back in the day, and then now you are like kind of head to 30%. So over the next 5 to 10 years, is a 40% a rational expectation? What is realm of expectations, right?

Well, you may say that. I couldn't possibly comment. I mean, basically, I've got -- we only guide to the current year. And just when we have something to say about 2021 and beyond, we'll say that. But I wanted to point out that we've consistently performed. We're consistently delivering that. And that's something that we're striving to achieve with efficient and effective allocation of capital internally within the business. And that's why I say that there's -- people ask me all the time, what could you achieve? I don't necessarily want to put anything out there from the perspective of who knows what we can achieve. If you can keep doing the 50% and dropping 50% and even the 50%, I'm reluctant to say because we can try to push that higher, too.

Right. Right. Got it. No, that makes sense, John. Then on the buyback, you have, I think, $269 million left in the buyback. Are you slowing it down right now because of COVID? Or has there been no change to the thought process gain buybacks?

So no slowdown. I mean, we're very disciplined and value driven, as you said, in everything we do. We plan to use $75 million of that $269 million in Q2 to repurchase shares. And we're aiming to return around 50% of free cash flow to shareholders through stock repurchases this year. We set that out as our plan at the start of the year, and we're sticking to that. That -- and we frequently revisit that repurchase program with our Board to evaluate the level of repurchase and whether there's any need to change that level. Essentially, with capital allocation, you're always trying to balance investment, risk, liquidity and capital return.

Got it. And then in your full-year guide, what is the growth profile embedding in for the hardware and the emulation business this year?

Oh, for hardware. I mean, so basically, hardware fits into our Functional verification group. But -- so I think when you look at hardware and emulation, I think you have to look at that function of verification group, and it's a verification suite. It wins in the marketplace because it delivers the best verification throughput driven by 4 best-in-class engines. I mean, we have Xcelium and Jasper on the software side, and then have Palladium and Protium on the hardware side. Now what we're finding is the hardware family, the Palladium Z1 and Protium X1 are kind of forming a bit of a dynamic duo. And that's proven very popular with customers. But when as we think about growth for the year, I certainly expect functional verification to be maybe the slowest grower of our 5 businesses but -- and that's generally just the result of some of our hardware cyclical that our emulation system is awesome and still a great emulation system out there in the market. But it's almost 5 years old now. But -- and generally, you tend to see kind of growth plateau around that time of the cycle. But it's getting a new lease of life with the -- because the Protium X1 is built on the same scalable infrastructure that reduces bring up time if you use Protium X1 and Palladium Z1 together. And like I said, the team in cider column is a dynamic duo that because the cross-selling opportunity is great there. But -- so yes, we're very pleased with the business and functional verification, of which the hardware piece fits in. But I expected to grow -- certainly expected to grow this year. But I would expect it also to be maybe the slowest of our 5 businesses.

Got it. Got it. And then I know a few years ago, you guys spoke about doing like more like a cloud-based approach. So what percentage of your revenues today are from the cloud?

Yes, I don't think we disclose that for competitive reasons. But we did have, I think, 15 new customers and some larger customers adopt our cloud module back in Q1. That -- now, some of that's driven by circumstance in terms of -- I think coronavirus, the outbreak and more people working from home probably helped accelerate some people to check out the -- our cloud offerings. But our approach to the cloud has really been with the -- to try and provide a different platform or a different way to use our tools. It's -- we were relatively agnostic, whether our customers move to the cloud or not, we're just trying to provide them access to our tools and access to the whole platform in whatever way they want to use the tools.

Is it a higher-margin business in general? Or is it op margin neutral?

I think it's relatively neutral. I don't think -- I think the difference is relatively insignificant.

Got it.

Where it does open up opportunities is that -- I mean, you look at the price point and say some of our hardware that it's quite significant. And in some cases, you might have a number of users that don't want to make the capital investments to purchase the whole system. And -- but with a cloud offering, you can use Palladium cloud, but -- and you're not committing to the big capital expenditure. Did I lose you Krish? Hi Krish, I lost you for a second.

Sorry about that.

I don't know how much of that you got. But...

I got your answer. So I assume we're running out of time. My final question is, saw the news of Lip-Bu joining the SoftBank Board, and we all know him as well as multiple [indiscernible]. I'm just kind of curious, does this strengthen or increasingly strengthen the relationship with ARM? Is there a way to read through it? Or is it like --

In terms of Lip-Bu. Lip-Bu reminds me of -- it's the same as -- Lip-Bu fits Cadence so well. It's like that antigrowth court. I've heard it so many times. The one where, what do they say bad companies are destroyed by crisis, good companies survive them and great companies that are approved by them. Cadence is a great company, and I expect this crisis will exit it stronger than we entered it. Lip-Bu is exactly the same. He's cut from the same hold. He will come out of this crisis stronger than he went into it. But I often find with like inspirational people, they always seem to do 3 things very, very well: They have a clarity of vision, they have the courage to their conviction, and then they have the remarkable ability to be able to communicate those things very effectively. But -- and Lip-Bu is that for us. I mean, he is fantastic. But yes, I think Lip-Bu joining the SoftBank Board is a credit to him. I think it's a great achievement. But -- and I expect, I mean, ARM is a key ecosystem partner for us. So I can imagine there's synergistic benefits to that. And that's very, very helpful to us. But yes, we're very privileged to have Lip-Bu as our CEO, and it's great to see him join SoftBank, it's a great company.

All right. Nice, nice. Thank you very much, John. Thank you very much for your time, and I appreciate your insights. Thanks, again.

Thanks, Krish. It's great to see you.

Thank you.