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

Good late morning, and thank you for joining us. I'm Rich Valera, and I cover technical and communications software for Needham. And very pleased to have with us for this next session, the management of Cadence Design. Specifically, we have CEO, Lip-Bu Tan; and CFO, John Wall. And before we get going, I'm going to ask John to do the honors of reading off his safe harbor disclosures.

Excellent. Thanks, Rich. Before we begin, we need to mention the safe harbor statements. Today's discussion will contain forward-looking statements and will 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. Thanks for that.

Thank you, John. So with that, Lip-Bu, I wanted to kind of take you back to when you started with Cadence a little over 11, I guess, 11.5 years ago now. We were covering at the time, and the stock we recall was right around $4 a share, a lot of things going on that were challenging at the time. And I just want to say I did do the math on the compound return over that period. And it looks like it's about a 35% compound return, which outperformed the stocks by about 10% and the NASDAQ composite by 15%. So congratulations on that. Quite a tenure. But with that, I wanted to just ask you what you see as some of the major events and milestones and maybe strategic decisions that you've made for Cadence over that time and that's kind of brought the company to where we are today?

Yes. First of all, thank you so much, Rich. And we've almost come to the 12 years now and -- the journey. A couple of things that I bring to the Cadence. First of all, is the culture change. And clearly, we focus on the teamwork. I used to be a basketball player in the college. So I like team. So I'm very, very proud of my talented team, and I'm very, very proud of them. And secondly, is to have a culture of innovations. Just an example, last 3 years, we have more than 20 organically developing software products and that meet the customer requirement. So that innovation culture is really kicking very nicely. And then the other part of the culture is really to delight the customer. And something is a customer obsession. And I spend a lot of time with my customer, listen to the customer and responsive to the customer. So we have a policy that in a -- within 48 hours, if the customer complain, we want to make sure that we're on top of it and listen to them, stay humble, working with the customer. And then the other part is the -- building -- rebuilding our ecosystem partners like TSMC, ARM, Samsung and others, and that is critical for our success. And the other part is really the technical being a VC, Venture Capital, background. If you are behind, you leapfrog. And so you just have to really deep dive into it and then catch the best talent and then to really drive the changes for the company.

That's great. Thank you for that little history there. Just wanted to jump right to the present and COVID, which obviously is affecting you and all of your customers. But yet, your business seems to have held up very well through that. So I'd love to -- if you can just go into some of the drivers underpinning the strength in EDA? And how they've managed to power through what we would think would be a meaningful headwind from COVID?

Yes. A couple of things that we are excited about. First of all, majority of my employees are working from home. And clearly, we make sure that they are productive at home. And I think John and I, we're providing the stipends for the -- providing the infrastructure required, the connectivity required to make sure that they are productive. And then the other part is we don't want to miss a bid with terms of a customer support. And so we really make sure that we're in touch with the customer, either using Zoom or Webex or other means to make sure that we're in touch with the customer, can support them. And then the other part is also more challenging is how to continue to innovate. And usually, you need to have small group, face-to-face meeting and brainstorming on the platform. And then we, again, try to find all the infrastructure we can get to make sure that they are productive in terms of innovation, and I'm still doing my regular deep dive with all the product group, make sure that they continue to innovate, and that's something that is very important. And then the other part, I think, is very good for our business is the resiliency of our business because we are subscription, ratable. And then John can talk about that more. I mean, it's more predictable. And we work with customers in the kind of longer-term approach and continue to drive innovation, add on to their business and helping them and to make sure that they don't lose a bid in terms of their design.

Got it. And just in terms of the macro drivers, which you've identified numerous times in the past, whether it's kind of AI, ML, design, hyperscale, IoT, 5G. Have any of them been affected? Or -- and I guess, Forte would be another big one. Have you seen any of them affected one way or the other from what's going on with COVID? Or are they all still pretty strong?

Yes. I'm kind of excited about this opportunity we have in front of us. I call it a data-centric revolutions, and it's all about data. And you collect the data and you organize the data and do the data analytics and then applying to all the various vertical markets. And so for example, like 5G, this is going to be picking up the infrastructure really exciting for me. Out of RF, [indiscernible] antenna design are very complex and that's where we come in to be supporting our customer to do that. Same thing with hyperscale data center, they're the fastest-growing for us -- opportunity for us. They are quietly building up their infrastructure to support people work from home or remote site in terms of storage requirement, in terms of the infrastructure requirements, in terms of the data analytics that they can do, a lot of AI machine learning application and then also applying to the medical, drug discovery and all the immunotherapy data to drive that. And then the other part, another big one is coming is the industrial transformation, digital transformation for the Industry 4.0 or the industrial IoT, and there are so many devices collecting data and how I kind of use the data effectively to drive the productivity and efficiency and new business model will come up. And so -- and autonomous driving is also continuing, even though a little bit setback on the automotive sector, but I think it's picking up. And so we are excited to support all the key players in terms of their ADAS development and also some of the sensors they want to develop. And so I think, all in all, I call it the 5 generation waves happening at the same time. And that drive a lot of design activity and it's really good for EDA and IP business.

Sure. Makes sense. John, I'd like to pivot to you for a sec here. So as you mentioned, the business has been surprisingly resilient. And in your last quarter, you actually raised your guidance for the year despite taking a bit of a write-off for some, I think, questionable customer accounts. Can you just talk about what you've baked into the guidance for COVID-related headwinds, what that is? And maybe how you're seeing the business trend versus sort of what you were expecting on that front?

Sure, Rich. Yes, it's a great question. And of course, it's multifaceted in terms of the impact. I mean our first priority always is to ensure health and safety of our employees, our partners, customers and their communities. So we took the decision very early to send people home and still the majority of our workforce are working remotely. We're hopeful that the disruption will eventually pass. And I expect cadence will emerge out of this pandemic stronger for the experience. I mean you've heard Lip-Bu talking, I don't know how many times he's mentioned customers already. We are very, very customer-focused. Here, it's easy being Lip-Bu's CFO. He's set such a great tone, and there's such a great culture at Cadence. The Cadence team has adapted really well to working remotely. I'm not sure any of us thought we'd be working for home for so long. But when it became clear that this could last for longer than any of us originally anticipated, we took steps to make sure our people were more prepared to work from home for longer. Lip-Bu mentioned that we've given some stipends to our employees. We've set up our employees to work from home for longer. They're -- we're thankful as well that our employees are very technology savvy. And as Lip-Bu mentioned, we're very data-driven. So we're probably in a better position than most companies to adapt to working remotely. We feel very blessed to have that -- a team that's so resilient. And you could see that in our Q2 results and the revised 2020 outlook, we're adapting quickly. Our team is positively thriving through challenging times. And our R&D and customer deliverables are tracking very well. As Lip-Bu says, we're very data-driven, we track everything. The sales and application engineering teams continue to engage effectively with all of our customers. And we're increasing our investment in infrastructure and collaboration platforms to make sure we maintain a high level of employee productivity. You mentioned that you had some customers that had some credit issues that we're helping some of our customers and partners where they have genuine difficulty making payments due to the impacts of the coronavirus. And we have some customers that are struggling to make contractual payments. And we highlighted during our Q2 earnings call that when we look through roughly about $3.8 billion of backlog at the end of last quarter, we decided to reduce it by approximately $70 million to reserve for noncollection of contractual payments from those customers that are most impacted. Effectively, we paused revenue on those bookings with the expectation that we won't be able to collect payments. I'm sad to report that of the $70 million, I think $20 million of that is in relation to customers that have already chosen to close their doors. So $20 million of that is gone. There's no hope. The other $50 million, we're still working with those customers, and we're still providing support to them, even though we don't expect to get paid. So just to be clear, our guidance assumes we do not collect any of that $70 million of bookings. And I think that's probably the right number. Even though it's around double our noncollections experience for the past 3 years combined, the $70 million we reserved is generally business with smaller start-up customers, and they're spread globally across all our regions. It's mostly on the software side of our business. And within software, they're mostly in digital. It's not all bad news. Of course, many of our larger customers seem to be thriving. And we're seeing an uptick in business among many of those larger customers. And the upside from that is outweighing any downside impact that we're seeing from those that are struggling. As a result, we increased annual guidance. Yes, we raised the annual guidance by $35 million last quarter. We now expect 2.6 -- approximately $2.6 billion of revenue for this year. And we increased our operating cash flow projection to approximately $825 million for the year.

Got it. Thanks very much for that update, John. Lip-Bu, I wanted to pivot back to you into a little bit of a bigger picture question. You mentioned in one of your earlier responses that you've been involved as a VC for quite a long time. And certainly, I think you've made a lot of investments in semiconductor companies, many of which would be potential or actual Cadence customers and technology companies. So I just wanted to get your thoughts on how being involved as a VC of technology, VC has been kind of synergistic and helpful in your role as CEO of Cadence?

Yes. First of all, I think it's very synergistic. Now being a venture capitalist, you have to make timely decision and take risk and that I applied to Cadence and I like innovations. So as I mentioned earlier, if it's behind, you leapfrog. And then you hire the best talent to bring on board. And then the other part is work as a team and then really focus on delighting the customer. Those are the few things I bring in to the company. And then the other part is the -- by being investing in the technology early stage and then work with the professors in the university give me a lot of insight about what the industry trend going to be happening. And so really understanding the customer, customer requirements. And then so that we can be truly a trusted partner for our customer, and we can help them to really meet their customer requirement. And so in a way, we become truly trusted by them rather than just a vendor. The discussion is much broader, rather than just pricing and terms. And here, we're talking about a roadmap, looking about the -- what the industry change will be happening and then what can we, together, and working with the customer to meet those challenges. And that to me is very exciting and I love innovation. And so this is away from me also to guide my engineering team and what is happening? Are we prepared for that? The AI and -- machine learning, AI application applied to our own tool, apply to our own customer requirement and then build the system analysis the customer is requiring, they need more new solutions. And so in the way, I can be more direct and then helping my R&D team and our sales team to support the customer more effectively.

And then I wanted to touch back on one of the things you said you really worked hard to instill at Cadence, which was the culture of innovation. And I think a great example of that is several years back when you effectively re-architected all of your digital products, brought in Anirudh and kind of gave him free rein there. Very successful in kind of creating a next-generation of digital implementation tools, and you've gotten some clear market share gains there. But I wanted to actually focus on sort of what you've learned in terms of computational software expertise in doing that? And how you apply that, I think, to get into the related but different system simulation market and how just that has really become kind of the core competence of Cadence?

Yes. It's a very good question. So first of all, digital is the largest end market for the EDA, as you know, and it's very critical to have that. And especially with the Moore's Law, the changing and the most advanced node and in the most leading customer, they are driving some of the changes and then move down to geometry. And so with that, I usually do a very deep dive into the product group-by-group. And I've decided there's a time to bring in some great talent. And I reach out to Anirudh and a few others to join me. And then to really re-architecture the whole digital floor and then two-by-two. So start with the signoff, and then we focus on the place and route and then the synthesis. And then -- so two-by-two, we want to be the best. And so as I mentioned earlier, and now if you are behind, you get the best talent. And then secondly, look at it and then see how can we intercept and then become the best tool. And that's why we're using massive parallelism. And then right now, we're applying AI machine learning to across all our tool in the digital. And in fact, one of them I just highlighted a few quarters ago, iSpatial. And using AI machine learning with the place and route in synthesis, in a physical optimizations to really drive the PPA and run time improvement. And the customer saw that, they're really excited. And then the other part is synthesis. And that has been our weakest area. And again, we deep dive into it, and then we also look at how can we intercept and then become the leader. And again, we are delighted working with some of the leading customers and then help us to understanding the requirement. And again, using AI, machine learning, deep learning and even cloud right now and then to really drive the performance, and the customers see that. And then we can starting to push for the whole full flow, and that means that the most advanced node, 7-, 5-, 3-nanometer, we're heavily engaging with our foundry partners and also our leading customers to really drive the differentiations and the customers see that, and that's why you say that 19 out of 20 top customer, they are embracing some of our digital flow. We mentioned about MediaTek and Samsung and [indiscernible] and then you saw the last quarter, we have expansion and proliferation at Micron and Renesas. And so those are good examples. And stay tuned, we're going to continue highlighting the customer success and adopting our flow. And then last quarter, we have 10 full flow -- digital full flow wins. And that is very, very satisfying for me. And then with that, Anirudh and I and then the team brainstorming, what are we really good at. And we are really good at computation of software. And then we decided part of this, I call it, the Intelligent System Design strategy, ISD strategy, to really embark on this, we call it, system analysis. And customer reach out to us that should you go into the system analysis, then we look at it and say, "Hey, maybe there's something that we can really play and we can really bring something to the table." And the good news, we have Clarity and Celsius that's electromagnetic and then the thermal, and we're able to show up to 10x performance. And we're delighted and to be able to show to the customer, and we are paying customers. And I think 2 quarters ago, I mentioned about 30 customers. And now we have 125 engagements with customer. And then the other part is, we mentioned a couple of names, customer embracing. And more important, and monitoring closely is our repeat orders. And you just buy a few copy, that's okay, but they're starting to buy more and repeat order, that means they really love the products. And that gives us a lot of encouragement. And then we continue to innovate. Stay tuned, we have a whole suite of products we're coming up. And I think this is an area we like a lot in the Celsius and Clarity, that's about $750 million TAM market we're going to go after. Then after that, there's a whole system analysis, a $5 billion opportunity, we're going to be aggressively go after. And that's something that -- answer your question, why we move into the system analysis, from the customer feedback band, they want it and then we're able to demonstrate a tool product and a customer -- delight the customer, and they love it by more, and that gives us a lot of encouragement to move forward.

That's a great response on that, Lip-Bu. I just want to remind actually the audience, I should said this upfront, but you do have the opportunity to ask a question. You should have an interface that you use to log in, and you have the ability to enter a question there. And if you do, we'll try to fit it into the discussion here. With that, I wanted to pivot back to you again, John. And talk about sort of margins and operating leverage, certainly an area near and dear to most investors' hearts and I think to your heart. And you guys have done a great job of generating incremental operating leverage the last couple of years while still growing at a healthy clip. And I think you pretty aggressively embraced the rule of 40 as sort of a guiding metric. But can you talk about how you think about growing the company, trading off growth versus margins and where the margins can go longer term?

Yes, yes. Okay. Yes, while growing the top line is a priority, we're very focused on driving innovation and supporting our customers over the long term. And that's helping us to achieve scalable and profitable growth. We love our recurring revenue model. It's super valuable to have such a high level of visibility into our revenue and cash flow, and it helps everyone to remain focused on the longer term. We're mission-critical to our customers. And we run an asset-light business that generates a lot of cash flow, and overall that translates into a business that scales really well. And as you said, our focus has been on driving incremental margin. Effectively, we've been targeting 50% incremental margin over the past few years and we've delivered it consistently every year since 2017. And what we mean by that is that we basically aim to have $0.50 of every dollar of revenue growth flow through to our operating income. Also, we've been targeting high single-digit to double-digit revenue growth, and our focus has been on achieving profitable and sustainable revenue growth. The trade-off between growth and profitability can be a blend of art and science. We're very disciplined and value-driven in everything we do. We're -- in many cases, we're investing alongside our customers. We're developing the tools we know that they will leave in future years. And we have great talent in the company to help us spot the winners. I mean you heard Lip-Bu mentioned earlier that winning with the winners is a big part of our strategy. And again, it's all about being data-driven. We look at multiple metrics to make return-based decisions on pricing, resource allocation and investments. We allocate our resources where we think we have the greatest opportunities for sustainable and profitable growth, and our approach has been paying off. Revenue growth is consistently hitting that high single-digit to double-digit range, and we're seeing all of our product groups and product categories perform really well this year. But it's not just revenue growth. So we have a great culture in the company. Our leaders in the company practice, what we call like servant leadership. Everyone is helping everyone else to be their most successful. Our people are very conscientious and they act like owners, which is super important. They are constantly looking for ways to drive greater operational efficiency and improve effectiveness. And we're blessed with such great people, and the numbers speak for themselves. I mean, we've delivered on our goal of achieving 50% incremental margin every year since 2017. And as a result of that, you've seen operating margin growth from less than 26% back in 2016 to approximately 33% that we've guided for this year. If we can keep that up, there's no real near-term ceiling on our operating leverage.

Got it. And kind of on a more timely basis. I think Cadence, along with lots of other companies has gotten some forced savings, if you will, because travel budgets have been pretty much zeroed out as well as some other sort of in-person sales, marketing activities, et cetera. What are your thoughts? I know it's very early at this juncture in terms of the sustainability of some of this savings. Clearly, there'll be some resumption of travel, but do you see a future maybe where there's less of that type of activity than there used to be, and you think you can still sort of get the job done. Just wondering how you're thinking about that as you look out a couple of years from now post-COVID?

Well, certainly, we're learning from everything that and I suspect that we won't go back to an all normal, there will be some form of new normal. But we have benefited from lower T&E expense. And we've invested a lot of those savings in helping our people get set up to work from home for longer so that we're more resilient. We've also invested in that -- in the infrastructure in the company to make it as seamless as possible to support customers remotely so that we can communicate with each other remotely. So I mean, that's all been very, very positive, and we factor that into our plans for the future. But of course, I mean, it's early days yet. We don't know how long this is going to last. But we pride ourselves in trying to be prepared for everything.

Fair enough. Lip-Bu I'd like to pivot back to you, and topic, China, which, I guess, a little over a year ago, you had to break out as a percentage of revenue because it exceeded 10%. And then you had some real -- obviously, it's more than over a year ago -- a couple of years ago. And you had a real strong year, then you had a little bit of a weaker year last year, I think, related to perhaps some of the -- any of these restrictions that some of your customers face, but business has been very strong this year, perhaps surprisingly so. So I just wondered if you'd comment on what's driving that strength in China. How sustainable you think it is? And what are some of the opportunities and risks in that business as you look out in the next couple of years with potentially risks around further geopolitical issues. But clearly, a lot of demand and desire on their part to increase their technological independence. So just wanted to get your thoughts on that business and the sustainability of your strength there, Lip-Bu.

Yes. So I think Asia Pacific is a strong growth region for us. And we've done well in China. And of course, quarter-to-quarter, sometimes there have some fluctuation in terms of percentage. But so far, we see a strong opportunity in IP and hardware business. And that's why I think you reflect the last 2 quarters. And I think all of us know, China is very committed to build the semiconductor ecosystem from the foundry to equipment to start this design. And so clearly, that's a great opportunity, and they also have the STAR market equivalent to our NASDAQ and they're able to raise money with a very high valuations. And in some way, they have more money to spend for IP and EDA tool and hardware and that we are delighted to support that. Saying that, clearly, we are a U.S. company. We strictly follow the compliance of the U.S. regulations. And clearly, we support the global customer, including China. And I think, overall, I think we still continue to be bullish about the economics globally. And I think I strongly believe in free global. And then -- but sometimes we may have to plan for 2 supply chains. One is U.S., one is China. And then China as long as clearly continue to comply with the U.S. regulation. Meanwhile, there are some other opportunities, start-up company that we're able to support. We continue to support. And then Asia Pacific is a fast-growing area, not just China, Taiwan, Korea, even Japan and some of the system companies starting to come out strong, and we are heavily engaging with some of them. And so I think this is a good opportunity for us.

Great. And you brought up IP as one of the areas of strength in China and the Asia-Pac. That's one of the areas that you, I guess, took the company into. I think it was with the purchase of Denali, that might have been the first major step there. But you've made -- you bought Tensilica and some other smaller deals and have obviously done a lot of work organically in that area. And it's turned out to be a real nice business for you. Can you just talk about your IP business, kind of how you see yourselves in the market? What your focus is in that? And if there's other things you need or want to maybe further build that business out organically or inorganically?

Yes. It's a very good question. When I took over as a CEO 12 years ago, 11.5 years ago, a couple of customers asked me about what is my IP strategy. And I said I have none. And so I listened to many of them, and I starting to realize IP is so important. When you build a system, SoC, you are kind of like the building block of Lego with other IP block that you try to put together. So I decided we should get into the IP business. And you are correct, in 2010, I used all the cash I have to buy Denali because we thought that the memory IP would be critical to not to be correct or the DDR controller 5 become very good business for us. And then we're starting to look at what are the other pieces we can get. And so we bought Tensilica, and that is a very good IP for audio, video and AI, machine learning platform. And so we're now benefiting from it, and it's a really good star IP that we'd like to have that can also have loyalty payment. That is a very good business to be in. Then we also look at the whole data center cloud, or that they really -- key IP they need to have as a high-speed study. So we bought a new semi for the 5,600 12-gig study and beyond. And then we also have PCIe Gen 4, Gen 5, Gen 6. Those are all heavily required by data center and cloud. And so I think we continue to build that whole IP business. If you recall, if I'm not wrong, 2 years ago, we decide to have a refining our IP strategy because while it's growing very fast, I want to make sure that it's comparable operating margin to our overall business. So we decided to really refine that. Really focus on the most advanced node and the 7-, the 5-, the 3-nanometer. Secondly, the leading customer that, either it's a hyperscale guy or the hyperscalers or the most advanced leading company in the sector, we want to work with them. And clearly, the IP outsourcing trend is happening. A lot of companies just tipping up with all the different version protocol, Gen 3, Gen 4, Gen 5 is a headache for them. So they're all looking for industry standard, the best quality company. So IP, you need to be the best quality. And that's what something we really focus on the best quality that the customer can have, and I'm very proud of my team. They're doing a great job. So in terms of going forward, we're going to continue to focus on star IPs. And the IP that are critical -- mission-critical for the customer, either it's a data center or in the automotive or the mil aero or medical, those IPs that are critical and essential to the building block, we'd love to have it.

Got it. Thanks for that, Lip-Bu. John, I wanted to pivot back to you in another area, I think, pretty topical for investors is sort of consolidation, industry, competitive dynamics and pricing. I think there's a perception out there that because of all the consolidation in the industry that there's a more rationally competitive environment than that -- your EDA vendors in general have been able to extract more value, maybe sort of rightful value for what they've been delivering recently. So can you just talk about how you think about that landscape and if Cadence has been able to, in fact, do that?

Yes, sure. I think that perception is fair and accurate. Generally, we don't compete on price. In the long run, we firmly believe that the best tools win. So we generally compete, if anything, for talent. But developing the best tools and solutions requires consistent, disciplined investment in R&D. And our aim is to create differentiated products and solutions for our customers. We collaborate deeply with our customers to deliver innovative and clearly differentiated solutions. And we're -- and like you say, we're very disciplined and value-driven in everything that we do. In many cases, we're investing alongside our customers, developing the tools that they need in future years to solve very, very challenging problems. So it's important that we get appropriate value for our products. So we generally, like you say, we don't compete on price and neither will our competitors. Doesn't make sense for anyone of us to do that. But it's a competitive business and pricing naturally varies from sector to sector and product to product at a high level, we take a very disciplined data-driven approach to the pricing. We track all ASPs for our products and measure deal quality. And I guess if there's -- I mean, a small and subtle change, but probably the one that's had the most significant impact to us has been -- we changed our internal processes for approvals of contracts. And instead of basing the approval levels on the price or the annual value of a contract, we base it on the annual value of the ASP of the products that are provided in the contract. So to give you an example of that, if, let's say, there's a pool of products and based on our analysis, the average selling price for this configuration should be, say, $10 million a year. And you're selling the exact same configuration to 2 customers. In one case, the customer is paying $8 million a year. In the other case, the customer is paying $12 million a year, which one would you want to review? And in the past, it would have been that, let's say, we had approval level higher than $10 million a year that we would have to approve it, that you'd want to see the one where we're giving $10 million of ASP value for less -- for a lower price than the higher -- I mean, the higher one, everyone's going to be happy with that. So we changed that approach. And like you said, we analyze ASP data by products and customers prioritize where we have the best opportunities to improve value. And then we allocate resources where we think we have the greatest opportunities to achieve sustainable and profitable revenue growth. And then you mentioned consolidation. I mean, we've tightened up contract structures to reduce consolidation risk, streamline contract renewals. So our customers get the best value for money. And also, so we leave room for add-on sales opportunities throughout the duration of a baseline contract. I mean, our typical contract is say, 2 to 3 years. On a 3-year contract, over those 12 quarters, we'll typically see our customers come back and make like 4 to 6 additional purchases during the life of that contract to purchase add-on software. And when we do those contracts, basically, what we do is, like if you're, let's say, 6 months into a 3-year deal, the add-on will then co-terminate with the underlying baseline renewal by the time the baseline renewal comes up for renewal, you're essentially bundling in all those add-on opportunities into a new baseline renewal and starting the process all over again. The approach has been paying off and revenue growth has been consistently hitting that high single-digit to double-digit revenue range that we're seeing in all our product categories this year.

Got it. Lip-Bu, I wanted to pivot to hardware, which I think has held up surprisingly well. I think historically, it was thought that hardware was more cyclically sensitive and might be affected by a downturn like we're in now, but you've had some really strong hardware results in both Palladium and Protium FPGA prototyping. Can you just talk us through that? And maybe the synergies between those 2 products at this point, the way you've kind of done the compiler front ends, particularly Protium having that similar compiler. But just talk about the strength of hardware in the midst of perhaps challenging economic condition, what's driving that? And then just maybe the synergies between Protium and Palladium?

Yes. I think the verification system modification become a bottleneck for a lot of our customers. Because of the design complexity. And it's very important for them to verify what they design is correct and can be in the fabrication and productions. And so I think this is something that we are really excited. We have provide the whole verification suite from Jasper Formal Verification and then to Xcelium. And I think we just have finished our -- the middle of our CDN life, we mentioned our Xcelium ML using the machine learning, deep learning AI to apply, you can see up to 5x better performance, customer love it. And then we have this hardware Z1, and are very delighted. People keep coming back and buy more. And I think it's a must have. In the most advanced design, that's the best in the industry, and we are very delighted. And Anirudh and the team work out with this prototyping, we called it X1. And in the past, we just have hardware emulation. But now we can provide the hardware-software regression, early-stage software development using our X1, where you can really point out with the front-end compiler. So in a way, if you are using the X1 for prototyping development, when you want the Z1 for the emulation, you don't have to go back and then go through all the inputs to the data, and that saved a lot of time. So customers just love it, just fully integrating from X1 prototyping regressions all the way to the emulation. And verification, we are very delighted with double-digit growth, just like our IP business, with double-digit growth. And stay tuned, we have more exciting thing to highlight. And then we are applying all the AI machine learning, cloud initiative to drive our solution to our customers.

Got it. Thank you for that, Lip-Bu. And we're just about out of time. I'm going to wrap up with one final question for John. Capital allocation. Popular investor topic. Can you just quickly take us through -- you guys generate plenty of cash. Just talk us through how you think about capital allocation?

Yes, sure. I mean, we're mission critical to our customers. We have a great asset-light business model with recurring revenue and high operating margins, which means we generate significant and consistent free cash flow. So we'll regularly review our capital structure and the use of free cash flow with our Board and management team. Generally on capital allocation and our use of cash, we aim to balance 4 things. It's really investment risk, liquidity and capital return. In normal times, we prefer to operate with less cash on the balance sheet. We will generally fund increases in our investment in R&D next year from this year's free cash flow. And we have a strong investment-grade rating and can leverage our strong balance sheet to fund M&A opportunities whenever that's appropriate. But the pandemic is playing into our approach on liquidity right now. We ended Q2 with over $1 billion of cash in our balance sheet. That's more cash than we would normally carry. But I would categorize that as a decision that was kind of equal parts offensive and equal parts defensive. No one's really sure how long this pandemic is going to last, or how disruptive it might get, but would we like to be prepared for opportunity wherever it presents itself. And if I may use a golfing analogy, our decision to carry more cash in the balance sheet right now is really the equivalent of choosing to drive the ball down the middle of the fairway. And so we're prepared to play offense or defense on the next shot. But -- and it really depends on how the macro environment plays out over the next few quarters. Yes. On the capital allocation and return of cash to shareholders, because we generate a lot of excess cash, consistent with our approach last year, we're aiming to return approximately 50% of our free cash flow to investors this year in the form of share repurchases. In Q3, we plan to repurchase $75 million worth of Cadence shares. And yes, I mean that we've targeted that, and we'll fulfill that commitment by the end of the year.

That makes sense. And with that, we're going to wrap it up. Thank you very much, Lip-Bu and John. It was a real pleasure.

Excellent. Thank you.

Thank you.