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

No, absolutely not. I mean, so there's no weakness at all in demand, if anything, it's the opposite. But we're part of the whole design cycle. I mean the chip capacity constraints are more on the production end of things. But if anything -- I mean, so when our customers use our tools for -- I mean, I'm an accountant. So when I -- I think of best, it's almost like city planning at a miniature scale. It's like that movie, Honey, I Shrunk The Kids. But if you could zoom into the like chip design, it's like a miniature little city. I think Intel has some great Youtube videos where they do that. You can zoom into chips at microscopic levels and you see what it looks like. And our customers use Cadence tools through, it's like chip design, chip verification, packaging and board, and then on the whole system simulation side as well. But -- and that's all the design cycle part of things. But -- so in terms of the chip capacity constraints, the -- it's not stopping people spending a lot of time on design. But in fact, design probably is more important, though, because when you do get a chance to tape out, you want to make sure it's exactly right. But -- I mean if that's normally a really high goal anyway or a really important goal anyway, but it's even more important when there's chip capacity constraints in the world. So demand is really, really strong. In relation to backlog dropping, what we have is a recurring revenue model. So like you said, every 2 to 3 years, you'll have those baseline contracts coming up for renewal. We typically get the best value when we renew exactly at the time, but the old contracts expire. Because the last 2 or 3 months just before the existing contract expires, you're basically just going through that process to roll off the add-ons into a new baseline contract. And like I say, the company is in a much better position. If you try to do it earlier, the customers typically would say, well, wasn't it for me if I do it early. But -- so we typically wait for the contracts to naturally expire. And Q1 just happened to be a quarter, where it was a light renewal quarter for us. But Q2 is probably a heavier renewals quarter by comparison. But as you'll see the contracts when we release our results at the end of this quarter. But generally, we don't try to do renewals earlier than their natural -- kind of than the natural expiry on the previous contract. There was an exception last year, so it's probably difficult comps as well. Last year, in Q4 '19 and Q1 '20 back in August 2019, we had one of those executive off-site things that we do that once a quarter. And typically, we try to use those to get the executive team to think about what would you do if this happened or what would you do if that happen? What should we do as a team and it's a good exercise. And back in August 2019, the fire drill that I wanted to take the team through was that we've seen the yield curve invert. And I did some data analysis that's suggested that over the previous 50 years, that following yield curve inversions, there was a recession within 8 to 14 months, typically. And 8 to 14 months would kind of put a recession out into Q2, Q3 of 2020 in our time frame for our calendar. So at that off-site, we talked about, okay, if you knew -- I mean, you can't predict these things. But if you knew that there was a recession coming, what would you do differently? Are we right to wait for the natural renewals in that environment. Then we thought that, well, if we don't have to give up any value, we should probably try and get some of that business done earlier. And we did that business in Q4 '19 and Q1 '20, but only with customers where we didn't have to give up any value for doing it. And because a lot of the customers, they see the whole bureaucratic nature of closing those deals -- are basically setting up the new baseline contract because there's -- like I say, a lot of bureaucracy kind of capture everything and put it all into 1 new baseline contract. But -- and we got that done early, and we're just lucky in terms of all the business we targeted -- the strategic business we targeted to do by the middle of March last year, we managed to get done. But typically, we wait for the renewal to come around.

Got it. Got it. Very helpful. Then on the M&A side, you made 2 systems analysis acquisitions so far this year. I think it's in the CFD area. How does the CFD impact your TAM? But also more generally can building out your multiphysics platform contribute positively to margin expansion over time?

Yes. Yes. Well, I suppose. When you talk about margin expansion, one of the things i did when I'm trying to understand Cadence more deeply when I got into the CFO role is, I did an analysis of the multiple businesses we have because you have like an analog franchise that -- Cadence was born in analog essentially. But -- and then we expanded into digital more heavily, but certainly over the last decade. The -- and when you look at the individual kind of profitability profile of each of our businesses, one thing I thought that was interesting was on the simulation side because there's a lot of simulation that happens in EDA. On the simulation side, what I guess, with all of our businesses, it's very -- I mean, the cost base is very people related. It's -- you compete for talent, you're getting those engineers in. So your expense base is very much tied to people costs. And then in a lot of cases, your revenue is tied to people as well. But -- because you need people to support the licenses, and -- like, for example, we have a great Virtuoso franchise in the analog space. And if you have an analog design company, you have 100 engineers, you're probably buying 100 licenses of Virtuoso. And we can't grow the license count there unless you grow your engineering headcount. But with simulation, what we find in simulation is that one engineer will kick off 1,000 simulation jobs as they get access to more and more compute capacity and more compute power. But -- so your revenue growth on simulation is not tied to the number of engineers, whereas your expense line is. And so from a profitability perspective, simulation is the more profitable area. And with that analysis, we talked about, well, clearly, if you're focused on driving incremental margins of 50% that you want to make sure that everyone understands where you're most profitable, that -- and then find ways to grow in those areas. And of course, you need to have the right to win as well. But it's all well in a good wanting to do that, but you need to have the right to be able to do that. But the interesting thing on simulations because EDA has been so competitive chasing Moore's Law for so long, this significant simulation expertise at Cadence. And what we thought was, from a strategic perspective that could we apply that simulation expertise to other areas in the whole design cycle? And when you go through what our customers do, they typically select IP first, and then they focus on -- like when you're doing that city design, that city planning -- like if you're doing city planning, you're probably not going to design. Like if you're going to design a new city, you might say, are you going to come up with your own version of a traffic light system? Or -- everyone understands that, you can buy that off the shelf. There's a whole bunch of IP there. I'll just buy the traffic light system off the shelf and a lot of people do that with IP. They'll take some IP off the shelf. And then on the piece of the design that they're going to differentiate on, then they focus on companies like Cadence for chip design tools, the chip design, chip verification, then to put packaging and board. But -- and then, of course, you have to go through the whole electronic system. And there's 2 areas there that kind of breaks down into 2 areas; finite element analysis and computational fluid dynamics. Finite element analysis is more on your physical things that are in the design and computational fluid dynamics would be things like so a part of -- like we have a thermal solver on the FEA side. But if something is getting hot in like your phone, that it's going to change the way air flows just above that and you need CFD tools to kind of analyze all that stuff. And that was an area, where it's a bit further removed from EDA. So we have to look more heavily at M&A for that. And NUMECA and Pointwise are great companies. We're delighted to have them on board. Like I say, in our goal to build out a multiphysics platform with the acquisition of NUMECA and Pointwise, I think we've taken a leap forward because we're able to expand into computational fluid dynamics. And that's -- you asked about the TAM, but that triples our systems, TAM to probably $2.4 billion. Now they're small -- oh, sorry, Siri is -- I did turn off the sound, but Siri is interfering. But -- Yes. So NUMECA has like over 5 -- what is it, about 450 customers, 500 customers across multiple verticals, such as aerospace, automotive, industrial, marine and includes NASA, Honda and Ford, that Pointwise solutions are being used by several marquee customers, especially in the aerospace segment. But -- so when we think about expanding into new areas like system analysis, that gives us a big leap forward and kind of builds out our whole multiphysics platform for us. So that's why we're going there.

Got it. Got it. Super helpful, John. And the other thing that has always stood out to me was Cadence -- you guys spend a lot -- a large amount in R&D, almost like 40% of revenues to R&D. So how do you effectively allocate that R&D resources? And is there any opportunity to be less R&D intensive?

Again, it's, like I said, Krish, it's a company created by engineers for engineers. So when we have investment -- we have more investment opportunities than we have dollars to invest in those. But -- so it's a case of selecting them carefully, and I'm blessed to be surrounded by such incredible people like Lip-Bu Tan as our CEO; and Anirudh Devgan is the President of Cadence. They're so knowledgeable in areas in which to invest in. So I look at my job is trying to make sure that everything is done in a really efficient way, so we can throw off cash and more investment dollars. And then I create investment pools that people can apply for. And then we need sponsors, but -- we'll allocate investment dollars. That's -- Lip-Bu and Anirudh will typically review the cases that people make for those investment dollars. I mean, if you're just doing the same thing as you were doing last year and it's nothing new, I expect you to be more efficient at that. I mean, we're all more efficient at what we did last year. But -- so I'll take away some of your budget, but -- and I'll create an investment pool with that. And so -- because we need that to allocate into new areas where we need to grow and where our customers need us to go. So we're very disciplined, data-driven about how we allocate resources. And then we're very disciplined about measuring because -- are we getting what we expected. Because if we're going to fail, I prefer to fail quickly and then we'll take those dollars away and invest it into another idea. And like I said, building out the margin profile, we know the areas where we're trying to get to the 50% incremental margin, we're targeting that. So it becomes part of the whole annual operating plan cycle. And I built out a plan to 2025, but -- now I think I have, it's like a plan that goes out to 2030. I mean we have great visibility. So you kind of build out the plan as you're trying to figure out -- if you did nothing new, here's what my revenue and profitability profile looks like, and then you're throwing off dollars to give to, like, say, to great people like Anirudh and Lip-Bu, who know how to allocate those dollars. But -- and that helps us drive both top line growth and margin. The other thing that we changed probably back around 2017 time was that we moved to a Rule of 40 type basis for measuring each of the individual businesses. Prior to that, I think IP -- our IP business attracted a lot of the investment dollars every year in our budget cycle because they seem to have the greatest opportunity for revenue growth. But it's not the highest profitable revenue growth unfortunately and I thought the right way to look at this was look at -- take a Rule of 40 type approach because you're basically allocating investment dollars. That's what an investment manager would do. And so Rule of 40 being that you add the revenue growth number to the operating margin, and basically if it's over 40%, that's generally considered a good thing. So 40% is not a target, of course. I mean we just hit 50 last year on that metric. And if we continue to drive incremental margins, the high 40s, low 50s is kind of -- that's where we're naturally going.

Got it. Got it. And then the next question I just wanted to touch upon is China. Clearly, China had a very significant impact on your 2020 results, and the region was up like 70% year-over-year. So how should investors think about lapping that tough comp? What does a more normalized trend look like? And what is the growth opportunity in China going forward?

Yes. So last year, I mean, China was fantastic for us in the second half of the year. And I mean there could be a variety of reasons for it. And then I don't particularly want to speculate why our customers were purchasing so much in -- particularly in Q3 and Q4 last year. But with the start of the year, we expected China to grow strongly for us and the start of the year looked pretty normal to us. I mean we did 12% in Q1 2020 with a 13% in Q2. And 12% to 13% seemed like reasonable -- this is 12% to 13% of Cadence revenue coming from China, seemed like a normal level of business for us and then it kind of went through the roof in the second half of the year. And I was worried that, that wasn't sustainable, particularly because Q3 -- the source for the growth in Q3 was very much on hardware upfront revenue in the functional verification space. And in Q4, it came from a variety of places. Of course, we had the extra week, benefited everybody. But we had some license compliance revenue, and we had some catch up. I don't know if you recall, we were tracking about $70 million worth of bad debt risk in the middle of the year during the pandemic, particularly from smaller customers. So there was a heavier proportion of that in China and in our software business in China. And we got a lot of collections in Q4, which kind of give us a boost to revenue in Q4, but that stuff is not repeatable. It's not like the recurring revenue, you couldn't see that repeating out into 2021. So in '21, when we were doing the guide initially, I thought, well, what would I want, and I figured that what I would want to do is be as transparent as possible. What I would want for me as a CFO was be as transparent as possible and derisk the guide for China. So I thought, well, let's apply what typically happens with our usual recurring revenue profile for the region. And we embedded that into the guidance. And what that meant was, of course -- that means China is flat on '21 versus '20, but that's what's in the guidance. And I'd be delighted to be surprised later in the year if we get an uptick again, but I don't actually expect one. I mean, what's in the guidance right now is, if I'm expecting China flat, I'm expecting a little bit of softness in IP in the middle of the year just because of lapping tough comps. The business is doing really well. And then on the royalty side, there's slightly lower royalties that -- there's another trend that's happening on the royalty side, I suppose, that's -- on a smaller scale that what you have in the -- like over the last few years with customers that were added to entity lists that those customers, if they had access to our technology, and were paying us royalties, of course, you continue to -- you're able to continue to collect those royalties, but those royalties will come down over time that -- because they don't have access to new technology, and as that technology gets older, naturally -- I mean, that happens with all of our customers who pay us royalties. There's a bump at the start when they launch a new product and then it kind of declined over time. So you had some benefit from that last year. You'll have less -- much, much less of that this year. And you're lapping that as well as a strong second half. So, like I say, it's embedded into the guidance kind of -- I'm expecting a softer second half. But with all the investments and everything we're doing that I would expect to bounce back a little bit in Q4, and I think it bodes well for 2022.

Got it. All right, actually, John, with that we are out of time. So thank you very much for your time and insights on the company and the industry, really. Thank you very much for that John.

Okay. No worries. Thanks, Krish. Thanks for having us.

Yes. Thank you very much, John.

Take care. Bye.