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

Good afternoon. Thank you, everyone, for joining us. My name is Elizabeth Elliott. I'm an analyst on the Morgan Stanley Software Equity Research team. I'm very pleased to have with us today at the NASDAQ conference, Cadence President, Anirudh Devgan; and CFO, John Wall. Anirudh joined Cadence in 2012 and has served as President since 2017. Once more, Anirudh will be transitioning to the role of CEO later this year. So big congratulations. John became CFO in 2017, and has held a broad range of leadership positions for the last 24 years of the company. Thank you guys so much for joining us, and we're really looking forward to your insights. [Operator Instructions] For important disclosures, please see the Morgan Stanley Research disclosure website at www.morganstanley.com/disclosures. And if you have any questions, please reach out to your Morgan Stanley sales representatives. And with that, I'm going to turn it over to Alan, Head of IR for some quick disclosures.

Thank you, Elizabeth. So before we begin, we need to mention the safe harbor statement and 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. Now back to you, Elizabeth.

Great. So John, to start with you, could you provide a brief overview of Cadence for those in the audience who may not be familiar with the company, just to kind of lay the groundwork for the conversation.

Yes, sure. Thanks, Elizabeth, and thanks to you, Morgan Stanley and NASDAQ for having us again this year. Yes, Cadence is a technical or a computational software company, largely in the EDA space or electronic design automation. We're a company that was originally created by engineers for engineers, with a very strong culture of innovation, with close to 40% of our revenue invested in R&D every year. Our customers are chip designers spanning multiple verticals, including mobile, hyperscale, aerospace, data center automotive and AI with a rough breakout of maybe 55% traditional semiconductor companies and 45% system companies. While we do have an IP business and a hardware business, where revenue is predominantly recognized upfront, the majority of our business is recurring in nature from a revenue perspective. It's mainly software. And the average contract length is typically a 3-year baseline contract, with weighted average duration of bookings in any 1 year, typically around the 2.5-year mark. But we generally do a 3-year baseline contract, and then throughout the 3 years, our customers won't do add-ons that co-terminate with the baseline contract. So the weighted average duration is typically in a range of 2.4 to 2.6 years, every year. Customer budgets are R&D-driven. And with the highly recurring business model -- or revenue business model that we get strong visibility into revenue for the year. Typically, we will know 90% of our next quarter's revenue before we can start the quarter. And then we'll know about 75% of next year's revenue before we start the year. We're executing to our intelligent design -- System Design strategy, but I won't say anything more on that because I'm sure you have questions for Anirudh, and he is the architect of that. So I'll let him speak to that.

Awesome. Yes. Great point to dive right into next. So Anirudh, as this key architect of the Intelligent System Design strategy, kind of what drove your decision to expand beyond EDA? And really, what does the strategy entail? And where could you guide the company in the future?

Yes, Elizabeth. Thank you for that question. So it's driven by where we think the customer is going and also where we think our strength is. So it's a combination of those 2 things. So in terms of where the customer is going, we look at the world in terms of 3 concentric circles, and the outer circle is the data circle. And then the circle within that is the system circle and the circle within that is the silicon circle. And a good example of that is like an electric car. You have all the data for self-driving, then you actually have the physical car, which is software and hardware, and then the chips that drive the car. And this kind of 3 circles is happening in all the key verticals, whether it's automotive or mobile or data centers. So that's where we believe the customer is growing -- is going. And in terms of power core strength, EDA has always been a good business. The question is like where else can it grow? And so to grow, we have to first see what is our core strength. So we believe our core strength in EDA is in what we call computation software. It's like numerical mathematical software. That's what EDA has done for 30, 40 years. And so if you take that vector of computation software and overlay with these 3 circles, what falls out is the core business, which is EDA and IP and then expand to the system design and analysis phase because system analysis is inherently computational. And then the third thing is AI and data analytics, which is also quantitative. So our strategy is intelligent, which is from the outer circle system, from the middle circle and design from the silicon design circle. So this focus on EDA and IP, be the premier provider for EDA and IP and expand into system design and analysis and data analytics in here. And this can go on for 10 years.

Great. And I wanted to dig in on one of those circles you mentioned. Cadence had made 2 system analysis acquisitions earlier this year and more in the computational fluid dynamics market or CFD. How does this impact your TAM? And can building out your multiphysics platform contributed positively to both revenue and also margin expansion at the same time?

Yes, absolutely. And I think that's why we like this expansion, not only it can increase revenue but system analysis is also higher margin business than EDA, and we are already seeing that in even our own efforts. And the reason for that is that simulation is not tied to the number of engineers. One engineer can launch like 10 simulations or 20 simulations to do various experiments. And so even within EDA, about 25% of our business is simulation for chip design, and that's also very profitable. And as we go to system design, that's inherently more profitable. And also, it has a lot of verticals that can be applied. So our move into CFD and then our previous move into electromagnetics is about -- the whole simulation market is $7 billion to $8 billion. But CFD plus electromagnetics, I think, we are getting close to $2.5 billion to $3 billion of addressable markets with our products. So that gives a huge opportunity for us to grow and to grow profit.

Great. And I want to switch it over to John to get a little bit more on the financials side. And so the midpoint of your updated outlook for 2021, Cadence is on track to achieve this double-digit revenue growth really for the second straight year. And that's on the back of your fiscal 2020, which did also benefit from extra revenue -- a week of revenue. So really, the question is, moving forward, is double-digit growth kind of the new normal we should expect for Cadence?

That's a great question, Elizabeth. I guess, look, I'm very pleased with our progress across all of our lines of business. This year, demand has been particularly strong across the board, whether that's core EDA software, hardware, IP or the system design analysis segment. The extra week that you referred to was in our Q4 2020 quarter. So we're lapping very tough comp this quarter. But our focus is very long term. So we tend to focus on growth over multiple years rather than any 1 quarter. My personal preference for tracking revenue growth is the 3-year revenue growth CAGR metrics that we published in our CFO commentary every quarter. That's because, like I said earlier, the -- our customers generally are on 3-year contract cycles with us. They'll have a 3-year baseline contract, and then they will purchase add-ons typically 4 to 7x during the 3 years. And then you end up with your average duration typically being around 2.5 years because the add-on contract always co-terminates with the baseline contracts. So those are always shorter in duration than the baseline contract. And our updated guidance for 2021 is now 11% revenue growth, but I'm most pleased that the 3-year revenue growth CAGR is continuing to accelerate every year, and I'm expecting that to increase to over 11.5% by the end of this year. I know your question is designed to try to get some color on our expectations for future revenue growth. And traditionally, we don't provide guidance for next year until we close out the current year. So I can't talk about our outlook for 2022 just yet. But what I can say is that every year, we aim for double-digit revenue growth. And we do that with a particular and specific focus on profitability. I don't like revenue growth for the sake of revenue growth. We have too much opportunity to spend time on doing any kind of less profitable work. So I'd particularly like to see over $0.50 of every dollar of that revenue growth dropping through the bottom line. So we generally try to optimize for a blend of revenue and margin growth, which is why you hear us talk about our Rule of 40 metrics from time to time. And we always think that our investors are best served by that dual focus or combined focus on revenue and profitability and not just revenue growth for -- as a singular focus.

Yes. Thanks for try to get that question in there, but the color was certainly helpful. Digging on, so we get the rebid on the margin side. You guys have demonstrated 4 years now going on 5 years of 50% plus incremental margins. How much runway do you have to continue to drive that type of expansion? And really just what drives that efficiency in cost savings?

Well, scale helps a lot. I mean, while growing the top line is a priority, we're very focused on scalable and profitable growth. We pay a lot of attention to driving effectiveness and operational efficiencies. And generally, we're very data-driven and look at multiple metrics to make ROI-based decisions on pricing, resource allocation and investments. And as Anirudh mentioned, when we think of expanding into new areas, the margin profile of those opportunities is always very important to us. And as I mentioned earlier, every year, we target the double-digit revenue growth and achieving over 50% incremental margins. But -- and we're pleased that we're on track to achieve that incremental margin growth for the fifth year running, but we don't take it for granted, but that type of profitability is difficult to achieve. It requires constant focus and effort to drive efficiency and improvements. But I think we have a great team. We have an excellent culture. We have the right incentives in place to reward people for achieving those results, and everyone knows what is expected of them. I mean it's we have a tremendous strategy. The Intelligent System Design strategy is an excellent strategy and the focus. And if we can continue to execute against that, we should continue to get what we're getting. But Cadence naturally scales very well. There's obvious benefits of scale for G&A. But our Intelligent System Design strategy takes us into new areas where we have obvious R&D synergies. We have simulation expertise that's already inherent in a computational software business like EDA, that scales really well into system analysis. And then there's also some sales synergies because we're dealing with many of the same customers. If you look at how we start each year, I know we target trying to get to 50% incremental margin. But I think if you go back over the last few years, we never started off with that, I mean, we're typically -- we have line of sight into maybe mid-30s to high 30s kind of incremental margin. And then we work throughout the year to try and drive cost efficiencies or revenue growth opportunities to work our way to achieving the 50% incremental margin. It's one of those goals where you really have to be on your game every quarter to achieve it. But I'm thrilled that we've achieved it now, we're certainly on track to achieve it 5 years running. And 2 of those 5 years been pandemic years. So when I'm talking to the folks internally at Cadence, we talk about what are you going to encounter next year that you haven't encountered the last 5 years. But I do think that we're set up well. As Anirudh said, I think there's probably a decade long runway for our growth opportunities. And if we -- for us to execute against our strategy.

Yes. That expansion is kind of execution against -- volatile and challenging kind of macro backdrop that we've seen more recently has been certainly impressive. Anirudh, I want to turn it to you. You recently launched the Cadence Cerebrus, which is a new kind of machine learning tool that helps automate digital chip design. What are the key benefits? And as chip complexity continues to increase, should we expect more and more of these AI-enabled solutions? And then just lastly, there's a debate out there, can AI start to democratize chip design and increase kind of the design activity? So curious to get your thoughts there.

Yes. Elizabeth, that's a great question. And we are excited about Cadence Cerebrus and the opportunity to present, because the tools are -- typically, as I say, digital floor will run for 1 or 2 days where the chip design takes like 6 to 12 months. So a lot of the iterations of running the tool over and over is done mainly by the designer intuition, which is great. But now we can help the designer by mathematically with ML -- with AI and ML, and it has given great results. So it can really help make the design easier as the chips get bigger. And also, it can alleviate -- there's always a kind of skill gap in the organization. Some designers are highly skilled. They maybe less so. And there's also geographical gaps, one team in one area, maybe more skilled than the other. So this kind of a AI-based tool can really help make the teams much more productive. And we are also using it ourselves because it can make our AE teams more productive when they work with customers. So the potential is there. I mean it's early days, the results are phenomenal. So we have to see how the market adopts them.

Great. And then the hardware business, which I know it hasn't been as big of a contributor, but it has performed remarkably well over the last couple of years. And earlier, you launched kind of the next generation of systems. Should we be expecting a ramp in demand similar to what we saw in previous hardware cycle? Or kind of how should we think about the fact that usually you go through these cycles of strength and the weakness, but you actually been stronger than I think investors had appreciated? So how should we think about this kind of new cycle as it comes up?

Yes, hardware is doing remarkably well actually over the last couple of years. And this is -- couple of things there. One is the system made demand is up because hardware helps not just chip verification, it helps some software bring up. So overall, I think the market is growing for hardware-based verification and software bring up. Second thing is that we also, in the old days, would have only one product, which is Palladium. Now we have 2 set of products, the Palladium and Protium, one targeted for chip verification and other targeted for software bring up. So that also smooths out some of the variability. And third thing is we have more customers running these products on the cloud. So of course, hardware and the cloud gives a more ratable model for hardware consumption. So overall, I believe the trend is up and hardware will not -- is never as predictable as software, because software is completely ratable. Hardware has more components to it. But I think with a diversified portfolio, with more cloud usage and more systemic growth, we expect -- we want to have a more smooth hardware business, going forward, as these things definitely help. But overall, the trend is great. We are very bullish on where we are positioned in terms of our hardware products.

Great. And then bringing it back over to John. China is a question that investors often ask about. And it looks like demand may be back to normalized levels from kind of the all-time highs that you saw in the second half of 2020. So just given the geopolitical uncertainties, is China still a good opportunity for American-based EDA companies? And what's the situation with domestic China EDA companies?

Yes. So great questions again, Elizabeth. It's a strong growth region for us, as is all of Asia, really. That -- and we've done very well in China. And it presents a continuous growing opportunity for us. But one thing I should highlight, though, when we report our China revenue, it's based on consumption. So our China revenue that we will show in our 10-Q and our 10-K is the proportion of our revenue from licenses that are used in China. So they may not necessarily all be sold into China. But like if we did a large renewal with the Bay Area company here, this quarter, and they said 10% of the licenses are going to be used by their employee population in China, then we would allocate 10% of the revenue from that contract to China because it's consumed there. The -- so I mean, it's been really strong for us. The reason I point that out is that we have found in the past that the geographical spread or mix can change pretty quickly from time to time. But although, like what we've seen in China continues to be strong despite export restrictions and everything. The -- China is committed to growing its semiconductor ecosystem. And we're doing all we can to support our global customers while still ensuring we comply with U.S. government export regulations, of course. But in our outlook, we assume that we're going to have our usual revenue mix in the region, I think last year, you mentioned that we had a spike in the second half of last year. We had an unusual upfront revenue mix in the second half of last year. In Q3, if I recall correct, I think in Q3, it was largely hardware that drove that. And in Q4, we had a bit of a catch up on credit and collections, that was in the -- trying to recall now. So I think in Q2, very early in the pandemic, we had a bunch of customers that we had to take a reserve against because they weren't able to pay us, and we made a conscious effort to make sure that these smaller customers that would continue to be able to operate that -- so we weren't chasing payments so heavily, and we reserved against that. And then in Q4, we had a catch-up on a number of those payments that we didn't actually expect to ever collect and that's -- there was a significant portion of that was in China, and that helped us. The EDA and IP market out there in China is very competitive, whether that competition is multinationals or Chinese companies. And we always take that competition very seriously, of course. But the best way to deal with it is through innovation, leadership in products and delighting customers and that's our focus, that's what we intend to continue doing. And that would be no different in terms of our approach to China as it is for our approach for the rest of the world.

Great. And then just a reminder to everyone on the line, we are taking audience Q&A. So questions can be submitted via the box on the webcast screen, and we'll work those into the conversation. One in particular that we're seeing is just around the kind of the global chip supply. And more specifically, does the global chip supply constraint right now impacts Cadence kind of both near term and longer term? And more specifically, are your hardware and/or IP businesses also impacted? Anirudh, if you want to take that one?

Sure, Elizabeth. So as you know, we are more on the design side in terms of most of our business. And so we are not seeing any slowdown in design activity. Of course, if the chip shortage goes on for a very long time, it may affect the design side. But right now, we don't see any impact on the design side and most of our business is tied through the design starts and design activities. Now in terms of our own supply chain, so that affects the hardware business. The IP business is still -- we deliver software -- an IP software, right? So that doesn't affect the supply chain. But the hardware business, we do procure components for our hardware business. And so we are watching it carefully. I mean it's definitely tight. But so far, we are able to manage it, and we'll see what happens in 2022. But right now, we are -- we did some earlier purchases for more inventory late last year that is helping us. So we are carefully monitoring that situation on our hardware business. So far, it's okay.

Great. And then we've gotten the questions on ESG, which is obviously a topic of rising importance across many businesses. And can you kind of elaborate on Cadence's ESG strategy? And what are ESG-focused investors should be mindful of when thinking about Cadence? John, I'll hand that one over to you.

Yes, sure. Thanks, Elizabeth. And a great question again. The -- look, when it comes to ESG, I think one thing that everyone should understand about Cadence is that the key metrics that our customers measure our products on are power performance and area. Power being a very, very significant one. I think were significant contributors to the reduction in power usage in the electronic products that we all use. But -- so Cadence takes ESG and corporate social responsibility very, very seriously. We have an annual sustainability report. And you can find that if you go to the Cadence website and just search for like Cadence sustainability or ESG report that -- and in that, you'll probably find -- I mean if you look at the -- I mean, we have a tremendous culture in the company, but that we'll talk about things like pay equity. We achieved global salary pay equity based on gender and U.S. salary pay parity based on race and ethnicity in July 2019, and we maintained that again in 2020. But We're proud of our diversity inclusion metrics, our emission reduction targets are set out there. But -- and we regularly feature in the Fortune 100 best companies to work for. I think we were listed on 23 Best Workplace Top 100's list last year in 23 different countries -- sorry, 14 different countries with 23 different workplace recognitions. And of course, our COVID-19 response, I don't think the team at Cadence has missed a beat through the pandemic. I mean they've proven just how well they're able to innovate working remotely or working in the office and have been delighted with that. For me, the key metric -- I've heard many people say that, "Oh, we're just as productive working at home as we are working in the office." But for me, the key metric was, well, new product introduction, how is that going? And I think this year is a great testament to how the Cadence team is operating, but we've launched 13 new products, significant new products this year in the first 3 quarters. I mean that's against the backdrop of our typical Cadence certificate upon is probably 20 significant new products every 3 years. Now some of the 13 in the first 3 quarters of this year is just -- we were not aiming to achieve a specific number every quarter. So there's probably a catch-up from some late last year. But still, I think the pace of product innovation at Cadence seems to be accelerating, and we're very, very pleased with that. And I think that's a reflection of just how well we've cared for this and supported our employees during the pandemic. I think we're also mentioned this best workplace for LGBTQ equality. But -- and I think we featured in the investor business daily Top 50 ESG companies. We were ranked #3 in the software category and #7 overall on investors business daily of the top 50 ESG companies.

Great. And I know that we're out of time now, but I wanted to just sneak one more in for Anirudh. Congratulations again on your transition to CEO later this year. Any early opportunities you're willing to share on how things can be different under your leadership?

Well, thank you, Elizabeth. I think I've been President for 4 years and working closely with Lip-Bu and John. And so I think we expect more of the same and faster, stronger, higher, but the same strategy.

Great. Awesome. Yes. So we're over our time. So thank you so much for the time today and sharing your insights with us and hope you guys have the great rest of today, and to all the rest of the investors on the line.

Excellent. Thanks for having us.

Thank you.