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

Hi, everyone. Good afternoon for folks in the East Coast, and good morning the Cadence team and those in the West Coast. Thank you for joining us today at the 2022 Needham Technology & Media Conference. My name is Charles Shi. I'm the covering analyst of the EDA industry at Needham. It is my pleasure to host this fireside chat with the Cadence Design Systems. Joining me today from the company are Mr. John Wall, Chief Financial Officer; and Mr. Richard Gu, our Vice President of Investor Relations. On behalf of Needham, I really want to thank John and Richard for spending time with us today. For those who are listening to this fireside chat live on the webcast, just so you can type in your questions in the Q&A box. I'll try my best to work your questions into the flow of this fireside chat. Before we get started, let me hand it over to Richard for a few safe harbor statements.

Thank you, Charles. Before we begin, I just wanted to mention the safe harbor statement real quick. 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. With that, Charles, let me hand back to you.

Yes. Thank you, Richard. So really to get our conversation started. First off, really just to recap a few interesting financial numbers of our Cadence to really just level-set the discussion. John, Richard, I really -- I've heard that like in the early 2010s, the consensus view on the EDA industry growth was really just around low to mid-single digit and even back in the days, I mean, besides consolidation with the smaller EDA vendors, large companies. We're really probably thinking about diversifying away from EDA, and definitely that kind of thing is not very popular -- not as popular as today. So today, because the backdrop is quite different today. Your financials are already showing that your 3-year growth CAGR is accelerating from like 7%, 8% in 2017, '16 to 13% this year based on your latest full year guidance. And so obviously, share gain has been part of that Cadence story and maybe let's put opinion that for now and discuss about it later. But the EDA industry seems to be accelerating. So really, just wanted to talk to you guys about what the drivers are behind that. And one of those is definitely system companies whose end products are not really semi, but they are entering the race and designing their own chips, it's not just Apple, it's also all the other big techs, Google, Amazon, Alibaba, Tesla and automotive, aerospace, defense companies. But here's the thing. One of the bare cases by Wall Street on EDA stocks is that whether those system companies doing chip design, could we -- is that really like a longer-term sustainable trend or is that just a fact some argue that -- right now, Apple seems to be the only one successful today in terms of getting the volume up for their own in-house chips. And some argue that many of those other system companies doing the chip design may fail eventually. So what is Cadence's view here?

Charles, I'll take that. Thanks so much for having us at your conference. Really appreciate you taking the time to spend time with us. You're right, more and more systems and services companies are building or acquiring chip design resources in order to better develop their product and meet their own customers' needs. That's a big part of our motivation behind the intelligent system design strategy. That helps us better service a broader array of customers and maximize those opportunities by taking an in product and vertical market view and expand beyond our traditional EDA business to tap into a much larger market. You asked about the drivers. I mean, it's really driven by trends such as like hyperscale computing, AI, machine learning, 5G, autonomous driving, IoT, design activity is really being fueled by workload-specific computing, system companies building custom silicon, new silicon start-ups and the digital transformation of industries that we're seeing everywhere, I mean you can see that in automotive, aerospace, medical and there's many other industrial applications. The increasingly complex use cases and compressed kind of product cycles that are accelerating the need and the trends to kind of, I think they call it shifting left, moving more upstream to the heart of silicon as opposed to the traditional kind of oil purpose chips, but all of those trends have -- silicon at their foundation, and are driving strong design activity, which we believe will play out over both the near and the long term. So yes, I mean, you can see that in our numbers, and you can see that in our consistent growth in our 3-year CAGR -- 3-year revenue CAGR, as you mentioned.

Yes. So I think one of the specific drivers you mentioned either on our earnings call or in other occasions, it's really about semiconductor industry continue to do well, which should support the growth of EDA and in particular Cadence. So however, the stock market, especially since the beginning of this year seems to believe that potentially a down-cycle semiconductor market may be coming. And at least we can say there are a lot of crosscurrents in the semi industry today. So really, some people are viewing -- maybe nobody has bare semiconductor downcycle, however, it does look to me that EDA wasn't quite affected by cycles, if you look at your passive performance, right? And also your peers' performance as well, over the past 10 years. And any thoughts on the cycle question, what seems to be a top of the mind of many -- for many investors, especially those coming from the semiconductor side?

John, I will take that.

Yes. Thanks, Richard.

Yes, sure. So at the highest level, right, if you look at things despite the macro -- near-term macro volatilities, we truly live in a golden era for semiconductors and electronic systems, right? You look at this powerful tailwinds from what John just talked about and mentioned the hyperscale computing, the AI and all, 5G, IoT, autonomous driving. And these are powerful and increasingly custom-build chips and they are truly proliferating, right, through every festival lives. If you look at things, we around our lives, it's like we are -- everything in our lives becoming smarter and more intelligent, the cars, what drive, the houses with the phones we use. So this is a long-term trend that's going to benefit us for many years to come. If you're zooming on the chip industry, it's close to $0.5 trillion last year -- as the end of last year. And that could well double in the next 7 to 8 years down the road. So I think this in turn is fueling a huge growth in chip design activities, not just in terms of the volume but also in terms of the sophistication and complexity. So I think EDA industry stands to benefit from the increased kind of design activities due to the growth for the semis. I know the phenomenon we saw is exactly like you and John just talked about, the sort of system companies coming downstream and driving increased hike in terms of the design activities. Not to mention the third leg growth for our business is also we're expanding into the system design and analysis simulation area. So I think our intelligent system design strategy really affords us with the enhanced resilience and diversification for our business model. I do want to highlight that our customers' kind of budgets are really very much R&D driven typically tied to their long-term more strategic future projects. So hence, the lease to -- they are the last to be impacted even if there were to be a down cycle. I think historically, we don't see high correlation between much credit between EDA industry and wax and win of the supply chain side of the equation for semis, right? So -- but I think the last but not least, our highly recurring business model provides us with good visibility into our revenue down the line and about 85% to 90% of revenue is recurring, right? So in our contract length in average is 2 to 3 years, it really gives us a good steady base to build on our business. So I think if you take everything together, we believe EDA industry at large is well positioned to -- for future growth.

Yes. Charles, just to add to that, what Rich said is exactly right. And key thing there is that our customers -- are their spend with Cadence is really R&D investment. The impact to us in the down cycle could happen if, let's say, you see a lot of large companies restructuring some engineers out of the workforce. What tends to happen there, we get some protection from our 3-year duration on the contracts. Most of our customers have a 3-year baseline contract. So even if, let's say, a customer cut the number of engineers in their workforce, they will continue to pay for what they purchased in the baseline contract until that comes up for renewal. And then they may renew at a lower rate, but often then they either hired back engineers? Or we found that those engineers have found work somewhere else and some other companies are buying tools for us. So we feel that Cadence is insulated somewhat from the cyclical nature in semis.

Thank you, Richard and John. I think this is something that people really want to hear in this kind of environment. So I want to really go back to something, Richard, you mentioned the growth drivers is not only about semi industry itself. It's not only about system companies, but also about products, right, eventually, your product company, right? And I think you've talked a lot about new products, for example, like 3D IC, for example, HeatWave, Emulation, prototyping, for example, AI, machine learning. And the history of EDA seems to be really about adding increasing number of design tools into a customer's design flow and obviously, companies talk about products all the time, right? But the question for many investors really is we really get paid for those new products. So it is not always obvious when the new product is something just nice to have for you to have. So maybe you defend your existing share of your customer spending? Or is it something that will really help you get that incremental dollar for a higher percentage of the R&D budget from your customers?

I'll take that one, and John can jump in. So Charles, I think fundamentally, we believe the best way to derive value from our products is to collaborate deeply with our customers, right, and really deliver innovative and differentiated solutions, which can add value to them. We view our technology as a key enabler for our customers to go change the world, right? And our products are essential and help really solve the biggest problems for our customers. And one of the key success metrics we use internally and externally is the PPA game for a customers. And I give an example, right, our [ vigorous ] product provides 5% productive again and 5% to 10% power reduction for some of our largest customers, right? It really uses the reinforcement kind of learning mechanism to help our customers automate and tune their full digital flow. And when you think about the functional verification kind of products we use, like the Dynamic Dual or Palladium. It really helped our customers speed up the verification, the tape-out and the software kind of bring up process, right, which is tremendously valuable to our customers. So this also ties back to our internal kind of investment philosophy and approach. We have an interim process where John and Anirudh put in place. That's sort of like a short-hand type of thing, where new product ideas were heavily scrutinized, debated and prioritize ultimately to make sure they can warrant the investment, right? And this helps us kind of stay truly disciplined and value-driven in our product development cycle. So I think the last point I want to make is, with our broad-based and comprehensive portfolio, our relationship with the customers become much more strategic and stickier, right? So I think this affords us with the opportunity to share the economic gain as our customers get more -- become more successful, right? So ultimately, I think we are aligning the customers' needs with our strength and where the market is going.

Yes. That's great, Richard. And Charles I think one of the things that I'd like to highlight in relation to Cadence here is that the A in EDA stands for automation that and as you see like the way our customer spends on R&D, it's a mixture of spend on people like engineers and the tools that are in the tool bag for those engineers, and we provide the tools and the tool bag. And a natural economic trade-off, as you see increasing cost for engineers, that you'll see the cost of the tool by kind of grow in line with that. And what we'd like to see over the next 20 years -- 20, 30 years, I would expect that the growth in complexity of design will probably far outpace the growth in the number of engineers. So more of share of wallet in our customers' R&D spend should be spent on tools naturally over time. And I think that's why it's so important that we are developing the AI and machine learning capability into our tool sets.

[Operator Instructions] I think we talked about the top line growth, we talked about different drivers. I want to switch gears a little bit and talk about profitability. And especially in this environment that when investors seem to get a lot more about profitability, free cash flow in the software or -- in the software world. You are getting greater than 40% non-GAAP operating margin, I mean, in the most recent quarter. I think back in 2017, John, I think that's the time I believe you became the CFO of Cadence. The fact that the company's operating margin was something like below 30%, I believe. And the investors I talked to you when they heard about your stock-based comp was like at or below 8%, and it was like great. That's relatively light compared to a lot of the software companies. So basically, relative to your peers, your profitability performance has been outstanding, and it has been well recognized by investors. However, the question here, I really want to ask how got here, right? And how sustainable your margin expansion will be from here? Any thoughts will be really appreciated. And maybe let me be a little bit more specific here, John. I think you famously do not have an operating margin target. But you do have a follow-through target, 50%. An incremental revenue dollar needs to generate $0.50 of the operating profits. Can you kind of help us understand what has been the rationale behind this kind of flow-through target rather than like an outright operating margin target. Do you kind of have to face any of the trade-off? Also, this is another related question between margin and market share because something I constantly hear from other industries outside EDA, well, we can have both in a lot of occasions.

Those are all great questions, Charles. I guess let me unpack it a little bit. I think you're exactly right to highlight our 50% plus kind of incremental margin. We're very data-driven. I think Richard mentioned that earlier. But we look at multiple metrics, and we make ROI-based decisions on pricing, resource allocation and investments. As a result, at the midpoint of our updated outlook, our 3-year revenue CAGR is now projected to exceed 13%, and we're on track to achieve a non-GAAP incremental margin of over 50% for the sixth year in a row, but EDA was always a great business. I mean back in -- if you see our CFO commentary, I always use 2016 as our baseline year because 2017, I became CFO, Andrew became President of R&D. Andrew and I worked very, very closely together on the annual operating plan from that point forward. I always joke with Andrew, but 2017 for me was 180 one after Devgan But -- so we kind of work our way through in a partnership the R&D group and with the sales team to make sure that we're data-driven, we're doing the right thing for the business. We try to treat Cadence like it's our family business. And I've always been focused on good quality revenue growth. Like if you have a look at like taking 2016 as a baseline year, you look at where we're guiding for this year, we're guiding to probably $1.6 billion more revenue over 2016. And over that time, more than $800 million of that is showing up in non-GAAP operating margin. That's the 50%. But critical to me also is that you're seeing that $800 million turn up in our operating cash line as well. So it's really a good quality. When I look back at 2016, 1 thing I thought, I did a lot of analysis back then just trying to understand. I was trying to learn Cadence myself in terms of what was most profitable versus which business was more profitable than others and what we're doing right, what we're doing wrong. And very simplistically, I wanted to make sure that we were giving ourselves the best opportunity to do more of what's working and making sure we stop doing what's not working or doing certainly less and what's not working. But when I look back at 2016, there were a lot of fixed costs in cadences first, kind of $1.8 billion of revenue. That first $1.8 billion of revenue is probably still a subset of what we do today, but it costs about $0.74 for every dollar of revenue that we generate. But it scales -- the business scales really well. I mean, in that time, like back then, at the Cadence campus, I think we had 6 different buildings. And -- but if I look at the Cadence campus now, it's still 6 buildings. We didn't have to double the number of buildings just because revenue is so high. But -- so every dollar of revenue sense then is flowing through naturally at over $0.50 incremental margin. So it's costing us -- actually, the numbers are about $0.45, $0.46. It's costing us about $0.45 to $0.46 for every dollar of revenue growth since 2016. And I know you say I haven't put a long-term target out there, but we have talked about setting the 50% incremental margin as a target for the longest time. We prefer relative targets that I was very resistant to trying to throw out a target. I didn't want to put to a target like mid-30s operating margin, particularly if you can see the company is scaling well and generating revenue growth so profitably and comfortably very, very profitably. I mean, bear in mind that we're generating that level of profitability while we're investing heavily in a new area for us to build out a multiphysics platform and system analysis. But -- so like I said, the business scales really well. But you also mentioned -- I think you said something about trade-offs between market share and margins. But the focus on incremental margin in the company shouldn't be interpreted as a focus on profitability over revenue growth. Really, what we're trying to do is optimize for the correct balance between the 2. We certainly focus on driving revenue growth. And you're starting to see the progress in that revenue growth in our 3-year revenue CAGR. I mean that's very pleasing to me to see that it's kind of gone up to 13% now, and I think that's a good start. But it shows that our focus is on scalable and profitable revenue growth. I look at it like a virtuous cycle. Increased profitability and cash flow allows us to invest more in R&D and that drives future revenue growth, which in turn, of course, generates more profit, more cash flow, allows for more investment and then leads to increased revenue growth again. And you can see that cycle through. I mean if you look over the period from 2016 to now, it's a fairly predictable cycle. The increased revenue, increased cash flow, allowing us to increase our investment in R&D. And then Anirudh been super astute at allocating those investment dollars to the areas that allow for the greatest opportunity for profitable and scalable revenue growth. So we like the model the way it is. We don't think there's any near-term ceiling in relation to operating margin. And what we're doing is working and like, I wouldn't even view the 13% revenue CAGR for the last 3 years as a ceiling either. I think the trend is there, and we're working really well as a team. It's very, very efficient, and we just keep doing what we're doing. But like we're not putting long-term targets out there, but the 50% incremental margin is a consistent target that we've had internally for the company. I don't intend changing that any time soon.

Next question. I want to ask you a little bit probably -- I mean, relative to a competitor, you seem to have a line of business, maybe not seeing as strong as your competition, which is IP. So your closest competitor, Synopsys, right? They have a target about like 15% kind of long-term IP growth. And in the year-to-date, the IP revenue seems to be growing well above that target. Your IP business, make no mistake. Yes, it's also doing well, but seems to be still kind of sticking to like 12%, 13% long-term growth target which was said like when -- like a long time ago, 2016 or so, right? So my question really has 2 folds, right? One, do you see the setup of the industry today can actually sustainably support a higher IP growth for you as well. I mean going forward -- I mean higher than 12% to 13%. And two, do you see a potential for Cadence to raise your IP growth targets and maybe at the same time without losing the scalability without losing that. I mean, without undershooting that 50% flow-through target there. Obviously, investors always want more, but we're not always right, but I believe many, including myself, would appreciate to have the opportunity to hear you about your IP strategy going forward.

Sure. Great question again, Charles. But on IP, I think when you're comparing us to near competitors, you're probably comparing us to Synopsys more than others. There are many other IP players that we compete with. But our focus has really been on differentiated star IP that we didn't want to build out a portfolio of commoditized IP. That doesn't fit with our strategy. I mean we're -- we wanted to focus on profitable and scalable revenue growth throughout all of our businesses that fall under the Cadence umbrella. And when I look at our IP business, I'm thrilled with how well they performed. I mean, back in 2016, when I did the initial analysis of all the businesses under Cadence's umbrella, what I discovered was IP was the least profitable business, and I thought we could do better there in terms of choosing the business that we rolled more carefully. And I mean we used to talk internally, but look, anyone can drive revenue growth. You can sell $20 bills for $15, you get loads of revenue growth, but the more you win, the more you lose, right? You want the more your investors lose. So we didn't want that. And we said very early on what we said was a goal of just getting to low teen revenue growth aim for 13% revenue growth. And we found by doing that, we empowered the team to be more discerning and thoughtful about what business that they signed up for. And over the last 3 years, with that low teen target, they've achieved mid-teen revenue growth. So we're very pleased with that. And not only have they achieved mid-teen revenue growth, but they've dramatically improved the profitability of the IP group's business and their contribution to Cadence's overall operating margin. The -- this year, they've started well again. Again, I was prudent in the guide, I want to keep the 13% there. So I've assumed 13% revenue growth at the midpoint of the guidance in my IP number. But the team, again, in Q1 achieved mid-teen growth. If it's consistent with the last 2 or 3 years, they'll continue to achieve that mid-teen growth, and I'll be forced to raise the guidance at some point later in the year. But I'm very, very pleased with the way it's working. The team has become tighter. They work very, very closely together. They focus on profitability. They partner with customers, and they focus on our more differentiated IP. So we're not -- but often, we're not competing against the other IP players, and we're partnering with some of them, but a lot of the IP that we have is quite unique. And then like I said, the team has done extraordinarily well. And I feel really good about the platform or the foundation they've created for growth from here on.

Okay. Good. [Operator Instructions] So I think we are close to the end of the session, I would say. We really enjoyed the conversation so far. Before we get into potentially some questions before wrap up, John, Richard, any closing thoughts remarks you want to address?

That's good point, Charles. I think one of the things that's maybe least understood about Cadence is that people that have sold the shares that I've met at conferences or often tell me that the reason that they saw was they thought that Moore's Law was slowing and didn't realize that is Moore's Law slows that we get longer time to harvest what we've created because all of our R&D spend is on future process nodes essentially. I mean when you look at R&D spend for Cadence, less than half of that R&D spend is generating -- is on projects and efforts that are generating revenue today. So from that perspective, we're continuing to invest heavily in the future. The company was created by engineers for engineers. We love engineers. We love that whole engineering community. There's many -- the modern day Da Vinci and Michelangelo live amongst us today in our customer base. And what we aim to be is really Da Vinci's paint brush. That's what Cadence wants to be, but we want to provide the tool to allow these people to maximize their talent.

All right. It looks like we don't have any questions on the line, and maybe this is a great place to end this fireside chat session. Once again, thank you, John. Thank you, Richard, for joining us today, and thanks to everybody on the line and hope you have a great conference, and have a good day.

Excellent. Thanks for having us, Charles.