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

Thank you very much. So maybe let me expand a little bit on this back-half loaded contract renewals, and you also touched about that it's very rare for customers who want to sign a smaller contract when they renew, when they do renewal. And they also mentioned about your retention rate, right, is very high, right? I mean it's -- it's not 100%. It's very high in the 90s. So now, I think one of the questions we've got is, given where the macro environment is and given where the semiconductor cycle is, given where the all the tech companies, so a lot of the system companies you are servicing today, they're putting more cost discipline to that. Could you possibly see a relatively -- I mean, smaller growth in terms of the contract value when they do renew in the second half of the year. So I think this is the question that people got a little bit, let's say, skeptical about so-called second half recovery. I think a lot of companies have been talking about that and investors probably just naturally a little bit skeptical about that. Can you address that?

Sure. So just so I understand the question, are you saying it clearly the environment this year is a bit more subdued than it has been in more recent years, and it's not a good time to be doing renewals. And I think it's what I hear you say.

Yes. The question is, is it not a good time to sign bigger contracts when they do need to renew, yes.

Okay. So look, it's a great point because I want to tie that back into the previous question that you had because the reason you may ask me like what -- why do we have so few renewals in the first half of this year? Or why do we have so few contracts expiring in Q1 and Q2 of 2023? And I do think it's not a coincidence instead of 3 years from Q1 and Q2 2020 when the pandemic broke out. But back in -- for those that have been followed us for a long time, we always have our management team off sites. And I mean, in the past, that I would be challenged to come up with something for the team as a scenario, and let's get the team working together on different team-building exercise or projects and stuff like that. In August of 2019, the yield curve been inverted. So I went to the management offsite and I told them this, okay, yield curve is inverted. If I go back over the last 50 years, it suggests that when the yield curve inverts, there could be a recession in April 2020, pure fluke, right, pure fluke. But I asked them for the exercise. I thought it was an interesting exercise for us to do, I told them that, okay, it probably might not predict a recession. We certainly won't predicting COVID, but I asked them that if we knew that a recession was coming in April 2020, what would you do differently? And I wanted them all to think about the business and Cadence and what they would do differently. And there was a bunch of discussions about that topic about that contracts that are coming up for renewal in Q1 and Q2, maybe I wouldn't want to be negotiating a 3-year contract in the middle of a recession, that would -- people are going to be more tied about their dollars that any softness you're kind of extrapolating out for multiple years if you try to deal with them. So what they looked at were the more critical or higher-value renewals, they wanted to try and close them early. And we made a project go and said, okay, let's try to do that, but what we agreed amongst ourselves was, let's not give any value away for doing something early but if any customer wanted additional value or additional discount or something to renew their contract early, you would say, no, we don't want to do that. We just wanted to take some business off the table to set us up for the next few years. And then, of course, what happens -- so we had done that. And then when you get to Q1 and Q2, when you've already taken some of the business off the table, in Q1 and Q2 of 2020 when people are very nervous about signing up to 3-year deals, our sales guys are comped on the -- like we're focused on growing that annual value. And to ask a customer who signed up for 3 years when they're so uncertain, it's difficult. So many of the contracts that came up, even though typically people do baseline renewals for 3 years, Our sales guys said, okay, if you're not comfortable with the 3-year value, why not just extend it by a year, extend by 2 years on your existing deal, will come back and talk about this next year, focus on getting through the pandemic. But -- so the result of that is the knock-on effect is that by the time you come around to win, so like if we were doing 3-year renewals, then when they would come around to naturally be expiring, that's just not -- there's not a lot of contracts expiring. That's the phenomenon you're seeing in backlog. It doesn't hurt us. In fact, I think it helps us that we're not having to negotiate in more difficult environments. So we've probably got lucky twice, start looking in 2020 and getting lucky again in the first half of 2023. But I think what typically happens -- again, we're focused on the annual value. We want to continue to grow the annual value. And if there's kind of softness in the general market, we don't have to do a 3-year arrangement. But it can be 1 year or 2 years until the customer is comfortable -- more comfortable to sign up for better terms for us. The -- what I do find is when I look at the -- see the weighted average duration of bookings at Cadence, if I look over any 3-year time horizon, the weighted average duration is typically somewhere between 2.4 to 2.6 years. It typically averages about 2.5. And the reason for that is, most customers over a 3-year time horizon, most customers will do a 3-year baseline contract. Some will do shorter, some will do longer, but the majority are doing 3 years. And then because customers are purchasing add-ons throughout that 3-year contract, what we do with add-ons is that if you don't have access to enough tools or enough licenses or some technology you didn't purchase in your original baseline contract, you want to add it on, we'll do an additional or addendum to the contract for you. But if you're like a year into our 3-year baseline contract, the add-on will be for 2 years because they all co-terminate with the baseline contract. And as a result, because all the add-ons are naturally less than 3 years. As a result, we typically average about 2.5 years over a 12-quarter window. But in any one quarter, like a pandemic quarter, it's going to be less, but that's not a reflection of the entire business. I do think, over 3 years, typically things seem to even out.

Got it. Thanks, John, for the great transparency here. I think we really appreciate the color like this. So certainly, it sounds like backlog and bookings. Well, you want to be flexible in terms of when to renew the contract, when -- what kind of contract to discuss with the customers, but you want to focus on the annual value that you already have and including add-ons and onto the -- so hopefully, when the time is -- becomes better, you can sign bigger contracts with our customers. So -- maybe I want to touch upon a little bit more on the IP side of the business. I know it's probably a smaller proportion of the Cadence business compared to your closest peer. We understand you don't want to chase revenue in IP, you want to grow profitably. I think the Cadence did set a goal of growing IP business at roughly low teens percent CAGR a few years back. But when I look at the IP growth numbers, the year-on-year numbers, it feels like you were growing at 10%-ish year-on-year '21, '22 But is '23 on track to grow above 10%. So that -- because I kind of think that you do need a little bit above -- well above 10% to really get to that low teen percent CAGR, if you will think about the 3-year horizon when we will calculate the CAGR.

It's a fair question. Very interesting observation there, actually. I would -- again, I would encourage you to go over a longer time horizon. The answer to your question, the short answer to your question is yes, we'd expect to grow faster than that. But if I look -- like if I go back to 2018, 2018 our IP business, our IP revenue is about in and around $250 million. That is 2019, we grew that to $300 million. Now 2020, you'd expect, okay, $250 million, $300 million should be $350 million, right? But of course, it's a 53-week year. We have that funny thing going on. But I think that ended up closer to about $370 million. When things you kind of normalize, you get back to 2021, about $400 million. But 2022, I think it was about $440 million. I think as we get into the 10%, $400 million to about $440 million. And for 2023, I mean, if we've gone a safety $250 million to $300 million -- I don't know, $370 million to -- with the extra week and everything to $400 million, $400 million to $440 million, I want like $490 million to $500 million, right? I mean, you would expect something like that. But I mean, if you go through that $440 million in '22, again, so again, if you look over a 3-year time horizon against the $300 million in 2019, that's about 13% to 14% annual growth. That's a low teens. But -- and I think $440 million to get anywhere near $500 million for this year, again, is low teens. But -- so I think the business is delivering low teens. But the most important thing to us has been, we've asked them to try and deliver low teens, but with increasing profitability year after year. But -- and that's been our focus when we review contracts back around the 2017, 2018 timeframe, we grew really fast up to that point in IP, but sometimes we were signing up to revenue growth, what it was -- like it was just so expensive and it just wasn't worth, you were tying up like precious engineering resources on activities that we're not generating income. And I always tell people what do you care more about your [indiscernible] or your take-home pay. Because I think everyone will kind of raise an eyebrow and said, look, I could double your gross pay, but your take home pay will be less. You wouldn't want that. But -- so we tell people that, look, we want to run this something that people will tell you that I'm like a broken record at Cadence. Most meetings and say, okay, would you do this? If this was your family business? Is this the decision you make? Would you sign up to this contract? And we always think about this as when you're thinking of yourselves as a compounder, we have an amazing strategy that we're becoming more and more important to the society and our customers in terms of like where the glue that holds everything together, there's such a high dependency on Cadence, but it's important to think long term. And like I say, compounder nature, we think long term. So we try to think, well, what would you do with your family business. And we talk to investors that way. I mean we take our responsibility. I'm treated accordingly that it's really important to us that we feel we're managing investors' money but that we want to invest in with our highest return. And I view returns on an income basis. So that's why the focus has been like that. There is some business that's available every year within IP, where you can sign up for any revenue growth you want. If you don't care about how much it cost you to deliver it. But I don't want to do that because that's not sustainable at long term.

Got it. Got it. So I think I want to move on a bit to discuss with you on the P&L lines. I think -- this is a question always a little bit worth checking in with you, John. I think you famously said no operating margin target. But you do have a flow-through target, right, 50%, meaning 50% of the incremental revenue falls directly to the operating profit line. A lot of investors kind of interpreted that as Cadence operating margin probably will converge to this 50% figure eventually, right? But I mean, mathematically, right, the path to that 50% maybe a little bit like a central curve, right? I know we always set a high bar for Cadence. But is there anything structural that can help you move that 50% flow-through target higher or maybe, I mean, asymptotically, Cadence operating margin can actually be tracking to somewhere above 50% over the long term. I know we set a high bar, but I want to hear your thoughts.

Great question, Charles. And I don't often have people ask me a question on a same topic basis. But what you're seeing is like when I say like if you like that question, you would have had in school that John travel -- has to travel a mile. If he covers half the distance in 10 minutes, how long -- if he covers half the distance every 10 minutes, how long does it take for him to get to reach the mile. And of course, you never reach it because if you're only ever going half the distance, half the distance, you never actually get to your goal. I think that's what your point is, right? Okay. The -- well, okay. So one thing is, although we kind of set expectations with people that we're trying to achieve 50% incremental margin, the one thing we discover with Cadence is, it scales dramatically well, particularly if you focus on your core center of gravity, I mean, we always spoke that our core center of gravity is that we were destined to be the largest core EDA company, and that's because where our routes were in analog, and we felt analog to digital is like orchestrator outbound, and it was easier for orchestra players to play in rock band. So naturally, we felt this -- it would only be a matter of time before you get to 50-50 in digital. We would retain the majority of the market in analog. So if your destiny is the largest company in core EDA, we've built our strategy around that because then we look at what our customers use our tools for its chip design, chip verification and then they do packaging board. So we have a packaging and board business. But then they go into system analysis. So we're branching out into system analysis. So we're building that kind of unified platform, if you like. And the -- and we're targeting areas where we feel we have the right to win and where we can benefit synergistically because it's a close adjacency. And what we found is that Cadence is a remarkable business where it scales really well. The challenge in the past was how do you grow it? Well, I think we have a really great strategy and a path for growth. But I mean, you can see phones are becoming smartphones, cars are becoming smart cars, buildings becoming smart, building cities will become smart cities. It's just -- it's pervasive, and we're in the sweet spot for all of that. I mean, prior to phones becoming smartphones, there was like a social media kind of explosion that doesn't benefit us at all. But all these other things, benefit us, and I think it's really, really helpful for us. But -- so when you think of -- what I looked at them was, okay, at the time that I stepped into the CFO role, Cadence had got up into the mid-20s for operating margin. And our incremental margin was only I think 11% at the time. And I thought we're investing in the wrong areas. We're not investing in the areas where you have the greatest opportunity for growth. So I thought -- and the challenge at the time was, revenue growth was decelerating. I think we went through a series of years where revenue growth went from like 12% to 11% to 10% and it's like heading down towards 7% or 8% that and I felt we had to turn that around. And one of the issues was investing in the wrong areas meant that -- look, while we were improving operating margin in the 2012 to 2016 period, we were improving by not investing in certain areas that was impacting the pace of new product introduction. And of course, that was having the knock-on impact of reducing revenue growth. So what was really important was to look at Cadence on a Rule of 40 basis, add your operating margin to your revenue growth and see if you could turn it around by allocating your investment more intelligent in the year. But -- so when we did that, that we found that we were able to turn around the pace of new product introduction. But we also found this, I set a goal of 50% plus incremental margin. I wanted every dollar of revenue growth to drop to at least $0.50 to the operating income line, but -- this is for non-GAAP, but $0.42 for the gap because we spent about 8% of revenue on share-based comp. So we've been strict about that as well trying to hold that. But on [indiscernible] debt basis, we're trying to up $0.50 of every dollar. Over the course of, I think, what is it, from '20 -- I mean over that last 6, 7 years, I think we have ranged 53% to 56% in any 1 year, something like that. But actually -- no, sorry, 53% to 56% over a rolling 3-year period. in incremental margin, 52% to 58% in any single year. So we've beaten that 50% in every one of the last 6 years. Now that's 6 years, very, very different years. That's 2 contract cycles, have a pandemic in the middle of it. But I mean there's -- if you're traveling at that pace for 6 years in a row, I see no reason why you can't continue to do that. Now, of course, -- but if let's say, we reach a static 56%, you will have that sync topic issue that maybe you get close to 56%, but you never get over it. But I think the 50%, we've been beating 50% so consistently, I think that will help. Now what you'll find though is that the pace of acceleration on margin probably slows the closer you get to your incremental margin. But what we thought was really important to us is make sure we have an efficient machine. We're doing things, we're scaling as well as we possibly can. And then you look to expand into other areas with investment so that you can put more and more revenue through this machine that's spinning off amazing cash flow and amazing profits for investors. And that's been our focus. That's what we've been trying to do. And every year, we're investing more and more in new product introduction. What's interesting? Back at the time when I started, that I just did like a [indiscernible] of all the engineers that were running the R&D groups. They were spending probably 1/3 -- my simple question was, how much of your time is being spent on products that generate revenue today? And how much of your time is spent on products that have not been released yet. And only about 1/3 of their time was being spent on products that haven't been released yet. And I felt that, oh, 2/3 of your time is spent on maintenance of existing products, that's not going to help you with new product introduction. I think that's pretty much flipped. I mean in the 6- or 7-year period, as much as we're spending in R&D these days. The majority of that R&D spend is not contributing a dime to revenue this year. It's all new products being generated for the future. It's us building out our capability. And as long as we keep the machine operating as efficiently as we can, it should split out operating income and cash flow for the benefit of investors for years to come. And that's why I say we're farmers, not hunters. If we plant now, harvest later.

Got it. Got it. I think that's a very good way for us to really wrap up today's discussion. I think, John, you provided a lot of transparency, especially the transparency to how as a CFO of Cadence, you think about managing the business as -- from a CFO point of view, I really appreciate that. And I think we are about to have to wrap up the session today. But really thank you, John and Richard for joining us today. Thanks, everyone, on the line. And I hope everyone have a good rest of the day.

Thanks, Charles. Thanks, Richard.