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

Hello, everyone. Thanks for joining. I'm Joe Gallo, Jefferies. And we're delighted to have Cadence Systems today. We've got John Wall, the CFO. I believe you just hit your 27th anniversary. It's fair to say you know a little bit about cadence. We also have Richard Gu Investor Relations as well. I know, Richard, you have a disclosure you'd like to read.

I'll be real quick. So today's discussion will contain forward-looking statements, including Cadence's outlook on future business and operating results. Due to risks and uncertainties, actual results may differ materially from those projected or implied in today's discussion. Back to you, Joe.

Awesome. Thanks. I know there are a lot of generalists in the room, John. So maybe just to kick it off, a quick overview of Cadence and what you want investors to know about you.

Yes, sure. Cadence is largely a computational software company. Its engineering software is distinct from enterprise software. Engineering software typically is purchased out of the R&D budgets of our customers, whereas enterprise software is probably be an IT spend. But the company does provide IP as well as hardware, but predominantly, it's a computational software company. When you apply it to silicon, that's EDA. When you apply it to things, physical things like phones and cars and buildings, things like that, that system analysis. And when you apply computational software to data that's AI and we kind of -- we sit at that kind of sweet spot where all of the engineers that are designing all of those gadgets that we can't live without, but they're using Cadence technology to build those chips and those products.

Awesome. It certainly feels like the golden age for semiconductors. Nobody wants to talk to me as a software analyst. I think most of the people here for semiconductor companies even the software meetings are asking about CapEx because they're trying to gauge the demand for semis. You're one of the few software companies that should truly see a benefit here from the semis rise. And maybe just talk a little bit about the secular growth drivers and how they pertain to your business.

Sure. I firmly believe that I think history will remember our semis customers really, really well in time. I think they'll be described as the renaissance artists of our time. I think Cadence really is the paint brush we're providing paint brushes to these artists. And thankfully, they're all painting masterpieces with them. But effectively, in this area now in the semi design and chip design that when we look at our customers' budgets, their R&D budget, they're probably spending about 88% of their R&D budget on people and about 12% of that budget on tools. And while there's a secular growth trend in the design or the proliferation of silicon, I guess, that as chip design becomes more democratized, that's really, really good for cadence because there's more people using our tools to design chips. But as they're doing that, it's more and more of the heavy lifting is being done by tools. So as it's 88-12 now, I think with the advent of AI and with AI doing more heavy lifting. I mean, the growth and complexity of design is far outpacing the growth in human population. So the engineering headcount cannot keep up. Like if I go back 10, 20 years, started in 2000s that you probably had a 500 person engineering team taking 5 years to design a chip. Nowadays, it's probably a 40-50 person team, and it's taken 6 to 12 months. I mean that's 100x improvement, productivity improvement. And people that buy our tools generally measure them for power performance and area and improved productivity, they're trying to optimize the value they're getting from each chip. And I think as we provide that productivity, we're getting more of the value. So as you see, semi companies and systems companies do more chip design, they should spend more on R&D. And more R&D is done by tools versus people we should outpace that growth in semi R&D spend.

Who are your biggest partners or customers like who -- I know you love all your children, but is there any kind of poster child for how you're helping somebody?

Well, I mean, we're in all the things you can't live it out, right? So all of the big names that you can think of that are designing chips that they'll all be customers of ours. But now we do have a concentration like top 40 customers, we generally generate about 55% to 60% of our revenue from just 40 names. It's probably close to 80% at $200 million so there's a big concentration that's -- those are customers that we treat them all like Jensen that they're used to concierge service white glove treatment from Cadence and they're partners of ours because their next generation of products are probably dependent on our tools. But as we expand more into the system space, we find our customer base expanding, but that's a new challenge for us because we're dealing with and a low-value, high-volume transactions, and we're building our channel partner program and our e-commerce offering for things like that. Makes sense.

Can we unpack AI a little bit? I mean you talked a little bit about how it's making it tougher for your customers because they can't keep up with just headcount anymore. But how is that impacting your business? Are you seeing more design starts, more licenses, better ASPs? Like where are we in the AI cycle for Cadence?

Well, we're certainly seeing more design starts, and I didn't mean for it to sound like AI is causing problems for customers, but I think it's actually helping I think what's challenging for our customers is that the pace and growth in all of our demand for technology. is just far exceeding population growth. But the growth in complexity design is outpacing population growth. And as I said, even without AI, you go back, like I said, 20 years to go from a 500-person engineering team taking 5 years to design a chip to like 50 people doing it in half a year. There's huge productivity gains. And AI is like that. I mean, we're always dealing with that. I mean, Cadence is a very disruptive company, very innovative company. We spent 35% of our revenue in R&D. And new product innovation, we disrupt ourselves. But when we launched our Z3, our new emulation system just back in March, on a 3-year. It took us 3 years to go through that production cycle to upgrade Z2 that previous cycles for 6 years in length. So the 2 best systems, 2 best emulation systems in the market right now are probably Z3 and Z2. And I think that AI is helping. I mean, the AI is helping doing more heavy lifting that for customers, you can do more with our AI copilots. And we're always trying to help people do more with less, so to speak. And generally, the more you spend with Cadence, the more you should save. And it's -- I think we're in a sweet spot from the perspective that -- like when I talk to it when I meet a lot of other CFOs when we're doing this network, they're quite envious that our spend is -- our customer spend is out of R&D because they invest in Cadence technology as opposed to spend in Cadence technology. The more you buy from Cadence, the more you probably sell yourself. And when you're -- like when people are focused on CapEx budgets and things like that, it's an investment because they think there's going to be a return on that investment and we should benefit from some of that investment ourselves.

It's great to hear about the disruption. I mean, since you brought up Z3, can you just talk a little bit more about Z3 and X3 and what the implications are to your financial model?

Sure. Yes. We probably give ourselves a little bit of an air pocket in Q2 because launch in Z3 so quickly. Like I say, we disrupt ourselves. Z3 is your -- on the verification suite of tools, that's our emulation system. An emulation system is -- it's a hardware machine that allows our customers to bring up a chip onto a hardware platform and simulate the chip so that software -- the software apps can be developed for the chip before the chip is even hardened. That's what causes the design cycle to shrink because back when it took -- I mean the reason it took 5 years a long time ago was because people used to have to design the chip and then the software folks would design the apps to go on the chip, but now they try to do that in parallel before the chip is even finalized. The software developers can start developing apps for it. Not only do they do that, but they can influence the chip designer with our emulation system because it's not hardened yes. But if a software developer thinks that the chip that they'd like to make changes to the chip, they'll discuss it with the chip developers, and they will collaborate on a final design for the chip. And it means that by the time you're -- by the time you have your chip in silicon that you already have your apps developed for it. It's quite disruptive. And the launch of that product alone kind of disrupted the flow because like I said in the past, chip designers did their thing, software designers, did their thing separately and rather than in parallel. Now they're communicating and collaborating more. Our prototyping system allows you to take that normally with our emulation system. When they're done with that. When they've hardened the chip, they'll transfer it over to the prototyping system and the software focus will continue to develop and then they'll free up the emulation system. But we have a suite of tools in our verification suite on the software side. When we launched the systems, and it's a greater claim, we launched it at CDN Live, I think Jensen said that it was the most important system in his life, more important to his refrigerator, but he said they used our previous version, Z2 to design Blackwell. And it stands to reason that you need to have a supercomputer essentially to design another supercomputer. And with C3 now it can handle 5x the size of backlog. But so I think we're ready for the next few years with that. But it will -- from our guidance perspective, because it's so popular. It takes us time to build those systems. So we took the guide for Q2 down. We didn't take the guide for the year up for our hardware systems. Our verification group have had multiple record years in a row, but we're expecting that to grow about 7% or 8% at the midpoint of our guide right now.

Is it the Millennium supercomputer that's the competitive differentiator? Or how do you think about the EDA competitive landscape and what your point of differentiation?

That's another great disruptive system because no one's ever approached things like that before actually. I'll let Richard. Will you talk Millennium.

Sure. Yes. I'd be happy to. So Millennium certainly is a groundbreaking kind of technology and innovation. Historically in the past, when companies are dealing with the physical simulation in the automotive or like aerospace, relations space, they only get to a similar 20% of those. Okay. Versus on the chip design side, we symptoms 99.9%. So it's a truly digital twin. The challenges and impediments historically in the past are twofold. One is accuracy because the solvers algorithm is not good enough in order to simulate the entirety of the very complex EDI flows. So we acquired this company called Cascade a years ago. Founded by the scientists, PhD students and professors in Stanford. Over years, they developed this really high fidelity EDI simulation model which it solves the problem beautifully and elegantly. But then comes the next challenge, which is the speed up is not enough because once you have a very complex software, obviously slows the machine down. So that's where the GPUs and the accelerated computing come into play, where we kind of -- over time, over the past couple of years, our R&D team has been working really closely with different companies like NVIDIA to really co-optimize GPU together with the high fidelity simulation solver to solve the proppant. Now the speed up is almost 32,000 versus the previous typical CPU. And the third piece of puzzle is the AI model, okay? So we use our own internal developed optimality to really orchestrate the entire workflow. All of a sudden, you have this tightly integrated optimize the 3 layers act really go there and solve the historically unsolvable problem. Now we launched the product about a few months ago. and got raving kind of really kind of testament and validation from companies like Honda, like [indiscernible] like GE, they are using, proliferating the tools across the board. So we have 2 different models. One is through SaaS and cloud, another is on-premise. So it's truly a plug-and-play and really solves one of the key naughty problem historically.

I think Richard raised a great point there with -- on the system analysis side, but that's a good area for growth for us. And we've been -- we've had this intelligent system design strategy for the last 6, 7 years with Atheros. When you think of what we've done on the chip design side of things, I mean, people don't physically make chips anyway. It's like it's so automated, like 99% plus of the process is automated. On the system analysis side, only about 20% is automated right now. So I think there's much more room for growth and disruption there. And then on digital biology side, it's probably less than 1%. There's probably another leg of growth there at some point.

Maybe just zooming back to the competitive landscape, I mean, what does that look like? Has that changed since kind of the rise of AI? Or is it still the same?

Yes. I'd like to say AI is not new to us. So we've been using AI for a number of years. And with the pace of change and the pace of this disruption, if you like, is not new to us either. But I think when you look at the competitive landscape for us, that's the area that we've played in has been quite narrow. It's been chip design, chip verification, packaging and board and system analysis. That's generally the area that we service our customers in a little bit of IP. But the company that's probably costs to us is maybe Synopsys, but Synopsys were heading down, they were much they're much bigger than IP and they had a software integrity business. And they weren't in systems. They've pivoted a little bit now, but I think they've offloaded the software integrity business in the and they bought ANSYS. So I think they're inclined to follow us now into that whole systems area.

You recently closed the acquisition of BETA. I mean how do we think about the strategic rationale behind that deal?

Yes. So BETA CAE, a great company. It's like a gold standard and structural analysis. I mean we think that our simulation capability is a super power. But Atheros says that you measure the capability based on the number of variables your matrix multiplier can handle. And our major plans product can handle like $50 billion by $50 billion variables. But I think the next closest was lease set a product that was doing $50 million by $50 million by comparison. I mean it's just huge are the magnitude difference. But this capability that we have means that for things like, say, crash testing a new car or something like that, that in a lot of countries, the laws require you to physically crash the car and put a dummy into the car and stuff. You do it more accurately for all different body types with simulation software like ours. So I think it's a good marriage between ourselves and BETA CAE. Also when I talk to Atheros about it, what he told me was that he thought BETA CAE like the last piece that we needed to be able to effectively compete product, product to product against ANSYS. Now we have a broader view of system analysis than ANSYS does because we take in digital biology as well. So he views ANSYS what ANSYS does is a subset of what Cadence does. But for probably less than $3 billion over the last few years, we've added some small tuck-in M&A into the Cadence portfolio because we like to make rather than buy, when we spend 35% of our revenue on R&D. So Cadence is like an innovative company. It's R&D driven, our leader is an engineer that -- so we'll make more things. And then we'll add some talk in M&A when it basically allows us to accelerate our strategy. So I think BETA CAE is the last piece of the puzzle essentially to be able to compete a factory with them. On the -- in contrast, then Synopsys incline to imitate and follow that they purchased ANSYS spend $35 billion on that. I think that's a good validation of what we've been doing for the last 6 to 7 years has been good value for our investors.

That's really cool. And really clear to hear on the crash test. It sounds like you might put a crash dummy suppliers out of business if they know longer have to be used on actual tests.

Well said, we can help a lot of people.

For sure and maybe just a that acquisition back to the financial implications of the model, right? How do we think about the margins and the growth profile and how does that layer in over time?

That's a great question. I mean over the last 7 years, we've prided ourselves on, we scale really well. For every $1 of revenue growth, we're dropping more than $0.50 to operating income. And it's probably closer to $0.60 organically that when we do M&A, we're never able to find companies that are as profitable as ourselves generally. And so it takes a while to get them up our level of profitability. So generally, when we have -- when we acquire a company, it will be a headwind to margins and for operating margin generally. But so what you see for us, like last 7 years, we've achieved that 50% incremental margin, actually, just a little bit more than that probably. That probably choke 54%, 55%, maybe. Organically, I'm confident enough that we'll achieve that again. But I looked at the end of Q1, we gave the guide that compared where we were at the end of Q1 in the previous 7 years where we had achieved 50% incremental margin and at the end of Q1 this year, we're ahead of 5 of those 7 years. So I think we're still on track to achieve that 50% incremental margin. BETA CAE is a big acquisition, though. So let me put it that I'm pretty confident we'll achieve a 50% incremental margin, if I can exclude BETA CAE, it might take a bit longer to integrate BETA CAE and then if we can achieve it by the end of '24, including BETA CAE, what we'll do is we'll measure '25 against '23, so you see how we're doing including BETA CAE.

It's good to hear on the incremental margin. Sometimes us investors, people and just like we managed a rule of 40, and you guys are actually well above that. So how should we think about the growth versus profitability profile? And what can the long-term margin be for you guys?

Look, I mean, if we're achieving more than 50% incremental margin, naturally, margins will levitate towards that level. It depends on the amount of M&A that we do. Now I do think that we don't need to do any more M&A that area that we're focused on. OpenEye has been a bit of a science project for us on the digital biology side. But if we're successful, the more successful we are there, I guess, might lead to some other tuck-in M&A over time, but I don't see anything like that in the near horizon. But from a margin perspective, we're very focused on profitable and sustainable revenue growth. And Cadence is really a compounder. But we're not going to blow the lights out in any one year. If you can pick a winner in AI, you're probably better off going after that one. But if you're not really sure who the winner is going to be, you know that we'll win with those winners. But over time, we tend to like win with the winners, and we'll be servicing a lot of companies, but there will be some come through and they'll end up spending more with us eventually.

Can you just double-click on capital allocation? Like obviously, you just mentioned M&A, small tuck-ins going forward, not needed for growth but you also have really strong cash flow. So what are you going to do with everything?

Yes. I mean, generally, what we do is 50% of free cash flow used to repurchase shares. We want to try and reduce the share count over time. And then in the past, it's been 50% of the cash flow has been used for investment in the business and in M&A. From a capital standpoint, we're probably under capitalized a little bit because we've been carrying about $1 billion in liquidity and cash, that used to be like 5% of our market cap. Now it's probably 1% of our market cap. So we could probably do a little bit more cash on the balance sheet, so we'll build up some cash. But our approach is to use 50% of our free cash flow to reduce share count over time.

Yes. I imagine you guys are probably mostly immune given you're helping companies in the R&D, but how do you think through macro and the implications? Have you seen any tightness of budgets? Because like at some point, your customers' customers customer might have an impact on?

Yes. So from a resection standpoint, I mean a company like Cadence is not immune, but we would be somewhat resistant in that -- but because our spend is -- our customer spend is their R&D budgets, it's normally the last thing to get cost. We have felt some impact from slowdown in China last year in our numbers for this year, but we're already seeing that improve in terms of design activity. Last year, we had a customer OPPO that they closed the design group and let 3,000 people go. And what tends to happen with games, of course, is that you had that ratable revenue coming for that group. And when the contract expires, when it renews, there's no need for them to renew but what will happen is that those 3,000 engineers will end up with other customers over time, and then those customers will purchase tools from us. The impact of things like that are kind of a slow kind of some semi weakness and some China weakness last year has turned up this year in our recurring revenue profile. Recurring revenues dipped from -- it's typically around 13%, low-teen growth. It dipped to about 9% in the first half of this year but we're projecting 11% second half of the year. So we already starting to recover. But yes, we're generally pretty resistant to everything. Like good business approach of a company would be around.

It's a great business model. That's what investors want. Maybe just final question to close out, one for each of you, Richard. Maybe what do you think is most misunderstood by investors and then John, if you had a magic wand to remove one constraint from the business to turbocharge growth or alleviate an issue in your life, what would it be?

Well, that's a great question. You want to?

For me or one of the things people talk about is Cadence is always a great quality asset but it's premium priced. I think I just encourage all of you to just look at the long-term growth drivers and tailwinds for the business for the next 10, 15 years. And none of that is going to change over time. They see all these long-term growth drivers going to stay intact. So I think that's probably the most important thing just to keep in mind for.

And yes, I think for us, our customers basically are change in the planet, and we hope they use it for good we think they're doing great things. Like I said, I really believe our customers will be remembered as the renaissance artist of our time, and all we're trying to do is give them the best tools. So we're just helping everybody do their jobs better.

Awesome. Thank you for the time. Thank you, everyone.

Thanks.

Thank you.