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

Perfect. So we'll go ahead and get started. I'm Joe Quatrochi, the semi and semi-cap analyst here at Wells Fargo. Excited to have the Cadence Design Systems team here, John Wall, CFO; as well as Matt from the IR team. Thanks for joining us.

Thanks for having us.

First, I think I've been asked to read the safe harbor. So let me get through that real quick. 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.

Perfect. With that, maybe before we get like just into kind of more pointy questions, John, curious, like can you talk about just what you think is underappreciated or maybe not understood by investors from the Cadence story?

Yes. Great question, Joe. Essentially, we're -- I guess, Cadence is so central to the whole AI infrastructure stack, and it's an engineering software company. I think we get bundled in with a bunch of -- well, we get bundled in with semi sometimes. We get bundled in with software companies, but it's engineering software and the workload is growing exponentially. So therefore, when you're central to AI and everything, it just generates so much work for us, and there's a whole flywheel of I suppose -- with the amount of work that we're doing with customers, it just gets more and more work. And if you have a look at what we've done over the last 10 years, double-digit, low teen kind of revenue growth with constantly improving operating leverage kind of speaks to the strength of the model. So it's just that essential nature and working with those biggest companies that are driving the whole AI world, it kind of informs our R&D road map as well. But -- so it's quite a good ecosystem.

Okay. You started this year thinking total revenue grow somewhere like 12%. Now your latest guide is about 14%. Can you just talk about like what's been the biggest upside driver as you think about like relative to the beginning of the year, what's been the biggest surprise that's been positive?

Right. I suppose that AI workloads are getting so complex that the growth in the license count is taking off on the EDA -- core EDA side. But we're seeing strength across the board across all our businesses because Cadence used to be like an EDA company, but now you've got that core EDA business and IP business and the System Design and Analysis business layered on top, and they've all become quite sizable. And of course, they all work seamlessly together. And I think we're just seeing strength across the board. But nothing is getting any less complex, which is probably good for us.

No. Yes. You think about -- you talked about, I think, last quarter, exiting the year with record backlog. And looking into '26, can you kind of help us understand -- you touched on it a little bit, but like what is driving that record backlog? Where are you seeing like the area like the strongest orders from customers? And like what are those things that they're really focused on just trying to accelerate the road maps?

Yes, sure. I mean that's great. I mean we have tremendous momentum right now with strength across all lines of business and multiyear contracts that we ended Q3 with record backlog. We back tested the last 10 years. I think there's only 1 year where Q4 bookings didn't exceed Q4 revenue, and we've had such a strong start to Q4. It looks like we'll exit the year with another record backlog, which kind of bodes well for planning for next year and everything. Yes, I mean there's just so much strength across all lines of business, lots of design activity. The complexity is kind of through the roof between AI, high-performance computing that all of the automotive companies are -- we're kind of pulling in new customers, I think, across the systems landscape as well.

And like when you think about '26 and relative to prior years in guiding and I say you're going to wait until February [Technical Difficulty] I'll try to speak up. I think like, I guess, as you think about '26 and you think about visibility, right? And this year, you've seen really strong demand from our systems and hardware refresh cycle. How does that -- how do you think about like your visibility in '26 relative to prior years in that dynamic?

Yes. Visibility is probably as good, if not better than what we've had before. Like in the past, we've always seen strong visibility on the [indiscernible] particularly on the software side [indiscernible] so it's quite [indiscernible]. [Technical Difficulty]

Okay, that's helpful. Maybe you can hear me. I don't know. So maybe on the core -- let's stick with the core EDA side for a second. How are you thinking about when you kind of parse out the business like AI growth versus non-AI customers, what is that -- what are the growth algorithm, I guess, look like? And like how do we think about the split of that business?

Right. So I guess most of you have [indiscernible] and you have that AI layer on top that [indiscernible].

So I guess like think about AI as kind of broadening your customer base? Or is this additional spend by existing customers? It sounds like maybe a little bit of both but -- yes.

[indiscernible] so that kind of deepens the relationship, not just as a customer but as a partner. And then it goes to a bunch of extra customers across the board, right across systems.

Okay. Maybe I think in the past couple of quarters, I think what's been interesting to me is you've highlighted particularly like strength from foundries. Can you kind of maybe expand on like what is driving that? Is it the foundry itself? Is it the foundries customers? Like just kind of help us understand that dynamic.

Yes. Well, they're key ecosystem partners since everyone wants to design silicon these days. But -- and then I don't think it's fair for TSMC [indiscernible] using the silicon. So they probably don't have the cycles or the bandwidth to cover everything that the world requires that -- which I think is great for the Samsung's, and Intel and GlobalFoundries and of the world. The -- yes, I mean, there's so much going on there. And of course, they're key partners for us because the more closely we work with them, you kind of build out the flows for future customers and then you get -- people tend to adopt their flows. So it's -- yes, it's a key relationship for us. What we've seen is -- I mean, we're very, very strong at TSMC, but we've been increasingly engaged in places like Samsung and Intel. And more recently, I think you've seen announcements on what we've been doing with Samsung. And it's kind of -- it's a new relationship for us really because we were never that strong at Samsung or Intel before.

That's helpful. Maybe spend a second like on non-AI semis, right? Like we've seen -- obviously, it's gone through kind of a pretty difficult cycle. Maybe things are kind of bottoming out, starting to maybe bounce a little bit off the bottom. Have you seen like a change in like their EDA -- whether it be like discussions or just kind of their planning in terms of if the market is kind of their market or their financials have kind of found some stability? Like how does that translate into kind of thinking about EDA spend?

Yes, we're seeing them come back a little bit. I mean the last couple of years have been lean years for many of those non-AI semis. But they seem to be gradually doing more and more. But this year, we're seeing bigger engagements and I think they've probably found their base now at this point.

Yes. Do you think that accelerates into next year?

I mean it's hard to tell, but everything seems to be accelerating. There's so much complexity in design that the tools become more and more essential to what our customers are doing.

Okay. That's helpful. Maybe back on AI, you guys have kind of been explicit in saying we're not ready to kind of quantify things in terms of the benefit of AI, what we think it could drive for EDA. Like are we getting closer to that? Or how -- where should we kind of think about where we're at in that?

Yes. It's -- I mean it's hard to bifurcate it because I mean, you've got so much revenue coming from the traditional kind of EDA workloads. But these AI tools that you can layer on top and the ability that it gives engineers to use multiple licenses does pull through quite a lot of additional revenue for us. Now it's mainly recurring revenue or ratable revenue. So it kind of shows up a bit more slowly, but we're definitely seeing that pick up faster than we originally anticipated.

Okay. That's helpful. Maybe switch gears a little bit. The hardware cycle has been a really strong year, record year again. I think you talked about last quarter thinking that you could see further growth next year. Like what inning do you think we're in, in that refresh cycle? Like how do we think about like that relative to prior cycles?

That's -- certainly it still feels like early innings because everything has become so much more complex, which means the hardware emulation becomes even more critical and more important. And there strategic purchases for our customers now, not just the need for design, but it's really, really important for them to get silicon right first time and do what they can with -- in terms of emulating the system because it speeds up their time to market essentially. The -- and with the large installed base we have, I don't think there's anything out there to touch it. We're still seeing demand. Customers are asking for our Z2s if we can't get them to Z3. So it's -- they're very, very popular.

I think you guys try to make some investments like in the supply chain to ramp up that. Like where are we at in terms of...

We're kind of a constant kind of rate of expanding that production line. We like to keep a strong backlog of orders. But -- so we're constantly increasing the amount of hardware we produce. The revenue in each year and each quarter is probably throttled by the volume that we can supply and we're still building a backlog of orders. We tried to aim for somewhere between 8 and 22 weeks of lead time. We're somewhere in the middle of that right now. And kind of throttle the -- we kind of throttle everything from a revenue perspective based on production. It's kind of the sweet spot for pricing and maintaining visibility into the backlog.

Okay. No, that's helpful. So I mean, when you think about, I guess, like you're talking about 6 months visibility of hardware. I mean, it sounds like -- I mean, it's a bit -- maybe a bit more than that right now.

Well, the BU itself, like the business group, they would tell me they have a lot more visibility. I don't like -- we're very prudent with the way we guide. I don't like including things in the guidance to see them in the pipeline. But -- and then at that will kind of -- we'll factor the typical kind of percentage closure we'd have our conversion rate for those opportunities. But they can see now from the large installed base and the kind of pattern of behavior from how customers purchase and replace older systems that they feel that they have more predictability there. I'm just cautious. I don't want any inventory issues and we'd rather slow and steady and we keep the -- what's working is working for us.

Sure. How does that refresh work in terms of customers kind of do a trade-in thing? Or do they actually keep some of those like Z2s and things like used kind of workloads.

Yes. So what tends to happen like you take Z2 and Z3 that what you're trading is like server room space generally. On a Z3 with the same footprint, you probably do twice the capacity. So if you can swap it out, you don't -- if you have a limited finite space in the room when you're swapping out one system for another, you're getting double the capacity for the same kind of footprint. They tend to pull a lot more power, though. But -- so often, there's some power changes that need to be made for -- in terms of the building infrastructure itself. And then we have this company that we bought a few years ago called Future Facilities, that people use that software to basically create a digital twin of their server rooms and decide to optimize what they can fit in and the power requirements for the room before they actually make the changes.

Interesting. That's interesting. Maybe shift gears a little bit to SD&A. In September, you guys announced the acquisition of the Hexagon, Design and Engineering business. Maybe can you talk about just where this business fits in the Cadence portfolio, what you're most excited about?

Yes, sure. I mean we're building out the Systems Design and Analysis portfolio. And Anirudh's focus is always on solving the customers' biggest issues that -- and MSC, which was a company that Hexagon bought and call it their Design and Engineering group, that's what we're pulling out of Hexagon. We think it's been underinvested, but we do think there's more we can do with it. They have specific solutions there that we think are very, very important to the physical AI space. And just the breadth of what we offer now in System Design and Analysis, we're basically trying to repeat what we did with BETA. BETA was a tremendous acquisition for us because not only did it bring top technology and top talent to Cadence, but it pulled through so much more other business from their customers, and it kind of opened up a whole bunch of doors for us in the automotive space. We think similarly with MSC, it's an opportunity to kind of land and expand.

Their customer base, I think you talked about the -- like just in the press release and last quarter, I think that there's not a lot of overlap? Or it sounds like there's a lot of new incremental potential customers there as well.

There will be, yes. Yes. So I mean the issue for us at Cadence in terms of starting is that -- so with Synopsys buying ANSYS, you're not just buying ANSYS, but you're buying the whole shopping mall, right? That they have the whole infrastructure and the sales infrastructure. With us starting from an EDA company and you're adding tools through innovation and then we're buying smaller companies that we basically have to build our own shopping mall. So that's where we saw the value of beta, a marketplace where those customers naturally came that was a conduit to selling more of our other offerings. We think they'll be the same with MSC. And we're kind of building out the whole Cadence licensing platform to be able to do that so that we can add more and then kind of have one kind of unified storefront, I guess, under the Cadence brand.

Okay. You kind of touched on that a little bit, but like can you walk us through like the integration process? Like just how do we think about like the model implications? I think the deal is supposed to close like first quarter-ish next year. What does that kind of look like in like time lines and things of what you normally would do like in closing an acquisition of that size?

Yes. I mean -- I guess with all acquisitions, and we're getting better at them, the more we do. But -- so there's there are integration teams throughout Cadence. But essentially, we'd expect something like that to be dilutive in the first year when we bring it in that -- that we pick up these things, normally, we'll identify kind of revenue synergies and cost synergies that -- but it will take us 12 to 15 months to extract those. You saw that with BETA. Now we normally aim for 50% incremental margin. And in 2024, we missed that 50% incremental margin target. Now what I told the team and the Board at the time was it wasn't so much that we failed to hit the 50%. It was just that we ran out of time. But because we're bringing in BETA so late in the year, it's kind of a headwind in the short term. And I told that we'll prove that in -- we prove that we just ran out of time in 2025 because once we extract the synergies, you'll see that incremental margins in '25 will be so much stronger. And if you look at '24 and '25 together, and actually, if you do look at '24 and '25 together now, you're probably getting incremental margin of about 53%, which is kind of 53%, 54% is what we've been averaging. We aim for 50% plus. We generally get a bit more because we're normally prudent with the guide. But the -- I think it's similar with MSC. The first year -- depending on when it closes, but I mean, I think they were doing about $280 million of revenue stand-alone, but they would do multiyear business. I think on an annualized basis that if you flip them all to annual contracts immediately, it's probably a run rate of about $200 million a year. But -- and we're kind of modeling a cost basis on that. We would think within 12, 15 months, not only will they be in tiptop shape for -- as part of the Cadence portfolio, but they'll probably be adding to our incremental margin by that point.

Okay. Yes, so I mean in terms of like cost, there's probably not a lot of costs you can really take out or -- there's a lot.

There's a lot. Because I mean it's not just -- so we'll probably spend more in R&D than we spend. But we can take out a lot of the infrastructure cost, the G&A costs and...

Okay. So that would come with it, I guess.

Yes, that's right. And there's a lot of synergies we get from the sales and marketing costs when you add in all the other portfolio of products that we have on SD&A.

Okay. Okay. That's helpful. So I mean, I guess like net-net, we think about like -- you're not obviously not guiding, but like you think about like the leverage or incremental margin structure for '26, maybe looks a little bit more like '24?

I think the next 2 years will probably have the same kind of profile as '24 and '25, depending on how early MSC closes. If the earlier closes the more time we have to go fix things up. Also, we're getting better at it. I mean you saw -- one of the things I suppose always feel stupid looking back, it's -- we're always like -- I'm at Cadence now over 28 years, and we operate with continuous improvement in my knowledge. So you're always doing things trying to do things better and better. And I shudder to think like what -- how bad we must have been in the past. But because when I look at BETA now, one of the silly things that it did was we kind of weighed -- when we were finding synergies, some of those synergies were coming on the Cadence side. We didn't have to wait for beta to close to go get those. So learning from that experience for this one with MSC, we've already taken some actions on the Cadence side. And you saw that already come through in margins in Q3. It will benefit Q4, but it kind of clears the playing field for when MSC does.

Yes. Hit the ground running.

Yes. Yes, exactly. So I think we'll get faster at converting these. But to the level of profitability we would want to get. And the pull-through opportunity, we expect, I think, could be significant as well.

Yes. Okay. That's helpful. You've grown like the SD&A business like organically as well as inorganically. I mean you -- when this acquisition closes, you look at like just kind of the portfolio you have, like are there still holes that you need to fill? Or do you feel like you've got like the right kind of portfolio for where the market is at today?

Well, there's always gaps, right, because the market moves as well, but the gaps are small that -- I mean, if you ask Anirudh and I will spend lots of time dealing with general managers of each of the groups coming asking us for more investments because they want to invest in something organically or plug some gap. But generally, it's stuff that we can address organically with more investment. There's not a lot out there from an M&A perspective, the occasional small tuck-in. MSC is the biggest thing we've probably ever done. But -- but I would imagine that our concentration will be on that in the next year or 2. But anything else we do will be small.

Small, okay. Maybe shift gears a little bit to Design IP. It's been an area of more focus for you guys over the last few years. Can you just kind of talk about like that journey some and just kind of where you've come from and where you're still going?

Yes, sure. I mean we were allergic to IP probably a decade ago that we just thought it wasn't the most rational business that people were offloading their own IP work, I guess. And you could print any revenue growth you wanted if you didn't care about profitability or cash flow. But, yes -- and that wasn't -- that's not our style. We're farmers, not hunters. So we're always thinking of the long term. And so we kind of backed away because it wasn't the right use of capital for us that we're always trying to, I guess, optimize the value of the scarce resource, which we think is engineering talent. But if you look at the operating income per employee at Cadence and adjusted for share-based comp or because you got to take share-based comp out because some of them get paid in shares. The Cadence and Synopsys, probably 2016, 2017 time frame, we're generating maybe $45,000 to $50,000 per employee in terms of operating income. If you look at where we are now, we're up to about just over [ $140,000 ], and I think Synopsys at [ $70,000 ] and that's been the benefit of applying or allocating that talent to the most productive use, I guess, for the company. But what we've seen over the last number of years, we also have all these data metrics. So Anirudh and I love the whole moneyball idea. So we were kind of trying to get metrics on everybody and identify who are the best engineers, keep them and that move the other ones on. And like I said, always trying to optimize for the value that we can create and allocate capital to the right areas. Over the last few years, we found IP has become much more rational that customers are asking us to play there. But of course, though, it doesn't make sense for us to go back and build an IP portfolio for older process nodes that -- so you're building it for -- so the market will gradually come to us more and more because we're building out our IP portfolio to where the market is actually going.

So where do you draw that line of like the 28-nanometer, is it 10?

Well -- I mean they let the customers draw the line for us. I mean things like the ARM Artisan libraries is customers coming to us and saying, okay, look, if you're not going to build from scratch, how about you take this and they're trying to do matchmaking between ourselves and ARM because they think that, well, if you've taken in just a little bit more investment now you can broaden your portfolio. But -- but it's thoughtful -- it's done in a thoughtful -- very thoughtful long-term partnership way with our customers. And our customers get it that I think they knew that they were taking advantage of companies that were willing to do IP business for kind of very low-margin business. But I mean, at one point, I mean, I freaked out at one point because I remember seeing them -- a contract come across my desk and it was like a bluebird, one of these $20 million bookings. And I'm like, wow, what's the $20 million IP booking that -- and of course, the sales got resolved for it. I called a friend of mine, the CFO of the company that was given us the $20 million booking. I'm like, guys, you're trusting us with this. And he's like, well, it was going to cost us $24 million. If you guys can do it for $20 million. And I thought, well, why do we think we could do it for $20 million when they have years of experience of doing it that -- and it was going to cost them $24 million. And of course, people are dangerous with spreadsheets and particularly if there's commission involved. But -- so I remember sitting down with Lip-Bu and Anirudh going, this does not make sense. It scares me. I can't sleep at night if we're doing stuff like this. So I'd rather let's redirect the business elsewhere. So that's why we shied away from it. Now I think -- and of course, customers knew what they were doing. But now it's gotten to the point where they really want us to play. And they know that for us to play, they have to be more rational on pricing.

Okay. I mean do you think like a piece of that is just also just the -- we talked about earlier, the increased complexity and just...

Absolutely -- because everything has to -- I mean, it's so complex now, and it's not getting any less complex that -- and everything has to work together seamlessly. So it's the portfolio right across System Design and Analysis, EDA and IP that makes the whole partnership work with our customers, particularly the bigger ones.

I guess, like as you think about that portfolio, right, I mean, you guys have maybe started adding some more things like in foundational IP. Do you feel like that is -- you have a good portfolio there. I mean it sounds like you're kind of going with customers on that journey in terms of progression of nodes and technology. But like how do you feel about like just the foundational library that you have today?

Yes, I think it's very broad now. The very -- it's like I say, mainly customer-driven that we engage with customers for them to help guide us in terms of what the road map is. And I met with our Head of IP yesterday. He's delighted with the way everything is going. They have their own gaps where they want to build something themselves, but he thinks he has the right critical mass now and the talent to be able to do it. I don't -- Matt, is there anything you want to say about it?

Yes. No, I was just going to mention that we're focusing in on those advanced areas, AI, high-performance computing, those 5 areas really being on the design [ PDR, ] PCIe [ PDIe, ] high bandwidth. I mean those are extremely important areas that our customers want us to get better on that.

That's perfect. And like can you remind us, I mean, obviously, your closest peer has had some issues with their IP business in terms of they talked about some maybe more idiosyncratic issues, but also like go-to-market or changing the way that maybe there's some pricing mechanisms and things. Like can you remind us kind of like how you go to market with that and those different pricing mechanisms that are involved in the IP business?

Yes. So you're talking about Synopsys?

Yes.

A great company, right? And we know lots of people over there. We think they're great people as well. They have a slightly different approach. I mean we're very much like I say, farmers, not hunters, that take a long-term partnership view of everything. I get the sense, like just from talking to our customers that Synopsys maybe over the last few years have become more transactional rather than...

Customized.

Yes, it's kind of customer field. It's about bookings or whatever. With us, normally, it's like Anirudh is always focused on what's the problem we're trying to solve and let's do it together and what's the plan. And it tends to be a multiyear approach, and then we're throwing whatever we have in the tool bag at it. Yes, I think what we're seeing is that, of course, they had a big head start in IP. We've started playing now in IP. It's more -- and customers asking us to play, probably didn't want to be captive to Synopsys or ARM, but I'm wanting more choice. And I think as the businesses move down the process, there'll probably be more competition from us. So that's probably what you're seeing.

Okay. Okay. Can you remind us just last question around Design IP, like the profitability profile of the -- I mean you talked about being very focused on like maintaining margins and they're fitting in your framework. But can you remind us kind of like where does the profitability of that business sit relative to kind of the corporate average?

I mean it's very, very strong. I mean it's getting stronger every year, again, because it's rational. It's tremendous for incremental margins. The importance to us in terms of -- I mean, we're getting a lot of incremental margin because scale, company scales really well. I mean when I look at organically now, we were aiming for over 50% incremental margin. We're probably hitting 60% organically. But -- and then with the M&A that we're doing, because it tends to be dilutive in the first year or so that kind of pulls us back towards the low 50s overall as a combined unit. But if you look at Cadence. We normally -- we budget for double-digit revenue growth, and we typically achieve low teens. But when you budget -- and I guess I was lucky, I was talking to the Board yesterday about like we look over the last 3 to 5 years, we've probably been averaging around 14% revenue growth. Maybe 2% of that is coming inorganically, 12% organically. But as we get these new acquisitions in and we clean them up essentially and get them into our kind of workflows, they adopt the profitability profile of the organic businesses that -- and it gives us a lot of bandwidth to go and kind of buy the small tuck-ins and continue to invest in R&D. I would say -- I mean, Anirudh will tell you that we're innovators and innovators lead, imitators follow, that it's really important. We continue to invest very heavily in R&D and help our customers go where they want -- where they need to go.

Okay. That's perfect. We just got a little bit of time left. A quick kind of have to ask about China, right? I think it's been a wild year for business in China. But maybe talk about just kind of the demand trajectory that you're seeing. Have things been back to normal? Are you seeing the customers kind of still being a little bit apprehensive in terms of potential further restrictions or restrictions going back in place?

I suppose the -- I could have used China for the surprise question because it's -- actually, we're surprised with the resilience of China customers. But it does feel like back to normal. There is a strong desire when those temporary restrictions were lifted in early July, there was a strong desire from all of our China customer base that, look, if we have hardware backlog, can we have it now?

Yes, sure.

And so we prioritized all of China hardware backlog. Like when I look at hardware backlog at the end of Q3 and probably end of Q4 now, there'll be much less of a percentage of China in it than there normally is because we're kind of prioritizing that at the moment. I would think -- if you step back and you look at the way the business is going in China, it will probably be a smaller and smaller percentage of our overall business. But I think because they don't have access to the...

Leading technology.

They don't have -- we don't see the same AI pull-through there as we're seeing in other regions. So probably slightly less than average growth is what I'd expect over the next 3 to 5 years. But it's still -- I mean, it's still a great region for us and a source of strong kind of revenue growth and cash flow for us.

Okay. Perfect. I think we're out of time. Thanks for joining.

Thanks for having us. Cheers. Thanks.