Cadence Design Systems Inc Q1 FY2020 Earnings Call

Good afternoon. My name is Josh and I'll be your conference operator today. At this time, I would like to welcome everyone to the Cadence First Quarter 2020 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. The operator provided instructions regarding the conference call. I'll now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence. Please go ahead.

Thank you, Josh, and I would like to welcome everyone to our first quarter 2020 earnings conference call. I am joined today by Lip-Bu Tan, Chief Executive Officer, and John Wall, Senior Vice President and Chief Financial Officer. The webcast of this call is available through our website cadence.com and will be archived through June 12, 2020. A copy of today's prepared remarks will also be available on our website at the conclusion of the call today. Please note that the discussion today will contain forward-looking statements and that actual results may differ materially from those expectations. For information on the factors that could cause a difference in our results, please refer to our filings with the Securities and Exchange Commission. These include Cadence's most recent reports on Form 10-K and Form 10-Q, including the company's future filings and the cautionary comments regarding forward-looking statements in the earnings press release issued today. In addition to financial results prepared in accordance with Generally Accepted Accounting Principles, or GAAP, we will also present certain non-GAAP financial measures today. Cadence management believes that in addition to using GAAP results in evaluating our business, it can also be useful to review results using certain non-GAAP financial measures. Investors and potential investors are encouraged to review the reconciliation of non-GAAP financial measures with their most direct comparable GAAP financial results. The reconciliations are available at the Investor Relations section of cadence.com. Copies of today's press release dated April 20, 2020 for the quarter ended March 28, 2020, related financial tables and the CFO commentary are also available on our website. I would also like you to note that we are adhering to social distancing practices and therefore are conducting today's earnings call from remote locations. Apologies in advance if there are glitches or handoffs take a little longer than usual. I'll turn it over to Lip-Bu.

Good afternoon, everyone and thank you for joining us today. I am pleased to report that in a difficult environment Cadence achieved excellent financial results for the first quarter of 2020. We are all going through truly unprecedented times and I hope that you and your families are safe and healthy. I will start by commenting on the rapidly evolving COVID-19 situation. Our first priority continues to be ensuring the safety and well-being of our employees, customers and communities. At this time the vast majority of our global employee base is working from home and that transition has gone very smoothly. From a business continuity perspective, our infrastructure, collaboration platforms and tight communication have enabled us to maintain a high level of productivity and our R&D innovation projects and customer deliverables continue to track well. Our sales and application engineering teams have also adapted well to this new work model and have continued engaging productively with customers on the business, training and support fronts. As I have stated earlier, there’s been a silicon renaissance in the industry, with strong design activity being driven by generational technology drivers such as 5G, AI, hyperscale computing and Industrial IoT. So far, even in the current environment, we do not see any slowdown in design activity, and I do believe this period to be an opportunity, especially for market-shaping customers to further invest in R&D and accelerate their innovation. Our business is predominantly tied to semiconductor R&D and in addition, our broadly diversified customer base, over $3.7 billion of backlog and highly ratable business model, all serve to highlight the resiliency of our business, particularly in challenging times. After carefully assessing the situation, at this time, we feel comfortable reaffirming our revenue guidance for the year. In a few moments John will provide more details and commentary on our Q1 results and guidance for Q2 and the year. Our Intelligent System Design strategy enables us to maximize these opportunities while tripling our TAM, through proliferation in our foundational Design Excellence segment, and expanding beyond EDA into System Innovation and Pervasive Intelligence. Now let us look at some of the Design Excellence highlights for the quarter, starting with Digital & Signoff. Our Cadence digital full flow, which has been proven through hundreds of advanced node tape-outs, was significantly enhanced to further optimize power, performance and area or PPA results across multiple application areas. The new full flow featuring our innovative iSpatial technology, which includes unified placement and physical optimization engines, plus machine learning capabilities, delivers up to 3X faster throughput and up to 20% improved PPA. The new full flow is being used by several leading customers and was endorsed by MediaTek and Samsung Electronics. Additional Digital & Signoff highlights for the quarter include a major Asian hyperscale company successfully used the Cadence digital full flow to tape out a machine learning inferencing chip and is deploying the full flow at 7 and 5 nanometers. A marquee Asian electronics systems company completed its first production Cadence digital full flow tape out on a 5 nanometer low-power process, beating its power targets, and a market-shaping semiconductor automotive customer committed to Cadence as its primary EDA vendor for digital design. Our Cadence Verification Suite wins in the marketplace because it delivers the best verification throughput, driven by its four best-in-class engines Xcelium, Jasper, Palladium and Protium. In Q1 we had multiple Verification wins across various verticals including cloud/data center, automotive and networking. Our hardware family had a banner quarter, with Palladium Z1 adding four new customers and nine major expansions. Our Protium FPGA-based prototyping platform continued its strong momentum, adding six new customers and six repeat orders as the X1 is increasingly deployed in Palladium accounts. Protium X1’s strong momentum is a result of its unique differentiation in having a common front-end compiler with the Palladium Z1, while also providing superior performance and capacity scalability for early software development and hardware regressions. Both the Z1 and X1 platforms showed particular strength at hyperscale systems companies, in addition to momentum at market-shaping semiconductor customers. Our IP business delivered double digit revenue growth, as our compelling offerings continued to benefit from the ongoing IP outsourcing trend, with design wins and expansions at several top tier companies as well as at startups. Tensilica did particularly well and was adopted for multiple audio applications as well as by surveillance and mobile customers. In Design IP, there was strong demand for our DDR portfolio as well as our high-speed SerDes and PCIe IP, particularly in datacenter, AI and high-performance computing segments. Now I will highlight our progress in the System Innovation segment of our Intelligent System Design strategy. Earlier this year we completed the acquisitions of AWR and Integrand, and we have received very positive response to the acquisitions from many of our partners and potential new customers. The integration is progressing well on all fronts and we are combining these technologies with our Virtuoso and Allegro platforms which will enable us to offer a comprehensive platform for designing high frequency RF millimeter wave products. Our System Analysis tools carried forward their strong momentum into the new year and we now have more than 30 customers, including Renesas, Rohm and Enflame. In addition to providing significantly better performance and capacity without compromising accuracy, Clarity and Celsius also provide a tighter integration with our flagship Virtuoso and Allegro design platforms. With that I will now turn the call over to John to review the financial results and provide our updated outlook.

Thank you, Lip-Bu, and good afternoon everyone. Let me begin with a few comments on the COVID-19 pandemic: Our first priority remains the health and safety of our employees, partners, and customers. And while some of our employees in China are already back working from our Cadence offices in the region, a vast majority of our global workforce are currently working in a remote environment. Our team continues to be very effective even though many are working from home. For this, we are very proud and very grateful. Even with the global disruption and uncertainty created by the COVID-19 pandemic, I am pleased to report we met, or exceeded, all of our key operating metrics in Q1. Now let’s review the key results for the first quarter, beginning with the P&L: Total revenue was $618 million, non-GAAP operating margin was 32.2%, GAAP EPS was $0.44, and non-GAAP EPS was $0.60. Next, turning to the balance sheet and cash flow. In mid-March, we borrowed $350 million under our revolving credit facility as a precautionary measure to provide additional liquidity in light of the recent global economic uncertainty caused by the COVID-19 pandemic. As a result, at the end of the quarter, our cash balance totaled $946 million while the principal value of debt outstanding was $700 million. Operating cash flow for Q1 was $218 million, DSOs were 42 days, and during Q1, we repurchased $100 million of Cadence shares. Before I provide our guidance for Q2 and fiscal 2020, I’d like to take a moment to address some points that I think are important to understanding the assumptions embedded in our outlook. Our guidance continues to assume that the export limitations that exist today for certain customers remain in place for all of 2020. The shelter-in-place orders that are in effect today as a result of the COVID-19 pandemic create some logistical challenges related to fulfilling some hardware and IP product orders, for which we recognize up-front revenue upon completion of delivery. At the low end of our revenue range for Q2, we are assuming that the government-mandated or recommended shelter-in-place orders in effect today will remain in place for the remainder of the quarter, and any hardware or IP products that we cannot deliver before the end of our Q2 will be delivered in the second half of the year. On the other hand, if, starting sometime in May, we can get sufficient physical access to complete hardware and IP deliveries, we expect to be closer to the high end of our revenue range for Q2. Assuming we have sufficient physical access to complete hardware and IP deliveries by the end of Q3, we do not expect any negative impact to our full year guidance from the delivery delays we are assuming for Q2. For Q2, our guidance is as follows: revenue in the range of $580 million to $600 million, non-GAAP operating margin of 30%, GAAP EPS in the range of $0.28 to $0.32, non-GAAP EPS in the range of $0.50 to $0.54, and we expect to repurchase $75 million of Cadence shares. For fiscal 2020, our guidance is as follows: revenue in the range of $2.545 to $2.585 billion, non-GAAP operating margin of 32% to 33%, GAAP EPS in the range of $1.58 to $1.68, non-GAAP EPS in the range of $2.40 to $2.50. We expect operating cash flow to be in the range of $775 million to $825 million, and we expect to use approximately 50% of our free cash flow to repurchase Cadence shares in 2020. You will find guidance for additional items as well as further analysis in the CFO Commentary available on our website. In summary, I am pleased with the results we delivered in Q1, and I have been impressed by the resilience of our business model and the agility and capability of our global team at Cadence to continue to operate so effectively in this environment. The world is facing unprecedented times, and we are all deeply sympathetic to anyone who has been impacted by the COVID-19 pandemic. We are clearly all in this together, so I would like to close by thanking our customers, partners, and our hardworking employees for all that they do. Please note that we are adhering to social distancing practices and therefore are conducting today's earnings call from remote locations. My apologies in advance if there are glitches or handoffs that take a little longer than usual. And with that, operator, we’ll now take questions.

And your first question comes from Rich Valera from Needham & Company. Please go ahead.

Thank you and congratulations to the Cadence team for delivering some very solid results in obviously challenging conditions. With that I just wanted to ask about your China revenue in the quarter which was actually up as a percentage of revenue year-over-year. Despite a very tough comp since last year, you didn’t have entity restrictions on Huawei or several other likely Chinese customers. So just wondering if you can talk about what drove the strength in China this quarter? Was it new customers, was it the ramp in demand for existing customers and if there is any color in terms of which products were in high demand there?

Lip-Bu here. So let me start. Our business enables design of future electronic products. China business remains quite good for us. Q1 was aided by both hardware and IP business which was mostly up on revenue and John can provide more color and detail here.

Yeah, I would say this is unusual. Our China revenue over the past nine quarters has fluctuated between a low of 8% back in Q2 2018 and a high of 13%, both this quarter and in Q4 2018. Q1 revenue was higher due to both hardware and IP business, which are mostly upfront for revenue.

Great and then just a question on the new system product ramp, I heard your new customer accounts sounds like that's up to 30 which is great. Just wondering if you can provide any anecdotal evidence of customer penetration i.e. customers that have ordered a single license, proved it out and been able to come back to order multiple licenses and if you’ve seen any customers sort of scaling up the way presumably you'd like to see.

Yeah I think so far we're very pleased with our system analysis tools that carried momentum into Q1. As you correctly point out we have more than 30 customers under the Clarity and Celsius product lines and clearly I think we're providing high performance, better results and scalability without compromising accuracy.

Great and just one quick one for you John, I noticed your non-GAAP stayed the same but your GAAP EPS actually went up. Can you just quickly explain the delta there?

Yeah just a slight difference in our assumptions for the M&A integration between what we had in the forecast for the start of the year and where we are now.

Got it. Okay. Thanks very much gentlemen.

Your next question comes from Jay Vleeschhouwer with Griffin Securities. Please go ahead.

Thank you. Couple questions, first on China and geographic mix generally, according to the 10-Q this evening your China revenues were record at about $84 million. You explained the reasons why it was so strong, but looking out over the next number of years and thinking about all the issues that surrounded China over the last year and where US government policy may go, how are you thinking about perhaps geographic risk mitigation again notwithstanding the very good results in China this quarter, how do you think about perhaps mitigating the dependency there by perhaps focusing on other parts of the world, Europe for instance had a very strong year in 2019 for EDA, so perhaps that would be a region to think about refocusing on as an example. So that's question number one. Question number two, you highlighted the newer products, Clarity and Celsius, how would you compare your experiences thus far with those two products with the previous generation of signoff products, Tempus, Voltus, Pegasus, which we frankly haven’t heard a great deal about. Is your experience in terms of customer adoption meaningfully different or would you expect it to be different than the prior generation of signoff tools that you introduced?

Yeah, so let me get started and then John can fill in more details. So first of all I think we will do everything we can to support customers while complying with all applicable law and regulation and we want to provide the best tool for our global customers that include China, Asia-Pacific, EMEA and the US, but that is our philosophy: give them the best product and support them in their design. In terms of the new products and clearly I think we are very pleased with the System Analysis products; the tools that came out clearly show the differentiation and we're delighted in our order backlog that we have more and more customers coming to us. It is a big end market for us. These two products' TAM is about $700 million. So I think we'll aggressively pursue that and clearly we have a big advantage in terms of performance. In terms of Voltus and Pegasus we continue to do well and then we'll continue to update you from time to time. Pegasus is most important with the foundries across various process nodes and over the last few quarters we have highlighted our process node successes and are starting to really drive some of the customer success. Stay tuned in the coming quarters.

And Jay I would add that I think you can see from our results and from our guidance for the year that our business benefits from the diversification we see across products and platforms and geographies. As much as we encourage investors not to look at any one quarter, I mean China contributed 10% of our annual revenue in 2018 and 2019 and we're happy to get off to a strong start for 2020. But hardware and IP are lumpy for revenue and so you should never focus on any one single quarter.

Okay. Just a quick detail question for you John. If I'm reading the Q correctly, it looks like you took some inventory reserve on hardware. If so could you comment on that?

Jay, I presume you are referring to the section where we say we include inventory reserves in our hardware COGS, but we consistently do that. I don’t think there was any significant change in inventory reserves from quarter to quarter, but generally if we have a hardware system that's out being demoed or on loan, we'll take depreciation and amortization for that into our P&L and include it in COGS even though we haven't sold it.

Your next question comes from Mitch Steves with RBC Capital Markets. Please go ahead.

Hey guys. Thanks for taking my question. The first one is a little more for Lip-Bu. When I look at your comments on design activity it sounds like design activity is picking up and that customers are trying to actually accelerate the design activity. So can you maybe give us a little bit of a broad overview of what you're seeing in China and in datacenters and in any sort of market in terms of what design activities are looking like across the different end markets or how we're doing in the verticals?

So let me try to give you a little more color. As I mentioned earlier, we're going through this silicon renaissance in the industry. Clearly we see strong design activity driven by these generational technology drivers — 5G, AI and machine learning platforms, and hyperscale. In this environment actually they deploy even more; they are all finally building up their own silicon teams. And then the whole digital transformation of the industrial group, we see a lot of activity. So I think clearly so far as we see today, we don’t see any slowdown in activity especially among what I call market-shaping customers; they double down, triple down in their R&D and we're delighted to support them. That's kind of how we see the opportunity in the design activity. Our business is predominantly tied with semiconductor R&D and that really benefits us and we have been very focused on the market-shaping customers and they are very excited to work with us on their various designs.

Got it and then second one is John just a little more in the financials, China is up pretty significantly. Is there any way to talk about that's just good to be sustainable or it's just from hardware? What do you guys think about the China percentage of revenue? I think that was a little bit surprising, but maybe you can give us a high-level comment of what the full year should look like, if it should be around that type of revenue percentage or not?

Sure, it was large in the first quarter and it was mainly due to hardware and IP business. At the start of the quarter I thought we'd have lower royalty revenue in the region and we were a bit too conservative in Q1 thinking. So IP outperformed versus my expectations for Q1. And then in terms of China for the year, like I said it's ranged by quarter from a low of 8% in Q2 2018 to a high of 13% now this quarter and in Q4 2018, but we're happy to get off to a strong start for 2020 and thinking double-digits continuing as China contribution to our annual revenue is reasonable.

Okay. Perfect. Thank you. I mean you guys did much better than that. So a great quarter.

Your next question comes from John Pitzer from Credit Suisse. Please go ahead.

Good afternoon, guys. Congratulations on this. John you did a good job with the June quarter revenue guide and kind of helping us understand the puts and takes around COVID to treating the low-end and the high end of the range, but I am just kind of curious was there any absolute impact to your revenue from COVID that you’ve also included because even at the high end you're coming in sort of below where the street was and then when you look at the full year number, would you have raised the full-year revenue outlook had it not been for COVID, i.e., are you building in some cushion on an absolute dollar basis there as well?

Thanks for the question. It's a great question and thanks for the opportunity to clarify. I guess when I sit and look at Q2, I think it's fair to view our guidance for Q2 as being a little bit conservative and maybe more conservative than normal, but when I look at the impact of COVID-19 on our revenue, for hardware we don't have our usual physical access to customer sites to deliver product and it's hard to predict when we'll get that access. If we deliver some hardware in the last week of June, it becomes Q2 revenue. If we deliver hardware that was planned for April but slips to the first weeks of July it's Q3 revenue. In both cases they're 2020 revenue. So I have more confidence in the year than I do for Q2 in terms of making those deliveries in time to Q2 revenue. When we said that we were prioritizing the health and safety of our employees and our partners and our customers, we don’t want to try and drive for too early delivery particularly if we don’t have physical access, because we can't control physical access to our customer sites. On the IP side the physical access is to our own Cadence sites because that's where our labs are for IP and IP revenue is generally determined by how much IP we can deliver in the quarter from our labs. We're already a little bit behind because we haven’t had access to our labs and it's not like it's a demand issue; it's more a matter of timing in terms of the delivery of revenue. So Q2 is, I suppose, the paradox of having a predictable revenue stream: it's very predictable for the year, but it's just less predictable in terms of what we can get done in June versus July at the current moment.

That's helpful and then maybe you can help me better understand a lot of the thought here as we try to figure out how the next several quarters might play out for the overall semi industry. For better or worse, we're kind of using the global financial crisis as a starting point, but there are some significant differences. When I look back and look at Cadence's performance through the global financial crisis, you were going through sort of an accounting change which heightened volatility. But you also saw a situation where things got bad enough for customers to cut R&D. Given the magnitude of the economic impact from COVID, why shouldn't that be kind of a baseline assumption as we go into the back half of the year? Or are there enough incremental drivers like hyperscale that really didn't exist back during the global financial crisis or China that didn't really exist that you think offsets that because right now at least how you're playing out the year is June is sort of a trough in revenue and it's a pretty shallow trough and I understand the business is a lot more predictable than the global financial crisis, but what are the puts and takes that you see out there?

Yeah so first of all I think clearly we're going through an unprecedented time in terms of the economy and unemployment and this virus across all the different regions. So first and foremost it's important for us to protect our employees and customer safety and well-being. That said, the impact of the economy on semiconductors ranges by product. Clearly hyperscale and video-conference related areas and then e-commerce benefit, and some sectors will be more challenged, especially in consumer and automotive related areas. So it's a lot across the board. There are some really exciting areas and clearly we are more tied in with R&D budgets. The good news is market-shaping customers in various hyperscale plays and high computing areas continue to benefit and we took on it. Overall I think we are very strong in resiliency because of our ratable model, backlog and our very diverse customer base which put Cadence in a very well-positioned place to manage through this.

And just as a follow-up, there was a couple earlier questions that touched upon the strength in China and it was up nicely albeit it seems to make sense relative to the ambitions that the Chinese semiconductor industry has. But I am just curious given the heightened rhetoric around US-China relations and the idea that the US might actually make foundries licensed to shift to certain customers, is there a risk that some of your Chinese customers are buying ahead and how would you handicap that risk or help us think about that?

Yeah it's a good question. Overall I would say that China business remains quite good for us. As John mentioned earlier, we assume that export restrictions will remain and we comply with that. Meanwhile we are doing everything we can to support customers globally in their innovation and design. All in all, we have carefully examined the situation. We felt that we can reaffirm the whole year because it's a ratable model and we have about $3.7 billion of backlog and so we can manage much better that way. Again, by partnering with customers deeply and building trust with them, that is the best way to drive success together.

And John here, I would just like to add that about 85% to 90% of our revenue is recurring in nature. So any additional pull-forward buying wouldn’t increase our annual revenue; the revenue is time-based and would occur maybe on IP and hardware, and there was no evidence of pull-forward buying in Q1.

Your next question comes from Gary Mobley with Wells Fargo Securities. Please go ahead.

Hey guys, thanks for taking my question and congrats again on the strong results. I wanted to start out asking a follow-up question to John's question about what's different this time versus '08 and '09 and just thinking about how you diversify your customer base to system OEMs. If you see your backlog measures continue to grow about 15% year-over-year, much faster than revenue growth, is it a new class of system-oriented customers who are taking control of their own IC designs driving that growth, and are their average deal sizes materially different than what you would traditionally license to semiconductor customers?

Okay Gary, I think good question. So let me touch on the first and then John can give you more detail on the deal size and others. I think overall we are excited about these generational technology drivers: 5G is deploying and hyperscale infrastructure is deploying, and high computing for AI and machine learning, whether startups or mature companies, they are all diving in big time into silicon and system-level design. Packaging also benefits us. All in all I think we see strong design activity that does not slow down and it continues to fuel the backdrop. Because our business is ratable, we are not dependent on any single quarter. We are well positioned.

Gary just adding that the biggest difference between where we are now and '08/'09 is we've got incredible visibility now into our backlog. We have $3.7 billion worth of backlog. We're very diversified and we have a lot of visibility into the second half of 2020.

Okay. And in the last guidance you gave for fiscal year '20, I believe you mentioned that the extra week in this fiscal year and the two acquisitions we saw closed were adding some of the 300 basis points to the 10% growth you were expecting. I presume that the extra week impact doesn't change but are you still looking for the same contribution from the acquisitions?

So Gary it's about $40 million. The extra week is worth about $40 million of additional recorded revenue to the year in 2020 and we're expecting about $20 million from the combination of AWR and Integrand, the two acquisitions we completed in early Q1. So yeah $60 million to the year. I'm not expecting any more or less than that for the year right now.

Your next question comes from Joe Vruwink from Baird. Please go ahead.

Great. Hello everyone. Just in regards to some of the product discussion and the new product offerings, is it possible to say with things like full digital flow or maybe the case of adding simulation to Allegro and Virtuoso workflows, how much this is increasing average contract value with the customer versus maybe a traditional measure of wallet share with your customers?

It's slightly difficult to bifurcate.

Okay. So no sense other than on simulation it's helpful to maybe find that it's a $700 million opportunity between Clarity and Celsius but other than that, no sort of uplift guidance maybe you can provide?

I think it's too early to tell right now, but certainly it's very welcome by our customers. Our customers are very happy with the products we provided but it's very difficult to bifurcate the value of one product versus others in an arrangement where there's multiple products being provided to customers.

The only thing I'll add on to that is basically these two acquisitions clearly give us a lot more opportunity in terms of a more comprehensive solution to provide to some of our key customers.

Okay. Great. On your operating margin outlook for the year, I believe the second half is implied to be closer to the 34% level, is that really just a reflection of the revenue guidance and maybe the particular revenue mix that you anticipate for the back half of the year or are there other OpEx items or costs that are more in your control that factor into this view as well?

There are two real drivers there Joe. One is the M&A where we lost some of the revenue in purchase accounting, so a lot of the deferred revenue purchase accounting impacts the first half of the year more than the second half of the year. That can skew some profitability towards the second half of the year on the acquisitions we brought in at the start of the year. The other impact is because we're assuming some deliveries that would normally happen in Q2 fall over into Q3, you can have a slightly more back-end-loaded margin profile for the year. I originally was thinking it would probably work out something like 31.5 and 33.5 and now I know we're guiding to 31 and 34.

Okay. Great, that's helpful. Thank you.

Your next question comes from Tom Diffely with D.A. Davidson. Please go ahead.

Yes. Good afternoon. So John you talked about how access to customers provides a little bit of conservatism in your second quarter outlook but I'm curious what are you seeing on the actual manufacturing front with emulation? Are you seeing supply-chain difficulties?

No. Not right now. We have a strategic sourcing group that have been working closely with all our suppliers. We think we have ample inventory and we have good second-source suppliers. The issue we have with revenue and predicting revenue for Q2 is really down to whether we can have physical access to customer sites to be able to deliver the physical product. That's where we've got some uncertainty and because of the uncertainty, I'm assuming some of that will naturally fall into the second half of the year.

That makes sense and then Lip-Bu I am curious through this crisis have you seen already your customers talking about acceleration to the cloud?

So I think clearly we provide multiple offerings and currently it's one of the areas that we focus on. We're delighted that we are extending our leadership in the cloud offering of providing customers with compelling productivity, flexibility and scalability benefits. And as we mentioned, we passed the 100 customer mark so I think we continue to make progress on that.

Okay. Is that bigger on the emulation side or on the design tool side?

I think the use varies by product offering; it depends on the product.

Your next question comes from Adam Gonzalez with Bank of America Securities. Please go ahead.

Just wanted to follow up on some of the comments that my peers made on your China sales and how strong they are growing. Can you talk about the ability of domestic substitutes in the region and how far behind China is in terms of being able to provide a complete, competitive full flow suite of products?

Yeah, I think so far we're monitoring closely. In China there are a couple of small point-tool solution providers but clearly Synopsys and Cadence have about 25-30 years of providing a complete full flow at the most advanced nodes. That said, we don’t underestimate local competitors because they do get government funding, so we keep a very close eye on their progress and recruitment activities and make sure that our team stays strong and that we continue to serve customers in Beijing, Shanghai and across China.

Great. And my follow-up is on the digital IC design signoff segment. I saw there's been a deceleration in year-over-year sales growth over the last three or four quarters. Is that deceleration a function of tougher comps or timing of bookings? Do you expect that the trends in that segment to turn around in the near-term?

So Adam one thing I would point out is certainly for Q1 and Q2 this year, we're lapping very tough comps because Q1 and Q2 last year were not impacted by the export limitations we currently have in China.

And if I can sneak in one last question. You talked about the Q2 outlook and how it really reflects just a few different scenarios and how long you have access to customer facilities. If these work from home orders were to be put in place long enough as people currently think, is there a chance that customers might switch their consumption of these hardware products more to a cloud based model?

I think it's too early to tell. We were quite happy that we had a really solid bookings quarter in Q1 with particular strength in Japan and we had 15 new Cadence customers in Q1 including several larger customers, but I think it's too early to say whether there will be a structural shift.

Your next question comes from Jackson Ader with JPMorgan. Please go ahead.

Thanks for taking my question. The first is I realized that the impact on revenue is just about logistically getting on site but what about the difficulties or maybe some execution challenges you’ve had on getting deals across the finish line maybe for software deals? I would expect or I think a lot of people would expect that there have been more moving pieces for larger deals just moving around internally as your customers are all working from home. So I am curious to hear whether you’ve seen any impacts on that side?

So Jackson our ability to close business hasn't changed but we have very, very close contacts with our customers, we're a very customer-driven company. We always stay close to our clients. Also, toward the end of last year Lip-Bu and I talked with the management team and we looked at the data following a yield curve inversion and prepared for a potential downturn. At the end of last year, we tried to close as much strategic account business early in the year as possible and we managed to do that, which helped.

Then the follow-up question, is it possible that there can be any trickle-down effects from the delayed either hardware or IP delivery? Would that change activity later in the year if people are able to get their tools in time?

Basically the challenge is executing and completing the delivery on the business. Demand continues to be strong; it's really getting access to customer facilities to be able to deliver hardware and in our case, for IP, getting access to our own Cadence labs to complete our IP deliveries that we've already contractually signed up to.

Your next question comes from Ruben Roy with Benchmark. Please go ahead.

Thanks for taking my questions. John you’ve had a lot of questions on China and I think I understand the near-term dynamics but I was wondering if you could refresh my memory on export restrictions. Obviously there has been some chatter in recent weeks around potentially tightening rules for some sorts of high-technology product shipments into not just current companies in China, but potentially to a broader swath of Chinese firms and I'm wondering if you can remind us what portions of your product lineup are subject to export restrictions? Are the hardware and IP products some or all subject to those restrictions or have you heard anything new on potentially tighter rules for your product specifically?

Most of our products are US origin, so they're impacted by export limitations. Our ability to deliver products and services to certain customers on the entity list is limited. Therefore we would expect our revenue in China to be higher if we didn't have those extra limitations, but for the purposes of guidance, we're assuming nothing will change right now. Like I say, because most of our technology is US origin, we are impacted by those export limitations across the board.

Okay. And then a quick follow-up John on sort of the assumptions: obviously the assumptions in Q2 guidance around the potential of getting back to work. How are you thinking about your own operating expenses and margins? Obviously you kept your guidance static but do you have any embedded assumptions in sort of when you expect things to normalize coming up or embedded in those assumptions for the year?

Sure. We're continuing to hire although hiring has slowed because it's more difficult to complete interviews and onboarding remotely, but we're continuing to hire. Typically we hire after getting contractual commitments from customers, but Lip-Bu and I are careful about adding investment dollars until we see commitments. In our guidance there is an impact: if hardware falls into the second half from the first half, the cost of goods sold associated with those hardware products will also fall into the second half. Originally I was expecting something like 31.5% margin in the first half followed by 33.5% in the second half; that's shifted now toward 31 in the first half and 34 in the second half because of some unexpected shift of hardware and IP revenue from Q2 into Q3.

Your next question comes from Jason Celino with KeyBanc. Please go ahead.

Thanks for taking my questions. In terms of operations in China obviously those were impacted from the coronavirus first in the global workforce. What types of learnings were you able to apply to your other segments in North America and Europe once you saw those restrictions put in place?

So one thing I learned is last quarter I thought there would've been a bigger impact to our royalty revenue and as it turned out it wasn't as big as I thought because some products did better and some products did worse and I think we benefited from diversification across our products and platforms. Another learning is that there's a lead time in terms of hardware orders: we were able to complete hardware orders in China in the latter part of the quarter when the hardware was already on site and being demoed by the customer. So we didn't have additional physical delivery to complete the revenue cycle. Whereas if we haven't got the hardware on site for the customer, we have to wait for customer sites to open. So that was the learning that led to our Q2 guidance being conservative; some revenue we would normally take in Q2 we expect to fall into Q3 now.

So from a progress standpoint and customer engagement standpoint, is there anything else that mirrors or differs from what you saw in China customers versus North America or Europe?

I don't think so. We are a company that operates in a fast-moving technology industry and we assume tomorrow will be different from today. We operate very closely with our customers, and those client relationships allow us to be resilient, flexible and agile and very effective in times of change. We are also very diverse with people in 47 sites across 22 countries all very close to customers, so we're able to navigate and move with change very easily. I'm delighted with how effective the teams have been.

Your last question comes from Krish Sankar with Cowen & Company. Please go ahead.

Hi. Thanks for taking my question. I had a couple of them mainly for John. John thanks for all the color on the China sales. I was just trying to figure out if some of the outperformance was in IP in China. Within IP can you say was it more on cloud/datacenter, was it mobile, was it auto? Any color would be helpful.

It was certainly on the IP side, but I don't think we give any further color in terms of which part of IP, but IP was very strong in Q1 and it outperformed expectations.

Got it and then some of the emulation and prototyping hardware is assembled and tested by subcontractors, are there specific geographies that you sub in right now?

Most of our hardware is made in the Americas, but we have close relationships with our suppliers and second-source suppliers. We also have ample inventory. I don't think we have any supply-chain issues right now.

And then just a final question, looking across your whole customer spectrum, for some of the smaller customers, do you worry about potential payment issues for them in the second half if the economy goes into recession?

That's a very good point. In our guidance we're anticipating some natural credit deterioration particularly in the longer tail of customers. Our top 40 customers generate 55% to 60% of our revenue and thankfully they're in a very strong position, many with the strongest balance sheets in the world. But in the longer tail, naturally we would be concerned about some credit deterioration so we built in some anticipation for that. If shelter-in-place orders remain much longer and we don't see improvement in the second half, that could impact our customers and cause credit to deteriorate more than we're currently anticipating. We haven't anticipated a great depression or anything like that, but we have assumed there may be some credit deterioration if this lasted through the end of June and that's reflected in our assumptions.

But can you quantify that credit deterioration?

It's only slight — maybe 5% to 10% slower payments in the long tail — because that could impact our revenue timing. You can have variable consideration. Our recurring revenue pool is typically even each quarter, but if there's credit deterioration, that can cause a little bit of a delay until we collect cash to recognize revenue.

There are no further questions. I'll turn the call back to Lip-Bu for closing remarks.

Thank you all for joining us this afternoon. Our Intelligent System Design strategy is paying off very nicely as we benefit from new opportunities in Design Excellence, System Innovation and Pervasive Intelligence and an expanded total addressable market. In this time of uncertainty, I'm very impressed with all the dedication and commitment shown by our employees to continue innovating and delighting our customers. We're all in this together and I'm convinced that we will collectively come out of this unfortunate situation stronger as a company and as a community. On behalf of all our employees and our Board of Directors, I want to give our heartfelt thanks to the extremely brave and courageous healthcare workers and others on the frontline who are tirelessly working to fight this pandemic. Have a wonderful day.

Thank you for participating in today's Cadence first quarter 2020 earnings conference call. This concludes the call and you can now disconnect.