Cadence Design Systems Inc Q3 FY2020 Earnings Call

Good afternoon. My name is Mike and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Third Quarter 2020 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. Operator Instructions. Thank you. I will now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence. Please go ahead.

Thank you, Mike, and I would like to welcome everyone to our third 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 Web site cadence.com and will be archived through December 18, 2020. A copy of today’s prepared remarks will also be available on our Web site at the conclusion of today’s call. Please note that the discussion today will contain forward-looking statements and that actual results may differ materially from those expectations. For information on 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 we 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 October 19, 2020 for the quarter ended September 26, 2020, related financial tables and the CFO commentary are also available on our Web site. Note that Cadence is continuing to adhere to social distancing practices and therefore we are conducting today’s earnings call from our respective remote locations. Apologies in advance if there are any glitches or handoffs that take a little longer than usual. And now, I will turn the call over to Lip-Bu.

Good afternoon, everyone, and thank you for joining us today. I'm pleased to report that Cadence achieved outstanding financial results for the third quarter of 2020. We exceeded our financial outlook on all key metrics as the Cadence team continues to successfully navigate through challenges posed by the pandemic. We also raised our outlook for the year. John will provide more details in a moment. The data centric revolution led by AI, data analytics, hyperscale computing continues to fuel strong semiconductor and system design activity. And our Intelligent System Design strategy uniquely positions us to enable our customers to accelerate their innovation. Now let us move on to the major highlights for the third quarter. Design Excellence is the foundational layer of our strategy and includes our core EDA chip design solution and IP portfolio. We significantly deepened our partnership with a global marquee customer through our wide ranging expansion of our EDA software and hardware portfolio. This customer is now accelerating the proliferation of our digital flow across their design teams. Momentum continued for our digital and signoff solutions with nine full-flow wins and a market-shaping automaker taped out their highly innovative and complex 7-nanometer design using our digital full flow. Our Verification Suite comprised of best-in-class core engines across simulation, formal analysis, emulation and prototyping, is particularly well suited to address our customers' mounting verification challenges. Hardware had its highest-ever revenue quarter, with Palladium Z1 and Protium X1 continuing to get new design wins and significant expansions, particularly at AI and hyperscaler customers. We introduced Xcelium ML, which uses machine learning to improve the regression throughput of our premier logic simulator by up to 5X. On the IP front, the top vertical end-markets for our Design IP in the quarter were hyperscale, enterprise and automotive, with a major hyperscaler adopting our PCIe and high bandwidth memory IP for use in 3-nanometer designs. Tensilica had strong royalties and wins for true wireless stereo and functional safety applications and was adopted by an automotive company for ADAS. In System Innovation, I’m very excited by the strong momentum of our new system products, both organically developed, as well as those we obtained through the AWR and Integrand acquisitions earlier this year. Earlier this month, we expanded our System Analysis portfolio with the addition of the Clarity 3D Transient Solver that delivers up to 10x faster system level EMI simulation. Clarity and Celsius continued to ramp nicely with broadening adoption, particularly in verticals such as AI, mobile and hyperscale segments. Systems companies like Teradyne and Rockley Photonics are deploying our Clarity EM simulator for production use. In the 5G/millimeter wave area, integration of our AWR and Integrand acquisitions continues smoothly, and the business is tracking ahead of our internal expectations. In Q3, we added more than 15 new customers in end markets that included 5G, automotive and aerospace and defense. Cadence has a long successful history in advanced packaging, which has become a linchpin technology for many systems companies, particularly automotive and hyperscalers, to deliver complex system level chip designs. In Q3, our innovative Allegro technology was used by a market-shaping automaker for their wafer level system packaging needs. Now, let us turn it over to John to go over the results in more detail and to update our outlook.

Thanks and good afternoon, everyone. I'm pleased to report we exceeded all of our key financial metrics for the quarter. We had a strong revenue quarter in China as a result of better-than-expected hardware and IP sales in the region. This was the main driver of the improvement in our profitability for the quarter, contributing approximately 2% to our non-GAAP operating margin. Looking at the key results for the third quarter, starting with the P&L. Total revenue was $667 million, non-GAAP operating margin was approximately 36%, GAAP EPS was $0.58 and non-GAAP EPS was $0.70. Next, turning to the balance sheet and cash flow, our cash balance was approximately $1.3 billion, while the principal value of debt outstanding was $700 million. Operating cash flow for Q3 was $207 million. DSOs were 41 days, and during Q3 we repurchased $75 million of Cadence shares. Before I provide an updated outlook for the remainder of fiscal 2020, I'd like to take a moment to share the assumptions embedded in our outlook. Fiscal 2020 is a 53-week year and the extra week will add approximately $45 million of revenue to Q4. We've seen higher-than-expected levels of hardware and IP sales activity in China during Q3 and we have assumed this will continue into the middle of Q4. As a result, our outlook includes approximately $40 million for this increased level of hardware and IP sales activity in the second half. You will recall that we had removed $70 million of bookings from our backlog at the end of Q2 due to COVID-19 related customer credit risk. The credit situation slightly improved during Q3 and we’ve revised our estimate down to $58 million. And as usual, our outlook continues to assume that the export limitations that exist today for several customers remain in place for the remainder of 2020. Embedding the aforementioned assumptions, our updated outlook for Q4 is as follows. Revenue in the range of $720 million to $740 million, non-GAAP operating margin of 34% to 35%, GAAP EPS in the range of $1.97 to $2.01 and non-GAAP EPS in the range of $2.68 to $2.72. We expect operating cash flow to be in the range of $840 million to $870 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 Web site. In summary, Cadence delivered another quarter of strong revenue growth and expanding profitability and naturally I'm pleased by this quarter's results. But we always recommend that you shouldn't focus too much on the results of any single quarter. What I'm most pleased about is the improvement in our three-year revenue growth CAGR, the fact that our team continues to operate very effectively during a pandemic and we're on track to achieve greater than 50% non-GAAP incremental margin for the fourth year running. I would like to close by thanking our customers, partners and our hardworking employees for all that they do. And I'd like to remind them all that their health and safety continue to be our first priority. And with that operator, we will now take questions.

Operator Instructions. Your first question comes from Gary Mobley from Wells Fargo.

Hi, guys. Let me first extend my congratulations on a strong second half progression. Related to the second half of the year, I wanted to ask about what seems to be about $65 million in extraordinary China-related revenue that maybe you didn't otherwise expect when the fiscal year started coming in the second half? To what extent is that influenced by some of the latest export restrictions and perhaps some customers over in China trying to get under the wire, so to speak? And then related to some of the mil/aero related export restrictions, have you further done some top down analysis on your existing customers in the serviceability of those existing customers?

John, we can’t hear you.

Sorry, I was on mute. Hi, Gary. That's a great question. In terms of China, the strength in China was higher than expected. We valued it at about $40 million. We think the second half of the year benefits from, like $45 million for the extra 53rd week of revenue and probably $40 million for this kind of spike in China revenue that we believe is mostly non-recurring revenue. But it's – you saw that the China percentage is about 17% in Q3. That's 4% higher than the previous record level. I’d like to say our valuation of that is about $40 million to the second half; split about two thirds, one third between Q3 and Q4. But I understand the concern about is there a pull-forward from next year? It's too early for us to say right now. What we can say is that that extra revenue is generally and predominantly non-recurring in nature, but I won’t know until early next year when I look at the pipeline whether it impacts 2021.

And clearly hardware and IP are big growth for us. And again we comply with all the U.S. export control regulations. And then China’s semiconductor is still a very strong growth engine.

Okay. As it relates to margins, you guys are just killing it on the operating margin. And I guess it's contrary to what we would have thought given the higher mix of hardware-related revenue. What’s sort of inner workings there as it relates to hardware mix, is China related to hardware mix that is much more profitable than say domestically originated hardware sales?

Yes, Gary, naturally we were continuing to invest in R&D, but hiring was slower than expected in Q3. And also the pandemic is helping margins with a little less travel and expenses. We seem to be creeping up into like the 33% to 34% range. We're probably at the high end of that range for as long as the pandemic helps us to keep certain expenses lower. But for Q3, we got an additional margin benefit of about 2% for that extra hardware and IP revenue in China, which is mostly non-recurring and one time in nature. I've assumed that continues into the middle of Q4 and we get about 1% extra benefit in Q4. And the extra week is actually about 0.5% of a headwind to margins in Q4. The baseline for margin is probably in the 33% to 34% range and there are some one-time things that are helping us in Q3 and Q4.

Got it. All right. Thank you.

Your next question comes from John Pitzer from Credit Suisse.

Good afternoon, guys. Thanks for letting me ask the questions. Congratulations on solid results. John, just a follow up on that. Can you help us better understand how much of a tailwind kind of the pandemic has been relative to OpEx, i.e. when we get back to a more normal state, how do we think about kind of op margin related targets?

Yes, John, great question. Like you say, I think we're probably solidly into the 33% to 34% range for operating margins right now. But with the pandemic-related items like lower T&E and things like that helping us to land at the higher end of that range. If we didn't have a pandemic, we'd probably be toward the lower end of that range. And then when you look at the bridge from our Q3 performance at 36% margin, which had the benefit of like 2% for that extra time to revenue. For Q4, I'm assuming 1% for the extra China revenue and then about 0.5% of a headwind because of the extra week. If you back out the extra week and Q4 was in a normal 52-week year, we'd probably be at about 35% but it will come in at about 34.5% we think at the midpoint, including the extra week.

And then just coming back to China, I'm sure you saw I think on Thursday evening of last week the Department of Commerce, this came out with some new emerging technologies to put on the export list and it's oftentimes difficult to translate government language into industry language. But there were some commentary around computational lithography software. I'm just curious, is there anything that came out of that ruling last week that would impact sort of EDA? And I guess as you look out over the course of calendar year '21, what are the puts and takes as U.S.-China tension continues to impact?

That's a good question. As I mentioned earlier, we comply with all the export control regulation. And clearly the situation is very fluid as of last week and we continue to monitor it closely about this computation and any impact to the EDA. And clearly we continue to drive global customer success and provide the best tools and IP, but meanwhile we comply with the regulation and it's very fluid. We’re just monitoring closely to do the best thing that we can.

But just a follow on. Is there any benefit from Chinese customers to order more than they need now and if they're concerned about potentially being cut off later, or does that not really help them in a situation where the band tightens?

John, you can certainly speculate on that. But we can't really tell what the motivation for our customers is for the additional purchases during Q3. At the moment, we can't really tell with a high degree of certainty if the strength in China in the second half is a shift from 2021 revenue into 2020. I think you're right to be cautious about it, but we can't tell if it's a shift or if it's just – what I can tell you is that it is one time generally in nature, most of it is one-time revenue because it's coming from hardware sales and IP. But whether it impacts 2021 or not, I don’t know. We’ll know more in January.

Thanks, guys. I appreciate it. Congratulations again.

Your next question comes from Mitch Steves from RBC Capital Markets.

Hi, guys. Thanks for taking my questions. I’ve got two. I got to start with the proverbial kind of M&A question assuming that Nvidia ARM closes, are you going to see any impact from that and maybe some comments on kind of the speculation around AMD and Xilinx as well? I think that settles a big topical point several years ago, but I just want to get a rehash and any sort of impact do you think from the recent M&A transaction may occur?

Yes, let me try to answer that. And first of all, we are not able to comment on any speculations on Nvidia and ARM and then clearly they are a great company and ARM is a very important partner for us, for Cadence, and we are well positioned with ARM to serve our common customer. I think clearly time will tell and we'll get approvals. And so I think that’s on the Nvidia and ARM. And then on AMD and Xilinx, they are all very good companies and we like them a lot. And clearly over the years, we managed well through consolidations and our very proactive engagement with the companies. And then any consolidation, they're all unique in respect to the vendor. They are all good companies and I think I cannot go beyond to comment any beyond that.

Okay. Maybe just to clarify that, so I guess on the ARM and Nvidia piece in a scenario, so we'll just go through the scenario that RISC-V loses market share to ARM. Does that impact at all the EDA space?

Yes. And again, we are supporting customer and then depend on whether they cope with ARM or RISC-V, but clearly ARM is very well positioned with that ecosystem in place in the software and we continue to work closely with ARM, and then meanwhile keeping a close eye. If a customer wants to have RISC-V, then we will support the customer.

Okay. Perfect. And then my second one is just going back to kind of the 3D Solver opportunity. From what we've seen, chiplet architecture is continuing to take off and that requires a lot of RF. And it seems like you guys are very well positioned on that. So I guess why is there not more I guess more marketing or more logos to talk about on that front? Because it seems like the product you guys have is significantly better than Ansys. So if you could talk about what you guys are seeing there. Is that a COVID issue in terms of getting more sales or is it just not something you want to highlight yet?

Yes, I think I noted our system design analysis is a very important growth engine for us and clearly we are excited about the system complexity on the advanced design, like 5G, automotive and HPC applications. And so clearly the system level analysis is very critical for them, but delighted with the organically developed and also the AWR and Integrand acquisitions that we have. So we have a very nice portfolio that the customer is delighted with us. And then clearly another 15 new customers this quarter for Clarity and Celsius is very exciting for us. And then we also announced the Clarity 3D Transient Solver that shows 10x faster system level EMI simulation. So I think all-in-all, we are excited about another opportunity and we like to under-promise and over-deliver. Meanwhile, we do the right marketing at the right time. But so far, I think we take one step at a time. And to support our customer, that's more important.

And Mitch, I would just like to add to that that we recognize revenue ratably on our systems analysis products. It's still early days. Our plan is to win mindshare first and then market share will follow. We've got plenty of repeat orders from these system companies and more than 15 came from the AWR and Integrand acquisitions.

Okay. Perfect. Another great quarter, so I’ll jump out of queue.

And your next question comes from Vivek Arya from Bank of America.

Thanks for taking my question and congratulations on the strong results. For my first one, I'm curious about how you think about your non-China growth this year? It's about 6% year-on-year so far this year. Would you call that trend growth, above trend, below trend, just how does that compare to what you thought the non-China growth would be at this point of the year? Just anything that has surprised you in terms of the non-China aspect versus what you thought before, whether it is customers or end markets or what have you?

Hi, Vivek. This is John Wall here. I'll take that question. But certainly 2020 was always going to be a very unusual year when we have the extra 53rd week for revenue that we're operating in the middle of a pandemic, you're seeing some China revenue spike in the second half of the year for us and we always tell people not to focus too intently on any one quarter. Personally, the way I look at it is I tend to track the three-year CAGR. If you look at our CFO commentary, you'll find on Page 2 of the commentary, I put the three-year CAGR view on there because I find that particularly helpful myself. But adjusting for the impact of the occasional 53rd week that impacts our numbers, you'll see there that our three-year revenue CAGR was showing a consistent level of about 8% revenue growth per year up to about 2018. It ticked up to 9% last year in 2019. And then based on our guidance for the remainder of this year, 2020 now looks like it's going to be a solid 10% three-year CAGR growth year, albeit with a China tailwind. But even if you assume that $30 million China revenue spike is one-time only and back that out of our second half, our three-year CAGR is still close to around 9.5%. So I think our typical contract cycle is two to three years. So if you stand back and take a three-year view of things, you probably get a more discernible trend in terms of what's happening with each line of business. But it's difficult to look at any one quarter and extrapolate from that.

Yes, I think in terms of the longer run, I am quite bullish about the semiconductor and system design. Clearly the opportunity and I call it the five generation waves and they're going to increase design activity. Meanwhile, we continue to work with market-shaping customers. We highlighted this quarter we expanded and deepened our partnership with a global marquee customer in the proliferation of our digital flow. So I think all-in-all, I think we have to take a longer term view and look at quarter-to-quarter noise.

Right and I appreciate that, John. I was actually looking just year-to-date the non-China growth was about 6% and was 9% last year, and what I'm trying to discern is, is there some macro impact there, i.e., if, let's say, next year hopefully the global economy picks up, does the non-China growth also start to reaccelerate? That's what I was trying to get a better sense for.

Yes, we are certainly seeing strong design activity in China. But I don’t know — in terms of next year, it's hard to predict quarter-to-quarter. I am bullish about AI, data analytics and hyperscale as drivers. Beside hyperscale, other areas with increasing design activity are industrial automation and automotive, including ADAS and system-level requirements. Those are meaningful opportunities.

All right, Lip-Bu. And just a follow up. As you look at next year, outside of hyperscale what are the other two or three end markets that you're seeing the most level of increasing design activity outside of hyperscale? Thank you.

As I mentioned in my remarks, clearly AI and data analytics and hyperscale are the big drivers for Cadence. Clearly beside hyperscale, industrial automation and automotive are important. Some customers are focused on ADAS and system-level optimization. It's very hard to predict quarter-to-quarter, but in the long run I'm very excited about the opportunity and we are well positioned.

Your next question comes from Joe Vruwink from Baird.

Great. Hello, everyone. I'll maybe be guilty of analyzing one particular quarter, but it does look like a pretty meaningful acceleration and growth for systems analysis. And I'm just wondering, it sounds like the new solver products are moving in the right direction but because of the ratable recognition maybe not contributing as much to that number. So are we really just seeing kind of the broader secular trends in terms of companies spending more on their PCB modeling tools and of course that benefits Allegro? And as the other products are kicking in or as you continue to get momentum on AWR, you're looking at above company rates of growth continuing. Is that the right way to think about recent performance?

Yes, I think we're very excited about the system design analysis space and this is one of the areas where our Design Excellence foundation is moving up into Intelligent System Design. We are delighted with the AWR and Integrand acquisitions. Integrating those with our tools makes a compelling offering for customers. We continue to develop Clarity and Celsius organically and demonstrate differentiating performance. We announced the Clarity 3D Transient Solver which shows clear performance benefits for system-level EMI simulation. This is a growth engine for us and we are excited.

Okay, great. Thanks, Lip-Bu. And then one more question and thinking about kind of the interweaving of tailwinds and headwinds into maybe next year's environment, because it sounds like China could see some normalization, $40 million is 200 basis points worth of growth. But one interesting thing that came up is some of the end markets that are adopters of your IP, things like automotive, aerospace are markets that obviously have had a pretty difficult 2020. So along the lines of an earlier question just in terms of maybe cyclical recoveries in some of your end market exposure, do you think there's enough there where while China perhaps normalizes, you actually get a bit of an improvement in other areas and it essentially is a wash, so we're still looking at kind of the targeted high-single digit growth profile?

Joe, generally you don't get too dramatic a shift in our results given the rate-based revenue model we have and that most of our contracts are time-based over two to three years. That's why I included the three-year CAGR view on Page 2 of the CFO commentary, because that tends to be the way I look at it. I'm always looking to see can we improve that three-year CAGR view. If I'm looking out to 2021, of course, we're not giving guidance yet and we will be in a better position to give guidance for 2021 in the new year when we have better visibility into the pipeline. 2020 has been a great year; it's been a bit weird but wonderful, but I'd be more inclined to extrapolate for 2021 off prior year numbers and look at three-year CAGRs and not over-interpret 2020 which was impacted by many one-time items.

Okay, great. Thank you.

Your next question comes from Jason Celino from KeyBanc.

Hi, guys. Thanks for taking my questions. One clarifying point on that marquee customer you talked about beginning, it's been a full year since we heard of another marquee customer expanding on the IP side. This expansion today, what does that entail and any other details maybe you could clarify?

Yes, Jason. This global marquee customer expansion is a wide-ranging expansion of our EDA software and hardware portfolio. They are accelerating proliferation of the digital full flow across their design teams. This reflects the relationship we have and our technology leadership across software and hardware solutions for their challenging designs. We're excited about this partnership.

Jason, I’d like to add that we have many marquee customers and this one is different from the one we talked about last year.

Great. Thank you for the clarification. And then one question on the system analysis customer you talked about. You actually mentioned two end markets; automotive and aerospace in events. It's the first time you talked about those verticals for Clarity and Celsius. Is this the case? And then, are these more of net-new customers to Cadence or are they kind of cross-sell ones?

We mentioned Teradyne and Rockley Photonics using our Clarity EM simulator. We have traction in 5G, automotive and aerospace. We added more than 15 new customers this quarter for our system analysis portfolio. Many of these are net-new for this category of products, which is exciting for us. This is just the beginning and we will have more to share in time.

Your next question comes from Jackson Ader from JPMorgan.

Hi, guys. Thanks for taking my questions. Just following up on the marquee customer win that you talked about and Lip-Bu I mean in your prepared remarks you went through a number of different digital full flow wins and in customers and expansions. And I guess I'm just curious, what should we maybe be expecting from that digital design segment? Because even John if I look at your three-year CAGR on the digital segment, it’s slowed down this year relative to 2019. So just seeing whether we should be expecting some acceleration as we head into 2021, given all the strength you've seen in digital full flow?

So we have nine full-flow wins and this global marquee customer proliferation. We have innovations like physical optimization engines that show significant improvements in PPA and throughput — for example, up to 20% improvement in PPA and 3x faster throughput in some optimizations. We are laser-focused on market-shaping customers and pushing full flows across design groups. We're excited about the progress.

And Jackson, again, we wouldn't focus too heavily on any one quarter. Q2 and Q3 for digital were particularly impacted by the customer credit situation that we had. Now that's slightly improved during Q3 where we had about $70 million of bookings at the end of Q2 that we took out of our backlog because we didn't expect to get paid. Updating that $70 million, about $30 million of that has gone. Of the other $40 million that's left, we expect to recover about $12 million and we still think there's about $28 million that we won't recover. So that's improved the situation slightly in Q3. But I'm expecting a strong Q4. And you can see that in the guidance, not just from the extra week as well. And if you look at the entire year, we're expecting all of our product categories to grow high-single digits or double digits.

Okay, great. And just a follow up checking in on the cloud and cloud adoption, any kind of either usage metrics that you guys track or maybe a revenue contribution from cloud usage given 2020 has been such a remote year?

We're not going to count revenue separately for cloud right now, but we did book our largest cloud order so far in Q3 and we've got good momentum with 150 customers that have adopted our cloud solutions now.

Okay. Awesome. Thank you.

Your next question comes from Tom Diffely from D.A. Davidson.

Yes. Good afternoon. Thanks for the question. So, Lip-Bu, just want to jump back to the processor question earlier and on just the fact that we're seeing the industry moves just from Intel base to all these other players, AMD and graphics chip, ARM based, that has to be good news for you, as you know, the more designs you have in leading edge, the better, I would assume. Is that correct?

Yes, that's correct. The general purpose CPU and GPU space will continue to do well, but workloads have changed a lot into application-specific and optimized processors, especially for AI and machine learning training and inference. There's a lot of new development from startups and established companies and hyperscalers also drive processor optimization for specific applications. That means more design activity, more demand for our tools and hardware emulation because designs are getting more complex. It also drives opportunities for system analysis and advanced packaging. We are excited about these opportunities.

Okay. And then I also wanted to get your view on just consolidation in general and what that means to EDA? And over the last five years there’s been several high profile customers of yours that have consolidated and it seems like it has very minimal impact on EDA in your ratable business with them. I'm curious, is that the way you think it is going forward as well where you don't worry too much about consolidation among your customer base?

Yes, consolidation is something we watch closely and we try to be proactively engaged. Historically we've managed well through consolidations. R&D is typically the last place companies cut and they continue to invest in innovation and efficiency. Our approach is to be a proactive, trusted partner and we have managed through previous consolidations successfully.

Okay. And as a final follow up here, John, when you talked about the extra week and the target was $43 million or $45 million of revenue, did I understand you correctly that the actual cost impact is more than that?

No, it's not more but it is a headwind for margins. The extra week is about $45 million to revenue and about $33 million to non-GAAP expense. So if you back those out, you'll find that the margin for a 52-week year is higher, but we're kind of running at 33% to 34% as a baseline for margin, closer to the high end of that range because the pandemic is helping margins at the moment. For Q3, we were 2% higher than that 34% because of the benefit of that spike in revenue in China that we've seen. We expect that to continue into the middle of Q4 at about 1% benefit. So add about 1% for that, you get to 35% for Q4 for a normal 13-week quarter. But when you add the 14th week — the extra week of $45 million revenue and $33 million expense — the margin impact backs it down to a midpoint of 34.5%.

Okay. Thanks for the detail.

Your next question is from Jay Vleeschhouwer from Griffin Securities.

Thank you. Good evening. Lip-Bu, let me start with you in terms of a question about the long-term implications of your Intelligent System Design and computational software strategy and then for you, John, a shorter-term question about hardware. So, Lip-Bu, we heard a good deal over the summer and again last week at the Cadence Live events about your computational software strategy and Intelligent System Design. You've spoken of it. Anirudh has spoken about it, of course. And the question is threefold, which is what are the implications in terms of your R&D, specifically the organization or methodology of your R&D as you orient Cadence towards this new strategy or opportunity? Similarly in terms of sales and pricing that might be for you too, John. And last and certainly not least, the role and competencies that you look for in applications engineers which I believe are your second largest part of headcount after engineering, vis-à-vis the new strategy.

Jay, thank you for the good questions. A couple of points. First, our core competency is computational software and Intelligent System Design is adjacent to our core; it's what customers are asking for. Beyond EDA for silicon, customers need system analysis such as EM and thermal envelope analysis and domain-specific optimization. These needs fit our computational software expertise and we will expand into that area. In R&D methodology, we focus on the tools that matter most to customers like Celsius and Clarity where we can demonstrate multiple-times improvements. Those wins justify further investment. In pricing, we are disciplined — we want to provide the best solution and price it appropriately to serve customers. In talent, we are focused on hiring top talent for R&D and for applications to serve customers effectively. Those are our priorities. John, back to you.

Lip-Bu covered most of it. From my perspective, the company will continue to invest in R&D and applications resources as we see validated customer demand. We'll balance investment discipline with customer-driven development.

No, that's fine. So turning to you, John, the shorter-term question, you've noted record hardware for the quarter and that's certainly substantiated by the increase in hardware cost of revenues that you show in the 10-Q. Interestingly though your inventories increased from the second quarter in which I assume are most if not entirely hardware. So in spite of the revenue upside in hardware, did you sustain an inventory build anticipating perhaps Q4, Q1 '21 shift scheduling by one or both of the marketing customers?

Yes, Jay, we continue to maintain our inventory levels due to ongoing strong demand for the hardware products. We don't want to be caught short of inventory with the demand that's out there. The Palladium Z1 emulator is doing so well and so is the Protium X1 platform, that prototyping platform. So we're continuing to build inventory.

Okay. And lastly, if I may, the physical verification and yield optimization category has been doing very well for a number of years now. Obviously, Mentor is a market leader there and their numbers have been quite strong. Could you update us on what's going on with Pegasus? Anirudh was quite definitive about that opportunity a year ago back when he talked about the respective changes in physical verification over the next number of years. So, what's actually happening for you there?

I can answer that. We're very excited about the Pegasus solution. It took years to develop and the engine is strong. We needed to ensure foundry partner certification because Pegasus interfaces with manufacturing flows. We are delighted that key foundry partners are certified across a range of process nodes including the most advanced nodes. We're starting to have multiple customers embrace it and use it. Stay tuned — I think 2021 will be an important year for Pegasus with certification in place so customers can confidently use it for production designs.

Okay. Thank you very much.

Your next question comes from Pradeep Ramani from UBS.

Hi. Thanks for taking the questions. I had a couple. First, just in terms of your memory exposure, I guess in terms of your share, do you feel like you have more share in memory versus logic or are they sort of comparable? And the reason I ask is there’s a lot of M&A speculation going on and this is not specific to respect to an M&A question, but in general I'm trying to understand your exposure to memory.

I think memory is increasingly important in data analytics and moving compute closer to memory and storage. This is an area of focus for hyperscalers and infrastructure. We have a strong foothold in memory — from IP like DDR, PCIe, memory controllers to tools used by memory customers. So we are well positioned and will continue to expand.

Okay. And my follow up is a little bit more on system analysis. So, we are hearing positive feedback on Clarity, especially versus competing tools. But I guess with the AWR and Integrand acquisitions, one, how did your prior $700 million market size inflect, how much higher does it inflect? And two, where are we with respect to the share gain on the organic side? Are you close to like 5% share already or how can you think about sharing this space as well?

First, the addressable market for Clarity and Celsius that you referenced is about $700 million and we are just at the beginning. Incumbents are established, and we need to demonstrate performance and get customer validation. The important signals are repeat orders — customers coming back and buying more. That indicates the performance is compelling. We are continuing to develop more capabilities, and combined with the AWR and Integrand acquisitions, we are ahead of our internal expectations in areas like 5G and millimeter wave. Automotive and other verticals are seeing strong interest.

Okay. And a quick follow up. I guess I just want to clarify this. So you said there were 15-plus customers for Clarity and Celsius this quarter and that independent from 15 customers for AWR and Integrand or are they the same? I just want to understand that.

We mentioned more than 15 new customers across our system analysis portfolio this quarter. That commentary reflects momentum across the combined portfolio, including organically developed Clarity and Celsius as well as AWR and Integrand.

Your next question comes from Rich Valera from Needham.

Thank you. I wanted to ask a question on your prepared remarks, John. You mentioned that system design and analysis was one of the drivers of your increased full year guide. And I was wondering if you could say, was it the new system in organic system simulation tools or the AWR/Integrand acquisition that was driving that?

It's the combination of both and the commentary really stemmed from the fact that we expect that to be our fastest growing segment for the year now.

Got it. That’s helpful. And then you mentioned that you were actually behind plan in terms of hiring in Q3, but it looked like you added about 300 heads which is the most you've added in a while. So just want to try to understand that dichotomy there?

Yes, we're continuing to invest in R&D and a lot of that investment is in headcount. The reason I called out slower than expected hiring was that that was part of the reason why we had such a strong operating margin in Q3 in comparison to what we guided. We were slightly slower on hiring earlier in the quarter which contributed to lower expenses in the quarter than we expected. We did add significant headcount, but the timing was a bit later than planned.

Got it, makes sense. Okay. Thanks very much.

Your next question comes from Joshua Tilton from Berenberg.

Hi, guys. Thanks for taking my questions. I just wanted to follow up on the systems design and analysis segment maybe from a different perspective. Given that Clarity and Celsius are still in very early innings, when we look five years out, how should we think about this segment as a percentage of revenue?

I don't think we will provide a five-year percentage projection, but we are excited about this opportunity. This is early innings. We have encouraging customer feedback and repeat orders. Over time, as we broaden the portfolio and continue innovation both organically and via acquisitions, the system analysis business will become a larger part of our addressable market and revenue mix.

That’s helpful. And then just wanted to follow up. In terms of the Clarity and Celsius to date, are you seeing them being more competitive replacements or are your customers allocating incremental budget to supplement their existing simulation capabilities?

This is a new business for us in many accounts. Given it's early, it's hard to fully attribute whether it's replacement or incremental budget. My sense is that we're seeing a mix — some customers allocate incremental budget and some are replacing older flows because of performance advantages. The important signal is repeat orders.

Our final question comes from Krish Sankar from Cowen.

Hi. Thanks for taking my question. I had two of them. First one, Lip-Bu, I think there were some questions on consolidation and clearly your customer consolidation has not really impacted you or even Synopsys for that matter. How much of that is the size that your customers as they consolidate did not cut EDA budgets or even raise the EDA budget versus as your customers consolidated, even the suppliers consolidated between you, Synopsys and Mentor that kind of was a tailwind that you had?

We are monitoring consolidation closely. You're correct that we've managed well through consolidation historically. Typically R&D is the last area to be cut and demand for design engineering remains strong. Consolidation does sometimes move people around, but overall we don't see a slowdown in design activity. We're optimistic about continued demand for our tools and services.

Got it, that's really helpful. And then as a follow-up I don't know if you can answer, either Lip-Bu or John, can you disclose if you've gotten any letter from the government requiring a license to ship to any Chinese customer?

We're doing everything we can to support our customers, but we're not disclosing any specific communications with the government.

Thanks, John. Thanks, Lip-Bu.

I will turn the call back over to Lip-Bu Tan for closing remarks.

Thank you all for joining us this afternoon. Our Intelligent System Design strategy is playing out very nicely as we benefit from new opportunities in Design Excellence, System Innovation and Pervasive Intelligence, and an expanded total addressable market. I’m very delighted to share that Cadence has been recognized by FORTUNE and the Great Place to Work Institute as one of the World’s Best Workplaces, for a fifth time. This recognition is a result of our global employees’ commitment and dedication to innovation, to delighting our customers, and to taking care of our communities and each other. And lastly, on behalf of all our employees and our Board of Directors, we give our heartfelt thanks to all of them on the frontlines who continue to work tirelessly to fight this pandemic. Thank you all for joining us this afternoon.

Thank you for participating in today’s Cadence third quarter 2020 earnings conference call. This concludes today’s call. You may now disconnect.