Cadence Design Systems Inc Q1 FY2021 Earnings Call

Good afternoon. My name is Olivia, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence First Quarter 2021 Earnings Conference Call. I will now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence. Please go ahead.

Thank you, Olivia. I would like to welcome everyone to our first quarter 2021 earnings conference call. I am joined today by Lip-Bu Tan, Chief Executive Officer; Anirudh Devgan, President; and John Wall, Senior Vice President and Chief Financial Officer. A webcast of this call is available through our website cadence.com and will be archived through June 18, 2021. 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. Forward-looking statements include, but are not limited to, statements about our business outlook, product development, business strategy and plans, industry and regulatory trends, market size, opportunities and positioning. These statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those projected or implied in today's discussion. 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, which was just filed, and the company's future filings and the cautionary comments regarding forward-looking statements in the earnings press release that was issued today. You should not rely on our forward-looking statements as predictions of future events. All forward-looking statements we make on this call are based on estimates and information available to us at the time of this discussion and Cadence disclaims any obligation to update any forward-looking statements except as required by law. 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. These non-GAAP financial measures should not be considered in isolation from or as a substitute for financial information prepared in accordance with GAAP. These non-GAAP financial measures are not based on any standardized methodology prescribed by GAAP and are not necessarily comparable to similarly titled measures presented by other companies. Investors and potential investors are encouraged to review the reconciliation of non-GAAP financial measures with their most direct comparable GAAP financial results. A reconciliation between each non-GAAP financial measure and its nearest GAAP equivalent may be found in our earnings press release following the financial statements. Copies of today's press release dated April 26, 2021 for the quarter and year ended April 3, 2021, related financial tables and the CFO commentary are also available on our website. For the Q&A session today, we would ask that you observe a limit of one question and one follow-up. You may re-queue if you would like to ask additional questions and time permits. And now I will turn it over to Lip-Bu.

Good afternoon everyone and thank you for joining us today. I'm pleased to report that Cadence had a great start to the year delivering outstanding financial results for the first quarter with broad-based demand for our innovative solutions, driving strong revenue growth, profitability, and cash flow. John will provide the details in a moment as well as our updated outlook. Generational trends like 5G, hyperscale computing, autonomous driving, and industrial IoT continued to propel the need for innovation in compute, memory, networking, and storage from the edge to the cloud with massive amounts of new data being generated every day. AI/ML and data analytics are helping transform that data through intelligence, providing actionable insights and accelerating digital transformation of several industries. These trends are continuing to drive strong semiconductor demand and design activity across a broad spectrum of end markets, and our Intelligent System Design strategy ideally positions us to capture these exciting opportunities. Now, let me talk about the Q1 highlights starting off with Core EDA and IP in the Design Excellence year of our ISD strategy. We had ongoing strength in aerospace and defense, and we significantly expanded our collaborations with marquee aerospace and defense systems companies that included the proliferation of our digital full flow as well as our functional and custom simulation solutions. Our Digital Signoff business had a strong revenue quarter, with multiple market-shaping customers successfully hitting 5-nanometer and below process nodes using our digital full flow. Increasing design complexity and the continuous drive of the secular trend for hardware-assisted verification and certification made Q1 a standout quarter for our Palladium emulation and Protium prototyping platforms. Significant expansions as well as multiple new wins contributed to Q1 being our best hardware revenue quarter ever. Additionally, we announced our new Palladium Z2 and Protium X2 platforms, delivering 2 times capacity and 1.5 times higher performance than our current leading Z1 and X1 systems. These next-generation systems enable the highest throughput hardware debug and pre-silicon software validation for million- to multibillion-gate ASIC designs and were endorsed by Nvidia, AMD, and Arm. Our IP business also delivered double-digit year-over-year revenue growth. There was strong demand for our high-speed SerDes IP by market-shaping customers for their next-generation data center and networking environments as well as continued strength in our memory interface IP business. Tensilica continued to expand its footprint in true wireless stereo and Bluetooth headsets, and our Vision P6 and HiFi products proliferated in the wearables and smart speakers end markets. It was another exciting quarter for the System Design and Analysis segment, delivering over 30% year-over-year revenue growth. Early this month, we acquired Pointwise, a leader in mesh generation for computational fluid dynamics. The addition of Pointwise Technologies and its experienced teams has broadened our System Analysis portfolio and complements our recently acquired NUMECA CFD technology and our organic multiphysics products. Pointwise provides highly innovative mesh and grid generation technologies to enable high-fidelity CFD analysis, and its solutions are being used by several marquee customers, especially in the aerospace segment. We want to congratulate our NUMECA team for the role their products played in the design of the Emirates Team New Zealand racing boat that won the America's Cup for New Zealand for the fourth time. The winning team used a simulator based on NUMECA's Fine/Marine CFD software and their computational dynamic modeling, and thanks to the unprecedented accuracy and realism of their simulators, they were able to accurately test new ideas and concepts long before the first boat ever touched the water. We introduced Sigrity X, our next-generation signal and power integrity solution with endorsements from Samsung, MediaTek, and Renesas. These solutions leverage new simulation engines and a massively parallel architecture to deliver up to 10% performance and capacity gain for system-level simulations of the most demanding hyperscale, 5G, automotive, and aerospace applications. Qualcomm expanded their usage of our flagship Virtuoso and AWR products for advanced RFIC design and Clarity for system analysis. Let me conclude with a few comments on some macro-level topics. We continued to monitor the semiconductor supply chain situation, and so far we are not seeing any slowdown in design activity across our customer base. Next, regarding the evolving state of the COVID-19 pandemic, while some countries are edging toward normalcy, there is a growing concern with the escalating number of cases in certain regions, especially in India. As always, the health and safety of our employees, customers, and partners is paramount and we will continue doing what is in their best interest while working closely with local regulatory agencies. Lastly, this past year has brought to light many social justice challenges, including the recent acts of violence against Asian Americans. I strongly believe that we have an obligation as individuals and as a company to take a stand against racism and set an example for inclusiveness and understanding. At Cadence, we are committed to listening with empathy, being inclusive of different points of view and as a result ensuring that our diversity enhances our experience and our innovative spirit. Now, I will turn it over to John to go over the Q1 results and present our Q2 and updated 2021 outlook.

Thanks, Lip-Bu, and good afternoon everyone. I'm pleased to report that we exceeded all of our key operating metrics for the quarter. Broad-based growth across many lines of our business combined with some earlier-than-anticipated hardware sales resulted in strong revenue growth in Q1. We continue to invest heavily in building out a multiphysics platform for system design and analysis. We completed our second acquisition of the year in the CFD space when we acquired Pointwise in April, a leader in CFD mesh generation. The focus over the past few months in completing acquisitions contributed to some delays to our expected pace of hiring in Q1, but we expect to get hiring back on track by the second half of the year. Now, let's go through the key results for the first quarter, beginning with the P&L. Total revenue was $736 million. Non-GAAP operating margin was approximately 38%. GAAP EPS was $0.67 and non-GAAP EPS was $0.83. Next, turning to the balance sheet and cash flow. At quarter end cash totaled $743 million while the principal value of debt outstanding was $350 million. Operating cash flow for Q1 was $208 million. DSOs were 48 days and during Q1, we repurchased $172 million of Cadence shares. Before I provide our updated outlook for fiscal 2021 and what we expect for Q2, I'd like to take a moment to share the assumptions embedded in our outlook. The ongoing chip capacity constraints along with the recent surge in COVID-19 cases in India are expected to create a headwind for IP revenue for the remainder of this year. The revenue impact has been factored into our outlook. We expect expenses to increase in the second half of the year, primarily due to headcount growth as we continue to invest in our expanding multiphysics platform. We've included the Pointwise acquisition in our 2021 outlook. And finally, our outlook assumes that the export limitations that exist today for certain customers will remain in place for all of 2021. Embedding these assumptions into our outlook for fiscal 2021, we expect revenue in the range of $2.88 billion to $2.93 billion, non-GAAP operating margin in the range of 35% to 36%, GAAP EPS in the range of $2.01 to $2.09, non-GAAP EPS in the range of $2.99 to $3.07, operating cash flow in the range of $900 million to $950 million, and we expect to use at least 50% of our free cash flow to repurchase Cadence shares in 2021. For Q2 2021, we expect revenue in the range of $705 to $725 million, non-GAAP operating margin of approximately 36%, GAAP EPS in the range of $0.44 to $0.48 and non-GAAP EPS in the range of $0.74 to $0.78. Our CFO commentary, which is available on our website, includes our outlook for additional items as well as further analysis and GAAP to non-GAAP reconciliations. In conclusion, the Cadence team delivered another quarter of strong operating results and remain focused on driving profitable revenue growth. We'd like to thank our customers, partners and of course our employees for a solid start to 2021. And I'd like to remind them all that their health and safety continues to be our first priority. And with that, operator, we'll now take questions.

And our first question comes from Jason Celino with KeyBanc. Your line is open.

Hey guys, thanks for taking my questions. Maybe my first one: historically customers have gravitated toward the latest and greatest hardware products, especially on the emulation side, but because emulation strength has been going on strong for several years now, how do you think the pace of uptake for the Z2 and Protium products could be?

So thank you for the question.

Yes, that's a great question, Jason. You might have noticed that we beat our midpoint of guidance in Q1; partly that was due to trying to manage the Osborne effect on transitioning to our new Palladium Z2 and Protium X2 systems. We had an incentive plan in place to try and sell as many of those Z1s and X1s before we launched the new products. So, we expect a strong uptick for those new products. The incentive plan worked really well, and Q1 was a really strong hardware quarter for us. It's a testament to the compelling value of our hardware solutions. They're providing value to both chip and system-level customers across multiple use models.

Okay, great. And then for my follow-up, maybe just an explanation here. John, you mentioned that chip capacity constraints and the COVID impact in India are a headwind for IP. Maybe explain why this would be an impact and could you quantify the dollar amount or the percentage?

Yes, sure Jason. On the COVID-19 situation, the worsening pandemic in India could have some impact to the timing of delivery for certain hardened IPs that require testing labs. As we said in our prepared remarks, that's been factored into our updated outlook. India built us out last year; if you recall, we had similar challenges back in Q2 last year in North America, and we're hoping we can do the same thing now, but it could cause some fluctuation in revenue timing between quarters. The bigger impact on the year is probably in relation to chip capacity constraints. Last quarter, when we talked about that, my expectation was royalties might be flat year-over-year. I now expect them to be slightly down. So, there is a slight headwind built into the guide this year for that.

Great, thank you. I'll get back in queue.

Our next question comes from Jackson Ader with JPMorgan. Your line is open.

Thanks for taking my questions guys. I'd like to start on remaining performance obligations and calculated bookings. They are down a bunch in the quarter relative to a pretty tough compare, but I was just wondering if you guys had any additional commentary on the bookings performance in the quarter?

Hi, this is John. I think that's just a reflection of a low renewals quarter. Yes, we'd expect remaining performance obligations to ratchet back up before the end of the year.

Okay, fair enough. And then on the geographic side, we saw remarkable growth from China in the second half of 2020; looks like that geo kind of came back down to earth here in the first quarter. Any particular product segments, hardware, software, IP that would be impacted for that geography coming back down?

Yes, China is back to more normal levels of business at the 12% level. The change this quarter is mainly because the strength appears to be more broad-based across geographies this year. If you recall in Q3 we had a really strong hardware quarter, and within China in Q1 a lot of the strength was within North America and more balanced across all regions. In our outlook, I've assumed China returns to our usual recurring revenue mix in the region as well and that, along with the fact that we have one less week in the second half of fiscal 2021, contributes to the conservative revenue outlook in the second half. When we get to the summer, we'll have increased visibility into revenue for the second half and the pipeline for the second half and we can update the outlook at that time.

All right, thank you.

Our next question is coming from the line of Gal Munda with Berenberg. Your line is open.

Hi, thank you for taking my question. First one is just, John, maybe a little bit expanding on what you just said. When I look at your historical trends of revenues, they tend to be fairly equally split throughout the quarters and Q2 tends to be sequentially slightly stronger than Q1. Is it because of this slight pull forward of hardware that you expect the mid-point of guidance to be materially lower this year?

Yes, Gal. We implemented an incentive; we incentivized the sales force to try and close some Z1 and X1 business as early as possible in the year in preparation for the launch of our new Z2 and X2 hardware systems. That was more successful than we originally thought and about $10 million of Q1's revenue I had originally forecast to happen in Q2. So of the $16 million beat at the midpoint for Q1, there's probably $6 million of that which was a true beat and $10 million was what we originally thought would fall into Q2 that happened a little bit earlier in Q1.

Got you. That's really helpful. Thank you. And then maybe a longer-term strategic question around building the CFD platform capabilities which kind of adds to your Clarity side. Thinking about potentially other physics that you might be adding over time, is that a potential for us or do you think simulation is something that's very applicable to cooling and everything of the system, so because of that you want to bring that in-house and the other ones maybe you partner? How do you think about it?

Thank you for the question. So first of all, we are excited about CFD; it is a very big segment into system analysis, roughly a $1.5 billion to $1.6 billion market. Pointwise is a leader in mesh technology, so we are glad to bring them in-house. We think combining Pointwise with NUMECA and our organic capability in parallel and distributed computing can give a state-of-the-art solution for the CFD market. We want to make sure we do well in CFD and, as you know, we are already in electromagnetics with Clarity and thermal with Celsius. So those are our focus areas for now and we'll see how things go in these segments. So far, we are optimistic. If you look at Q1 results, we had good growth versus Q1 of last year, so like John said, we are continuing to invest in this space and we are still early in CFD, but optimistic about it.

Got you. Thank you.

Our next question is coming from the line of Joe Vruwink with Baird. Your line is open.

Great. Hi everyone. I was hoping to talk about the product cycle for the new emulation and prototyping to get two platforms launching at the same time that have new silicon behind each. I think that's a pretty unique situation. John, I get the timing and incentivizing of the older generation, but could it be possible that the performance on the new generation means that net demand ultimately is higher than being forecasted? Or is it likely more of a second-half driver?

I think that's a good observation Joe. We're building the systems as quickly as we can. There is clearly demand there. The systems, the dynamic duo for the tight integration with unified compiler and interfaces, are designed to address the challenges faced by those designing for the most advanced electronic applications, including mobile consumer and hyperscale computing design. So we expect demand to be very strong and customers can achieve up to 2 times capacity and 1.5 times performance improvements with each platform. They work very well together—customers call them the dynamic duo—so it is important for us to launch them together which we're building them as quickly as we can. There is plenty of demand for them, but it might impact the second half of the year more than the first as we ramp production.

Okay, that's helpful. And then just a follow-up on the margin guidance for the year, because I think you ended up beating your forecast in Q1 by $28 million and the full year moves higher by $12 million or $13 million. Is that purely a function of hiring being back half-weighted or are there other things like product mix or other investments to consider as well?

That's exactly right Joe. It's basically the compounded effect of revenue happening a little bit earlier than originally forecast because of the success of that incentive program and the success of sales of Z1 and X1 in Q1, and then hiring getting delayed a little bit to later in the year as we focused on closing acquisitions in the CFD space.

Great, thank you very much.

Our next question comes from the line of Jay Vleeschhouwer with Griffin Securities. Your line is open.

Yes. Thank you. Good afternoon. A couple of paired technical and financial questions for Anirudh and John. First for Anirudh: on the last call we discussed how customers' design flows and methodologies are evolving. The follow-up is how might that affect Cadence's pricing and product packaging commensurate with customers' evolution of their methodologies? Could there be any effect on how you price annual software packages or anything else? Second, with respect to System Design strategy and overall computational software strategy, how would you compare the R&D and AE intensity or requirements for system analysis, particularly as you add more in CFD and other physics, versus core or classical EDA which is synthesis, implementation, RTL simulation and the like? Do you expect meaningful differences between those two parts of the business? Thanks.

Thanks Jay. Let me take the second one first. Even in our EDA software business, perhaps one-fourth of it is more simulation-based—circuit simulation and logic simulation. Those simulation-based businesses are generally more profitable than overall EDA; for example Spectre is usually more profitable than place-and-route. So I expect a similar trend in System Analysis. System Analysis is inherently simulation-based whether it's Clarity for electromagnetics or CFD tools. In steady state, I expect System Analysis to be more profitable than Core EDA. So far, we are pleased with both the revenue growth and the margin performance of the System Analysis business. On your first question regarding packaging and pricing, we are looking at it carefully. One big trend is more full-flow use at lower nodes. We are selling many of these tools together, so we continue to monitor and enforce pricing discipline with our customers and internal teams. John, do you want to add anything on pricing?

Yes, Jay. You're exactly right. Look at the tools we create on the software side—there is a lot of R&D and AE intensity in supporting those tools. You can bifurcate licenses into two groups: interactive tools where every license needs a driver, and simulation tools which are batch process tools where one engineer can kick off many simulations. That's partly why system analysis and simulation parts of the business are the most profitable part of our software business—our expenses are generally tethered to R&D and AE headcount required to support the software, but the revenue for simulation is not as tightly tethered to the number of engineers or interactive licenses. That's why we see higher profitability there.

Understood. Thanks very much.

Our next question is coming from the line of Gary Mobley with Wells Fargo. Your line is open.

Hey everyone, good afternoon. Thanks for taking my question. I wanted to ask about the news around export restrictions from the U.S. Commerce Department targeting China and about half a dozen supercomputer companies. I realize not all those are focused on developing processors, but presumably a handful are Cadence customers. With respect to those specific customers or any other export restrictions, how has that impacted your ability to do business in China?

Let me answer that first. We clearly will continue to comply with all export control regulations including military end-user rules and the lists you've mentioned. We are not going to comment on specific companies, but everything we know we have already built into our guidance.

Okay. And John, can you confirm if roughly $190 million as reported in your cash flow statement was the amount paid for NUMECA in the first quarter, and how much you would expect from both Pointwise and NUMECA as contributors to 2021?

Nice try, Gary. We're not disclosing those amounts separately, but we're very pleased with both acquisitions and delighted to have them as part of the Cadence family.

All right, thank you guys.

Our next question comes from the line of John Pitzer with Credit Suisse. Your line is open.

Yes, good afternoon. Thanks for letting me ask the question. I wanted to go back to your commentary about some of the headwinds you see this year. I understand the COVID India issue. I'm still a little confused by the royalty commentary because even though we're in a capacity-constrained market, unit volumes and revenue should be up pretty significantly year-over-year for the industry. Can you help me better understand what's causing that royalty headwind in your volume-based businesses?

Yes, John, good question. Last quarter I thought for the year royalties might be flat because of unit volumes. We weren't expecting an improvement in unit volumes. In Q1 our royalty revenue was flat compared to Q1 2020, but looking out over the next three quarters and after a detailed analysis, the mix of customers from whom we generate royalty revenue suggests we'll be slightly down now. That headwind is built into our forecast. I don't mean this as a commentary on the entire industry, it's just in relation to the customers from whom we recognize royalty revenue and their expected unit volumes.

Is there any way to characterize the end market those customers play in, or is that a level of detail you are not going to give?

No, we can't give that, sorry.

No, that's helpful. And as my follow-up, maybe another way to ask about China: when you think about the full-year guide, how have you modeled China? I understand the geographic mix broadened out in the current quarter—China was down significantly—and some investors are concerned that the second half of last year represented a pull-forward. As you think about the full-year guide, any broad strokes on how you feel China trends for the rest of the year?

For China we've basically assumed a mean reversion back to our normal mix of business between upfront and recurring revenue. In the second half of last year we had more upfront revenue than average, particularly in China, and I wasn't comfortable extrapolating that for all of 2021 because it looked like an anomaly. For guidance purposes, and to be conservative, we assumed a reversion to our normal recurring revenue mix, which is typically in the 85% to 90% recurring range for the company, even though China can be slightly more upfront. My expectation is China is hard to predict but likely somewhere in the 12% to 13% range for revenue and that's what we embedded into the guide. We'll have better visibility in the middle of the year and we'll update then.

Perfect. Very helpful. Thank you, John.

Our next question comes from the line of Tom Diffely with D.A. Davidson. Your line is open.

Yes, thank you and good afternoon. Maybe John, one more question on the really strong quarter for hardware. Did the incentives impact your margins at all in the quarter in any meaningful way?

I would say it did naturally. The extra revenue boosted margins in Q1 at the expense of Q2, but that is more a shift between one quarter and the other. The delay in hiring also benefited Q1 and the year. We expect to catch up with hiring, but because we didn't hire in Q1 as quickly as we thought, those savings are present in Q1 and the year.

I was wondering more if the incentives included discounts so the pricing went down in the first quarter.

No, the incentives I was talking about were more sales incentives for our sales team, not customer discounts.

Okay. And then a longer-term question for Anirudh or Lip-Bu: when you look at node transitions in the industry and whether they happen every two years or every three years, how impactful is that duration between nodes for you if underlying demand is still strong?

I can start first and then Anirudh can add on. Clearly I think the complexity and the dynamics of the demand are very strong on this generation of nodes. We don't see any slowdown in design activity. In terms of process node migrations, we're marching forward down to 5-nanometer in production and 3-nanometer in design—engagements are happening right now. Each node is a new opportunity for us and we are heavily investing in that.

Thank you, Lip-Bu. One exciting thing is that node transitions are continuing and from an R&D standpoint we are working on 2-nanometer now. 3-nanometer is early design activity, but promising is that multiple foundries are doing these advanced nodes. The industry overall seems healthy. We see multiple foundries working on advanced nodes and that coupled with 3D ICs means a lot of design activity. If a foundry comes out with a new flavor of the same node, that's helpful depending on customer adoption; the R&D work for a variant of the same node is typically less than for a completely new node. Overall, it depends on customer choices, but we're seeing a lot of activity.

So when a fab comes out with a new flavor of the same node, that's almost as helpful to you as a new node would be?

It depends on customer adoption. The work for variants is less than for a new node. It depends on what customers choose based on their requirements.

Okay, thank you.

Our next question comes from the line of Pradeep Ramani with UBS. Your line is open.

Hi, thanks for taking my question. I have a couple on System Analysis. Now that you've had NUMECA and Pointwise, do you feel like you have the distribution you need to scale both NUMECA and Pointwise together, or do they have to be finally bolted onto a Cadence platform in an integrated mode? If so, what do the R&D investment and go-to-market time horizons look like? Is it a one-year thing or a longer-duration investment cycle?

That's a great question. We feel pretty good about Pointwise and NUMECA; they have good technologies and scale and we can scale them more with our sales force and customer connections. At the same time we will enhance them with our organic technologies in parallel and distributed computing. We'll definitely enhance them further. All these investments are built into our guidance and we feel good already. We have significant R&D investment in System Analysis from Clarity and other products, so we feel we have capabilities to scale in the CFD market.

Okay. And as my follow-up, in terms of AWR, can you update us on how AWR is doing in terms of customer traction and year-over-year growth as part of the System Analysis business?

Definitely. Our System Analysis business is up significantly year-over-year, close to 30% comparing Q1 this year to Q1 last year. AWR is a key part of that. Some of the growth is from M&A, but organically also AWR and other acquired products are growing well. As mentioned in Lip-Bu's comments, Qualcomm expanded use of AWR and Clarity. We don't break out each product separately, but overall they're growing well and we are happy with the AWR and Integrand growth after acquisition because we can provide a more complete solution along with Virtuoso and Clarity.

Thank you.

Our next question is coming from the line of Ruben Roy with WestPark Capital. Your line is open.

Thank you. John, a quick follow-up on the chip supply situation. You're talking about impacts on your full year and you've given full-year guidance for 2021. Commentary from the industry has been all over the place on when we might see some improvement, with some folks thinking as soon as the second half. Do you have any perspective on when we might see improvement in supply and when that might impact your business? Is that more of a 2022 event?

The forecast my team provided shows some softness in Q2 and Q3 for the particular mix of customers from whom we generate IP royalty revenue, with recovery in Q4. I don't mean for this to be a commentary on the industry at large; it's just the mix of customers that generate royalty revenue for us.

Okay, I appreciate that. I'm trying to get as many data points as I can. A quick follow-up for Anirudh or Lip-Bu: your customers and foundries—large North American customer activity and partnerships with you and your competitors—do you have any perspective to add on what's going on here with that customer and if you're seeing any benefits coming from things like onshoring or changes in foundry strategy that will impact your business over the next several years?

Manufacturing in the U.S. is a welcome development and any new foundry or expansion is good for us in terms of tool and IP enablement. We are excited about the opportunity; increased local capacity will increase design activity and meet customer requirements for advanced nodes and packaging. Overall, this is a positive development and we welcome the opportunity to provide design and IP enablement.

All right, thank you Lip-Bu.

Our last question comes from the line of Vivek Arya with Bank of America. Your line is open.

Lip-Bu, I wanted to follow up on your commentary about U.S. manufacturing. If there is more U.S.-based manufacturing, packaging and related activity, is that incremental to your business or is it a substitute for what you're doing in other regions?

It's hard to tell precisely, but I think overall it should be a net increase. We have deep partnerships with TSMC and Samsung; anything new and additional capacity will create more IP and optimization work and require process design kits, so I think overall it will be a net improvement for us. We're happy to help customers move to new foundries—this requires different tools and optimization and overall it's positive for Cadence.

Got it. Very helpful. And John, one for you on operating margin. Q1 was about 38% and you are guiding Q2 to about 36%, and the full year to 35% to 36%—suggesting the back half will be lower. How are you thinking about leverage in the model and, more importantly, when do you think you can get back to that 50% incremental margin rule you were able to achieve before?

Good question, Vivek. We don't see a near-term ceiling on operating margins. Even with the outlook at 35.5% at the midpoint, I think we're at roughly 50% incremental margins comparing 2021 to 2019. As long as we're delivering incremental margins of 50% that's where the operating leverage is. The reason operating margins are slightly lower in the second half is the combination of two acquisitions and delayed hiring activity into the second half, and we also have a merit cycle that kicks in July 1. With all that said, we're heavily investing in building out a multiphysics platform for the future and I believe there is no near-term ceiling to that operating leverage.

Got it. Thank you.

Ladies and gentlemen, that's all the time we have for questions today. I would now like to turn the call back over to Lip-Bu Tan for closing remarks.

Thank you all for joining us this afternoon. I'm very excited about the growing market opportunity and the business momentum so far in 2021. Our Intelligent System Design strategy is playing out very nicely as we benefit from the new opportunities in Design Excellence, System Innovation and Pervasive Intelligence and an expanded total addressable market. I'm very pleased also to share that Fortune and Great Place to Work have honored us as one of the 2021 100 Best Companies to Work For, which marks Cadence's seventh year being named to this prestigious list. Cadence was recognized as one of the best companies to work for thanks to our outstanding people-first culture and our history of innovation. Lastly, on behalf of our employees and our Board of Directors, we want to thank our customers and partners for their continued trust and confidence during this unprecedented time.

Fortune and Great Place to Work honored us as one of the 2021 100 Best Companies to Work For, marking Cadence's seventh year on this prestigious list. Cadence was recognized as one of the best companies to work for because of our outstanding people-first culture and our history of innovation. On behalf of our employees and our Board of Directors, we want to thank our customers and partners for their continued trust and confidence during this unprecedented time.