Cadence Design Systems Inc Q4 FY2021 Earnings Call

Good afternoon. My name is Jumyria, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Fourth Quarter 2021 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. 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, Jumyria. I would like to welcome everyone to our fourth quarter and fiscal year 2021 earnings conference call. I am joined today by Anirudh Devgan, President and 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 March 18, 2022. 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. Due to known and unknown risks and uncertainties, actual results may differ materially from those projected or implied in today's discussion. 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 and the cautionary comments regarding forward-looking statements in today's earnings press release. And please note that our 2021 Form 10-K was filed about 1:30 today, Pacific Time. You should not rely on our forward-looking statements as predictions of future events. All such statements are based on estimates and information available to us at this time, and Cadence disclaims any obligation to update any forward-looking statements, except as required by law. In addition to the 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 GAAP results. These non-GAAP financial measures are not based on any standardized methodology prescribed by GAAP and may not be comparable to similarly titled measures from 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 in today’s earnings press release. Copies of today's press release dated February 22, 2022 for the quarter and fiscal year ended January 1, 2022, related financial tables and the CFO commentary are also available on our website. For the Q&A session today, we’d also 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. Now, I will turn the call over to Anirudh.

Good afternoon, everyone, and thank you for joining us today. I'm pleased to report that Cadence delivered outstanding financial results for 2021. We exceeded our original growth target, achieving 11% revenue growth, 37% non-GAAP operating margin and operating cash flow of over $1 billion. Generational trends such as 5G, hyperscale computing, and AI/ML are propelling the digital transformation of multiple end markets and fueling a golden era for semiconductors and electronic systems. With robust design activity providing a strong tailwind, we expect our innovative solutions to continue driving broad-based business momentum in 2021 and 2022, accelerating revenue growth and profitability. John will provide more details in a moment. Our Intelligent System Design strategy triples our total available market. And our compelling portfolio of chip, package, board and system design solutions, leveraging our computational software expertise, uniquely positions us to capture a wide range of exciting opportunities. During the year, we significantly expanded our core EDA and IP solutions footprint with market-shaping customers, as new customers accelerated their adoption of our expanding systems portfolio. We deepened our partnerships with leading foundry, IP and cloud service providers and launched key strategic initiatives. Earlier today, we announced an exciting strategic partnership with Dassault Systèmes that brings together Cadence Allegro and Dassault's 3DEXPERIENCE platform to provide virtual twin experiences for optimizing the entire value chain for electromechanical system modeling, design, simulation and product lifecycle management. Central to our strategy is the relentless commitment to innovation. In 2021, we introduced 13 significant differentiated products across our business groups that will be key to our future growth. Now let's talk about some of the product highlights for both Q4 and 2021. Our Digital and Signoff business had another strong year with 10% revenue growth. Deployment of our digital full flow, delivering industry-leading quality of results at the most advanced nodes, continues to accelerate as more than 45 additional customers adopted it during the year. In 2021, we strengthened our relationship with Oppo, a leading mobile phone manufacturer in China, with our digital full flow and an expansion of our system design and analysis products. We expanded our relationship with Socionext, who used our digital full flow, delivering the best quality of results to successfully tape out several advanced node automotive and hyperscaler designs. Our transformative Cadence Cerebrus solution incorporates sophisticated machine learning technologies to explore the entire design space and intelligently optimize the digital full flow in an automated manner. Several leading customers are increasingly deploying Cadence Cerebrus in production designs and gaining exceptional power, performance, area and productivity benefits, including a market-shaping U.S. automotive company that reduced the power consumption of critical 5-nanometer SoC AI blocks by nearly 10% in just two weeks. Additionally, a premier Asia Pacific system company reduced power of their 4-nanometer design by 10% with one-tenth the effort of manual optimization and then applied the Cadence Cerebrus-trained ML model to other designs, further improving their power and productivity. Cadence Cerebrus enabled a marquee U.S. semiconductor company to tape out their next-generation SoC with a 5x productivity improvement on several critical blocks. Rapidly escalating system verification and software bring-up challenges continue to drive heavy demand for our verification full flow solutions, delivering the industry's leading verification throughput. Our verification business grew 20% year-over-year, fueled by a record year for hardware. Our next-generation Palladium Z2 and Protium X2 platforms provide best-in-class solutions to address system verification and software bring-up challenges of complex multibillion-gate designs. Demand for these platforms that were launched earlier last year has greatly exceeded our expectations, as customers quickly embrace their superior performance, capacity and debug capabilities. The compelling value offered by the common front-end compiler led to more than half of our customers purchasing both Palladium as well as Protium platforms during the year. Our hardware family added over 30 new customers and over 100 repeat orders during the year, with particular strength seen in hyperscaler, mobile and networking verticals. Our verification software product, which includes the Xcelium Logic Simulator and Jasper Formal Verification Platform, continues to proliferate, with Jasper having an exceptional year, adding 40 new customers with particular strength in compute and hyperscale. Today's complex memory and mixed-signal high-frequency design underscore the need for high-performance and very accurate circuit simulation. Our Spectre platform has been a long-standing leader in simulation technology solutions for analog and RF design. With the recent addition of Spectre FX, our next-generation FastSPICE simulator for memory and large SoC design, we provide the industry's most advanced comprehensive cross-domain circuit simulation platform. Several leading customers have already deployed Spectre FX on their production designs. For example, SK Hynix has successfully evaluated and deployed the Spectre FX simulation solution to improve their design methodology and productivity in DRAM verification. Micron adopted Spectre FX simulators, as it gave very compelling FastSPICE simulation performance for accurate verification of DRAM and flash designs. In 2021, our IP business grew in multiple vertical markets, including mobile, 5G, hyperscaler and automotive. Our leadership DDR and PCI IP portfolio continue to proliferate at the 5-nanometer and lower process nodes, and our design IP portfolio had several wins at top customers, including a significant expansion at a marquee U.S. semiconductor company. Our Tensilica DSP portfolio continued expanding its footprint in audio, imaging, computer vision and ML applications. During the year, we introduced the Tensilica AI platform, delivering scalable and energy-efficient on-device to edge AI processing. Pricing and system complexity for advanced 5G, automotive, and HPC applications is driving the need for a seamless platform solution across design, simulation and analysis. Our System Design and Analysis business, which is driving our expansion beyond EDA, continued its strong momentum, delivering 18% year-over-year growth. There is rapidly growing demand for sophisticated multi-die integration and packaging solutions, and our revolutionary Integrity 3D-IC solution, providing tightly integrated system planning, implementation and analysis technology, has been gaining strong customer traction. Our Integrity 3D-IC platform was recognized at TSMC's OIP ecosystem forum by winning Partner of the Year Award for joint development of 3D Fabric design solutions as well as winning a customer choice award for 3D-IC design. Last year, we furthered our system analysis strategy by building out a disruptive, comprehensive multiphysics platform through the acquisitions of NUMECA and Pointwise. The integration has gone well and we have added nearly 100 new logos, including competitive wins across multiple end markets, notably in aerospace and defense. We expanded our collaboration with Schneider Electric, a leader in digital transformation of energy management and industrial automation, as they standardize on Allegro X platform for PCB design as well as adopting our Clarity Solution for system analysis. In Q4, we significantly strengthened our partnership with EDI, with a wide-ranging expansion of our EDA product, along with deployment of our System Design and Analysis solutions, which will enable them to develop more complete end-to-end solutions for their customers. Butterfly Network leverages our Clarity 3D solver for advanced mobile ultrasound design. Lastly, usage of our Cadence Cloud portfolio continued to scale with over 250 customers using our solutions in the cloud. Cadence Cloud-ready products are enabling our customers to realize meaningful scalability, performance and productivity benefits through the availability of several flexible use models. Now, I will turn it over to John to provide more details on the Q4 results and our 2022 outlook.

Thanks, Anirudh, and good afternoon, everyone. I'm pleased to report we exceeded all of our key operating metrics for the fourth quarter and fiscal year 2021. The underlying strength in demand for our essential technology and solutions continues to drive consistent growth across the business. A strong finish to 2021, combined with our relentless focus on innovation, customer success and inclusive employee culture and continued execution, helped Cadence to achieve revenue growth of 11% and the fifth consecutive year of non-GAAP incremental margin of greater than 50%, which contributed to an increase in our operating cash flow to $1.1 billion for the year. Here are some highlights from the fourth quarter and the year, starting with the P&L. Total revenue was $773 million for the quarter and $2.988 billion for the year. Non-GAAP operating margin was approximately 36% for the quarter and 37% for the year. GAAP EPS was $0.63 for the quarter and $2.50 for the year. And non-GAAP EPS was $0.82 for the quarter and $3.29 for the year. Next, turning to the balance sheet and cash flow. Our cash balance was $1.09 billion at year-end, while the principal value of debt outstanding was $350 million. Operating cash flow in the fourth quarter was $216 million and $1.10 billion for the full year. DSOs were 40 days and we repurchased $61 million of Cadence shares during the year. Before I provide commentary for Q1 and fiscal 2022, I'd like to take a moment to share the assumptions embedded in our outlook. Our outlook assumes a non-GAAP tax rate of 17.5%. At the midpoint of our 2022 outlook, we are assuming our annual upfront revenue percentage will increase slightly from 2021 to 2022. This is primarily due to higher upfront revenue in Q1, resulting from a very strong hardware bookings finish to 2021. And finally, our outlook assumes that the export limitations that exist today will remain in place for all of 2022. Embedding these assumptions into our outlook for fiscal 2022, we expect revenue in the range of $3.32 billion to $3.38 billion, non-GAAP operating margin of 37.5% to 39%, GAAP EPS in the range of $2.46 to $2.56, non-GAAP EPS in the range of $3.70 to $3.80, operating cash flow in the range of $1.15 billion to $1.25 billion. And we expect to use at least 50% of our free cash flow to repurchase Cadence shares in 2022. For Q1 2022, we expect revenue in the range of $850 million to $870 million. Non-GAAP operating margin of 40% to 41%, GAAP EPS in the range of $0.70 to $0.74, non-GAAP EPS in the range of $1 to $1.04. And we expect to repurchase approximately $250 million of Cadence shares in Q1. 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, I would like to take a moment to acknowledge the entire Cadence team for continuously improving our 3-year revenue growth CAGR and delivering over 50% incremental margin for 5 years in a row. As a result of the compounding impact of all their efforts, I am pleased that at the midpoint of our outlook, we expect revenue growth of 12% and over 38% non-GAAP operating margin for 2022. As always, I'd like to close by thanking our customers, partners and our employees for their continued support. And with that, operator, we'll now take questions.

Your first question will come from the line of Joe Vruwink with Baird. Please proceed with your question.

Great. I wanted to start. In the past, Cadence has alluded to certain product segments maybe having a faster growth opportunity over the course of an upcoming year. I'm curious if maybe you could give an updated rank ordering. And I guess two questions. One, on maybe the growth a bit more towards verification in 2022, given the ongoing new product cycle you alluded to? And then maybe 1b to this question. Is there any region that might contribute outsized growth for Cadence over the coming year?

Yes, Joe, this is a great question and let me start and John can comment more. I think what I would like to say is that we feel that all business groups in all product areas and all regions are performing well at this time. So we feel pretty good where we are in the design activity we see. We are expecting good growth across our portfolio. And I think we feel good about how we are positioned.

Yes, Joe, I would add to that that if you look at the CFO commentary on Page 5, we've outlined the 3-year revenue CAGR by product category. I find that the most interesting view for me because it's typically one contract cycle with customers. If you look at how we finished 2021, you have strong double-digit growth across all lines of business with the exception of Custom IC, which is high single-digit growth. Looking at the guide that we have for 2022, I'm expecting slight improvement on all of those for 2022 over 2021. The one I've hedged back a little bit is IP. I've got low-teens growth in the guide for IP for 2022. There may be upside to that, but right now, I feel comfortable with low-teens.

Okay. That's great. And then just on the outlook and maybe more of a midterm focus question, but if I leave Q1 aside, given the elevated upfront product contribution, it seems like the rates of growth for the remainder of the year are not too far from these three-year CAGRs. We're talking about 11%, 12%. As you kind of think mid-term, and we've gotten some midterm frameworks from some of your peers in the space, would you expect Cadence to deviate that much from kind of these 11%, 12%, 13% rate of growth? As you say, you seem to have quite a good degree of visibility, so it seems like it may be sustainable, but curious on your thoughts there.

Yes, I can take that, Anirudh. So on that, Joe, I think you're right to assume that. We're expecting a very strong Q1, and we have a lot of visibility into core EDA. We continue to expect double-digit growth there. I called out IP. IP, we typically aim for low-teens. If you look at the three-year CAGR, we've achieved mid-teens in that, but we typically aim for low-teens, because we're looking for the highest level of sustainable, profitable revenue growth there. I don't want to give the team the opportunity to walk away from some business if it's not the profitable nature we want. And then on System Design and Analysis, we've typically driven to kind of high-teens there. I kind of expect that. The challenge in terms of visibility is on the upfront business, on the functional verification side and on the hardware side; it's tough to have visibility into the second half of the year until we get to the summer.

Okay. Very helpful. Thank you.

Your next question will come from Charles Shi with Needham & Company. Please proceed with your question.

Good afternoon and thank you for taking my question. Maybe as we exit 2021, could the management team kind of provide us an update on how much of your revenue is coming from system companies versus semiconductor companies? How does that number stack up with previous years?

Charles, I think what we say is that about 45% of our revenue is coming from system companies versus semiconductor companies. Over the years, that has increased — it used to be 40%, now trending toward 45%. As you know, more and more system companies are doing silicon, and semiconductor companies are becoming more system companies and vice versa. So that is a good trend for us and for the industry. Our product portfolio is also adding more system design and analysis products, which makes us work more with system companies. So that's a trend that is positive, and I expect it to be especially positive for Cadence in the future.

Got it. So maybe the next question is really to John Wall. I think your first quarter guidance operating margin is well north of 40%. I know you have this metric you called out, 50% flow-through for incremental margin. As your operating margin gets to the 40% plus, at one point your margin expansion, if you don't change that target, the 50% flow-through is going to moderate at some point. I just wonder any thoughts, updated thinking here, when do you think you want to raise that flow-through rate? Thank you.

Yes, Charles, good observation. We're very pleased with the fact that our incremental margins have come through at over 50% for five years running now. It's actually averaged 55% over those five years. I'm delighted that the start for this year, the incremental margin we've embedded in our outlook is the highest on record for Cadence on an outlook basis. We're certainly targeting to try and drive that up to 50% and higher again for this year. But as long as we're driving incremental margins that are higher than the underlying margin, we'll continue to see operating margin expand.

Got it. Thank you.

Your next question will come from the line of Jackson Ader with JPMorgan. Please proceed with your question.

Good evening, guys. Thanks for taking my questions. On the System Design and Analysis side, the growth rate in that product segment came down pretty steadily and precipitously through the year. So I'm just curious what gives you the confidence to go from this fourth quarter growth rate in the low single digits back to that low double digits that might be embedded in the outlook?

Jackson, this is John. That's one of the easier ones to forecast given that we're mostly recurring revenue in that segment. And like you said, we've embedded high-teen growth into the guide there. Most of this is coming from recurring revenue.

Okay. Great. Easy enough. And then on the partnership with Dassault, just curious what the commercial relationship will actually look like? And I guess I would have thought that maybe Cadence was already trying to go from your PCB Allegro business to 3D electromagnetics. How does this all fit together and what does your organic electromagnetics business fit into the puzzle?

Yes, that's a great question. I'm really excited about this partnership with Dassault because this is two leaders in their respective spaces coming together to address the problem that is becoming more and more important: where the industry is going. The market is moving toward mechatronics — a combination of mechanical and electronic with software and data — and then silicon driving all these engines. From the mechanical side, whether it's a car or a washing machine or an airplane, the first electronics you see is the PCB, and then the chip, package and chip again. With Allegro, our position in PCB gives us a great platform, and we also have chip and package solutions. Dassault is the leader in 3D mechanical design and product lifecycle management. This is a natural combination to do seamless integration of data and applications that span from concept to design to manufacture. It's a broad-ranging, multiyear partnership, and we are at the beginning of it. Regarding electromagnetics, that's one specific application we have and are developing, but there are many things Dassault does that are orthogonal to Cadence, such as 3D mechanical design and PLM. So there is good synergy between the two leaders coming together to address mechanical plus electronic systems.

All right. Thank you.

Your next question will come from the line of Jay Vleeschhouwer with Griffin Securities. Please proceed with your question.

Thanks. Good evening. Anirudh, we've seen over the last 6 to 12 months a quite material increase in semiconductor R&D spending for a number of the large semiconductor companies. We call it the great inflection in R&D. When we look at numbers from AMD, Intel, NVIDIA, Qualcomm and so forth, to the extent that EDA perhaps as a percentage of semi R&D has held steady or even increased in recent years, would it be fair to say that a good part of this inflection in R&D has already been reflected in your business, hence your $500 million increase in backlog over the past year? And is that what accounts for at least part of your accelerated growth expectation for 2022? The second question: you've had a recurring theme in your technology development for the last number of years of commonality and integrations across the product line. Could you mention perhaps which of the integrations, whether organic or via acquisition, might have been the most meaningful for you in terms of incremental business? For example, AWR and Allegro or anything else you might care to mention.

Yes, Jay. As you know, R&D spending includes semiconductor and also system companies doing semiconductor design, which is adding to the strength. Our portfolio is increasing beyond traditional semiconductor to system design and analysis as well. All these factors are contributing to the strength, and I see a lot of design activity continuing to be very strong across multiple regions and verticals. On the second part of your question regarding integration, we believe we have to provide complete solutions. The industry has to move beyond point tools to more comprehensive solutions. We've driven that across all segments, from digital implementation to verification to system design and analysis. We also partner with leaders where it makes sense, like we did with MATLAB a few years ago and now with Dassault. In terms of integrations that are meaningful, there are several areas growing: 3D-IC and chiplet-based design, where our Integrity solution and system analysis provide value; the whole hardware platform family, Palladium and Protium, with a common compiler integrated with the rest of the verification suite; and Cadence Cerebrus, the integration of AI driving chip design. These three — 3D-IC design, verification and software bring-up with hardware, and AI-based design with Cerebrus — are particularly significant.

A clarification on the Dassault relationship. Would it be fair to say that it pertains to both your direct and indirect channels and perhaps both their direct and indirect channels?

Yes, Jay. This is a wide-ranging arrangement, and it will start with enterprise and then go to the other parts of the market.

Thanks Anirudh. Thanks John.

Your next question will come from the line of Pradeep Ramani with UBS. Please proceed with your question.

Hey thanks for taking the question. Congratulations on the strong results. I had a question about the trajectory of margins through the year. It feels like very strong guidance in Q1, despite what you could argue is a very big hardware quarter. The full year margin guide at the midpoint is roughly 38.5%. Is there something going on with the mix? Maybe it's a big IP back half, or is the guidance just conservative? Can you help us understand that trajectory? I have a follow-up.

Sure, Pradeep. On the revenue split, I've modeled it so the first half versus second half is probably around 50% revenue in the first half versus the second half. On the expense side, it's probably 49 and 51 because we typically do our pay increases and promotion cycle effective July 1. So you'll probably see margins higher in the first half compared to the second half, and then we continue to improve efficiency through the year so that we start the next year higher than the previous year. On the hardware side and the upfront piece, that's certainly benefiting Q1. It's a pipeline business, so it's tough to see into the second half, and the second half may be conservative right now. I don't know.

And for my follow-up on hardware, can you speak to maybe where you are with respect to penetration? I know visibility into the second half is not clear, but in terms of penetration with respect to the installed base and your growing customer base, where do you think we are as of Q1?

Let me take that on the hardware business. There are two big trends helping us. One is the market is growing: hardware-based verification and software bring-up is increasing across multiple verticals because more semiconductor companies become system companies and more system companies design semiconductors. The second is our competitive position is improving tremendously. Historically, we participated less in prototyping and more on the Palladium side, but now with the combination of Palladium and Protium and these new systems, we feel strongly about our positioning in the market. So the market will continue to expand over the next few years, and we feel good about our market position. It's difficult to predict exactly how far into penetration we are, but both market growth and our position are net positives.

Thank you.

Your next question will come from the line of Gary Mobley with Wells Fargo Securities. Please proceed with your questions.

Hey, guys. Hope all is well. Thanks for taking my question and congrats on a strong finish to the year and a strong start to fiscal 2022. I wanted to give a little bit of a pushback on your fiscal 2022 guide. If I look at your next 12-month backlog as disclosed in your 10-K, it's up about 18.5%. If you back out the extra week from fiscal year 2022, you just grew 13.3%. How do the assumptions that the backlog didn't increase as a result of the hardware sales you're expecting in the first quarter square with the conservative view on fiscal 2022 revenue growth?

Great question, Gary. There's nothing unusual about the structure of backlog. We have about 75% of the guide for next year's revenue coming out of backlog. Our backlog includes RPO plus IP access arrangements. About $2.5 billion of the roughly $3.3–$3.4 billion guide is coming out of backlog, in round numbers.

That’s helpful. Going back to the end of 2019, I think leadership pulled in some license renewals when projecting a recession. Now we're about two-and-a-half years past that mark. Should we expect to see some higher level of renewal activity given that we're around the two-and-a-half-year mark?

Generally, most of our customers are predominantly on a three-year baseline contract, and they'll do add-ons throughout the contract that co-terminate, which results in roughly a two-and-a-half-year average duration on a weighted basis. RPO was up; we had a very strong finish to the year ending at $4.4 billion. The only unusual thing I called out in my prepared remarks was a slightly higher upfront revenue percentage in the guide than in the prior year. Typically 85% to 90% of our revenue is recurring, 10% to 15% is upfront. Last year, it was 88% recurring and 12% upfront; in the guide it's about 87% recurring and 13% upfront — a 1% increase in upfront revenue, much of which falls into Q1, which is why Q1 is strong.

Got it. That’s helpful. Thank you.

Your next question will come from John Pitzer with Credit Suisse. Please proceed with your question.

Yes, guys, thanks for letting me ask a question. Congratulations on the results. John, maybe to follow up on Gary's question a little differently: if Q1 and the full year play out as guided, Q1 will be about 25.6% of the full year guide, which historically would be the highest ever. I know the linearity of some of the hardware stuff is falling in Q1, but is the SKU such that this could be a historic year? And as you think about visibility into the back half, especially around hardware sales, when would that start to materialize one way or the other?

I do think it's going to be a historic year. You can see from the guide that the three-year CAGR continues to accelerate. With 12% revenue growth embedded in the guide for 2022, the three-year CAGR rounds up to 13%. The guide is off a strong Q1. The second half is tougher to predict for hardware, which is why I modeled it with about 50% of revenue in the first half versus the second half. If demand continues to flow into the second half, that would take the guide up. Typically our visibility in hardware and the pipeline is about six months, and that's how we constructed the outlook.

I'm wondering if you could help me better understand the impact of AI in the design process. What percent of designs are intended to be impacted by more AI functionality embedded in design? Is it higher velocity, higher variety? Is it bringing down entry cost for new customers? What would be the longer-term impact you see on the design business and the growth rate there?

That's a good question, and you've made several key observations. AI is still in the early innings, but demand for Cadence Cerebrus and AI solutions is phenomenal. We are engaged with almost all of our major customers. Over the next 12 to 24 months, it's not a question of who is using AI-driven design but who isn't. Most of our top customers are moving toward that, and we're seeing phenomenal results: power and timing improvements comparable to what you'd get moving process nodes. The value proposition is well understood and recognized by customers across regions and verticals. The benefits are significant, mainly in productivity: customers can do more with the same number of engineers, and it helps where there are varying skill levels across geographies. I expect Cerebrus and AI to become primary drivers of how people design chips. Also, even though we started Cerebrus with digital, similar technologies can be applied across the design flow, which could provide big benefits to the industry.

Anirudh, not to push you too far on a three-year CAGR that's been accelerating, does the addition of AI allow you to maintain the gains you've made, or does it actually open the promise of even faster growth ahead?

I think the promise is there. We have to see how much of the design process is taken over by AI. Another point is that when functions are automated with Cerebrus, we run many experiments in parallel; it's not just one experiment. We typically run 10 to 20 experiments in parallel, each using multiple CPUs, so you're running hundreds or thousands of CPU hours and multiple design iterations in parallel. That naturally consumes more licenses, which is good value for customers. In terms of CAGR, we need to observe the effect on license counts and utilization and what percentage of design teams move to an AI-driven flow. We'll update you more over the next 12 to 24 months.

Perfect. Thanks, guys.

Your next question will come from Gal Munda with Berenberg. Please proceed with your questions.

Good afternoon. Thanks for taking my questions. First, on Cerebrus: how do you capitalize on it in terms of contract size and negotiations? Does it increase contract value and pricing, or do you include it as a new SKU that goes in as a direct uplift to existing contracts or does it help in contract renewal? When do you usually engage customers on it?

Cerebrus is a new product. We ensure the base products are best-in-class; the Innovus platform and Genus are the whole digital flow. Cerebrus is an additional capability and is an add-on sale on top of those. When customers run Cerebrus, they run multiple copies of Innovus or our digital full flow in parallel.

Would it increase usage of the core products because you could run more experiments in parallel, expanding the bottleneck and potentially requiring more of the basic products as well?

Absolutely. When you run Cerebrus mathematically, you run many parallel experiments. When running manually, you run one or two. So naturally it increases use of the base products.

And as a follow-up, you've been talking about the systems segment outgrowing other segments and posting strong performance. In terms of verticals, you mentioned auto and hyperscalers. How important is auto today versus other verticals, and what kind of growth do you see in auto specifically?

Auto has multiple aspects. Cadence has traditionally done well with auto semiconductor design because auto chips are often mixed-signal and we have broad capabilities. With our expanded product set like CFD and system analysis, auto is an important segment beyond just semiconductor components — including physical car modeling, electromagnetics and thermal dynamics. For example, Tesla is a key customer. Three big markets for our system analysis are auto, aerospace & defense, and high-tech electronics/hyperscalers. As we expand our system portfolio, we aim to do well across all three. The Pointwise acquisition is particularly strong in aerospace and defense. With the Dassault partnership, we further amplify connections into auto beyond semiconductors into mechanical and system design.

Perfect. That's very helpful. Thank you.

Your next question will come from Vivek Arya with Bank of America. Please proceed with your questions.

Thanks for taking my question. Anirudh, I'm curious: with the foundries increasing leading-edge pricing, is that pricing some EDA customers out of the leading edge or making them stay at N-1 nodes or be more judicious about using the most leading-edge process, given expense? What's the correlation between foundry cost inflation and customers' willingness to engage in leading-edge designs?

We support the whole range of process technology. We're working at the most advanced nodes like 3 nm and beyond while continuing to support legacy nodes and RF and 3D-IC. In 3D-IC and chiplet-based design, customers mix process nodes — some chips at 3 nm, some at 7 nm. From Cadence's standpoint, the key is to have a broad solution addressing chiplet and 3D-IC, advanced digital, and mainstream legacy nodes. Customers will choose what's best for their end markets and economics, and we are positioned to support their choices across foundries and process nodes.

That's helpful. A follow-up for John: the earnings growth you're guiding to this year is 14%, but free cash flow growth is modest at 4%; CapEx is doubling. Is free cash flow growth modest because of CapEx, and relatedly, if you are spending a large portion of the buyback allocation in Q1, does that mean buyback activity is modest for the rest of the year?

On buybacks, our first priority is organic R&D, then smaller tuck-in M&A, and then repurchasing shares. We aim to use at least 50% of free cash flow to repurchase shares each year. We're planning to repurchase $250 million in Q1, which is more than 50% of expected free cash flow on a quarterly basis, and we're taking advantage of prices we see today. Regarding free cash flow, some timing of cash and extra cash taxes affect the number. Due to tax rules effective January 1, 2022, certain items that were previously expensed must be capitalized and amortized, which creates a bit of extra cash tax burden in 2022, and we've embedded that in the guidance.

Thank you.

We have reached the end of the allotted time for questions and answers. I would now like to turn the call back over to Anirudh Devgan for closing remarks.

Thank you all for joining us this afternoon. It's an exciting time for Cadence as we enter 2022, with strong business momentum and a thriving semiconductor and system industry offering tremendous market opportunity. Our Intelligent System Design strategy, relentless execution and customer-first mindset are driving accelerating growth as we continue expanding our portfolio with new innovative solutions. We are proud of the innovative and inclusive culture we have built at Cadence and are grateful for the recognition we have received over the years. On behalf of our employees and our Board of Directors, thank you for your continued trust and confidence in Cadence. Thank you.

Thank you for participating in today's Cadence Fourth Quarter 2021 Earnings Conference Call. This concludes today's call. You may now disconnect.