Earnings Call Transcript - CDNS Q3 2025

Operator, Operator

Ladies and gentlemen, good afternoon. My name is Abby, and I'll be your conference operator today. I would like to welcome everyone to the Cadence Third Quarter 2025 Earnings Conference Call. Thank you. I will now turn the call over to Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead.

Richard Gu, Vice President of Investor Relations

Thank you, operator. I'd like to welcome everyone to our third quarter of 2025 earnings conference call. I'm 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 and a copy of today's prepared remarks will be available on our website, cadence.com. Today's discussion will include forward-looking statements, covering our outlook on future business and operating results. Due to risks and uncertainties, actual results may differ significantly from those projected or implied in today's discussion. For information on factors that could cause actual results to differ, please refer to our SEC filings, including our most recent Forms 10-K and 10-Q, CFO commentary, and today's earnings release. All forward-looking statements during this call are based on estimates and information available to us as of today, and we reserve the right to update them. Additionally, all financial measures discussed on this call are non-GAAP unless otherwise specified. These non-GAAP measures should not be viewed in isolation or as a substitute for GAAP results. Reconciliations of GAAP to non-GAAP measures are included in today's earnings release. Now I'll turn the call over to Anirudh.

Anirudh Devgan, President and CEO

Thank you, Richard. Good afternoon, everyone, and thank you for joining us today. Cadence delivered excellent results for the third quarter of 2025, with strong operational and financial performance across all product categories and geographies as we continued the disciplined execution of our strategy. Bookings exceeded our expectations with backlog growing to over $7 billion, underscoring our continued technology leadership and reaffirming Cadence as the trusted partner enabling customer success. Given the ongoing strength of our business, we are raising our full-year outlook to approximately 14% revenue growth and 18% EPS growth. John will provide more details on our financials shortly. The accelerating AI megatrend is fueling an unprecedented wave of design activity across industries ranging from hyperscaler infrastructure to the fast-growing physical AI realm of autonomous driving, drones, and robotics to the emerging domain of sciences AI. As AI drives exponential design complexity and new system architectures, Cadence is uniquely positioned to capture this generational opportunity with a differentiated and comprehensive portfolio spanning EDA, IP, 3D-IC, PCB, and system analysis. The Cadence.Ai portfolio embodies our strategy of design for AI and AI for design, empowering customers to build out the global AI infrastructure, while we infuse AI into our own products to deliver breakthrough automation and productivity. With deep partnerships across AI innovators, foundries, and system leaders, and a comprehensive chip-to-systems portfolio, Cadence is driving transformative PPA and productivity gains, positioning us well for sustained growth in the AI era. In Q3, we meaningfully expanded our partnership with Samsung through a wide-ranging proliferation of our core EDA software as well as our system software across PCB, advanced packaging, and system analysis. We also deepened our long-standing partnership with a leading semiconductor company in Q3 through a broad proliferation of our core EDA, IP, and systems portfolio and are closely collaborating on next-generation agentic AI EDA solutions. We expanded our long-standing partnership with TSMC to power next-gen AI flows supporting TSMC's N2 and A16 technologies. Our Integrity 3D-IC solution provides comprehensive support for the latest TSMC 3DFabric die-stacking configurations. And our design-in-ready IP, including HBM4 and LPDDR6 on N3P-enabled next-generation AI infrastructure. At TSMC's OIP conference, Broadcom highlighted Integrity 3D-IC full flow deployment success for hyperscaler high-capacity ASICs. Our IP business maintained strong momentum in Q3, driven by global accelerating IP demand and increasing customer proliferation of our expanding IP portfolio. Our profitable, scalable IP strategy focused on AI, HPC, and automotive verticals positions us well for continued growth. Increasing complexity of interconnect protocols driven by AI and chiplet architectures, along with new foundry opportunities are providing strong tailwinds to our IP business. Bookings were strong and tracked ahead of our expectations. Our design IP portfolio secured several competitive wins at top AI and memory customers. For instance, we won a highly competitive engagement at a marquee memory company that embraced our HBM4 and DDR5 IP for its new AI design. The recently completed acquisition of the Arm Artisan Foundation IP further augments our design IP portfolio with standard cell libraries, memory compilers, and IOs optimized for advanced nodes at the leading foundries. Our Tensilica audio and vision DSPs and Neo AI accelerator NPUs scored multiple design wins with leading customers in the U.S. and Asia for mobile, automotive, and data center verticals. Our core EDA business delivered strong results, driven by growing adoption of our AI-driven design and verification solutions. In digital, Cadence Cerebrus AI Studio, the industry's first agentic AI, multi-block, multi-user design platform continues to deliver unparalleled PPA and productivity benefits. Samsung U.S. taped out a SF2 design using Cadence Cerebrus AI Studio to achieve a 4x productivity improvement. In another instance, Samsung used Cadence Certus, Tempus, and Innovus to rapidly close and sign off a multibillion-instance AI design on SF4, with 22% power reduction and first-pass silicon success. Our Virtuoso Studio and Spectre platforms saw strong momentum, with their AI-driven features and workflows gaining rapid traction as the customers leverage the automated design migration and optimization capabilities. Our hardware verification platforms have become the de facto choice for AI designs, offering industry-leading performance, capacity, and scalability. Hardware had a record Q3 with several significant expansions, especially at AI and HPC customers. We deepened our overall collaboration with OpenAI, as they expanded their commitment to our Palladium emulation platform in Q3. Verisium SimAI saw growing adoption as it delivered dramatic debug productivity, test bench efficiency, and accelerated coverage closure. NVIDIA, Samsung, and Qualcomm, all presented SimAI success stories at CadenceLIVE India, highlighting 5x to 10x improvement in verification throughput. Our system design and analysis business achieved another solid quarter, driven by expanding sets of innovative solutions and growing adoption across a broadening customer base. In Q3, we significantly expanded our Cadence Reality Digital Twin Platform library, with NVIDIA DGX SuperPOD model and DGXGB200 systems to accelerate AI data center deployment and operations. Three major memory providers significantly increased their clarity and security usage as they transition to a full Cadence flow for advanced IC packaging, displacing competitive solutions. BETA CAE continued its momentum with multiple competitive displacements, underscoring its accuracy and performance advantages, including a significant competitive win at a large Tier 1 automotive company in China. In Q3, Infineon Technologies standardized its PCB design workflow on the Cadence AI-driven Allegro X platform for their future designs. Last month, we signed a definitive agreement to acquire Hexagon's D&E business, including its MSC software business to bring industry-leading structural analysis and multi-body dynamics technologies to Cadence. Complementing our multiphysics portfolio, this will accelerate our expansion in SDA and put us at the forefront in unlocking new opportunities across automotive, aerospace, industrial, and the rapidly emerging world of physical AI. In summary, I'm pleased with our Q3 results and the strong momentum across our businesses. The AI era offers massive market opportunities and through the co-optimization of our entire portfolio with AI and accelerated computing, Cadence is uniquely positioned to be the trusted partner to deliver AI-centric transformational solutions across multiple industries. Now I will turn it over to John to provide more details on the Q3 results and our updated 2025 outlook.

John Wall, Senior Vice President and CFO

Thanks, Anirudh, and good afternoon, everyone. I'm pleased to report that Cadence delivered strong results for the third quarter of 2025 with broad-based momentum across all our businesses. We exceeded our guidance for Q3 revenue, operating margin, and EPS and are raising the full year outlook across these key metrics. With the updated outlook and at the midpoint, we now expect our 2025 revenue to grow approximately 14% year-over-year on track to achieve double-digit growth across all our product categories for the year. Third quarter bookings were strong, resulting in a backlog of $7 billion. Here are some of the financial highlights from the third quarter, starting with the P&L. Total revenue was $1.339 billion. GAAP operating margin was 31.8% and non-GAAP operating margin was 47.6%. And GAAP EPS was $1.05, with non-GAAP EPS $1.93. Next, turning to the balance sheet and cash flow. Cash balance at quarter end was $2.753 billion, while the principal value of debt outstanding was $2.5 billion. Operating cash flow was $311 million. DSOs were 55 days, and we used $200 million to repurchase Cadence shares. Before I provide our updated outlook, I'd like to highlight that it contains the usual assumption that export control regulations that exist today remain substantially similar for the remainder of the year. With that in mind, for Q4, we now expect revenue in the range of $1.405 billion to $1.435 billion, GAAP operating margin in the range of 32.5% to 33.5%, non-GAAP operating margin in the range of 44.5% to 45.5%, GAAP EPS in the range of $1.17 to $1.23 and non-GAAP EPS in the range of $1.88 to $1.94. As a result, our updated outlook for 2025 is revenue in the range of $5.262 billion and $5.292 billion, GAAP operating margin in the range of 27.9% to 28.9%, non-GAAP operating margin in the range of 43.9% to 44.9%, GAAP EPS in the range of $3.80 to $3.86, non-GAAP EPS in the range of $7.02 to $7.08, operating cash flow in the range of $1.65 billion to $1.75 billion, and we expect to use at least 50% of our annual free cash flow to repurchase Cadence shares. As usual, we published a CFO commentary document on our Investor Relations website, which includes our outlook for additional items as well as further analysis and GAAP to non-GAAP reconciliations. In conclusion, I'm pleased with our Q3 results, strong 2025 as we continue to deepen strategic partnerships across the ecosystem. As always, I'd like to close by thanking our customers, partners, and our employees for their continued support. And with that, operator, we will now take questions.

Operator, Operator

And our first question comes from Vivek Arya with Bank of America Securities.

Vivek Arya, Analyst

Your IP business is now, I think, tracking to over 20% growth for the second year. Anirudh, I was just hoping you would give us some sense for what's driving this growth because your competitor expressed a lot of concerns about their IP business, whether it is in China or at Intel or just IP visibility in general. And I think they were talking about a new business model. So how do we square that with the growth you are seeing? How sustainable is this growth? And what is your visibility in your IP business?

Anirudh Devgan, President and CEO

Thank you for the question. I'm quite pleased with the performance of our IP business. We don't focus on any single quarter, but looking at last year, this quarter was exceptional. Overall, our IP business is performing well, supported by a solid backlog and activity going into next year. There are several reasons for this. Firstly, our IP business is distinct and offers more profitability than general IP businesses, despite being slightly less profitable than our EDA business. A significant portion of our growth is coming from design IP. This growth is driven by our focus on AI and HPC at advanced nodes. We strategically targeted these areas as the future of our business. Many of our IPs, such as SerDes, PCIe, and HBM4, are well-positioned in this market, which is performing strongly globally. Secondly, there are more foundries entering the market, particularly at advanced nodes. We have established partnerships with key players like TSMC, Samsung, Intel, and now Rapidus, giving us a solid position. Lastly, as our IP business improves, our performance in power, performance, and area (PPA) has also enhanced, attracting a significant demand from customers who want to transition to Cadence. These three factors give me a sense of optimism about our IP business. Looking ahead to the next year, I would expect our IP business to grow at a rate surpassing Cadence’s overall average, given the favorable profit margins. If our profitability is slightly lower than EDA, then the growth rate should exceed the Cadence average, creating a positive trend over the next three years. Overall, I'm satisfied with our IP performance.

Operator, Operator

And our next question comes from the line of Jason Celino with KeyBanc Capital Markets.

Jason Celino, Analyst

Great. Last quarter, I think you mentioned the second half having good renewal opportunity with some of your large customers. With the uptick in backlog, I imagine some of that strength was from some of these renewals. But as we think about Q4, do you still have renewals on the docket?

Anirudh Devgan, President and CEO

Yes. Thank you for the question. I'll let John address the timing of the renewals. Overall, I believe our performance in Q3 exceeded our expectations. This is true across all regions, primarily due to the accelerating build-out of AI infrastructure, where we play a crucial role. As I've publicly stated, I see three major phases of AI: the first being AI infrastructure, followed by physical AI and then science AI. Our focus and investment are mainly on the first phase, which has been accelerating over the past six months. We are also fortunate to collaborate with all the Mag 7s, and there is an increase in investment in internal chip design, along with major silicon companies like NVIDIA, Broadcom, and AMD. This is reflected in our booking activity in Q3, and so far, we anticipate strong demand continuing into the future.

John Wall, Senior Vice President and CFO

Yes, Jason, I would just like to add that the mix as well is healthy across EDA, IP, hardware, and SDA. And the core EDA and IP backlog is weighted toward multiyear recurring arrangements, and that supports durable double-digit growth.

Operator, Operator

And our next question comes from the line of Joe Vruwink with Baird.

Joseph Vruwink, Analyst

Great. I guess I'm struck by the number of times the word acceleration has already been used on the call so far. And I guess the third quarter bookings much stronger than we were expecting, and it would support a future acceleration. I know it's atypical to kind of get 2026 comments, but Anirudh already did for the IP business. I'm just wondering if you can maybe start to frame expectations for next year based on what you have in hand and it certainly seems like things are setting up well. Do you have the type of visibility at this point to maybe comment on it?

Anirudh Devgan, President and CEO

Yes. I want to emphasize that we consistently evaluate our business based on the performance of our products. As you know, we have five lines of business, and I'm pleased to report that all five are performing very well at this time. This year, I believe we will achieve double-digit growth across all five lines. Additionally, our performance holds strong in all geographical areas. Regarding our products and markets, we are aligned with leading companies and are recognized as trusted partners by influential market players. When considering our product offerings, geographical reach, and customer relationships, we are in a strong position. Looking ahead to the new year, we adopt a cautious approach to our outlook, and we will provide an update about next year around January or February. Overall, I believe that Cadence is better positioned now than it has been in recent years, and we are eager to continue working with our customers moving forward.

John Wall, Senior Vice President and CFO

Yes. Joe, we won't guide FY '26 today. But exiting FY '25 with probably record backlog and broad-based momentum from deepening strategic and trusted partnerships across the ecosystem positions us well for next year. You can expect our framework to remain disciplined. We typically aim for double-digit top-line ambition, continued operating leverage, and balanced capital allocation. And that's all underpinned by secular AI demand across chip to systems.

Operator, Operator

And our next question comes from the line of Lee Simpson with Morgan Stanley.

Lee Simpson, Analyst

Great. Congratulations on another strong quarter. I wanted to ask about China. It seems you're up approximately 53% year-on-year, with a mix increase to 18%. This feels more than just a rebound from last quarter's restrictions; there seems to be real momentum. Could you explain what is driving this? Is it intellectual property, hardware, or core EDA? What are the contributing factors?

John Wall, Senior Vice President and CFO

Thanks for the question, Lee. Yes, I mean, we saw broad-based strength and China design activity remains very strong. The region returned to business as usual for us in the second half that with the lifting of the export regulations that changed for EDA in early July. But Q3 really was only slightly better than we expected, and we now expect China to be up year-over-year for fiscal '25. Anirudh, do you want to add anything to what's happening in China?

Anirudh Devgan, President and CEO

Yes, that's a good question about China. Overall, I would say that the situation in China has returned to normal. There was a disruption in the second quarter due to various policies, but the behavior we are seeing in the third quarter is back to usual levels. A lot of this resurgence was due to us prioritizing hardware deliveries that could not happen in the second quarter but were fulfilled in the third quarter. Design activity remains robust in China, as semiconductors are essential to all countries, and China continues to invest in this sector. I believe our strength is widespread and not limited to any specific region. There was some recovery from the second quarter to the third quarter. It is challenging to predict future trends, but currently, I do not notice any unusual activities in China or any indications of pulling in demand from future quarters. We observe overall strength across other regions as well.

Operator, Operator

And our next question comes from the line of Siti Panigrahi with Mizuho.

Sitikantha Panigrahi, Analyst

Great. Congratulations on another strong execution. Anirudh, I want to ask you about your system design, mainly the simulation analysis market. Help us understand your strategy. You made acquisition last year, BETA CAE, and this year, again, you've announced MSC software. Help us understand how you're going to position yourself against your competitor in that market. This is definitely a growing market. I would appreciate any color on that.

Anirudh Devgan, President and CEO

Thank you for your question, Siti. I'm quite satisfied with the overall performance of SD&A. It's important to remember that Cadence initiated this shift in 2017 and 2018, and it's now clear that silicon and systems are coming together. The acquisition we completed this quarter is more focused on future technologies, specifically the three horizons: horizon 1 is infrastructure AI, horizon 2 is physical AI, and horizon 3 is sciences AI. Our investment is concentrated mostly on horizon 1, about 70% to 80%, with around 20% in horizon 2 and a small percentage in horizon 3. Horizon 2, which includes cars, drones, and robots, presents a significant market opportunity. AI will also evolve in this area; reports suggest a shift from LLM-based AI to world model-based AI. In training robots or cars, the challenge lies in the lack of available data compared to LLM models, where data is abundantly available online. Training data for robots must be generated, often manually, which is time-consuming. The most effective way to create data for world models is through simulation, which we have discussed before in relation to the essential simulation of multi-body dynamics in horizon 2 physical AI. Hexagon possesses a leading simulator for multibody dynamics and structured simulation, which supports various electronics and automotive applications. I am optimistic that this will position us well in physical AI. Following the acquisition, our SD&A business will have two strong pillars. We expect the run rate to exceed $1 billion in 2026 if the acquisition is completed. One pillar will focus on 3D-ICs and chiplets, leveraging Allegro, which is the industry standard for package design. Combining Allegro with Sigrity, Clarity, and Celsius—our electromagnetics and electrothermal tools—creates a robust area for merging silicon and systems. This will account for about half of our SD&A business, given the expected growth in chiplet-based architectures. The second pillar will encompass physical AI and structural analysis, integrating BETA, a leader in pre- and post-processing, with Hexagon’s numerous solvers like multibody dynamics structural analysis. We also acquired an excellent new CFD solver from Stanford a couple of years ago. Together, these solvers with BETA will constitute another significant portion of our SD&A business, giving us a strong position in physical AI. Overall, Hexagon will provide us with two solid foundations in SD&A in the fastest-growing areas: one focusing on 3D-IC and HPC, and the other on physical AI and connected technologies.

Operator, Operator

And our next question comes from the line of Jim Schneider with Goldman Sachs.

James Schneider, Analyst

I was wondering if you can maybe frame for us some of the tailwinds you expect you might see over the next couple of years as a result of inclusion of AI features into your products on the core EDA side. Maybe talk about any kind of productivity metrics you can give us in terms of time to market or developer productivity and how that might translate into either revenue or adoption rates of that technology and features.

Anirudh Devgan, President and CEO

Absolutely. Great question. As we've mentioned before, our AI strategy consists of two components: design for AI and AI for design. The first component involves building the AI ecosystem, encompassing both infrastructure and physical AI. We are well-positioned alongside all the leading companies. Your question seems to focus on the second component, which is applying AI to design. This time, we've highlighted several examples, including at least five major platforms. Notably, SimAI is using AI to accelerate verification, which is a complex task in chip design. With SimAI, we're seeing a 5 to 10 times improvement in logic simulation efficiency and coverage, a crucial tool in verification. Moreover, during CadenceLIVE, both Samsung and Qualcomm showcased these benefits confirmed by customers themselves. Another area is back-end physical design with Cerebrus AI Studio, where Samsung reported a fourfold increase in productivity and a 22% improvement in power, performance, and area. These numbers are significant, especially as the industry invests billions in node migration, typically yielding only a 10% to 20% improvement in those metrics. If we achieve better optimization through AI, it brings tremendous value to our customers. The encouraging news is that AI tool adoption has become almost standard, with major customers incorporating our AI tools. As I've mentioned, monetization usually takes some time—typically around two contract cycles—but we expect to perform well. The productivity gains from implementing AI in Electronic Design Automation (EDA) are substantial. This process in EDA differs from others mainly because we've been automating for three decades; around 80% to 90% of chip design is automated already. AI can provide the additional 10x improvement. Over the past 20 years, we've enhanced chip design efficiency by 100 times, and AI can deliver the next leap. Additionally, chip design workloads are exponentially growing—over the next five years, chips will become 5 to 10 times larger and their complexity may increase by 20 to 30 times due to software and chiplet integration. Hence, AI productivity is essential for keeping pace with these demands, setting us apart from industries with linear workloads. Customers anticipate greater productivity from us and are willing to integrate these advancements into their designs.

Operator, Operator

And our next question comes from the line of Harlan Sur with JPMorgan.

Harlan Sur, Analyst

Great job on the quarterly execution as always. On the third-generation upgrade cycle on your emulation and prototyping platforms, you're about 5 quarters into the upgrade cycle, drove record revenues in Q3. If I rewind back to your second-generation launch, right, the team drove 3 years of record revenues post launch. You still have the same drivers in place, right, design, software complexity increasing exponentially, the Cadence of new chip program introductions, accelerating addition of new customers like OpenAI, as you mentioned on the call today, and proliferation of all of these challenges into new markets like automotive and software-defined vehicle. Given the lead times for your Protium and Palladium systems, I assume you're already booking into next year. What's the demand curve look like? And do you anticipate continued momentum and growth in 2026 for the hardware platform?

Anirudh Devgan, President and CEO

Yes, Harlan, you have a keen understanding of the market trends. Hardware is performing exceptionally well, and I anticipate this trend will persist. Will 2026 surpass 2025? That is what we expect. However, we approach this with caution because, unlike the software business, hardware does not provide full-year visibility. At the beginning of each year, we have only six months of visibility, which is why we are careful in our hardware forecasts. If the business aligns with our expectations, similar to this year, we can adjust our forecasts for the remainder of the year. This cautious approach helps us manage risks for our investors. Regarding fundamental technology and market trends, we are in a strong position in hardware. We are unique in that we manufacture our own systems and produce our chips at TSMC, creating full reticle chips. These racks contain 144 liquid-cooled chips linked by InfiniBand and optical connections, allowing customers to connect 16 racks, emulating designs with up to 1 trillion transistors. No other platform can match that. Additionally, the demand for hardware is not only driven by the rise in AI designs but also by the progression from 3-nanometer to 2-nanometer and eventually to 1.4 and 1 nanometer over the next 7 to 10 years, which will lead to an increase in chip sizes and consequently, a higher demand for hardware. Overall, I believe we are well positioned in the hardware market, but we remain cautious with our guidance for any given year. John, do you have anything to add?

John Wall, Senior Vice President and CFO

Demand remains very strong, particularly in the AI, HPC, and automotive markets. We have been scaling our manufacturing capacity and working to improve lead times. Our hardware gross margins have also become healthier. We are focused on throughput to meet the increased demand from AI designs. Looking at our financials this quarter, you will see that we have been building inventory to address the demand reflected in our pipeline for the next six months.

Operator, Operator

And our next question comes from the line of Jay Vleeschhouwer with Griffin Securities.

Jay Vleeschhouwer, Analyst

Anirudh, you gave several examples of customer activity, customer engagements, and so forth. And I would like to ask you about the recent announcement of the joint work that NVIDIA and Intel are going to be doing. Would it be fair to presume that combined GPU and CPU work would necessarily lift up demand and capacity requirements for multiple types of EDA tools, also IP, probably hardware as well? So there would be a general uplift as a result of that combined work. But at the same time, would it also necessitate your increasing your investments, for example, in AEs as you did when you had that breakthrough with Intel several years ago?

Anirudh Devgan, President and CEO

Yes. Jay, that's a good observation in terms of CPU, GPU together. By the way, I've said this for almost 15, 20 years that the CPU, GPUs need to work together because EDA is a very well-optimized workload. And it is computational software, mathematical software, which is very similar to AI. And what happened in the history of EDA is that, of course, there are a lot of SIMD tasks like which can be done in a GPU kind of machine, but there are also a lot of conditional tasks that need to be done on a CPU kind of machine. So we always wanted both CPU and GPU. And we also wanted CPU and GPU to be close to each other. And actually, to NVIDIA's credit and Jensen's credit of Grace Hopper and then Grace Blackwell, I mean, they are one of the first people to track to kind of watch this trend. And now if you look at all the major designs from other companies too, there is a combination of CPU and GPU together. And that's the reason for the last several years, we are already working on porting our workload to CPU plus GPU. And a perfect example was when we announced Millennium earlier in the year, so we are moving not just system analysis workload, which are more GPU friendly, but also EDA workload, which are critical for accelerating EDA and 3D-IC to CPU, GPU combination. So what I would like to say is I'm actually very pleased to see that the whole industry now is going towards this combination of CPU plus GPU, whether you look at Apple's chips or AMD chips and of course, NVIDIA, amazing platform. And this partnership with NVIDIA and Intel is good for us in terms of gives us a new kind of x86 plus GPU. And also, we have a long-standing partnership with NVIDIA. And then as Intel does more work with NVIDIA, it's also good for our overall discussions with Intel, which I think are proceeding well. And I think Intel has to invest both in its ecosystem for foundry and also its own products. And I think Lip-Bu knows that, and it's good to see the investment on both sides.

Operator, Operator

And our next question comes from the line of Gianmarco Conti with Deutsche Bank.

Gianmarco Conti, Analyst

Congrats on another great quarter. Maybe just going back towards China, especially given the amazing quarter you guys have had, of course, part of it was recouped from Q2. But how should we think about a sustainable growth rate in the region beyond what was recouped last quarter? And potentially, if you could give some color on if there's any real risk from yet another ban in the region. Obviously, there was some news flow going on. And I think investors want to be a bit wary about like what was real in terms of potential risk to EDA or what is sort of like a broader macro level impact? Any commentary there would be great.

Anirudh Devgan, President and CEO

Yes, I believe that in China, the design activity appears to have returned to normal. At the beginning of the year, we were cautious because, based on my visit to China last year, there were expectations of a challenging macro and geopolitical environment, which has proven to be accurate this year. Therefore, our conservative guidance for China at the start of the year was justified. At this point, as John mentioned previously, we anticipate growth in China. The extent of that growth remains uncertain, and we will have a clearer understanding towards the end of the year. However, I do expect positive growth this year. It's also encouraging to see ongoing discussions between the two presidents and among major economies, as any stability and certainty in this area would benefit our business. I remain optimistic about strong design activity, and provided there are no unexpected developments and the environment remains stable, it should support our operations. I want to highlight that our strong performance in the third quarter benefited from activity in China, but is also widespread due to the expansion of AI infrastructure, the emerging design of physical AI, and the overall AI megatrend. We are pleased with this situation. While we are not reliant on any single country, it is reassuring to see improvements in the Chinese environment.

John Wall, Senior Vice President and CFO

Yes. And Gian, I want to remind you that our Q4 and full-year outlook assumes the current export regime stays mostly the same. We always take into account potential regulatory changes. We will continue to comply rigorously while supporting customers around the world. As Anirudh mentioned, we are experiencing strength across all businesses and geographies.

Operator, Operator

And our next question comes from the line of Joe Quatrochi with Wells Fargo.

Joseph Quatrochi, Analyst

I was wondering if you could just maybe help us understand like the OpEx dynamics. I think 3Q is a bit better than expected, but 4Q is a bit worse than expected. Is that related to just the Artisan deal timing of closing that? Or just any sort of help there would be helpful.

John Wall, Senior Vice President and CFO

Sure. Yes. But yes, I mean it's really just the timing of some hardware delivery shifting between Q3 and Q4. But overall, the year is slightly ahead of what we were expecting, and we're pleased by the broad-based execution, strong demand across all product categories. Core EDA software is performing very well. Hardware continues to be strong. We're continuing to make progress in SDA, and we've continued IP momentum and healthy renewals set up for Q4.

Joseph Quatrochi, Analyst

I guess maybe just a question on the OpEx...

John Wall, Senior Vice President and CFO

Yes. So on the OpEx side, we did a small restructure that benefited Q3. The hardware gross margins were very healthy in Q3. And then it's offset a little in Q4 by some new expenses we're picking up from new acquisitions.

Operator, Operator

And our next question comes from the line of Charles Shi with Needham.

Yu Shi, Analyst

Anirudh, congratulations on the impressive results, and John, similarly for you. I noticed that the overall company's growth rate has remained around 40% over the last three years, which is truly remarkable. It seems like you didn't experience any significant disruptions. However, when I delve deeper, there are many variables to consider. Comparing last year to this year, China struggled last year and hardware growth was slowing, primarily due to your transition to the Z3 and X3. Currently, your upfront revenue suggests a potential growth rate closer to 50%, and it appears that China may grow above the corporate average. Looking ahead to next year, do you believe that both hardware and China can sustain their current momentum? Particularly regarding hardware, I recall the Z2 and X2 cycles showed a slowdown in growth during their third years. Do you think this time will be different for hardware growth? Also, could concerns from customers about transitioning to the Z4 and X4 in the next one to two years contribute to a slowdown in hardware revenue? I realize this is a lengthy question, but it feels crucial for understanding Cadence's performance as we approach next year.

John Wall, Senior Vice President and CFO

Thanks for the question, Charles. We're analyzing it. I wouldn’t concentrate too much on any specific quarter or even half regarding results. Last year, the revenue curve was primarily back-end loaded. Year-over-year comparisons in Q3 can be somewhat misleading, especially with China, due to the temporary restrictions we faced from May to early July. However, demand for hardware remains incredibly strong, and we have seen a consistent upward trend in hardware demand for several years as complexity continues to grow. The pipeline looks very promising for the next six months, and we're increasing our inventory to meet some large orders in the upcoming quarters. There is significant momentum, and over the last five to six years, it has been typical for Cadence that Q4 bookings surpass Q4 revenue. We concluded Q3 with a record $7 billion in backlog. Given the timing of renewals in Q4 and the visibility we currently have, we anticipate ending 2025 at a new high. The healthy mix across all our various businesses suggests a positive outlook for next year.

Charles Shi, Analyst

So maybe a quick follow-up. So Anirudh, from your perspective, the current hardware Z3, X3 enough to support 1 trillion transistors, but with AI really moving really fast, do you foresee like when you probably need to like do another hardware refresh? And is there any light you can shed on this?

Anirudh Devgan, President and CEO

I'm very confident in our hardware position. We discussed Palladium and noted that we are the only company that designs our own chips, along with Protium's FPGA systems, which are performing well alongside the Dynamic Duo. As John mentioned, we are experiencing strong demand. I want to remind you that when we provide guidance, we are cautious since hardware is less predictable than software. Although we reported some upfront revenue, many large customers are buying nearly every year. Their purchasing behavior has shifted compared to four or five years ago, as they are heavily involved in design. For many significant customers, this has become almost like an annual subscription, even though it is recorded financially as upfront revenue. I currently see no reason to believe that the hardware trend won't continue, and I expect 2026 to be stronger than 2025, though the extent of that strength will become clearer as we progress. In terms of our next generation, we consistently invest in research and development. As you know, 35% of our revenue goes into R&D, and approximately 65% of our expenses are allocated to R&D, with about 25% for application engineering. This means that over 90% of our investments and headcount are focused on engineering, customer support, and R&D, including hardware. While I won't go into all the specifics, you can be assured that we are well on our way to designing the next generation of hardware systems, which will be delivered on time. Notably, our current systems support designs with 1 trillion transistors, expected to come online by 2030. Before that timeline, though, we will introduce a new generation of hardware that will cater to needs for the following five years. I'm confident in our hardware roadmap. Regarding demand, as you know, with AI, the chips are becoming increasingly larger. For instance, with Blackwell, it's no longer just a single chip; customers are now working with multiple chips and architectures like Grace together. They're not merely emulating one chip but are looking at systems involving multiple chips that can double in complexity with each node. The demand for hardware could outpace Moore's Law or traditional technology scaling, particularly with the emergence of 3D-ICs. We'll observe how things develop, but systemically, we see no issues in hardware demand or our competitive positioning.

John Wall, Senior Vice President and CFO

Charles, there was a lot in your question. I think you referred to upfront recurring revenue as well. I mean we continue to frame '25 around 80-20 recurring to upfront on a rolling 4-quarter basis. And I think as you mentioned in your question, the variability quarter-to-quarter is driven mainly by strong upfront businesses like hardware and IP and the timing of China ratable revenue earlier in the year. But with core EDA growing so well, we're comfortable that 80-20 is probably the right kind of mix of business for the foreseeable future.

Operator, Operator

And our next question comes from the line of Gary Mobley with Loop Capital.

Gary Mobley, Analyst

Let me extend my congratulations. I really just had a clarification or a question to get to a clarification. So if I recall correctly, given the timing of the export control repeal, which I believe is July 2, your China backlog was not in your June quarter ending backlog, but I presume now that it is. So given that $600 million revenue or $600 million delta in your backlog, how much of that was a function of the inclusion of China backlog versus the prior quarter?

Anirudh Devgan, President and CEO

Yes. I'll address that. Our backlog increased from $6.4 billion to $7 billion, reflecting a growth of $600 million. Of that, I would estimate around 25%, approximately $150 million, is attributed to catching up from Q2 to Q3, while the remainder represents robust growth across our business. John?

John Wall, Senior Vice President and CFO

Yes, that's right. No, that's exactly right.

Operator, Operator

And our next question comes from the line of Clarke Jeffries with Piper Sandler.

Clarke Jeffries, Analyst

Anirudh, I appreciate the comments on the mechanics of the strength in the IP business and specifically the demand for design IP you're seeing for AI projects. I wanted to follow up with just how the wallet opportunity is changing with those AI projects. Specifically, do you see any potential for growing pains or lower profitability to serve the industry as they make more customer bespoke technologies with chiplet or custom memory designs incorporated into those AI and HPC designs? Has Cadence changed its investment plan or selling motion to serve that more custom nature required by the industry? Or is that even needed at all?

Anirudh Devgan, President and CEO

Yes, that's a great question. Custom silicon design is definitely a significant trend. We've discussed it for years, with system companies engaging in silicon development. Currently, approximately 45% of our business comes from system companies and 55% from semiconductor companies. With the rise of AI, we’re seeing an increased focus on custom silicon. What's different now compared to six months or a year ago is that major system companies are becoming increasingly dedicated to developing custom silicon. We maintain strong partnerships with companies like NVIDIA, which is expected to perform exceptionally well, as will custom silicon overall. Broadcom's results also support this, and we collaborate closely with them and their clients. There's a considerable opportunity as demand is surging; many large customers anticipate that their AI compute requirements will double annually for the next few years, indicating growth potential for everyone in this space. The custom silicon advantage, particularly for inference tasks, is substantial enough that companies are willing to invest in internal chip design and EDA tools. The financial and customization benefits for our clients, including major players like Google, Meta, Microsoft, Amazon, and Tesla, are significant. As these companies engage in more internal design, they will naturally need to invest in EDA, intellectual property, and hardware. I believe this trend is very positive. Regarding profitability, we aim to maintain discipline in pricing, resulting in consistent profitability; however, the benefit to our system companies is considerable as they develop their own chips.

Operator, Operator

And our next question comes from the line of Ruben Roy with Stifel.

Ruben Roy, Analyst

Anirudh, I have a quick question regarding your comment about collaborating with a customer on next-generation agentic AI solutions. Are you observing this trend across many of your end customers? If so, could you elaborate on the implications of these collaborative efforts, particularly in terms of potential long-term monetization? Additionally, how do you view agentic AI in relation to specific custom solutions for each customer versus a broader agentic AI solution set that Cadence might provide to the wider ecosystem?

Anirudh Devgan, President and CEO

It's a great question. We could discuss this for quite some time. We are fortunate to partner with several companies on AI, focusing not only on the design of AI but also on employing AI in our solutions, especially in the area of agentic AI, which is emerging. We have about five major AI platforms, but what sets agentic AI apart is the generative AI aspects. A significant application of AI is in coding or software development, and chip design also involves coding. We have automated about 90% of the chip design workflow, yet one component that remains manual is the writing of RTL, which is the register transfer language that describes the chip and occurs early in the chip design process. This remains a manual task, but the algorithms assisting in coding for general software development can also aid in RTL development. This has the potential to greatly benefit that remaining 10% of the workflow. Consequently, we are making substantial investments in agentic AI, which will be evident as we announce more products in the future, supported by several partnerships that we are highlighting. Our market approach includes JedAI, which I have discussed previously. JedAI is our joint enterprise data and AI platform, featuring standardized components. The database is standardized, and all models are accessible with interfaces to our AI tools. A portion of JedAI is uniform across all customers, while we collaborate with foundries to train our models. Some aspects can be tailored to specific customers, with the data held on site. We designed JedAI to function both on-premises and in the cloud, addressing different customer preferences for data localization. Over the years, we have invested in this unique platform, which enables us to create specialized solutions like RTL development and verification plan development, and to deploy these in either a general or customer-specific manner. I am optimistic about the potential of agentic AI to automate the remaining manual components, allowing our customers to focus on more advanced tasks and alleviating some of the routine tasks associated with RTL coding and verification plan generation.

Operator, Operator

And our final question comes from the line of Joshua Tilton with Wolfe Research.

Joshua Tilton, Analyst

Congrats on a very strong quarter. Given the time, I'm just going to actually ask a pretty direct clarification question. John, I think it's pretty much for you. In the event that you do see some impacts in the China region, given the ongoing tariff negotiations this coming quarter, do you feel or can you help us understand how you kind of handicap the updated guidance for some, if any, potential negativity in the region?

John Wall, Senior Vice President and CFO

That's a great question. I'd love to be able to tell the future. As always, we exercise caution regarding regulatory variability. We base our guidance on the assumption that the current export regime will remain largely unchanged through the end of 2025. However, it's very challenging to predict what will happen. From what we've heard, we believe that geopolitical tensions are lower than many expect.

Operator, Operator

And I will now turn the call back to Anirudh Devgan for closing remarks.

Anirudh Devgan, President and CEO

Thank you all for joining us this afternoon. It's an exciting time for Cadence with strong business momentum and growing opportunities with semiconductor and system customers. With a world-class employee base, we continue delivering to our innovation roadmap and working hard to delight our customers and partners. On behalf of our Board of Directors, we thank our customers, partners, and investors for their continued trust and confidence in Cadence.

Operator, Operator

And ladies and gentlemen, thank you for participating in today's Cadence Third Quarter 2025 Earnings Conference Call. This concludes today's call, and you may now disconnect.