Earnings Call Transcript - CDNS Q2 2022

Operator, Operator

Ladies and gentlemen, thank you for standing by. Good afternoon. My name is Brent, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Second Quarter 2022 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 Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead.

Richard Gu, Vice President of Investor Relations

Thank you, operator. I would like to welcome everyone to our second quarter of fiscal year 2022 earnings conference call. I'm joined today by Anirudh Devgan, President and Chief Executive Officer; and John Wall, Senior Vice President, 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 contain forward-looking statements, including our outlook on future business and operating results. Due to risks and uncertainties, actual results may differ materially 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 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 disclaim any obligation to update them. In addition, we will present certain non-GAAP measures, which should not be considered in isolation from or as a substitute for GAAP results. Reconciliation of GAAP to non-GAAP measures are included in today's earnings release. Today's earnings release for the second quarter of fiscal 2022, related financial tables and 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. 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 outstanding financial results for the second quarter, with accelerating broad-based demand for our innovative solutions driving double-digit growth across all our business groups. We beat our guidance on all key metrics and are significantly raising our financial outlook for the year, resulting in 17% year-over-year revenue growth as well as exceeding the Rule of 55. John will provide the details in a moment on both our Q2 results and the updated outlook for the year. Generational trends such as 5G, hyperscale computing, and autonomous vehicles are underpinned by AI/ML and data analytics, accelerating the digital transformation across multiple industries. Notwithstanding the macroeconomic uncertainties, our customers continue to invest relentlessly in their next-generation innovation, with semiconductor companies benefiting from increasing silicon content and system companies investing in building custom silicon. These exciting trends are fueling robust design activity and driving a strong secular tailwind for end-to-end core EDA, IP, and expanding systems portfolio. In Q2, we significantly accelerated our Intelligent System Design growth strategy through the introduction of five innovative products as well as through the transformative OpenEye Scientific and Future Facilities acquisitions that expand our total addressable market and position us well for future growth. This morning, we announced our intent to acquire OpenEye Scientific, a leader in the computational molecular design space. Over the past few years, we have successfully extended our multi-decade chip-level simulation expertise to the system level, first to finite element analysis and, more recently, to computational fluid dynamics. With OpenEye, we are now expanding into molecular modeling and simulation, an emerging area of growing interest as pharmaceutical and biotechnology companies accelerate their emphasis on software solutions for drug discovery. The acquisition will allow us to leverage our solver and AI/ML leadership, along with large data management infrastructure, to significantly enhance the speed and accuracy of biosimulation. This will drive disruptive innovation in the life science market by increasing the efficiency and success rate of traditionally long and complex drug discovery processes. Additionally, OpenEye's market-leading cloud-native SaaS platform can capitalize on our cloud expertise, benefiting highly computationally intensive biosimulations. OpenEye's scientifically proven innovative solutions are used by 19 of the top 20 pharma companies, including Pfizer and AstraZeneca, as well as leading biotech firms, and we look forward with excitement to Dr. Anthony Nichols and the OpenEye team joining Cadence, bringing their deep science expertise and rich domain knowledge. During the quarter, we also acquired Future Facilities, a pioneer in the datacenter digital twin space, that expands our CFD portfolio and extends it to datacenters. In addition to electronics cooling analysis, Future Facilities’ innovative solutions enable customers such as HP Enterprise, Digital Realty, and Equinix to optimize thermal and power efficiencies in the datacenter using physics-based 3D digital twins, thereby helping reduce their carbon footprint. We are excited to welcome Hassan Moezzi and his talented team to Cadence. Now moving on to Q2 product and customer highlights. A key element of our approach has been to partner closely with market-shaping customers and win their confidence by providing leadership platform solutions based on best-in-class engines. In Q2, we deepened our long-standing partnership with Samsung to a wide-ranging expansion of our core EDA system software and hardware solutions. We are excited to have extended our collaboration with AMD to a far-reaching commitment to our innovative core EDA, hardware, design IP, and system software solutions. Demand for our core EDA software remains strong and broad-based. Our digital business had another strong quarter, with 14% year-over-year growth fueled by key competitive displacements as well as significant expansion at several market-shaping customers. Adoption of our digital full flow, delivering the industry’s leading quality of results at the most advanced nodes, continues to accelerate with close to 25 new wins in the first half of the year. Our innovative, automated, and scalable Cadence Cerebrus solution with unique self-learning capabilities allows users to explore the entire design space and intelligently optimize the digital full flow to meet the aggressive PPA, schedule, and productivity goals. Cadence Cerebrus continues to see accelerating proliferation, especially with market-shaping customers as they realize transformative results across a broad range of complex production designs and achieve as much as 30% reduction in leakage power and up to 30x productivity improvement for design tasks ranging from Design Technology Co-Optimization, automated floor plan implementation, and final PPA push. At our recent CadenceLIVE Silicon Valley User Conference, customers, including Intel, NVIDIA, Broadcom, Samsung, and Renesas, presented their remarkable successes using Cadence Cerebrus. Functional verification is becoming a key differentiator as we enable our customers to improve system quality and speed up their time to market. In Q2, our business grew 13% year-over-year led by strong growth in hardware and Jasper. Strong secular demand for our industry-leading Palladium Z2 and Protium X2 platforms, especially from hyperscale, AI/ML, and server customers, led to our best Q2 ever for hardware. With 10 new customers and nearly 50 repeat orders, more than two-thirds of the orders during the quarter included both platforms. Our IP business had a very strong quarter, growing 30% year-over-year as the continuing IP outsourcing trend drove strong design and foundry activity for our star IP, especially at the most advanced nodes. Our leading DDR IP solution continues to proliferate strongly, especially at hyperscalers and memory customers, while our PCIe portfolio had significant wins with compute and automotive companies. Tensilica continued to expand its footprint in true wireless, stereo, and Bluetooth headsets and had notable wins in automotive, mobile, and AR/VR end markets. Our System Design and Analysis business that is driving expansion beyond EDA continued its strong momentum in Q2, delivering 29% year-over-year growth as we increase our footprint in several verticals, including high-tech electronics, hyperscalers, aerospace and defense, and 5G communications. In Q2, Ciena, a leader in intelligent networking, adopted our advanced node custom design, Photonics, multiphysics analysis, and 2.5D/3D packaging solutions for their next-generation coherent optical solutions. Exploring design complexity, coupled with rising product development time and cost, is driving the need for innovative packaging solutions that can handle heterogeneous integration in a modular manner. We are seeing accelerating growth for our integrity 3D-IC solution, which is the industry's only comprehensive platform with all in-house technology that provides a truly tightly integrated optimized solution across system-level floor planning, implementation, packaging, and system analysis. Our System Analysis portfolio, delivering disruptive performance and capacity without compromising accuracy, is proliferating nicely with both semiconductor and system companies. For example, in addition to multiple repeat orders, Clarity 3 Solver was adopted by leading companies, including a marquee U.S. semiconductor company, a market-leading U.S. company providing RF and mobile communication chips, and a global marquee hyperscaler. We also announced a new multiyear partnership with McLaren Racing, who will use our Fidelity CFD software to investigate airflow. We are also very excited to have introduced Optimality Explorer, bringing the revolutionary AI technology implemented in Cadence Cerebrus to the system space for the first time. This solution enables the delivery of optimized designs about ten times faster on average than traditional manual methods, with up to a hundred times speedup seen on some designs. Optimality is quickly ramping up with early adopter customers as they realize these compelling results, with Microsoft, MediaTek, Baidu, and Ambarella providing strong endorsements for the product. As we innovate on our systems technology, we are also enhancing our go-to-market strategy. In Q2, we launched our transformational on-cloud SaaS and e-commerce platform, a scalable solution offering instant access and flexible use models for companies adopting a cloud-first approach. This new e-commerce platform is the industry’s first and offers a consumption-based use model built upon the established Cadence CloudBurst task platform. Several customers, including Bombardier, Cisco, and Amazon Web Services, have endorsed the significance of this game-changing platform. To summarize, semiconductor and system companies are investing relentlessly to accelerate their innovation, which continues to drive secular tailwinds for our business. Q2 was an outstanding quarter as we raised the financial outlook for the year while advancing our Intelligent System Design strategy and positioning ourselves well for future growth by expanding into new end markets with our OpenEye and Future Facilities acquisitions. Now I will turn it over to John to provide more details on the Q2 results and our updated 2022 outlook.

John Wall, Chief Financial Officer

Thanks, Anirudh, and good afternoon, everyone. Cadence achieved strong results for the second quarter of 2022 driven by broad-based strength across our technology portfolio. All of our product categories saw a double-digit year-over-year revenue growth, and we exceeded all key financial and operational metrics in Q2. Here are some of the financial highlights from the second quarter. Total revenue was $858 million. GAAP operating margin was 33%, and non-GAAP operating margin was 42%. GAAP EPS was $0.68, and non-GAAP EPS was $1.08. Operating cash flow was $325 million. We used $350 million of cash to repurchase Cadence shares. At the end of the quarter, our cash balance totaled $1.03 billion, while the principal value of debt outstanding was $350 million. Before I provide our updated outlook for fiscal 2022 and what we expect for Q3, I'd like to take a moment to share certain key assumptions embedded in our outlook. We assume the export limitations that exist today will remain in place for the remainder of the year. We have included the expected impact of both the Future Facilities and OpenEye acquisitions. At the midpoint of our fiscal 2022 outlook, we have included the following for these acquisitions: Revenue of $15 million and an operating cash outflow of $60 million, largely due to our expectation that some of the price paid for these acquisitions will flow through operating cash in the second half. Embedding these assumptions into our updated outlook for fiscal 2022, we now expect revenue in the range of $3.47 billion to $3.51 billion, GAAP operating margin in the range of 29.25% to 30.25%, non-GAAP operating margin of approximately 39.25% to 40.25%, GAAP EPS in the range of $2.59 to $2.65, non-GAAP EPS in the range of $4.06 to $4.12, and operating cash flow of approximately $1.2 billion. We expect to use our free cash flow to repurchase approximately $900 million of Cadence shares in 2022. For Q3, we expect revenue in the range of $860 million to $880 million, GAAP operating margin in the range of 26% to 27%, non-GAAP operating margin of 37% to 38%, GAAP EPS in the range of $0.58 to $0.62, and non-GAAP EPS in the range of $0.94 to $0.98. We expect to use approximately $150 million of cash to repurchase Cadence shares in Q3. 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, 2022 is shaping up to be another strong year for all of our businesses at Cadence. I am pleased that revenue growth and profitability continue to improve. At the midpoint of our annual outlook, we now expect revenue growth of 16.8%, non-GAAP operating margin of 39.75%, and non-GAAP EPS growth of 24.3%. As always, I'd like to close by thanking our customers, partners, and our employees. And with that, operator, we'll now take questions.

Operator, Operator

Your first question is from the line of Gary Mobley with Wells Fargo Securities.

Gary Mobley, Analyst

And let me extend my congratulations on a strong first half of the fiscal year. I wanted to start off by asking if you could give us some additional detail as to how material multi-physics simulation software is becoming now as a portion of your systems analysis business? And then along the same lines, given that you're now moving into areas like aerospace, life sciences, data center infrastructure, and other non-semiconductor end markets, could you share your view on how you need to build out your sales channel or your SaaS model to address these non-traditional customers for Cadence?

Anirudh Devgan, President and CEO

Hi, Gary, this is Anirudh. That's a great question. First of all, we are very pleased with our execution of the Intelligent System Design strategy. We are doing well applying computational software expertise to our core and new areas. All our businesses are doing well, and as we expand into the system space, like we did with finite element and then CFD, we believe it’s essential not just to disrupt existing areas of simulation, but also to get into new, emerging areas of simulation like we announced today with molecular simulation. This naturally adds to our customer base and expanding opportunities. Now in terms of OpenEye, it will operate as an independent business unit when it closes later, but we are focused on expanding our go-to-market. If you look at the cloud, there's another way to reach the long tail and expanding customer base. Overall, we have structured our go-to-market strategy to be slightly different in these new areas due to not just the direct channel but also the indirect channel and now the cloud and SaaS offerings.

Gary Mobley, Analyst

I appreciate that, Anirudh. If I could just ask to double-click on the backlog metric of $5.6 billion. Any notable changes to the average license duration and could you speak to the diversity of the backlog growth?

John Wall, Chief Financial Officer

Yes, sure. Gary, great question. Yes, of course, there's an element of time in that backlog number. If you look at the RPO number, that excludes the $171 million from other arrangements with non-cancelable commitments. It's about $5.4 billion in RPO, of which about 51% of that is backlog expected to generate revenue in the next 12 months. The systems business itself is about 12% of revenue, and probably a similar percent of that's one-year backlog.

Gary Mobley, Analyst

Okay. And just to be clear, there weren't one or two particular customers that drove the increase in the backlog?

John Wall, Chief Financial Officer

Well, the first half was very strong for us. We had some big renewals in the first half. In the last quarter, we discussed a U.S. marquee semiconductor company with a record contract. We had big renewals again in the second quarter. When you look at the backlog, the one-year backlog reflects the quality of the backlog, and the $5.4 billion reflects the amount of time booked with customers.

Operator, Operator

Your next question is from the line of Vivek Arya with Bank of America Securities.

Vivek Arya, Analyst

If I go back to the start of the year when you reported Q4, you had suggested a 12% growth rate for the year, and now you're guiding to 17%. I'm curious, what created this big 500-point delta? I don't remember the same kind of pace of upgrades of revenue through the year, especially if the business has recurring elements. What is driving this pace of upside surprise? And is there a sustainable growth rate for Cadence now at this new baseline of mid-teens growth or is it more like 10% or 11%, like what your exit Q4 revenue implies?

John Wall, Chief Financial Officer

Vivek, all great questions. I'll take that if you don't mind. Essentially, at the start of the year, we were guiding to 12% with an expectation that 87% or 88% of our revenue would be recurring in nature. But it's been a great year, especially for our functional verification, particularly in the hardware business. IP has performed well in the first half, resulting in a higher mix of upfront revenue. If you extract the impact of inorganic revenue included in our outlook for the remainder of the year, the actual growth is up to 16.5%. That's largely due to growth across all our business lines.

Vivek Arya, Analyst

Is this mid-teens growth the new baseline for Cadence? Has something changed to get you to this higher tier of growth? Or is the previous growth rate of 11% still the way to think about Cadence long-term? What happens if there is a downturn?

John Wall, Chief Financial Officer

To unpack it a bit, I think if you're looking at the underlying growth rate, consider the three-year CAGR, as that reflects the business over one contract cycle. We saw more upfront revenue this year compared to previous years. I suggest looking at the three-year CAGR as a predictive metric of long-term growth. In relation to downturn impacts, I'll hand over to Anirudh.

Anirudh Devgan, President and CEO

Vivek, that's a great point. Our business is very resilient. We have three primary reasons: we are critical to our customers' R&D, we are essential products for their current and future road maps, and we have a highly predictable business model, giving us visibility and historically strong renewal rates. Also, we are very diversified in terms of geographies and end markets. We are monitoring the macroeconomic environment closely, but overall, we feel good about where we are. The generational trends remain intact.

Operator, Operator

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

Jay Vleeschhouwer, Analyst

Anirudh, referring back to a couple of important points made in your keynote addresses, you've stated that AI-based EDA is the next big thing. What are the implications for your services model and the kind of AE capacity needed to support that for both semi and systems customers? Also, regarding EDA needing a framework for optimizing multiple runs in single-run history, do you have that now, or are you still working towards it?

Anirudh Devgan, President and CEO

Yes, Jay, thank you for attending the keynotes. Our strength is in computational software, which encompasses not just simulation but also optimization and design. EDA has a rich history of creating some of the most complicated optimization software. AI is not just relevant for simulation; it is game-changing for optimization, evidenced by the success of Cadence Cerebrus, which provides dramatic results. We are applying this multi-run data analytics and AI across our product portfolio, allowing our customers to accomplish more with our software. Over time, we should be able to capture a higher share of their R&D spending through automation.

John Wall, Chief Financial Officer

In relation to headcount, if you noticed, the second half saw margins tick down due to employee costs. Following our July 1 pay increase, we expect to continue hiring at pace during the rest of the year. Chip design activity remains very strong. The market for talent is competitive with how we've performed in employee satisfaction rankings, so we're not slowing down hiring.

Operator, Operator

Your next question is from the line of Charles Shi with Needham & Company.

Charles Shi, Analyst

How much of your business is exposed to startups? Over the last few years, VC funding for semiconductor startups has risen significantly, and I believe that has added to your growth. With worsening macroeconomic conditions, how do you quantify your exposure to startups, particularly pre-revenue? Also, what do you think regarding potential impacts on your business over the next 12 months in this segment?

John Wall, Chief Financial Officer

Charles, yes, great question. Chip design activity is very strong. We have observed more caution in spending among startups, but overall demand remains across the board. Our exposure to the startup side is quite small. For example, at the height of the original COVID outbreak, we reserved $70 million of bookings for mainly small customers, and we collected about half of that. Therefore, we don't have significant exposure to the startup community. We included any potential impact on our pipeline within our guidance.

Charles Shi, Analyst

Got it. A second question on the 3D-IC solutions; congrats on the new traction. TSMC recently introduced 3D blocks, which include interoperability of 3D-IC design tools across vendors. How do you view your foundry customers' actions? Will they diminish some of your product differentiation? What does that mean for your 3D-IC strategy?

Anirudh Devgan, President and CEO

Charles, that's a good point. We are pleased with our progress in 3D-IC. We work with all leading foundries, given our market position. Our primary focus is on the design side, as our products are used for that. More onshoring or government investment to improve manufacturing does require more EDA enablement. Thus, this trend creates additional demand for our products. We believe an integrated solution gives better results, and while customers have the option to use a mixture of other tools, we want to deliver the best productivity to our customers.

Operator, Operator

Your next question is from the line of Harlan Sur with JPMorgan.

Harlan Sur, Analyst

Good afternoon, and congratulations on the solid results and execution. A recent dynamic for semiconductor companies and their customers focuses on geopolitical and national defense risks. How does this impact EDA and IP businesses? Would demand for library development and new IP increase due to diversification in manufacturing partners?

Anirudh Devgan, President and CEO

That's a good point. We are diversified across all segments and geographies, allowing us to work with leading foundries. While focused on the design side, any kind of manufacturing-driven uptick in enablement is beneficial for our business. We want to ensure our products provide excellent results in designing solutions.

Harlan Sur, Analyst

Regarding your IP business, you've mentioned strong positions in next-generation processor platforms, including DDR5 and PCIe Gen 5. With all these transpiring, we expect your IP business to continue strong year-over-year growth?

Anirudh Devgan, President and CEO

Absolutely. Our IP business is doing strongly, evident in our Q2 results. We are focusing on star IP, and design activity remains strong. We see broad-based strength in all segments, and our focus on star IP has improved profitability in the last few years.

Operator, Operator

Your next question is from the line of Blair Abernethy with Rosenblatt Securities.

Blair Abernethy, Analyst

Nice quarter, gentlemen. I wanted to dig in a little more on the OpenEye acquisition. It looks like this is more like a platform play in the healthcare vertical. Is that the right way to look at it?

Anirudh Devgan, President and CEO

That's a good question. We believe we are leading in computational software, including simulation and design optimization. With our focus on system simulation, we want to penetrate established markets like finite element and CFD while also exploring emerging areas such as molecular simulation. This holds numerous applications, including healthcare and biosimulation. The acquisition of OpenEye gives us valuable synergy and leadership in this emergent vertical, and we are pleased with their strong SaaS position in the market.

Operator, Operator

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

Joseph Vruwink, Analyst

I wanted to revisit the current RPO. If I calculated correctly, it seems the rate of growth has accelerated from the teens to north of 30%. Given the strength of your bookings, do you believe your forecast for recurring revenue growth could accelerate over the next 12 months?

John Wall, Chief Financial Officer

Yes, great question. We are pleased that the current backlog or the one-year backlog has reached $2.75 billion, which reflects strength across all our businesses, especially driven by hardware. This increase indicates a higher proportion of hardware business in our last few quarters. That said, we are seeing solid demand across our lines.

Operator, Operator

There are no further questions at this time. I would now like to turn the call back over to the CEO, Anirudh Devgan.

Anirudh Devgan, President and CEO

Thank you, everyone, for joining us this afternoon. We are excited about our business momentum and the tremendous market opportunities ahead of us. On behalf of our employees and our Board of Directors, we thank our customers, partners, and investors for their continued trust and confidence in Cadence. We look forward to speaking with you again on our 2022 earnings call. Thank you, and have a great evening.

Operator, Operator

Thank you for participating in today's Cadence Second Quarter 2022 Earnings Conference Call. This concludes today's call. You may now disconnect.