Earnings Call Transcript - CDNS Q1 2023

Operator, Operator

Good afternoon. My name is Emma, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence First Quarter 2023 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 first quarter of 2023 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. A webcast of this call and a copy of today's prepared remarks will be available on our website at 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. Reconciliations of GAAP to non-GAAP measures are included in today's earnings release. For the Q&A session today, we'd ask that you observe a limit of one question and one follow-up. Now, I will turn the call over to Anirudh.

Anirudh Devgan, President and CEO

Thank you, Richard. Good afternoon, everyone, and thank you for joining us today. I'm pleased to report that Cadence delivered strong results for the first quarter of 2023, with ongoing robust demand for essential and innovative solutions driving solid double-digit growth. In view of the strong start to the year and the continuing momentum of our business, we are raising our financial outlook for the year. John will provide more details in a moment. Generative AI design tools are revolutionizing chip and system development by delivering unprecedented optimization and productivity benefits. Customers have already been benefiting from our ground-breaking generative AI solutions in the digital, verification and systems areas, and with the recent introductions of Virtuoso Studio and Allegro X AI, we now have an unmatched chip to package to board to systems generative AI portfolio. Leveraging 30 years of industry leadership, Virtuoso Studio accelerates heterogeneous system design, and through AI-powered layout automation and optimization provides an average 3x productivity boost for designs in the notably complex analog domain. Several customers including MediaTek, Renesas, Analog Devices and TSMC provided testimonials for the launch. Allegro X AI technology utilizes the latest innovations in generative AI to accelerate PCB design with more than a 10x reduction in turnaround time, and at the recent launch, it was endorsed by Schneider Electric and Kioxia. All of these powerful engines are fueled by our unique, differentiated big data analytics JedAI platform that unifies massive amounts of design and verification data to carry forward learnings and insights to future designs. Our rapidly proliferative generative AI solutions are enabling customers to reap significant power, performance and area benefits through better optimized designs while greatly improving engineering productivity and accelerating design closure. Along with AI, other generational trends such as hyperscale computing, 5G and the digital transformation across multiple verticals continue to propel thriving design activity across semi and systems companies, creating rich market opportunities for our differentiated end-to-end EDA, IP and systems solutions. I am pleased with the momentum in our core EDA business as well as our continued expansion into systems area that provides us both revenue and margin opportunities. Now let's talk about our key highlights for Q1. In Q1, we deepened our collaboration with MediaTek, which includes a broad base of our digital, analog, verification and systems design and analysis solutions. We significantly expanded our collaboration with a marquee aerospace and defense systems company, that included the proliferation of our digital full flow, custom, verification products, as well as our RF and system analysis solutions. And Cadence expanded its collaboration with TSMC and Microsoft, as we leveraged our Pegasus Verification System and Cloudburst platform to accelerate giga-scale physical verification in the cloud. Ever increasing complexities in system verification and software bring-up continued to propel our verification business, to a 31% year-over-year revenue growth. Hardware-based verification has become a must-have part of the customers design flow. And on the heels of a record year, our Palladium Z2 and Protium X2 hardware platforms delivered a record Q1 as market demand remained strong for these best-in-class solutions. With 14 new customers and nearly 30 repeat customers, more than 50% of the orders during the quarter included both platforms. Demand for hardware was broad-based, with particular strength seen in the aerospace and defense and automotive segments. Our new Verisium platform leverages big data and AI to optimize verification workloads, boost coverage and accelerate root cause analysis of bugs. Customers are realizing significant efficiency gains, with Renesas seeing up to a 6x improvement in debug productivity, shortening the time to market for its R-Car designs. Our digital IC business had another solid quarter, with our digital full flow continuing to drive growth especially at the most advanced nodes at market shaping customers. Our innovative Cadence Cerebrus solution provides customers an AI-driven cockpit by applying generative AI to explore the entire design space and intelligently optimizing the digital full flow in a fully automated manner. Cadence Cerebrus now has well over 180 tapeouts. And at last week's CadenceLIVE event, several leading customers, including TI, Renesas, Broadcom, Canon and Arm described the remarkable benefits they realized with Cadence Cerebrus. Our system design and analysis business, which is driving our expansion beyond EDA, continued its strong momentum in Q1, delivering 27% year-over-year revenue growth. Accelerating hyperconvergence between system and silicon domains requires seamlessly integrated chip implementation, system design and analysis solutions. Our Integrity 3D-IC platform exemplifies that by natively integrating all the required engines to provide a comprehensive multi-chiplet and advanced packaging flow. Additionally, the growing complexity of designs as well as accelerating virtual prototype trends require sophisticated multi-physics solutions that not just provide higher capacity and performance, but also result in more optimized designs. Our system analysis portfolio couples our expertise in physics-based modeling with AI-driven optimization and are delivering superior results to customers across multiple end-markets. We are pleased with the new wins and growing repeat orders for our organic Clarity and Celsius products, as well as our CFD technologies. During Nvidia's GTC2023, Nvidia CEO Jensen Huang talked about our joint partnership, and the throughput and energy efficiency benefits offered by Cadence's CFD offerings running on Nvidia's accelerated computing platform. And last week, we announced a multi-year technology partnership with the San Francisco 49ers that's focused on sustainability and based on our Future Facilities digital twin technology. In summary, I'm pleased with our Q1 results. Exploding chip and system design complexity will drive a significant non-linear growth in the workload requirements, opening up a massive opportunity for computational software to help realize these innovative products by investing more of the R&D spend in automation. In addition to our strong business results, I am proud of our high-performance inclusive culture and thrilled that we have been selected yet again by Fortune and Great Place to Work as one of the 2023 100 Best Companies to Work For, for the ninth consecutive year. Now, I will turn it over to John to provide more details on the Q1 results and our updated 2023 outlook.

John Wall, Senior Vice President and CFO

Thanks, Anirudh, and good afternoon, everyone. I am pleased to report that we exceeded our key financial and operating metrics for the first quarter of 2023. As planned, we increased our hardware production capacity to improve delivery lead times, resulting from strong demand for our hardware solutions. Here are some of the financial highlights from the first quarter, starting with the P&L. Total revenue was $1.022 billion. GAAP operating margin was 31.6% and non-GAAP operating margin was 42.1%. GAAP EPS was $0.89 and non-GAAP EPS was $1.29. Next, turning to the balance sheet and cash flow. Cash balance at quarter-end was $917 million. Operating cash flow was $267 million. And we repurchased $125 million worth of Cadence shares. Before I provide our outlook for Q2 and the year, I'd like to highlight that it contains our usual assumption that the export control regulations that exist today remain substantially similar for the remainder of the year. Also, for the year, we continue to expect our revenue mix to be consistent with the 15% upfront and 85% recurring revenue mix that we experienced in 2022. With that in mind, our updated outlook for fiscal 2023 is: revenue in the range of $4.03 billion to $4.07 billion; GAAP operating margin in the range of 30% to 31%; non-GAAP operating margin in the range of 41% to 42%; GAAP EPS in the range of $3.26 to $3.34; non-GAAP EPS in the range of $4.96 to $5.04; operating cash flow in the range of $1.3 billion to $1.4 billion; and we expect to use approximately 50% of our free cash flow to repurchase Cadence shares. For Q2, we expect revenue in the range of $960 million to $980 million; GAAP operating margin in the range of 29% to 30%; non-GAAP operating margin in the range of 40% to 41%; GAAP EPS in the range of $0.73 to $0.77; non-GAAP EPS in the range of $1.15 to $1.19; and we expect to repurchase approximately $125 million worth of Cadence shares. As usual, we've 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, we had a good start to the year. With the increase in our outlook, at the midpoint, we now expect revenue growth for the year at approximately 14%. 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

Your first question comes from Gary Mobley with Wells Fargo. Your line is now open.

Gary Mobley, Analyst

Good afternoon, everybody. Thanks for taking my question. I wanted to ask about an observation that your upfront revenue, your functional verification revenue and your China-related revenue were all very strong in the first quarter. So, I'm curious to know if all those were related and relate specifically to maybe some pull-forward of some customer deliveries or some customer orders, or was it more so a function of having the ability to turn the hardware verification business around a little bit quicker than expected?

John Wall, Senior Vice President and CFO

Yes, Gary, that's a great question. They are all connected. We were very happy to increase our hardware production due to strong demand for hardware solutions in the functional verification sector. We successfully boosted that production in the first quarter, and the resulting upfront revenue positively impacted functional verification and our business in China. China now accounts for 17% of our revenue for Q1, primarily driven by hardware sales. Additionally, I want to emphasize that last year, our recurring revenue made up 85% of our total revenue, with 15% as upfront. We expect this to remain the case this year. However, in Q1, due to the rise in hardware deliveries, the mix was 80% recurring and 20% upfront for the quarter. We do not anticipate this trend continuing for the rest of the year.

Gary Mobley, Analyst

Okay. And related to that, John, if I'm not mistaken two-and-a-half months ago, when you gave the initial fiscal year '23 revenue guide, you were expecting maybe the hardware-related business to tail off into the second half of the year. Is that still the expectation? Or are you still running near record backlog for that hardware verification business? And that's it from me. Thank you.

John Wall, Senior Vice President and CFO

Great question, Gary. We were very pleased with hardware bookings in Q1. We haven't adjusted expectations for the second half of the year yet; I want to wait until summer to assess the pipelines since hardware is primarily a pipeline business. However, we did increase our expectations for the year by $20 million. This increase partly reflects the strong performance in Q1, particularly from hardware, but a significant portion also comes from the software side, mainly in system design analysis. We anticipate growth across all our businesses this year, but I prefer to hold off on adjusting the hardware outlook for the second half until mid-year.

Gary Mobley, Analyst

Thank you.

Operator, Operator

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

Jay Vleeschhouwer, Analyst

Thank you, John, for addressing the RPO. According to the 10-Q, there appears to be a sequential decline of about $400 million since Q4, as well as a decrease in expected revenue for the next 12 months from RPO. I understand that this can fluctuate due to hardware and contract timing, but could you please discuss the significance of that sequential decline in RPO and any expectations for the remainder of the year? Then, I have a follow-up question.

John Wall, Senior Vice President and CFO

The second half of this year is significantly focused on bookings for the entire year. We experienced a slow first half for software renewals. However, the second half, particularly Q3 and Q4, looks very promising for renewals. In contrast to last year, when we had several large software renewals in the first half, this year is different. In the second half, any major renewal we have in Q3 will be less than what we had at the end of last year, which had a nine-month contribution to current remaining performance obligations (cRPO) but now only has six months. This situation mainly relates to the timing of renewals, with the first half of the year being light for renewals. Additionally, Q1 and Q2 mark three years since the pandemic emerged in 2020, which historically saw lower renewal activity. Therefore, the second half of the year will carry a heavier load for software renewals, which will also reflect on RPO and cRPO. There was a slight drop in hardware due to high delivery volumes in Q1, but the main issue is the renewal timing.

Jay Vleeschhouwer, Analyst

Okay, understood. Anirudh, for you on AI, the product launches in the last couple of weeks, including last week, and the customer presentation was certainly very interesting. But just want to ask you about management comment at the conference last week that you were making "massive investments in AI." And what was interesting about that is just some of the ad hoc conversations at the conference suggested that the AI development teams are relatively small, perhaps a few dozen per product or per group, but not necessarily very large percentage of your R&D headcount. So, when you say massive investments, in what other ways perhaps do you mean that?

Anirudh Devgan, President and CEO

Thank you for the question, Jay. I want to expand on what John mentioned earlier. While there may be some variations in renewal timing, our business is not particularly affected by that. Our primary revenue comes from stable, recurring business, and I'm encouraged to see that design activity in both system and semi companies remains strong. Our products are essential and therefore resilient to the macroeconomic environment. Additionally, our diversification across geography and markets further supports this resilience. Regarding AI, it's significantly impacting the automation we can offer. We are integrating AI across all our products, as highlighted during our CadenceLIVE Conference last year, ensuring it becomes a core feature of our product lineup. I'm pleased to see our JedAI platform, which is vital for AI-driven data analytics, alongside five major platforms that are built on top of JedAI. This includes Cerebrus, which has achieved over 180 tapeouts; Verisium for verification; Virtuoso Studio for analog design and layout migration using AI; X AI for Allegro in PCB and packaging; and Optimality for system design and analysis, giving us a comprehensive portfolio. The level of R&D investment varies across products, with some efforts occurring within the products and others externally. However, AI will be integrated throughout our offerings. Our strong foundation in computational software allows us to embed AI capabilities not only within our specific AI R&D initiatives but also in our general R&D activities, leveraging our extensive experience in EDA and competition software. Ultimately, the goal is to implement AI comprehensively to enhance productivity, automation, and deliver significant PPA benefits to our customers.

Jay Vleeschhouwer, Analyst

Okay. Thank you, both.

Operator, Operator

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

Charles Shi, Analyst

Good afternoon. Thank you for letting me ask a question or two. So, we really just want to go back to the second half EDA renewal, the expected strength. May I ask those expected renewals, are they already in the backlog or not? Or are they not in the backlog, you expect to sign the renewal in the second half of the year? That's my first question.

John Wall, Senior Vice President and CFO

Yeah. So, Charles, yes, just for clarification, all of our renewals will already be backlog. But if there's, let's say, you have a renewal that's coming up in September, you would have had nine months of backlog left on that renewal at the end of Q4 last year. Now, you have six months left in backlog. And then, when you get to September, you'll have nothing left in backlog and then you have the renewal will come through.

Charles Shi, Analyst

Got it. So, those renewal contracts are not yet in your current backlog, that's what you're saying?

John Wall, Senior Vice President and CFO

So, the new ones will not be until we do them in the second half of the year.

Charles Shi, Analyst

Got it. So, may I ask, please go ahead.

John Wall, Senior Vice President and CFO

I wanted to clarify that the remainder of the existing bookings will be in backlog, but that will decrease until we reach the actual renewal date. Then, on the renewal date, we'll have a new booking come through.

Charles Shi, Analyst

Got it. I believe another analyst mentioned that implied bookings appear to be down in Q1. You provided some explanations, but I'd like to approach this from a different angle. In the March 2021 quarter, you may recall that you experienced relatively lower bookings around that time. Looking back, it seems that it was just a temporary dip in bookings and not indicative of a broader industry trend. Is the situation similar this time, or are you observing something that might suggest a more significant trend affecting the industry today? Thank you.

John Wall, Senior Vice President and CFO

Oh, thanks for the opportunity to clarify there, Charles. Certainly, I didn't see any weakness in bookings in Q1. Bookings in Q1 were stronger than we were actually expecting at the start of the quarter. What I was trying to convey was that we had very few software renewals that came up for renewal in Q1 and therefore bookings were expected to be light. The beauty of the recurring revenue model that we have is that the timing of those renewals is not especially important, but it's the annual value of those renewals. And that we continue to see growth in the annual value of those bookings, and we see growth across all of the businesses.

Charles Shi, Analyst

Thank you, John.

John Wall, Senior Vice President and CFO

Thanks.

Operator, Operator

Your next question comes from the line of Harlan Sur with J.P. Morgan. Your line is now open.

Harlan Sur, Analyst

Hi. Good afternoon, and nice job on the strong quarterly execution. We had a call last week with one of the largest ASIC semiconductor companies, a very large customer of yours, that they've got chip design programs with many of the cloud and hyperscalers. And they told us that they're seeing a pickup just over the last sort of 60 to 90 days, just the meaningful pickup in design activity and design project pull-ins on their accelerated compute and AI SoC programs from their hyperscale customers. I guess, it's not a surprise given the AI arms race amongst the cloud titans. But have you seen this recent pickup in customer design activity, program pull-ins reflected in your recent discussions on upcoming renewals and/or customer engagements?

Anirudh Devgan, President and CEO

Absolutely, Harlan, you make a valid point. Overall, as I mentioned earlier, we're witnessing a significant amount of strong design activity among our customers, both in the semiconductor and systems sectors. When I engage with our ecosystem partners, including foundries and IP providers, the consensus is that design activity remains robust. Specifically regarding your question about AI, there's definitely increased interest. One of the contributing factors is the emergence of generative AI and the discussions around tools like ChatGPT. Historically, AI inference was primarily carried out on CPUs, but now with generative AI, training continues to rely on GPUs, and even inference, when posed with questions, increasingly occurs on GPUs. This transition highlights GPUs as a beneficial accelerating platform, albeit one that tends to be pricier than CPU setups. Consequently, this will not only enhance the adoption of GPU and accelerated computing in cloud environments but will also drive the demand for customized silicon to perform these tasks more effectively and efficiently, in terms of both performance and power consumption. We're observing generative AI and the shift towards reinforcement learning in training and inference, particularly inference, fueling the demand for more customized silicon, and you are right in your observation. Generally, we've discussed for years the ongoing need for customized silicon—whether for generative AI or in applications like self-driving technology—and we are pleased to see the continued momentum in this area.

Harlan Sur, Analyst

No, I appreciate that. And then, maybe just a follow-on to that question, many of your cloud and OEM customers that historically have worked with these large ASIC companies, we're also hearing that some of them may be trying to build extra distance, right, and pull together the capability to do the entire chip design themselves, right, what we call COT based models, which I would think would mean further expansion of their design teams beyond just front-end design, right, which again would be maybe more market opportunity for things like your Virtuoso franchise, and many of your back-end physical implementation of verification tools. Are you guys seeing this trend as well?

Anirudh Devgan, President and CEO

Yes, definitely. I believe there are at least three phases in the transition of system companies developing their own silicon. That's why I've mentioned before that we are still in the early stages of this trend. If you look at other companies, particularly in the mobile sector when they began creating their own silicon, the first phase involves using an ASIC provider. We have excellent relationships with nearly all major ASIC providers and strong partnerships with world-leading ASIC firms across various regions. Typically, system companies start with an ASIC provider but eventually move to a customer-owned tooling (COT) model. This shift allows for more back-end design opportunities, which is favorable for Cadence, as it enables optimization between front-end and back-end processes. While ASIC providers can manage this, customers usually transition to a COT flow as time goes on. Another trend is that these companies are undertaking more designs. Initially, they may start with one or two designs, as seen with companies like Amazon starting with networking chips. Once a networking chip is successful, they advance to more complex chips like Graviton for computing servers, and later to AI chips. This progression leads to an increase in the number of chips being developed. The third reason for more business in this area is the emergence of new system companies. Traditionally, in sectors like automotive, only a couple of companies initiated this process, but now more are entering the space. This is why I believe the growing trend will continue, as companies shift from partial in-house processes to fully in-house capabilities, moving from ASIC to COT models, increasing the number of designs, and a growing number of companies working on silicon. All these trends are advantageous for Cadence and the products we offer.

Harlan Sur, Analyst

Yeah, insightful. Thank you.

Operator, Operator

Your next question comes from the line of Jason Celino with KeyBanc. Your line is now open.

Jason Celino, Analyst

Hey, thanks, guys. Just two questions from me. Maybe my first one, John, you mentioned taking up the full year guidance based on some strength in system analysis. I'm curious, was this driven more from your existing business there, or was it from OpenEye? I guess, how is OpenEye doing relative to expectation?

John Wall, Senior Vice President and CFO

Yes, Jason, so we took up the year by about $20 million, about half of that was with hardware from Q1 because that was a big portion of the beat in Q1. And the other half of that was spread across our software business, mostly in the system design and analysis space and mostly organic. But there was some inorganic contribution as well.

Jason Celino, Analyst

Okay. And then, my second question, please continue, Anirudh.

Anirudh Devgan, President and CEO

Go ahead, Jason.

Jason Celino, Analyst

Oh, sorry, yes. And then, my second question on the guide, it looks like second quarter is going to decline sequentially by about 5%, consistent with what we saw last year too. So maybe just a quick refresher on what's driving the seasonality here?

John Wall, Senior Vice President and CFO

Yes, Jason, when you look at it, it will show up in the functional verification number next quarter. I think Q1 was great. Functional verification was up 30% year-over-year. The quarter was up low teens. Q2 also looks great. It's expected to be up low teens again compared to Q1 '22, but functional verification will likely be up closer to 20% rather than 30%. We expect that in our guidance, we're assuming the recurring revenue mix for the year stays at 85% recurring and 15% upfront, the same as last year. In Q1, it was 80% recurring and 20% upfront, due to a lot of open revenue for hardware deliveries that went out in Q1. For Q2, Q3, and Q4, we expect the mix to be less than the 80-20 split, and it will average 85-15 for the year. You'll see that reflected in the Q2 guidance.

Jason Celino, Analyst

Okay. Excellent...

Anirudh Devgan, President and CEO

Also, Jason, just to add on to what John said, if you look at the Q2 guide, we're still up nicely from Q2 of last year.

Operator, Operator

Your next question comes from the line of Vivek Arya with Bank of America. Your line is now open.

Vivek Arya, Analyst

Thank you for taking my question. I have a short-term inquiry and a more overarching one. In the short term, I’ve noticed that your IP sales have experienced a decline for three consecutive quarters and are actually down year-on-year. Anirudh, could you explain what is causing this slowdown? Do you anticipate IP sales will grow in accordance with the company’s overall 14% sales growth? What do you think will drive a reacceleration in those sales for the latter half of the year?

Anirudh Devgan, President and CEO

So, Vivek, in general, IP is still a good business, and we expect, in 2023, IP business to grow in the low teens compared to last year. So, there is some quarter-by-quarter fluctuation, but in general, we expect IP business to perform well in 2023, yes.

John Wall, Senior Vice President and CFO

And so, yes, what I would add is that IP revenue can often be inconsistent because some of it is received upfront and depends on the timing of deliveries. Last year, we had more deliveries in the first half than in the second half. This year, however, more IP deliveries are expected in the second half compared to the first half. This has affected the year-over-year figures, but we are very pleased with the performance of the IP business. As Anirudh mentioned, we are generally aiming for increasingly profitable low-teen growth each year for our IP business, and we are on track to achieve that.

Vivek Arya, Analyst

Got it. And then my bigger picture question is, what is the right kind of public metric to gauge how much benefit you're getting from AI? Is it accretive to your pricing to your growth rate? So just what is the best public metric to appreciate how much benefit you're getting from AI? And is there a scenario where just the improved productivity, right, or accuracy that AI provides, could it even cannibalize some of your hardware or software part of the business, or do you think it's kind of net accretive longer term, just given the larger TAM size and the greater customer engagement? So, just what have you seen so far from AI? What is the best way for us to track how much incremental benefit? And do you expect it to be net accretive over time?

Anirudh Devgan, President and CEO

Yes, Vivek, I would say that AI represents a significant advancement in automation, continuing the trend in our industry towards greater automation. I view AI as the third major wave of automation and productivity enhancement. The first wave involved moving up abstraction levels, transitioning from transistors to gates to RTL to C level, which was pivotal in driving our industry. The second wave over the past decade has been focused on parallelism, with Cadence making substantial investments in this area, whether on-premises or in the cloud, starting in 2013 with numerous paddle products. Now, the third wave revolves around utilizing AI, particularly for optimization through approaches like reinforcement learning and generative AI. Over the past 20 to 30 years, we've consistently seen that these advancements do not cannibalize existing activities; rather, they increase activity, software utilization, and optimization, allowing for more designs to be completed with the current workforce. I anticipate AI will continue this trend, providing significant benefits that lead to more efficient designs. For instance, some leading figures in our industry have noted that Moore's Law has slowed down in terms of improvements from one node to another, such as the reduction from 65 to 40 nanometers yielding a certain level of enhancement, while the transition to 5 to 3 nanometers now offers much less improvement. Even so, tools like Cerebrus and other AI-driven tools can deliver 5% to 10% improvements in power, performance, and area, equivalent to the benefits of a half or full node process technology upgrade. This potential for substantial enhancement through this third wave of automation using generative AI is significant. We've published metrics on our PPA and product improvements, which we monitor closely with our customers. Additionally, there’s an opportunity to extend these improvements across other areas beyond digital implementation, such as package design, board design, and simulation. As the complexity of these challenges escalates, the need for automation increases, making it possible for us to capture a larger portion of R&D investments in automation, even as the workforce may not grow at the same rate. I expect that R&D spending by our customers will continue to grow over the next five to ten years, but we can aim for a bigger share of that investment directed towards automation.

Vivek Arya, Analyst

Thanks, Anirudh.

Operator, Operator

Your next question comes from the line of Gianmarco Conti with Deutsche Bank. Your line is now open.

Gianmarco Conti, Analyst

Hi, there. Hi, Anirudh and John. Thanks for taking my questions. So, on my first one, I just want to touch base again on the AI suite piece. Firstly, whether you're entering a more mature phase of the price discovery mode as you're accelerating volumes? And secondly, perhaps thinking about the specifics of what are the AI demand drivers here, whether those are correlated to increased design at the lower nodes, are there other trends that we should be aware of other than the increase in complexity, i.e. some specific trends in the industry that you're seeing beyond the semi players, particularly as you've mentioned, of course, Optimality in SD&A? Is there anything that we can sort of like track or understand what's going on behind the bonnet? I'll ask a follow-up question after. Thank you.

Anirudh Devgan, President and CEO

Absolutely. We discussed how AI can assist in the third wave of automation related to chips, and this concept is also relevant at the package and system levels. It's important to note our emphasis on the integration of systems and semiconductors, where companies are merging these areas. We can offer solutions for system design and analysis, including thermal simulation, electromagnetic simulation, and fluid dynamics. Traditionally, the simulation capabilities in these areas could be enhanced, particularly in terms of speed. For instance, Clarity for electromagnetic simulation has seen significant improvements compared to traditional methods due to our expertise in computational software, allowing for more extensive simulations. Additionally, there are two factors contributing to our system design and analysis growth. One is the utilization of GPU acceleration, which I mentioned in my prepared remarks, as it plays a critical role in this area. The other is the application of AI to enhance simulation. EDA has historically focused on optimization as well as simulation, but the introduction of AI for generative optimization is relatively new in system design and analysis. Previously, there was limited optimization capability, but now we are receiving an overwhelming response from Allegro X AI and Optimality because for the first time, not only simulation is possible but the optimization of that simulation as well. When you're working on thermal designs or data center configurations, you want to optimize everything from the shape of a wing to the layout of racks in data centers. All of this is now feasible with generative AI, making the impact on system design and analysis substantial, alongside its influence on chip design. We are uniquely positioned to integrate these two areas and apply AI effectively in both.

Gianmarco Conti, Analyst

Thank you. My second question is about mergers and acquisitions; is there any M&A activity planned or a strategy to expand the portfolio in systems and analysis, or is 2023 aligned with the approach of returning cash to shareholders through buybacks?

Anirudh Devgan, President and CEO

Yes. I mean, in general, we want to start with the strategy, and we feel we have a very, very strong strategy with intelligent system design, this combination of silicon system and data. And we are very pleased with our progress, and we continue to grow organically and perform well both in terms of revenue growth and margin. So that's our base strategy, base outlook. Now, we always evaluate M&A as it comes up and if it's a good return for our shareholders and good return in terms of R&D. But in general, we are pleased with our strategy and our organic execution.

Operator, Operator

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

Blair Abernethy, Analyst

Thank you. Just a quick question on the multi-physics side of things, the system design. The growth, I think you called it, was around 27% year-over-year. Just want to clarify, was that including the acquisitions, or is that organic? And then, secondly, just on the multi-physics side of things, how are you doing in terms of your go-to-market strategy and scaling the business up? It looks like it's getting close to a $500 million run rate. Just want to see how you're doing in the go-to-market side of things.

Anirudh Devgan, President and CEO

Yes, absolutely. The growth rate is a mix of both organic growth and contributions from past acquisitions. Regarding our go-to-market strategy, there is much overlap with our existing customers, but we also have new customers we are targeting. We aim to utilize our current channels while also establishing a dedicated sales team to reach new customers that we haven't historically engaged with. It's important to note that in the system design and analysis space, many leading companies already have strong relationships with Cadence. We continue to sell to engineering organizations, and while our engineering software for electronic design automation and system design and analysis might cater to different customer segments, the engineering organizations are increasingly integrated. When it comes to our strategy for system design and analysis, we follow a three-pronged approach: first is direct sales, similar to our electronic design automation business, where we maintain excellent relationships with leading global customers who utilize both EDA and SDA. The second aspect involves a significant portion of indirect or channel sales. We have a solid channel for our Allegro and OrCAD products and have recently expanded this channel to include SDA in collaboration with new partners globally. The third component of our strategy focuses on leveraging cloud offerings, especially for smaller customers who prefer not to manage their own IT departments. This approach is particularly appealing in the systems domain, where many customers are open to direct SaaS cloud solutions. Overall, this is a continuous journey, and as we scale the business—especially in system design and analysis—we are committed to this three-pronged approach of direct sales, indirect sales, and cloud solutions. A key advantage is that many of our top customers in SDA are already existing EDA customers, which supports our go-to-market efforts.

Operator, Operator

Your next question comes from the line of Ruben Roy with Stifel. Your line is now open.

Ruben Roy, Analyst

Thank you. Thanks for taking my questions. John, I had a question on the commentary around renewals. And just thinking back to the pandemic and how you guys thoughtfully took into account some of your smaller customers and how that might impact some of your software renewals. Just wondering, given the state of the economy right now, and we've already seen some slowing in IT spending, do you think you might see some uncertainty given the soft macro and renewals in the second half? Are you calibrating that into your thinking for full year guidance at this point, or is that not something that you're worried about?

John Wall, Senior Vice President and CFO

Yes, Ruben, I'm not really concerned about the renewals in the second half. The renewals are with very large, highly creditworthy customers. However, we did notice some weaknesses among lower creditworthy customers, like start-ups, in Q1. We've already considered that in our guidance for both Q2 and the full year. Generally, the significant renewals are with some of the strongest creditworthy customers in the industry.

Ruben Roy, Analyst

Right. Got it. Thank you, John. And then, a quick follow-up for Anirudh on the hardware. It's come up now a few times, Anirudh, on your call, which is nice to see that the take rate, or attach rate, I should say, of hardware continues to move up. The numbers have been quite strong, obviously. Is there a way to think about the percentage of your customers now that are on the new Palladium and Protium systems? Just wondering if there's a continued refresh cycle coming around that relevant metric at all to think about kind of what the percentage of customers is. And that continues to go up, is 85-15 sort of the right way to think about the longer-term mix for the company?

Anirudh Devgan, President and CEO

The positive aspect of hardware is that, as we've noted before, it has become nearly indispensable to the design process. It is almost impossible to design these intricate chips without utilizing hardware platforms. I would say that all our major customers, particularly those that contribute significantly to our revenue, are already using hardware. There is always potential for refreshing the hardware they use. Additionally, as the chips transition to different technological nodes—like moving from 5-nanometer to 3, then to 2, 1.4, and down to 1—there are at least ten years of node refresh opportunities ahead of us. With each new node, the chip size increases and the number of gates on the chip expands, which typically leads to a greater demand for hardware. Consequently, the need for hardware capacity is on the rise. This indicates that hardware is likely to experience long-term growth. Not only is it essential, but the demand for it is also increasing, which is expected to continue for at least the next decade, if not longer. There are also occasions when smaller customers may require additional hardware, and we have various business models to support them. Currently, the majority of our larger customers are using hardware, and growth remains a factor as chip sizes expand; for example, if they use Palladium, they may invest in more Protium and vice versa.

John Wall, Senior Vice President and CFO

I would like to add to that, Ruben, that your question seems to come from the fact that back in 2021, our mix of recurring revenue to upfront revenue was 88-12. That led to growth in upfront revenue, and hardware was particularly strong last year, shifting to 85-15. We're guiding to 85-15 for this year as well, with the understanding that we will reevaluate in the summer. If we continue to see strength in hardware, we may adjust the guidance upward for the second half of the year, as that strength has carried into Q1. While we are currently guiding for 85-15, I would suggest leaning toward the optimistic side on the 15 rather than the conservative side.

Ruben Roy, Analyst

That's really helpful, John. Thanks. I guess, just really quick, I know I'm only allowed one follow-up. But just on that point, have lead times normalized, would you say, or is there more work to be done on the production side?

John Wall, Senior Vice President and CFO

We should get back to more normal lead times by the middle of the year, but we thought it was really important in the first half to prioritize deliveries to customers that have been waiting the longest for the hardware. I mean, as you know, we have multiple uses for the hardware. We want to set up demo models for customers for future sales and things like that. But the first quarter was heavily weighted towards deliveries to customers that have been waiting a long time for those orders. We're still working through those lead times, but we expect to be back to more normal lead times by the middle of the year.

Operator, Operator

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

Joe Vruwink, Analyst

Thank you for including me. I'd like to revisit the subject of AI adoption. Considering implementation efforts, particularly with Cerebrus, can you share what percentage of total block engineers are currently utilizing the product? Additionally, as we approach the next round of renewals, do you anticipate broader deployment across the entire team?

Anirudh Devgan, President and CEO

Yes, Joe, I would say that out of our top 20 customers, about 10 are currently using Cerebrus for production. We are actively engaging all our top customers and five hyperscalers are on board as well. However, I believe there is still significant growth potential. The way I see it, platforms like Cerebrus, JedAI, and others are set to become the primary tools. In the past, Innovus was the go-to for digital implementation, allowing customers to run experiments. Now, Cerebrus can mathematically perform those tasks with AI, while still allowing for manual experimentation. I anticipate that in three to five years, nearly all designers will adopt Cerebrus in place of Innovus, as well as for Optimality and Allegro X AI. We still have some distance to cover, and there's a gradual progression needed. We are connected with our customers, who are using the system, but over time, I expect the dominant approach will shift to using Cerebrus instead of older methods. It's like the transition from manual to automatic cars; while some may prefer manual driving, more will gravitate towards automation with Cerebrus. We are still in the early stages of this transition, and there are several years ahead for this to evolve. This is positive for our business as we focus on annual contract value and let natural adoption unfold in the coming years.

Joe Vruwink, Analyst

Okay. That's great. Can you provide an update on where you expect growth to be in 2023 for the system design segment? In light of the development and the increase in bookings, is it possible to identify key factors influencing the growth you've experienced? You mentioned the repeat orders for organic solvers and the expansion of your CFD business, along with some new channel initiatives. Are any of these factors more significant than the others in driving the growth you've seen?

Anirudh Devgan, President and CEO

I expect 2023 to be a strong year for system design and analysis. We have various initiatives underway, and our priority remains on delivering best-in-class products. If our products stand out, customers will choose them. Initiatives to enhance channels and increase product awareness through marketing are beneficial, but our main focus is on creating and supporting top-notch products. Recently, I mentioned the positive developments we've made. I'm particularly optimistic about the role of GPUs in system design and analysis. GPUs have significantly advanced AI by speeding up computations. While GPUs have had limited impact in electronic design automation, they can greatly enhance system design analysis due to the nature of physics-based simulations and matrix multiplications, which align closely with AI processes. Our collaboration with NVIDIA has led to Cadence CFD on GPUs achieving a 9x speed improvement and 17x better power efficiency at the same cost. Although GPUs are typically 3 to 5 times more expensive than CPUs, the performance improvement we achieve on GPUs translates to a net 10x or 9x increase when cost is taken into account. This represents a substantial advancement driven by our unique algorithms. Our extensive experience with massive parallelism in CPUs is now being effectively utilized with GPUs, especially in system design and analysis across both electromagnetic and CFD applications. This presents a significant growth opportunity. Additionally, our work with AI in chip and system design, alongside the propulsion of GPU-accelerated computing for system analysis, creates another strong growth avenue. Even within OpenEye, we leverage GPUs for acceleration. We have numerous strategies to strengthen our position in system design and analysis, but our commitment to delivering best-in-class products remains our top priority.

Operator, Operator

Your next question comes from the line of Andrew DeGasperi with Berenberg. Your line is now open.

Andrew DeGasperi, Analyst

Thanks for fitting me in. I guess one question I had is, and I know you've talked a lot about AI on this call, but just wondering if you think this could potentially lead to more pronounced market share shifts in the future? I know historically, there's not been a lot of market share changes in EDA. But just wondering if we thought with the portfolio that you have relative and your investments that you've made relative to your competitors, do you think that could change?

Anirudh Devgan, President and CEO

Yes, that's a good point. In general, as I mentioned, we are always focused on providing best-in-class solutions, and AI can play a significant role in that. However, I believe the real opportunity for the industry, particularly in EDA and SD&A, is the increasing share of R&D that is being allocated to automation. This trend will benefit all players, and of course, we are investing heavily to ensure our products are best-in-class. The larger trend is that things are becoming so complex that there won't be enough personnel to design these systems in five to seven years. Therefore, the broader opportunity for the entire industry lies in the shift towards automation, which I believe is advantageous for everyone.

Andrew DeGasperi, Analyst

That's helpful. And then, maybe on just general trends this quarter. Just wondering in terms of the systems business, have you seen any change, particularly in the data center side in terms of demand, or is it being kind of consistent relative to the previous quarters?

Anirudh Devgan, President and CEO

I believe the current environment is challenging overall, but the design activity remains robust. Our results are strong, and data center customers continue to invest significantly in automation and research and development. The recent increase we discussed earlier seems to be focused on enhancing infrastructure to support generative AI. This area is very active among major data center companies, as the complexities involved in serving the generative AI base necessitate specialized hardware and a different hardware mix within the infrastructure. I anticipate this transition will create new opportunities for us.

Operator, Operator

Your next question comes from the line of Arsenije Matovic with Wolfe Research. Your line is now open.

Arsenije Matovic, Analyst

Hi. This is Arsenije on for Josh. So, just a double click on the systems company strength. And I wanted to see if there was any kind of call-outs, in particular end markets, and how many dealerships the end markets have changed relative to last year, or any kind of outlook changing in terms of end market demand within those companies? Thanks, and then a quick follow-up.

Anirudh Devgan, President and CEO

In system companies, the data center sector is seeing a lot of activity driven by generative AI. As mentioned in our prepared remarks, we are observing significant design activity in automotive and aerospace & defense as well. If I were to highlight a few key areas, I would definitely point to data centers with AI, and also automotive with a focus on electrification, as well as more activity in aerospace & defense, which we are noticing in our engagements with customers.

Arsenije Matovic, Analyst

Got it. And then, if we could kind of think about some of the strength in hardware, how much of that is driven from refresh from existing large semi customers versus maybe new purchases from systems companies? If you kind of like quantify that from a high level would be helpful.

Anirudh Devgan, President and CEO

I believe it's a mix of factors. The semi company has more designs, and newer designs necessitate increasingly advanced hardware. System companies, by their very nature, also incorporate software; otherwise, they wouldn't be system companies. In system companies, our dual dynamic view of Protium and Palladium is particularly beneficial, as Protium focuses on software bring-up while Palladium is geared towards chip bring-up. Therefore, I would argue that both are performing well, but there is inherently more software content within the system company.

Operator, Operator

I will now turn the call back over 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 in the semiconductor and systems industry. We are proud of the innovative and inclusive culture we have built at Cadence. And 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.

Operator, Operator

Thank you for participating in today's Cadence First Quarter 2023 Earnings Conference Call. This concludes today's call. You may now disconnect.