Earnings Call Transcript - CDNS Q2 2024

Operator, Operator

Good afternoon. My name is Brianna, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Second Quarter 2024 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'd like to welcome everyone to our second quarter of 2024 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 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, 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 disclaim any obligation to update them. In addition, we'll 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. For the Q&A session today, we will ask that you observe a limit of one question and one follow-up. 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 strong financial results for the second quarter of 2024, with broad-based momentum across our product portfolio. Bookings were stronger than expected, leading to a healthy backlog and underscoring the robust demand for our innovative technologies. We exceeded our outlook on all key metrics and are updating our revenue guidance for the year to over 13% year-over-year growth. John will provide more details on both our Q2 results and updated outlook for the year. Generational trends such as hyperscale computing, 5G and autonomous driving, all underpinned by the AI super cycle, are driving strong design activity across multiple verticals, particularly in data center and automotive. Along with increasing chip complexity and system companies building their own silicon, these trends are creating tremendous tailwinds for our differentiated solutions. We are steadfastly executing to our intelligent system design strategy, extending our leadership in core EDA, while steadily expanding our footprint in the new system design analysis area. Customers are ramping up their R&D spend in AI-driven automation. Our Cadence.AI portfolio offering unparalleled quality of results and productivity benefits continues to gain momentum with orders more than tripling over the last year. Our solutions are enabling the massive AI infrastructure build-out across the semi and system space. Additionally, we continue embedding AI in our EDA, SDA, and digital biology solutions. In Q2, our long-term development partner, NVIDIA, broadly deployed Palladium Z3 to deliver to its next-generation AI product roadmap, further solidifying Cadence's leadership in the industry. A marquee hyperscaler meaningfully expanded its partnership with Cadence in Q2, through a broad proliferation of our Cadence.AI EDA, SDA, and hardware portfolio. The growing foundry ecosystem is driving increased design activity and creating significant opportunities for our industry-leading products. And in Q2, we expanded our collaboration with several leading foundry partners. We announced that Cadence.AI digital and analog tools were optimized for Samsung's advanced node SF2 gate-all-around process, driving enhanced quality of results and accelerating node migration. We extended our long-standing collaboration with TSMC, through a very comprehensive and innovative technology advancement, ranging from 3D-IC to design IP and photonics, and providing optimized digital and analog full flows for TSMC's latest N2 process technologies. Our Integrity 3D-IC platform is the industry's leading unified design, analysis, and sign-up platform for multi-chiplet architectures. Integrity has been certified for all of TSMC's latest 3D fabric offerings and now has enabled several new features like hierarchical 3D-IC design. We also announced that Integrity has been enabled for all of Samsung Foundry's multi-die integration offerings, accelerating the designer assembly of stack chiplets. Additionally, we released a complete Intel Foundry EMIB advanced packaging reference flow that is optimized to work seamlessly with Intel 18A technology. We are also collaborating with multiple foundries to optimize our industry-leading IP cores for AI, HPC, mobile, and automotive applications for their advanced process technology, so as to ensure seamless integration into customer designs. We saw strong momentum in our IP business with delivering 25% year-over-year growth in Q2. As we executed to our profitable and scalable growth strategy, AI use cases, HPC, and heterogeneous integration were the primary drivers fueling the demand for our HBM, PCIe, DDDR, 112 gig SerDes, and UCIe products. We expanded our system IP portfolio with the addition of Cadence Janus Network on a chip solution, that manages high-speed communications effectively with minimum latency, enabling customers to achieve their PPA targets faster and with lower risk. Emulation and prototyping have become mission-critical elements of chip design and software bring-up flows. Following the launch of our market-leading Z3 and X3 platforms, there is robust demand for these best-in-class systems, particularly by AI, hyperscale, and automotive companies, and we continue to ramp up our production capacity accordingly. Verisium, our AI-driven verification platform, continues to see rapid customer adoption with several market-shaping customers, including Qualcomm, successfully using Verisium Sim AI for coverage maximization and achieving up to a 20x reduction in verification workload time. Our system design and analysis business continued its strong momentum in Q2, delivering 20% year-over-year revenue growth. As chiplet-based architectures gained traction, our industry-leading Integrity 3D-IC platform had increased adoption and expansion from large deployments at 5G hyperscale, memory, and consumer customers. Our AI-enabled Allegro X design platform, which is being rapidly adopted and driving competitive displacement as multiple aerospace and defense hyperscalers and EV customers take advantage of the platform's productivity and next-generation capabilities. Allegro X's design analysis capabilities are also driving a pull-through of our Multiphysics analysis solutions. In Q2, a leading EV auto company forged a strategic partnership with Cadence, making a significant investment across the breadth of our Multiphysics portfolio. With the close of BETA CAE in Q2, we now offer a comprehensive Multiphysics platform covering electromagnetics, electrothermal, CFD, and structural analysis solutions. Our digital IC and custom businesses delivered another solid quarter. Proliferation of our digital full flow at the most advanced nodes continued with close to 40 full flow wins over the last 12 months, especially at hyperscalers. With over 400 tapeouts, customers are increasingly relying on Cadence Cerebrus, the leading AI tool in the industry as it continues to deliver amazing PPA and productivity benefits. For example, Cadence Cerebrus has been delivering up to a 10% PPA gain for a global marquee systems company and is now deployed as part of the default flow for their latest designs at the most advanced nodes. Samsung Foundry leveraged Cadence Cerebrus in both DTCO and implementation to achieve more than a 10% leakage power reduction on their SF2 gate-all-around platform. Socionext utilized SerDes closure and temper sign-off to reduce timing closure time by 73% and doubled productivity while reducing memory cost by 90%. Our AI-driven Virtuoso Studio is the leading automated solution for analog and RF designs, and its new AI features allow much more efficient migration from one process node to another. Virtuoso Studio added 35 new logos in Q2, led by top hyperscalers, aerospace and defense, and automotive customers. In summary, I'm pleased with our Q2 results and the continuing momentum of our business. The AI-driven automation era offers massive opportunities, and the co-optimization of our comprehensive EDA and SDA portfolio with accelerated computing and AI orchestration uniquely positions us to provide disruptive solutions to multiple markets. Now I will turn it over to John to provide more details on the Q2 results and our updated 2024 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 second quarter of 2024, finishing the first half with a backlog of approximately $6 billion. Also, we expanded our Multiphysics platform in Q2 by completing the acquisition of BETA CAE. Here are some of the financial highlights from the second quarter, starting with P&L. Total revenue was $1.061 billion. GAAP operating margin was 27.7% and non-GAAP operating margin was 40.1%, and GAAP EPS was $0.84 with non-GAAP EPS $1.28. Next, turning to the balance sheet and cash flow. Cash balance at quarter end was $1.059 billion, while the principal value of debt outstanding was $1.350 billion. Operating cash flow was $156 million. DSOs were 49 days and we used $125 million to repurchase Cadence shares in Q2. Before I provide our updated outlook, I'd like to share some assumptions that are embedded. Our updated outlook includes BETA CAE and it contains the usual assumption that export control regulations that exist today remain substantially similar for the remainder of the year. Our updated outlook for 2024 is revenue in the range of $4.6 billion to $4.66 billion. GAAP operating margin in the range of 29.7% to 31.3%. Non-GAAP operating margin in the range of 41.7% to 43.3%. GAAP EPS in the range of $3.82 to $4.02. Non-GAAP EPS in the range of $5.77 to $5.97. Operating cash flow in the range of $1 billion to $1.2 billion, and we expect to use approximately 50% of our annual free cash flow to repurchase Cadence shares. With that in mind, for Q3, we expect revenue in the range of $1.165 billion to $1.195 billion. GAAP operating margin in the range of 27.7% to 29.3%. Non-GAAP operating margin in the range of 40.7% to 42.3%. GAAP EPS in the range of $0.83 to $0.93 and non-GAAP EPS in the range of $1.39 to $1.49. 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 am pleased with our strong Q2 results. We exceeded our outlook on all key financial metrics, a good finish to the first half and ongoing demand for our solutions sets us up for strong growth in the second half of 2024. As always, I'd like to close by thanking our customers, partners, and employees for their continued support. And with that, operator, we will now take questions.

Operator, Operator

Thank you. We will open the line for questions. Your first question comes from Charles Shi with Needham & Company. Please go ahead.

Charles Shi, Analyst

Hi. Good afternoon. Thank you for taking my questions. Anirudh and John, my first question is quite broad. While you've raised your outlook for the year, a significant portion of that is attributed to BETA CAE. My broader inquiry concerns the global semiconductor sales, which appear to be set for much faster growth compared to both your company and your peers. This seems to contrast with the trend of the past three years where you outpaced the semiconductors. Given that AI is a major driver for semiconductors, I'm curious whether Cadence might be able to capture a larger share of the overall semiconductor market, especially in AI, through pricing or other strategies. I’m not specifically asking for ways to alter the trend in value capture, but I would appreciate any insights you can share. Thank you.

Anirudh Devgan, President and CEO

Thank you for the question, Charles. Overall, we are pleased with our performance. Looking at the bigger picture, we expect to achieve over 13% revenue growth and around 42.5% operating margin, which is a strong combination of growth and margin. Our compound annual growth rate over the past three years also indicates positive growth and margin expansion. It's encouraging that the semiconductor sector is expected to grow this year, unlike last year. However, our spending is more closely linked to our customers' R&D expenditures than their revenue. When their revenue increases, they tend to invest more in R&D. Nevertheless, our customers in both systems and semiconductors continue to invest in long-term R&D projects. While improvements in semiconductor revenue may not lead to immediate changes in R&D spending, we are optimistic about the overall increase in semiconductor investments. Our backlog remains healthy, and as AI expands beyond the datacenter into automotive and consumer devices like phones and PCs, I feel confident about our position in the industry as a fundamental provider of design software.

Charles Shi, Analyst

Got it. I have a quick follow-up on China. It seems that China revenue is still relatively low in the second quarter. I remember you mentioning that the contribution from China would likely be slightly below the mid-teens or around 15%. However, if we consider a scenario where China revenue reaches approximately 14%, it would still indicate a slight reacceleration of growth in the second half. Is that still accurate, or do you think that compared to three months ago, the outlook for China might actually be weaker than you initially anticipated? Thanks.

John Wall, Senior Vice President and CFO

Thank you for the question, Charles. Regional revenue is difficult to predict. At the midpoint of our current revenue guide, we only need China to account for 13% of our overall revenue to meet that target. In the second quarter and the first half, we experienced strong bookings and positive customer feedback on our new hardware systems. Both our IP and SG&A businesses are growing well, and our core operations continue to scale effectively as we focus on profitable revenue growth. I understand that you mentioned we haven't raised our outlook, but we did increase our non-GAAP EPS by $0.06, which reflects our improved profitability. Looking at our current guidance, we are on track for a 50% incremental margin, excluding the impact of BETA CAE. Although BETA CAE is included in our guide at $40 million in revenue and contributes about $0.12 dilution to non-GAAP EPS, it also affects operating cash. Overall, we are quite satisfied. We felt it wise to assume lower revenue expectations from China this year, but at the midpoint of our guidance, we still only need 13% from China to achieve our goals.

Charles Shi, Analyst

Thanks, Anirudh and John for that additional color. I appreciate that.

Gianmarco Conti, Analyst

Yeah. Hi, there. Thank you so much for taking my questions. And so on my first one, could you talk a little bit about the implied Q4 ramp-up to 29% growth at the midpoint of guidance? And what is giving you the confidence in reaching the target? Is it mostly hardware visibility coming through or are there an unusually higher number of Q4 renewals that you're waiting for? Any color here would be great. Thank you.

John Wall, Senior Vice President and CFO

Yes, Gianmarco. There is no significant change from what we discussed last quarter. Essentially, it reflects the expected revenue curve for the year. We anticipate a considerable increase in upfront revenue during the second half, primarily due to the timing of shipments. Typically, upfront revenue comes from intellectual property, hardware, and to a lesser extent, some software on the SG&A side. With hardware, there is a time requirement for system assembly, leading to higher revenue in Q4 compared to Q3. Additionally, we recognize revenue from intellectual property based on delivery timing. We are confident in our guidance, and our expectations for Q3 and Q4 are outlined accordingly.

Gianmarco Conti, Analyst

My follow-up question is about hardware. Can you share your visibility for the second half of the year? Are you booking and delivering in the same quarter, which might explain the lack of significant backlog growth? I'm trying to understand if you're booking manufacturing and delivering all within the same quarter for hardware. Thank you.

John Wall, Senior Vice President and CFO

Thank you for your question. Yes, for some of the newer systems, there is a lead time involved in their production. We have more bookings than we can currently fulfill, but we do have some inventory of older systems that we can deliver this quarter. There is always a mix of product availability. In the past, we faced challenges with inventory and ramping up production to meet demand, but we've addressed many of those issues. In the operating cash guidance, we plan to purchase a significant amount of raw materials for inventory production in Q3, which accounts for the largest portion of the changes in our operating cash guidance.

Anirudh Devgan, President and CEO

I want to add to the overall hardware cycle. As you recall, we launched new systems in April, just a couple of months ago, and the response has been phenomenal. These palladium and protium systems can design chips with a capacity of 1 trillion transistors, whereas the largest current chip has about 200 billion transistors, with most being 100 billion or less. This gives us 5 to 10 times higher capacity than what is required, which should benefit the industry for the next several years. Additionally, I'm pleased to report that we have delivered production deployments of our new systems to several major customers, including NVIDIA, our development partner, which has made a significant deployment of Z3, as well as one of the top mobile companies and one of the leading hyperscalers. We are delivering our latest systems across multiple markets, and they are performing exceptionally well. This positions us favorably for the future and strengthens our competitive edge. We have a significant lead due to the nature of our systems, with protium based on FPGA and palladium using our own chips at an advanced TSMC process. Cadence is the only provider that offers this combination and delivers unique value. Overall, the hardware business is performing well, and since these are multi-year upgrade cycles, we are not expecting all activity to occur in 2024. We will monitor developments in 2025 and 2026.

Gianmarco Conti, Analyst

Got it. Thank you.

Vivek Arya, Analyst

Thanks for taking my questions. So on an absolute basis in fiscal '24, organic sales growth rate is robust. But in terms of revisions, it has stalled, right, essentially no real movement since what you suggested at the start of the year. So I'm curious, Anirudh, how has the year transpired versus what you thought and how do you think about bookings and backlog trends into the second half? Should we expect that backlog stays around the $6 billion? Will it start to pick up? Just I'm trying to understand that should we be thinking about sales accelerating from here or this being kind of the sustainable growth rate for the company?

Anirudh Devgan, President and CEO

Yeah. Hi, Vivek. Good question. So in general, what I would like to say is, like we mentioned the last two times, the shape of the curve this year is unique to Cadence, given multiple factors. This is not what we expected over the last two years. So this time it's more back-end loaded for the reasons we mentioned before. So the guide is a little different and we are also given that shape of the curve more prudent in our guide like we were in Q2 and then we rather overachieve and deliver that and give the team flexibility to do the right business for the long term. So I think that's the difference this year versus the last few years is given the shape of the curve, we have more prudence in our revenue guide like John mentioned and John can comment on the backlog expectations, yeah.

John Wall, Senior Vice President and CFO

We do not provide guidance on bookings, but we were very pleased with the strong bookings in the first half. I understand your question, Vivek. Essentially, we are observing strong demand for our hardware systems and strength across all our businesses. If your question is about improving revenue guidance with the addition of BETA CAE, I want to point out that we would like to see an increase in the percentage of revenue from China. It was 12% in both Q1 and Q2, and while it did improve in Q2 compared to Q1, our guidance currently only requires it to reach 13% in China to achieve the midpoint of that guidance.

Vivek Arya, Analyst

Got it. And for my follow-up, you mentioned BETA CAE quite a drag to EPS. I think you mentioned $0.12 dilution. And almost, I think what is like a $300 million hit to operating cash flows. Can you describe that acquisition a little more? And when does it start to become accretive to your financials? Thank you.

John Wall, Senior Vice President and CFO

So yes, Vivek. Regarding the $300 million decrease in operating cash, I want to clarify that approximately 40% of this decrease is related to mergers and acquisitions. For instance, in the case of BETA CAE, some of the purchase price impacts our operating cash due to the geographic distribution of the cash flow. A larger portion of the impact on operating cash is attributed to our strategy of pre-purchasing a significant amount of raw materials for the hardware demand we are experiencing. Consequently, you will notice a rise in our inventory in the third quarter as we acquire these raw materials. Our goal is to ensure we have all necessary materials to support the growth in our hardware systems. As for BETA CAE, it is a recent acquisition, and the details remain consistent with our press release. We indicated that we expect $40 million in revenue at the midpoint, which is now included in our guidance. Additionally, we anticipate a $0.12 dilution from our non-GAAP earnings per share in the guidance as well. We expect it to be operationally beneficial next year, although there will be some interest costs associated with the acquisition, but we believe it will still be accretive next year.

Anirudh Devgan, President and CEO

I want to clarify a couple of points. First, the purchase of inventory for the hardware systems will be beneficial over several years, not just in 2024. This represents a one-time investment that will yield returns for multiple years, which is a wise decision to secure the necessary components for future needs. Regarding BETA, it enhances our system analysis portfolio by adding structural analysis and strengthens our position in the automotive sector. Data centers are significant, especially with the AI super cycles, but the automotive sector is also compelling due to electrification and the integration of AI in self-driving and driver assistance technologies. We are observing considerable design activity in automotive, which is advancing through innovations like chiplets and 3D-IC, aligning perfectly with our IST strategy. The automotive industry is experiencing increased silicon content, necessitating more system design, and AI plays a crucial role in data processing and computational software. Therefore, BETA CAE completes our automotive portfolio and positions us favorably for the future. This trend extends beyond semiconductor companies; OEMs are increasingly engaged in chip design and seeking our system solutions. Additionally, I want to acknowledge and congratulate McLaren for their remarkable achievement, securing first and second place in the Hungarian F1. We have collaborated with them over recent months and years, and it is rewarding to witness their success as we implement our strategies. Our automotive solution encompasses a blend of silicon systems and AI, and we are seeing positive outcomes from both organic and inorganic growth.

Vivek Arya, Analyst

Thank you.

Joshua Tilton, Analyst

Hey, guys. Can you hear me?

John Wall, Senior Vice President and CFO

Loud and clear, Josh.

Joshua Tilton, Analyst

Great. The first point I'd like to clarify is regarding the questions about the mix of upfront versus recurring revenue. I am trying to understand if my calculations are correct, but it seems to me that the upfront component was somewhat low in the second quarter, and now it appears to be more focused on the second half of the year, particularly the fourth quarter, due to the time needed to develop inventory. Am I considering this correctly?

John Wall, Senior Vice President and CFO

That's a fair point, Josh. I agree that bookings were stronger than we anticipated in Q2, which led to an increase in recurring revenue. This has eased some pressure on the upfront side. We're actively taking orders, and there's strong demand for the hardware, which we are producing as quickly as possible, especially for the newer orders. Our intellectual property is performing well, and system design and analysis is also doing great. Our guidance reflects our expectations for how much revenue will be recognized in Q3 and Q4. We took the opportunity to mitigate risk in our guidance for the year by lowering our expectations for China. For upfront revenue, we still expect to remain in the 80% to 85% range, but we might see slightly higher recurring revenue due to the strong bookings in the first half.

Joshua Tilton, Analyst

That makes super clear. And then I guess just my follow-up to that is and I guess it's another visibility question, but how much of what's baked into the guide from an upfront perspective? Do you feel like you have good inventory levels to meet that guidance or does the guidance that you put out today still require you to build and develop inventory between now and shipping those boxes?

John Wall, Senior Vice President and CFO

Yes, we definitely need to build hardware, and you'll see the impact on our inventory in Q3 due to the amount of raw materials we're purchasing. As Anirudh mentioned, this is a one-time effort to acquire raw materials and to quickly build those systems. A significant portion of our expected revenue in the second half will come from the strength in our IP business, which has orders in backlog that we need to execute against. Additionally, we expect to see some upfront revenue from system design analysis scheduled for Q3 and Q4, much of which is driven by existing orders. On the hardware front, we anticipate the SPG Group to deliver mid to high-single digits to achieve the midpoint of our guidance.

Gianmarco Conti, Analyst

Thank you. I have one more question about the inventory. Am I correct in assuming that it's primarily for the Z3/X3? Has there been any change regarding the expected general availability of those hardware products?

John Wall, Senior Vice President and CFO

Yes, that's correct. But the vast majority of the purchases are to get raw materials to help build those new systems.

Anirudh Devgan, President and CEO

To clarify, we have two systems. We design the palladiums ourselves and manufacture the chip at TSMC, and we also design the protium ourselves, but the silicon mainly comes from AMD with Xilinx FPGAs. A significant portion of this purchase is for X3s and the FPGAs, which should last us for several years. Regarding Z3, we are already shipping and deploying them in production this quarter. I want to note that Z3 has a slightly different mix of silicon content compared to X3.

Ruben Roy, Analyst

Yes. Thank you. John, I have a quick question followed by a follow-up and then a more substantial inquiry. Regarding the inventory purchases, am I correct in assuming that they are primarily meant for the Z3/X3? Also, has there been any change in the timeline for when we can expect general availability of these hardware products?

John Wall, Senior Vice President and CFO

Yes, that's correct. But the vast majority of the purchases are to get raw materials to help build those new systems.

Anirudh Devgan, President and CEO

I think we're witnessing an increase in design activity, as you mentioned, with a consistent cadence in product development. This includes a variety of chips, not just the large data center ones, but with increasing customization within them. Hyperscalers are developing their own silicon, and our partnership with Qualcomm highlights this trend, as they are creating AI devices for consumer and edge laptops. The expansion of AI is reaching other sectors beyond the main focus on data centers, and the pace of data center design is picking up. Looking ahead, we expect the AI aspect within data centers to continue accelerating over the next couple of years. Additionally, while automotive projects typically require more time, we are observing design activity there as well, although deployment may lag behind data centers. Consumer products, including phones and laptops, are already incorporating AI. Overall, we see a rapid adoption of AI across the semiconductor ecosystem, and we are proud of our strong position in it, whether through 3D-IC, data center chips, or our own AI offerings. We are excelling in various engagements related to our AI portfolio, indicating a significant increase in AI design and deployment.

Ruben Roy, Analyst

Regarding Josh's question about the revenue mix for Q3, we expect that 80% to 85% of our revenue will be recurring for the year. Q3 falls within that range, and the remainder will be in Q4, so you can calculate the upfront portion from that information.

Jay Vleeschhouwer, Analyst

Thank you. Good evening. Anirudh, the question about the evolution of the product portfolio for EDA generally and perhaps for SG&A specifically. What I'd like to ask about is how you're thinking about packaging the products? Over the last year, you've introduced a couple of products with the term Studio in the name. And I'm wondering if you're thinking about more and more bundling or packaging of that kind via that nomenclature for the EDA products and then specifically for SG&A? And now that you do have multiple codes, how are you thinking about packaging or integrating across the various simulation codes that you've assembled now in acquisition? Then I'll ask my follow-up.

Anirudh Devgan, President and CEO

Hi, Jay. That's a great question. In electronic design automation, as we move to smaller nodes, the need for more integrated solutions increases, whether in digital, analog, or verification. This shift is further enhanced by AI technology. For instance, Cerebrus in digital now integrates not only place and route but also synthesis and sign-off. This trend is definitely evident. Similarly, our leading AI product for verification, Verisium, combines our four major verification platforms. We're increasingly adopting a platform-driven approach, which we can implement with SD&A because we have a comprehensive portfolio. A leading electric vehicle manufacturer has already deployed our complete portfolio, illustrating our ability to deliver integrated solutions rather than focusing on individual products, integrating across our native capabilities in analog, digital, verification, and now with SD&A.

Jay Vleeschhouwer, Analyst

All right. As follow up, I know it's still quite early in the propagation of AI and ML by you and your peers to the customers, but are you beginning to see any commonality or convergence towards a relatively small number of use cases that customers are mostly employing the tools for? And then relatedly, are you also seeing AI/ML adoption having any meaningful effect on your services revenue?

Anirudh Devgan, President and CEO

Yes, Jay. I believe the number of use cases is currently on the rise. One significant use case we've focused on is digital implementation, which has a complex design process. Automating this process has proven to be greatly beneficial. This quarter, we saw Cerebrus deployed at a leading system company for default flow, also in use by Samsung, and verification being utilized by Qualcomm. In terms of the Cerebrus implementation use case, we are not just seeing it applied to design; it is also being used for design technology co-optimization and for higher-level design processes like floor planning and 3D-IC exploration. This indicates that we are addressing not only the implementation of designs but also architecture and exploration aspects. Additionally, there is an increase in workflow automation. Customers are becoming more familiar with Cerebrus, utilizing it throughout the entire design process rather than at the end. This shift enables us to enhance workflow automation, and Cerebrus has adapted to support a broader range of workflows beyond specific implementation use cases. We are also observing an increase in various use cases, such as packaging, where Allegro X is performing well. A major customer in the 3D-IC sector recently leveraged its capabilities to automate routing and placement in PCB and package design, which was previously unavailable. Overall, I see a maturation of workflows. With advancements in large language models and generative AI, we have developed several workflows for transitioning from specifications to RTL, some of which we highlighted last quarter. I do notice a turning point in the deployment of AI within the design process, starting with Cerebrus and digital implementation and extending to LLM-based architecture specifications, design technology co-optimization, 3D-IC, analog, packaging, and verification. We offer the most comprehensive AI portfolio across all five major product lines, which is a promising outlook compared to a year ago.

Harlan Sur, Analyst

Hi. Good afternoon. Thanks for taking my question. Is the bookings profile for the full year still expected to be 40% first half, 60% second half? Because if it is, then that would imply book-to-bill greater than 1 for the full year, total backlog up about 9% this year to about $6.5 billion. But, I guess, how much of that backlog is due to the BETA CAE acquisition? What I'm just trying to figure out is ex BETA CAE, if core cadence orders and backlog are expected to be up this year, which would continue the strong sort of six to seven-year trend of increasing orders and backlog for the team?

John Wall, Senior Vice President and CFO

Yes, it's hard. And again, like I say, we're not guiding bookings, but we were very, very pleased with the strong first-half bookings. The BETA CAE contribution to backlog is very, very small. It's immaterial because BETA CAE, their revenue is upfront. So that's the upfront piece of the business rather than the recurring revenue. But yeah, we're very pleased. I mean, you can typically expect us to always be driving for a book-to-bill of greater than 1, but we don't guide. We don't guide bookings though.

Harlan Sur, Analyst

Okay. Perfect. Thank you. Anirudh, there's a pretty interesting dynamic with your memory customers, right? They're big customers of your custom product family Virtuoso, but they are moving more and more to advanced digital design, right? The HBM control logic chip, for example, is moving to leading edge technologies and advanced chip design. Similarly, with some of your NAND customers, they're moving towards more of this sort of bonded CMOS periphery to array. The periphery chip again is also moving towards advanced digital design as well. So are you starting to see more adoption of your advanced digital implementation and verification products by your memory customers? And then does the leadership in memory via Virtuoso sort of give you an advantage as they bring on more advanced logic design capabilities?

Anirudh Devgan, President and CEO

Yes, Harlan. That's an important point, and we are fortunate to have strong, long-standing partnerships with all the major memory companies. There are at least three key players, along with a couple of others in the next tier. Overall, our strength, as you noted with Virtuoso being the platform of choice for memory implementation, positions us well. There is a significant increase in digital implementation design occurring at memory companies, primarily driven by trends like HBM. While they have always engaged in digital design, it has intensified recently. There is also a trend toward integrating TSMC technologies with memory, which, combined with our strong partnership with TSMC, benefits us in the memory sector. The largest memory companies are advancing their 3D-IC capabilities, expanding memory layers from 8 to 12, and this plays to our advantages. I mentioned our partnership with Samsung regarding 3D-IC in my prepared remarks, and this is true for the other major memory players as well. We are pleased with our position in memory and the emerging trends in HBM and 3D-IC integration, and we will monitor how these develop. It's worth noting that memory is often an overlooked aspect in the discussion of the AI super-cycle. While the focus tends to be on large logic chips, memory is crucial, and we are solidly positioned alongside leaders like NVIDIA on the logic side, with significant partnerships with Samsung and other major memory companies.

Harlan Sur, Analyst

Thank you for the insights.

Jason Celino, Analyst

Great. Thanks for taking my questions. So lots of questions so far on the hardware timing. But I think, John, on prior calls, you said that the hardware delivery times typically are like eight to 10 weeks, that's what it is for like a normal cycle. But are you saying the lead times for the Z3/X3 are longer than this because the demand is much better than what you're seeing?

John Wall, Senior Vice President and CFO

Demand is strong. Demand is strong. What I was trying to point out was that we do have inventory of the older systems that we can deliver right away. The newer systems we're having to build them as quickly as we can because the orders are coming in faster than we can build them. So the lead times is a bit of a moving target in that respect. We are planning to purchase a lot of raw materials and build as quickly as we can in Q3. So you'll see a significant uptick in our inventory balance at the end of Q3.

Jason Celino, Analyst

Okay, that's helpful. Just to clarify, I believe you mentioned that the SDA group needs to achieve mid to high-single digit growth to meet your guidance. I'm not familiar with FDG; is that the functional verification guidance for the year? Additionally, if you're breaking it down, what does that imply regarding what we need to see on IP, since that's another key component to meet the guidance? Thank you.

John Wall, Senior Vice President and CFO

Yeah, that's fair. IP is having a really strong year, and so is system design analysis; those will be our two fastest-growing areas this year. Additionally, there's some upfront revenue from them that's more weighted towards Q4 rather than Q3. The shape of the curve is really influencing our guidance, and I would describe it as prudent. Anirudh, would you like to add anything?

Anirudh Devgan, President and CEO

No, that's correct, John. I apologize for the acronym. SVG refers to the System Verification Group, which means verification. I believe that's what John was hinting at. While we expect verification to grow, we are not anticipating significant growth this year, but it should increase compared to last year. As you mentioned, some of the upfront revenue comes from our IP. In Q1, we announced a new partnership with Intel, where we are deploying our IP portfolio for their processes. This takes time to execute, and some of that will be delivered in Q3 and Q4. Additionally, we've discussed our expanded partnership with Intel regarding their EMIB, packaging, 3D-IC platform, and 18A.

Lee Simpson, Analyst

Great. Thanks for fitting me in and well done in a good quarter. Just wanted to get some clarification. I don't know if I heard correctly, but I think I heard you say that a mobile OEM had taken the Z3 platform. And if that's the case, do you have a sense for what the emulation work might be? Would it be for chips on device or would it be for chips both on device and perhaps in, let's say, a network situation? Thanks.

Anirudh Devgan, President and CEO

That's a great question. We typically don't discuss individual customers or their specific use cases, but generally speaking, these hardware systems are utilized for both chip design and system software development. We are the leading platform in this area, with offerings like Palladium and Protium, and that holds true even for AI applications, particularly in data center AI scenarios where much of the focus is on software development. Palladium serves as a preferred platform for our AI chip customers, allowing them to provide a model to their clients, enabling performance evaluation even before the actual chip is ready. This applies to both chip design and system design across various sectors including data centers, mobile, and automotive. Thank you.

Lee Simpson, Analyst

Yeah. Thanks. Just on those multiple verticals, if we look at the incidence of 3D-ICs coming through, I get the sense that that's starting to hit the tape now in automotive. You have mentioned EV companies as a collaboration of late, but you have mentioned a number of chip makers also. I wonder if it's possible at this point or even if it's relevant to just maybe talk about the split between the customers? Are we talking system customers, i.e., OEMs and Tier-1s in the majority right now or is it still major semis, chip makers for the automotive work? Thanks.

Anirudh Devgan, President and CEO

Great question. To start, the use of 3D-IC technology has become much more common in the automotive sector compared to six to twelve months ago. Initially, it was primarily focused on high-performance computing and AI in data centers, but now various chiplets and 3D-IC platforms are transitioning into automotive applications. Over time, I anticipate this technology will expand into other sectors, such as consumer electronics, where we've seen some movement already with laptops utilizing 3D-IC chips. This trend will likely span all industries, but automotive is clearly a major focus right now. The chiplet architecture allows customers to avoid redesigning every chip while enabling the use of standard chips alongside customized, value-added chips, which is particularly advantageous in automotive as each original equipment manufacturer aims to stand out from the competition. This shift is not limited to semiconductor companies; original equipment manufacturers are also embracing it. I believe the 3D-IC trend aligns well with OEM needs since it facilitates customization and differentiation. We're observing this trend across various regions as well, particularly in China with its strong electric vehicle market, followed by the US and Japan, where significant activity is occurring. Overall, there is increased activity in the automotive sector regarding 3D-ICs, involving both semiconductor companies and OEMs.

Clarke Jeffries, Analyst

Hello. Thank you for taking the question. My first question is, Anirudh, how do you expect the delivery of these third-generation systems to translate to additional software consumption in the recurring revenue portfolio? These products are happening with verification acceleration software bring-up, but how do you see that additional consumption panning out after the delivery of a new ZRX system? And then I have one follow-up.

Anirudh Devgan, President and CEO

That’s a great question. As John mentioned, when we refer to the System Verification Group, hardware is included in that category. Despite being a substantial business on its own, we integrate it within the verification segment. One key reason for this is that beyond hardware systems, we also offer various other successful verification products like Jasper for formal verification and Xcelium for logic simulation. Customers are seeking a comprehensive verification solution. Relating to Jay's earlier inquiry regarding the situation in SDA, we have consistently believed that the future of EDA lies in integrated verification solutions. As our hardware products continue to strengthen, we anticipate that they will enhance our software verification offerings, including Xcelium, Jasper, and Verisium, since some hardware capacity is utilized for simulation acceleration using Palladium. Thus, there’s a natural connection between our verification software and hardware products. We’ll have to see precisely how this develops, but we expect that the strength of our hardware will contribute positively to our overall portfolio.

Clarke Jeffries, Analyst

Perfect. And then one follow-up for John. I think just to kind of finally put a cap on the whole discussion around timing. I guess, then is it fair to say that sort of $600 million odd of upfront revenue in the second half, maybe a majority of that is coming from IP and SG&A and not necessarily the Gen 3 systems and that maybe the interpretation is that there's going to be more of a demand curve in the beginning of '25 rather than this $600 million being strongly driven by third gen Palladium and Protium. Is that a fair takeaway?

John Wall, Senior Vice President and CFO

No. I think that is, Clarke. Yeah. That's exactly right. I mean, we always knew that it would take time to build the hardware system. So, we originally included that in our guide in the first place.

Joe Vruwink, Analyst

Great. Thanks for fitting me in. I did want to follow up to stay with verification and just this raw material investment. So, the thing I'm trying to reconcile is, I would imagine you entered this year expecting the new platform, strong demand, meeting the scale production and therefore invest in inventory. So, I guess, I'm wondering what changed in the quarter that warranted this updated assumption for cash flow and raw material purchase? And really at the heart of the question, did something change about your hardware demand expectation, not necessarily for 2024, but maybe out into 2025 and we just happen to be getting that news now because of the need to update your cash from OPs forecast associated with the inventory input?

John Wall, Senior Vice President and CFO

That's a great question, Joe. I've spent a lot of time with the leaders of that business this last quarter as they were monitoring demand for the new systems. Demand is quite strong. The key point to note is that it's a one-time multi-year purchase of inventory raw materials. They are very confident in the longevity of these systems and the sustained demand. They decided to pre-purchase multiple years of inventory in Q3, which was new information for us. We thought it was a one-time event, so we included it all in Q3 to avoid impacting future periods. This decision will have a favorable effect on next year's operating cash.

Joe Vruwink, Analyst

Okay. Great. Then lastly, you mentioned at the start, orders for Cadence.AI tripled year-over-year. I don't think that's possible without also getting a lift in the base business, both across EDA and SD&A. I guess, on an ACV run rate basis, what has the AI lineup meant for Cadence overall? And does this create a step up in value where, as you start pulling these contracts from backlog in coming quarters, it will become more noticeable in revenue and we'll kind of see the AI contribution more than we have to this point?

Anirudh Devgan, President and CEO

AI has become essential for us. All our new contracts now feature our Cadence.AI portfolio as customers increasingly adopt these tools. Once customers start using the AI portfolio, they find it hard to revert to previous methods. While I won't specify how this will impact future revenues and bookings, we remain cautious. Generally, we've observed an increase as more customers adopt AI. Whenever we secure new contracts, we include AI solutions when it makes sense. 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 in delivering to our innovative 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

Thank you for participating in today's Cadence second quarter 2024 earnings conference call. This concludes today's call. You may now disconnect.