Earnings Call Transcript - CDNS Q3 2022

Operator, Operator

Good afternoon. My name is Aby, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Third Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. Thank you. I will now turn the call over to Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead.

Richard Gu, Vice President of Investor Relations

Thank you, operator. I’d like to welcome everyone to our third quarter of fiscal year 2022 earnings conference call. I’m joined today by Anirudh Devgan, President and Chief Executive Officer; and John Wall, Senior Vice President 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 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 is included in today’s earnings release. Today’s earnings release for the third quarter of fiscal 2022, related financial tables, and CFO commentary are also available on our website. For the Q&A session today, we would ask that you observe a limit of one question and one follow-up. You may re-queue if you would like to ask additional questions and time permits. Now I’ll turn the call over to Anirudh.

Anirudh Devgan, President and CEO

Thank you, Richard. Good afternoon, everyone, and thank you for joining us today. I’m pleased to report that Cadence delivered excellent results for Q3 driven by our technology leadership, strong execution, diversified customer base, and resilient business model. We beat our Q3 guidance on all key metrics and are raising our financial outlook for the year yet again, to 19% year-over-year revenue growth and 40% operating margin. John will provide more details on our Q3 results and the updated outlook for the year. Notwithstanding the prevailing macroeconomic uncertainties, our thesis about generational drivers such as 5G, hyperscale computing, and AI/ML driving robust design activity over the long term remains intact. These secular trends are accelerating the digital transformation across several end markets, while the growing hyperconvergence across multiple domains - mechanical and electrical, hardware and software, and systems and semiconductors is driving the strong need for continued innovation in compute, connectivity, and storage. Customers are investing heavily to differentiate their next-generation platforms, with system companies increasingly developing purpose-built silicon, and semiconductor companies benefiting from expanding silicon content. Our comprehensive offerings comprised of leading end-to-end EDA solutions, IP, hardware, and an expanding systems portfolio uniquely position us to support our customers, while providing us with ample growth opportunities. In an environment of increasing design complexity, tighter time-to-market requirements, and a growing shortage of talent, sophisticated AI/ML solutions can greatly help democratize chip and system development, while dramatically increasing productivity and quality of results. Customers deploying our game-changing AI-driven Cadence Cerebrus and Optimality solutions are realizing amazing results, and in Q3, we augmented our portfolio with the transformative Verisium AI verification platform and the JedAI data platform. Verification continues to be the critical path in system time-to-market, consuming the vast majority of resources, with debug being the largest component. Verisium provides a generational shift in verification, moving from a legacy single-run, single-engine approach to algorithms that leverage big data and AI to optimize multiple runs across multiple engines, leading to a 10x boost in debug productivity. Several customers, including Samsung and STMicroelectronics, have observed impressive results with Verisium for automatically triaging and root causing bugs. JedAI is our revolutionary AI-driven, big data analytics platform that is foundational to unifying our AI innovations across Cadence Cerebrus, Optimality, and Verisium. JedAI operates on vast amounts of data, including all types of design, verification, analysis, and methodology information, to facilitate smarter design optimization and enhanced productivity. In Q3, we significantly expanded our footprint with market-shaping customers as they increasingly embraced our optimized platform offerings. We deepened our partnership with BAE Systems across our core EDA and systems portfolio, including the proliferation of our digital full flow and analog products, and a broad expansion of our PCB and multiphysics system analysis solutions. Additionally, in Q3, we strengthened our collaboration with Teradyne, which included a broad proliferation of our core EDA software across digital, analog, and verification, as well as a significant expansion of our PCB and systems analysis business. Demand for our core EDA software remained strong and broad-based. Our digital business had another strong quarter, with 22% year-over-year growth, driven by key competitive wins and continued proliferation at market-shaping customers. Thirteen new customers adopted our digital full flow in Q3. It’s been just over a year since we launched Cadence Cerebrus, and it’s fast becoming a linchpin technology for customers, as they derive incredible productivity and PPA results on a wide variety of their most advanced SoC designs. Several leading customers have major multi-design, multi-project production deployments underway and are reporting up to 30% improvement in quality of results and 30x productivity improvements. Additionally, we see accelerated growth in our front-end and signoff offerings, in part due to the Cadence Cerebrus pull-through effect. We launched the Certus Closure solution, which dramatically accelerates complete design closure, by using an innovative hierarchical architecture, and a fully automated environment for concurrent full chip optimization and signoff. Using Certus, Renesas observed 6x faster chip-level signoff closure versus current methodologies, and Maxlinear experienced overnight full chip signoff closure while realizing up to 5% of untapped power savings. Our Custom IC business continues to define the analog market with its bold vision, market-leading technology, and comprehensive portfolio. In Q3, it grew 12% year-over-year driven by our best-in-class Virtuoso platform and strong growth in our Spectre simulation solutions. Now moving onto Functional Verification. In Q3, our business grew 31% year-over-year, led by hardware and Xcelium. Our Palladium Z2 and Protium X2 hardware platforms, providing industry-leading system verification and software bring-up capabilities, added 3 new customers and had 20 repeat orders, including from high-end mobile, AI, and hyperscaler customers. Our IP business, led by our Star IP offerings at the most advanced nodes, continues to benefit from the ongoing IP outsourcing trend and from customers increasingly embracing IP reuse for risk reduction and faster time to market. During Q3, we signed our largest IP contract ever with a marquee U.S. semiconductor company, and had a major expansion at a leading U.S. 5G company. Tensilica extended its leadership in the True Wireless Stereo market while proliferating its functional safety and infotainment solutions with automotive companies. We also had multiple design IP wins across our leading PCIe, DDR, and die-to-die portfolio. Our System Design & Analysis business is a key tenet of our growth strategy to leverage our computational software expertise and expand our TAM by growing in near adjacencies. This business continued its strong momentum, delivering 29% year-over-year growth, as we increased our footprint in several verticals including Aerospace & Defense and high-tech electronics. Our broad systems portfolio providing tightly integrated platform solutions across design, simulation, and analysis is resonating strongly with customers as they increasingly choose a broader set of our solutions across these domains. In Q3, we broadened our collaboration with Emerson, a global industrial technology and software leader, as they significantly expanded their use of our Systems solutions, notably our PCB, AWR, and systems analysis technologies. Fidelity CFD software, which was announced earlier this year, is ramping nicely and facilitating customers in verticals such as Aerospace, Marine, and Turbomachinery to do design optimization, leading to efficiency improvements and meaningful reductions in emissions and energy consumption. The addition of Future Facilities’ digital twin-based thermal and power optimization technology will further help data center customers reduce their carbon footprint. Lastly, we completed the acquisition of OpenEye Scientific, a leader in the computational molecular design space. We are very excited to bring our system-level simulation and AI/ML expertise to the life sciences market to help improve the speed and accuracy of biosimulations, thereby enhancing the efficiency and success rate of the drug discovery process. Integration of both our Future Facilities and OpenEye acquisitions is progressing well. In closing, Q3 was an outstanding quarter as we advanced our Intelligent System Design strategy and continued to closely collaborate with our customers on their next-generation designs. We are managing our business with an intense focus on innovation and operational excellence to drive both revenue growth and margin expansion, and are very well positioned to capitalize on the massive opportunities ahead of us. Now, I will turn it over to John to provide more details on the Q3 results and our updated 2022 outlook.

John Wall, CFO

Thanks, Anirudh, and good afternoon, everyone. I am pleased to report that we completed the acquisitions of OpenEye Scientific and Future Facilities in the third quarter of 2022. Cadence exceeded all key financial and operational metrics for the quarter. Here are some of the financial highlights from the third quarter. Total revenue was $903 million. GAAP operating margin was 29% and non-GAAP operating margin was 39%. GAAP EPS was $0.68 and non-GAAP EPS was $1.06. Operating cash flow was $317 million. We used $150 million of cash to repurchase Cadence shares. At the end of the quarter, our cash balance totaled $1 billion while the principal value of our debt outstanding was $800 million. Before I provide our updated outlook for the remainder of fiscal 2022, I’d like to take a moment to share certain key assumptions embedded in our outlook. We expect the impact of the recent changes to U.S. trade restrictions on our business to be limited and manageable. The impact is included in our outlook. Our outlook also assumes that the export limitations that exist today remain substantially similar for the rest of the year. Embedding these assumptions into our outlook for fiscal 2022, we now expect revenue in the range of $3.532 billion to $3.552 billion, GAAP operating margin in the range of 29.7% to 30.7%, non-GAAP operating margin in the range of 39.7% to 40.7%, GAAP EPS in the range of $2.71 to $2.75, non-GAAP EPS in the range of $4.20 to $4.24, operating cash flow of approximately $1.20 billion to $1.26 billion, and we expect to use approximately $1.05 billion of our free cash flow to repurchase Cadence shares in 2022. For Q4, we expect revenue in the range of $870 million to $890 million, GAAP operating margin of approximately 24%, non-GAAP operating margin of approximately 35%, GAAP EPS in the range of $0.50 to $0.54, non-GAAP EPS in the range of $0.89 to $0.93, and we expect to use approximately $300 million of cash to repurchase Cadence shares in Q4. Our CFO Commentary, which is available on our website, includes our outlook for additional items as well as further analysis and GAAP to non-GAAP reconciliations. In summary, I’m pleased with our progress across all lines of business this year. At the midpoint of our outlook, our Q3 revenue CAGR continues to increase, and I’d like to thank our Cadence team for their exceptional execution and financial discipline. At the midpoint of our outlook, we expect our annual non-GAAP operating margin to exceed 40% for the first time, which is especially pleasing. As always, I’d like to thank our customers, partners, and our employees for their continued support. And with that, operator, we’ll now take questions.

Operator, Operator

Thank you. Your first question comes from Jason Celino from KeyBanc Capital Markets.

Jason Celino, Analyst

Can you guys hear me?

John Wall, CFO

Yes, Jason. Go on.

Jason Celino, Analyst

Okay. Perfect. I just want to be straight to the point here, but China is on everybody’s minds. It was 50% growth in the quarter. To some extent, it was an easy comp, but it is the largest revenue that you’ve seen in that period. So I guess, where did you see the strength? And then how would you describe the linearity of that strength? Was it all throughout the quarter, or was it front-half loaded or back-half loaded? I’m curious. And then, I’ll have a follow-up.

John Wall, CFO

That’s a great question, Jason, and thanks for the opportunity to clarify. In Q2, 13% of our revenue came from China, and that jumped to 17% in Q3. Most of that increase was due to hardware sales, with revenue recognized from deliveries into China during Q3. So, the rise in China revenue is entirely from upfront revenue sources.

Jason Celino, Analyst

Okay. Perfect. And then, I did notice that backlog was kind of sequentially down a smidge in the quarter. How much of that was due to the inclusion of some of these new restrictions? Thanks.

John Wall, CFO

Yes, another great question, Jason. Last quarter, our current RPO was 2.75, and it has decreased to 2.7 now. This change is partly due to the hardware delivery into China. Additionally, this quarter, we have accounted for the impact of the new U.S. export regulations. Regarding backlog, it decreased from 5.6 to 5.5. The RPO segment experienced a slight decline, while we saw an increase in IP. We have signed our largest IP contract ever, which is part of the non-cancelable commitment portion of our backlog.

Operator, Operator

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

Charles Shi, Analyst

I really just want to go back to the China question, maybe not immediate Q4 or fiscal ‘22, but to try to look a little bit ahead. Among your kind of like mid-teens of the total revenue coming from China, I know you sell to China to various kinds of customers. You’ve got multinationals, you’ve got the large semiconductor companies, domestic, you’ve got AI startups, and Chinese system companies. But across this wide spectrum of the different kinds of customers in China, what kind of customer, the sales to the customer, could be the most impacted by the export control? And can you quantify for us how much of the percentage of your revenue is going to be impacted because of the latest round of export controls? And I have a follow-up to that.

John Wall, CFO

Charles, this is John. Yes, good point there. We did call out that the impact is limited. We believe the impact is limited and manageable. That’s not just for Q4 but for the foreseeable future going forward.

Charles Shi, Analyst

Any thoughts on specific types of customers that may have a greater impact in your China market?

Anirudh Devgan, President and CEO

Yes. Hi Charles, this is Anirudh. Overall, China is a diversified customer base, and we have a lot of design activity in China. To think about Cadence, we participate in all kinds of designs, right, whether analog or digital or memory in different market segments. So overall, I feel that that will be intact. I think there is some effect on local, like China foundries in the latest regulations, as you probably know. But overall, our business is very diversified, not just in China but other geographies, so we feel the impact is limited and manageable. And like what John said, not just for the remaining of the year but also going forward.

Operator, Operator

Your next question comes from the line of Gary Mobley from Wells Fargo.

Gary Mobley, Analyst

I wanted to talk about perhaps the indirect impact from the China export restrictions and as well the general semiconductor market backdrop and the challenges this may present for companies like Cadence. So, you have some of your large customers who can’t ship product to China because of various export restrictions, one of which can’t ship $400 million worth of product because of these export restrictions. So to what extent, long term, might the R&D budgets of those types of companies be impacted? And related to that, the chip design activity as they can no longer sell to various and large end markets like China. And then related to the overall market backdrop, are you seeing any change in customer behavior with respect to the time it takes to get signed off on any large license deals?

Anirudh Devgan, President and CEO

Hi Gary. This is good point, especially the indirect effect and also overall macroeconomic uncertainties. And we are carefully monitoring the situation on both of these fronts. As you know, we are more on the design side than on the volume of shipments. So on the macroeconomic trends, of course, there’s a lot of news in the press, and we are carefully monitoring it. But right now, we see robust design activity. As you know, we participate in all the market verticals. So even if some verticals may be weaker on their shipment side, they will still do design. But then some verticals are still good on the shipment side as well. So with this combination of us being on the design side and then us being very diversified across multiple verticals, right now, we still see very robust design activity. And that’s reflected in the results that we are reporting today, right, and our outlook for the rest of the year. Now on the indirect effect on China, that’s to be observed also. But again, we are pretty diversified. And then yes, there’s always some effect on some of our customers, but again, we feel that that’s manageable, and we will carefully monitor that going forward.

Gary Mobley, Analyst

So, I wanted to switch topics to your JedAI-based AI machine learning tools, including Cerebrus and some of the others you recently announced. I know you’re in the early days of price discovery and introducing those products to market. What has been the feedback as it relates to “price discovery”? And related to that, how deeply you may be seeing penetration at some of your early days customers there?

Anirudh Devgan, President and CEO

That’s a great point. We are very excited about this new AI-based solution because, as I mentioned earlier, it presents an excellent opportunity for EDA to enhance value for our customers. Historically, EDA has made significant productivity improvements for our clients, but this has typically occurred within a single-run environment. You would run our tool once, and customers managed the multiple runs. In practice, during the design process, our tools need to be run multiple times. With data analytics and AI, we can truly offer solutions for this multi-run environment, and AI plays a crucial role in that. However, in a multi-run setting, data management becomes essential since AI tools rely on all the data generated. We are very proud of our new JedAI platform, a data analytics system designed to capture various data points throughout the design process, which integrates our solutions across this field. We have three major applications built on the JedAI platform: 1) Cadence Cerebrus, launched last year; 2) Optimality, which operates in the system space using similar technologies as Cerebrus but tailored for system simulation; and 3) Verisium in verification, which is notably one of the most time-consuming aspects of the design flow and generates substantial data. Logic simulation and hardware verification produce the most data in EDA. Therefore, having JedAI to unify these processes and prepare for increased data in verification was crucial. The adoption has been impressively strong. Our major customers are engaged, and we have endorsements from several large clients for Verisium. Last time we spoke about Cerebrus, and now all major customers genuinely want to implement these solutions. We are witnessing wider adoption and are very pleased with the progress so far.

Operator, Operator

Your next question comes from Jay Vleeschhouwer from Griffin Securities.

Jay Vleeschhouwer, Analyst

Anirudh, for you first, when you look back at the last one or two years, how would you rank the contribution to your bookings growth and/or share gain in what we define as core EDA from the various products that go under your nomenclature? I assume Innovus has been part of that given the size. But when you look at some of the various other sign-offs and tools you’ve introduced under that nomenclature, again, how would you rank the new momentum or incremental contribution from those and perhaps even look out ahead over the next one to two years in that respect? Secondly, for you, John, what has been your experience to date in terms of the predictability of your IP business? This is not a China-specific question, but feel free to talk about China specifically in terms of the increasingly material upfront component that we’ve seen for IP revenue recognition and for your services engagements related to IT. Thank you.

Anirudh Devgan, President and CEO

Hi Jay, that’s a good question. I’m very pleased with the strength of our portfolio in core EDA. We have been doing increasingly well over the last couple of years. Cadence's core EDA portfolio is strong as it has ever been. We want to apply our expertise in computational software to new areas like system analysis and system design analysis, but it’s critical to maintain leadership in the core because core always comes first. The core parts are, let’s say, three big areas: in core EDA - digital, analog, and verification at a high level. I feel that we have a very strong portfolio now. In terms of contributions of growth, in analog, we were always strong; there were some areas to improve in Spectre Simulation, which have been fixed over the last two years so I think analog is more steady. You can see even this quarter, it grew a healthy 12%. But a lot of the growth has come from digital and not just Innovus, which is placed in route, but also now with synthesis and sign-off and Cerebrus. So, I would say digital is growing very well also in terms of strengthening the position in the market. I’m especially pleased with verification. There are systemic growth drivers that are helping hardware, but I think that some of it is the strength of our portfolio, and some of it is hardware becoming more critical to the design portfolio. I’m actually pleased with Verisium, our logic simulator. I think that’s doing really well this year and over the last couple of years. This completes our overall verification platform because we are now strong in hardware with Palladium and Protium and Jasper, where we have always been the leading solution in formal verification. And with the strength of Xcelium, it completes our verification platform. I would say the growth in core EDA is driven by digital, number one; verification as a close second; and then maintaining and strengthening our position in analog.

John Wall, CFO

In relation to your IP question and particularly the predictability of IP revenue, our focus remains on profitable growth through differentiated Star IP that’s highly reusable and easier to scale. I’ve been very pleased with the discipline from the management team that runs that business for us and their ability to target more profitable and sustainable revenue growth. We always ask them to run IP like it’s our family business, sign us up to business that you’d want to do if this was your family business, not just a public company. Of course, with IP in amongst that profitable, sustainable, regular recurring revenue, there’s also some upfront components to IP that can have more variability. Naturally, we’re cautious on that going forward, but we’ll have to look at the macroeconomic environment on the impact of that for next year. We see a lot of upfront revenue this year in our numbers. Upfront revenue for 2022 is on track to be almost 50% growth year-over-year. That sets up some pretty tough comparisons for next year. Most of that’s coming on the hardware side. Looking at all businesses across Cadence, they’re all on track to go by low-teens or more growth this year. I feel very, very confident in the IP business because we’ve focused on profitable and sustainable revenue growth.

Operator, Operator

Your next question comes from Vivek Arya from Bank of America Securities.

Vivek Arya, Analyst

I wanted to ask the China question in a different way. How much of your 17% of sales to China were to customers involved in or who would eventually be involved in sub 14-nanometer logic design or leading edge NAND or DRAM? It’s just not intuitive that leading-edge design is not possible without your tools. China just got restricted from doing leading edge, yet you’re not seeing the restriction in any way. It’s just not intuitive to me at all.

John Wall, CFO

Hi, Vivek. We’ve taken the necessary steps to be in full compliance with the new export regulations, and our guidance includes the full impact. But we haven’t broken out how much of our China revenue is sub 14-nanometer, but we do believe the impact to the company is limited and manageable.

Vivek Arya, Analyst

But is that a near-term view, John? Is it because you are more involved in analog? Is it because you are in two- or three-year contracts, or is it because you think that there are other revenue sources outside of China that can help you kind of offset that deficit?

John Wall, CFO

We feel it’s limited and manageable going forward. Again, I mean, we’re applying these rules. We’ve included the impact in our guide. We believe it’s limited. It’s manageable from an R&D perspective, and we have to look at some resources and maybe redeploy some of those resources.

Vivek Arya, Analyst

Okay. And for my follow-up, I’m curious what happens if semiconductor sales go down 10% or 15% next year? What happens to the budget for EDA? Like even if you don’t decline, is it possible that the growth rate slows down from the mid-teens, or I guess asked in a different way, under what scenario would Cadence’s growth rate slow down next year?

Anirudh Devgan, President and CEO

Yes, this is Anirudh. I want to emphasize that we believe our business is quite resilient. However, we are still affected by the broader economic environment. The impact on us hinges on whether there is a recession and the severity of that recession. A very severe recession would affect everyone, but generally, our business has three factors that contribute to its resilience. First, we play a crucial role in the design process and are not directly linked to volume or shipment modes related to design activities. Design activities continue in both semiconductor and system companies, and we are expanding into system portfolios. Secondly, a significant portion of our revenue is predictable and steady. Lastly, we operate in various geographies and sectors, which provides us with added resilience compared to other companies in this context. Nonetheless, as I mentioned, we cannot ignore the possibility of a severe downturn, and we are vigilantly monitoring the situation. By the time we speak again in January, we should have more insights into the macroeconomic landscape and can offer further clarification on our outlook for the next year.

John Wall, CFO

The macro will really impact upfront more. We have very resilient, robust stream of recurring revenues. I think that’s what Jay was getting at in his earlier question about the predictability of the IP business. I feel very confident in the IP business because we’ve focused on profitable and sustainable revenue growth. We’ve had a really strong hardware revenue year this year. I don’t know myself, if there’s a severe downturn in macroeconomic conditions, IT budgets are one of the first things that look at to determine whether you need to purchase hardware, capital equipment, and things like that, and that could impact us on the upfront side.

Operator, Operator

Your next question comes from Harlan Sur with JP Morgan.

Harlan Sur, Analyst

Maybe as a follow-up to the last question. Your functional verification portfolio, which includes hardware simulation and prototyping, right, is up 25% through the first nine months of this year, very strong growth. But if I think about a weaker semiconductor industry next year and think about where the risk would be, you talked about some of the upfront portion of your revenues. I think about hardware emulation and prototyping platforms. On the flip side, we continue to hear that design verification and early software development continue to be significant bottlenecks in these next-generation digital SoC chip designs, which are critical to your customers’ overall design process. Do you guys agree with this? Given your pipeline visibility and backlog, do you see your hardware emulation and prototyping pipeline, at least as you’re looking at it now, remaining relatively strong into next year?

John Wall, CFO

From a backlog perspective, we probably have six months of hardware revenue in backlog. Any kind of increased issues on the macroeconomic front will probably slow down hardware purchasing going forward. We’ll need another few months to assess what the climates like there. Hardware is really a pipeline business. You get about 3 or 6 months kind of visibility into what that pipeline looks like. So again, I think, on the hardware side, it’s been a phenomenal year. The functional verification group has had a tremendous year this year. We’ll be lapping some tough comps next year, but we need a few more months to assess before we can guide anything to next year.

Anirudh Devgan, President and CEO

Your thesis is correct. Hardware has become indispensable to the design of chips and electronic systems. Without emulation and prototyping platforms, it’s almost impossible to design that. As the chips get bigger and as you go to near nodes, in terms of the number of gates, the next node always has more gates than the previous node, even if the chip size is the same. As the number of gates gets larger, it requires more verification and emulation. There is systemic support for how much verification and emulation needs to be done, so it depends on how that overall baseline growth required gets affected by any large macroeconomic shift. These hardware platforms are almost indispensable now as you do design, and almost all our big customers are relying on them.

John Wall, CFO

From a business perspective, we are building out our cloud infrastructure to provide that hardware in the cloud. That changes spending for emulation capacity from being capital spend to expense spending. From a revenue standpoint, emulation capacity that’s used in the cloud, we would have to recognize that revenue ratably. But we do have a business solution if there are cutbacks on CapEx spending.

Harlan Sur, Analyst

I appreciate that. And maybe just a longer-term question because we’re hearing more and more about this. The move to 800 gig and higher optical space in the data center is driving a strong focus on more integrated silicon photonics-based solutions, whether optical module based or co-package electro-optical. Intel, Marvell, Broadcom, NVIDIA, and Cisco, all of some of your big customers are working on thoughtful solutions. I know you guys have a strong portfolio here, also with Photonics, you have some advanced packaging and module design solutions, thermal and power modeling solutions as well, and you have partnerships with some of the manufacturing firms. How do you see this market opportunity unfolding for the team over the next few years?

Anirudh Devgan, President and CEO

That’s a great point. Photonics is big, and then you also touched on package-level integration. We are in a good position there based on the strength of Cadence. A lot of these things are done in Virtuoso platform, which is the flagship platform, and then also Allegro, which is again, a flagship platform for advanced packaging. Over the last four years, we’ve built analysis tools like Clarity and Celsius for electromagnetics and thermal, which are critical for photonics and 3D-IC. We have a broad solution. The exciting part is there are multiple vectors of growth possible with Cadence, and this is definitely a very exciting area as you know. We are working with all the big customers because of our position in Virtuoso and Allegro and the new analysis tools.

Operator, Operator

Your next question comes from Gal Munda with Wolfe Research.

Gal Munda, Analyst

Maybe the first one, John, for you. When I think about the guide heading into Q4, especially around the OpEx, it was implied to get to that level of profitability. Is there anything accelerated, anything that we need to kind of factor in that in terms of the hiring or on cost side, or do you think that incremental margins implied are kind of low-30s to get you to that number? Is it more conservative? How would you assess that part of the guide?

John Wall, CFO

Yes, sure. Good question, Gal. On the operating expense side, of course, it includes a full quarter now of expense for OpenEye Scientific and Future Facilities, plus incremental hiring that we did during Q3 and intend to do again in Q4. But you get the full bow wave effect of any hiring in Q3, the full quarter of that expense in Q4. Also, on the bookings front, we’ve seen substantial increases in bookings compared to our forecast this year; sales have been very good; and so there will be increased commission costs embedded into that Q4 guide as well.

Vivek Arya, Analyst

That’s helpful. As a follow-up, obviously, hardware has done really well this year. Looking back nine months, what has surprised you most? Was it the hardware itself, how strong it’s been this year, or has there been anything else that’s allowed you to keep raising the guide on the top line throughout the year?

John Wall, CFO

I’ve been very, very pleased with the performance of all the businesses. Every single one of our businesses is performing exceptionally well. The lowest performing business is showing teen growth year-over-year. It’s absolutely tremendous. What I wasn’t expecting was upfront revenue to grow by almost 50% over 2021. I don’t think any of us would have predicted that. You’re seeing a lot of that upfront revenue coming through from hardware. The popularity of our emulation systems has just been off the charts. Long may it continue, but it’s hard to determine how long that will continue for. We have substantial backlog already and a long lead time, and we’re making those systems as fast as we can. If you look at the inventory, we have less than $10 million of finished goods; the majority of that is already out on demonstration with customers. There’s a triage situation that goes on; every system that comes off the production line has a plan for getting it to a customer quickly.

Operator, Operator

Your next question comes from Johnny Conti from Deutsche Bank Securities.

Johnny Conti, Analyst

Congratulations on delivering another great quarter. Given the strong performance that you’ve had in system design analysis and JedAI and Cerebrus, could you provide some color on how your customers are reacting to budgetary decisions regarding spending in this category, given the current economic climate? Are you seeing customer stickiness similar to that of EDA consumption, or is this category of software spending more volatile?

Anirudh Devgan, President and CEO

Yes. Hi. This is Anirudh. It’s a good question. As I mentioned earlier, we are pleased with the adoption of these AI-based solutions because I think it can provide more automation than what EDA tools have done in the past. To some extent, these solutions are also deflationary. There’s an opportunity for the entire industry to move more of the work from people to automation, from people to tools. This is possible with JedAI and then Cerebrus, Optimality, and Verisium, where many lower-level tasks which were very mundane can be automated, allowing designers to focus on more valuable, higher-level tasks. This theme of our AI-based solutions moving mundane work to automation is popular, even in a tough environment because there’s a need for more automation. This is a very timely launch for those solutions. Organizations can increase productivity and create value with the same resources, making it especially relevant given today’s situation. I believe we have a very good platform with JedAI and three major solutions on top. You’ll see more from us next year in this area. We’re very pleased with the progress.

Johnny Conti, Analyst

Could you shed some color on whether there have been any changes to the backlog growth pipeline conversion and lengthening of sales cycles, given all that’s happening in software? Are your expectations unchanged from Q2, whereas half of the backlog is expected to flow into revenues over the next 12 months? Any commentary here on economic impacts for next year would be fantastic.

John Wall, CFO

When I look at the current RPO, I’m pleased. Despite the fact that it’s slightly down from Q2 to Q3, it includes the impact of the latest U.S. export restrictions and also the fact that we shipped more hardware into China in Q3. I feel confident in the current RPO. Generally, Q4 is a good add-on quarter for us, and I feel very pleased in terms of where we are. Annual value is about $2.7 billion now off of a total backlog of $5.5 billion. The annual value is $2.7 billion, representing time, but $2.7 billion is the annual value there. I anticipate this should grow through to the end of the year and set us up well for next year for our recurring revenue.

Johnny Conti, Analyst

That’s very fair. It’s interesting to see how much upfront revenue has actually generated this year. Thank you.

Operator, Operator

Your next question comes from Joe Vruwink from Baird & Company.

Joe Vruwink, Analyst

I wanted to go back to the IT topic and specifically ask about the record award. Looking at your non-cancelable access arrangements, it looks like that value went from $171 million to $434 million. Is that primarily reflecting this award? Is there anything unusual, or is this a normal term length, so kind of reading between the lines, this big step-up in what’s visible in backlog, we should see that kind of hitting revenue next year?

John Wall, CFO

Yes. Joe, that record contract in IP is included in our non-cancelable commitments in our backlog number. We’re delighted with the performance of the IP team and how well they’re doing. What’s interesting, which I always find is kind of not intuitive when looking at Cadence’s results is that sometimes in the biggest bookings quarters, you may not have a great increase in your current RPO for that particular business. We tend to play defense on the renewal and then leave room for add-on opportunities later. You can have big booking quarters that may not generate a huge amount of growth in current RPO. In contrast, you might have lower booking quarters where a lot of add-on opportunities get booked, increasing your current RPO and driving growth for the company. This particular case is a record contract, so we played more defense with something like that. You haven’t seen a huge uptick in current RPO for IP this quarter, but I think that will come later.

Joe Vruwink, Analyst

That is helpful. I appreciate you’re not guiding to next year, but there has been some conversation just around how good upfront deliveries have been this year, which creates a tough comp. I wanted to take the other component and just focus on recurring revenue. John, I believe in the past, you framed recurring revenue on a 3-year CAGR basis. Last quarter, the number was 12% to 13%. You mentioned how you thought that rate of growth was sustainable. A quarter later, some things have changed, but given the visibility you have in hand today, any changes to that 12-13% rate on a 3-year CAGR basis as it pertains to recurring revenue?

John Wall, CFO

I feel more confident now that we understand the U.S. export restrictions. I'm optimistic about our recurring revenue moving forward compared to last quarter. The main concern from a macroeconomic perspective is how the overall economic climate will impact our upfront business for next year, which is difficult to predict. We need additional time to determine what that will mean for next year.

Operator, Operator

Your next question comes from Blair Abernethy from Rosenblatt Securities.

Blair Abernethy, Analyst

Hi. Nice quarter, guys. Thanks for sliding me in the questions here. I just wanted to talk a little bit about Cadence on Cloud, specifically the Palladium Cloud. Can you walk us through how you’re looking at this cloud-based emulation? How should a customer approaching you for a decision between an on-prem hardware solution versus Palladium Cloud view that? What about how you’re thinking about pricing?

Anirudh Devgan, President and CEO

Hi Blair, this is Anirudh. Thanks for asking this question. That’s a very important point. We really like these cloud offerings, especially for hardware. Even if you think about the regular cloud, right, with the CPU cloud by the big cloud vendors, what they’re doing is amortizing hardware across multiple customers and moving from CapEx to OpEx model. The cloud model has been successful in hardware first, and then you build all kinds of software solutions on top. This is the hope for our Palladium business. We want more customers to go to our cloud offering because that also makes the hardware business more ratable and provides flexibility to our customers. One of the issues with Palladium and Protium being popular is that smaller companies sometimes can’t deploy as much as bigger companies due to the upfront cost of a full Palladium rack. However, on the cloud, it gives smaller companies access to hardware emulation as they undertake more complicated designs. It makes it more ratable, and we encourage all our customers to move to the cloud. We have built infrastructure in data centers together with some big data center partners to have this capacity in the cloud. It depends on customer choice; if customers want to buy for in-house use, we support that. But I sense customers are becoming more flexible in choosing between on-prem or cloud hardware.

Operator, Operator

Our final question comes from Ruben Roy from Stifel Nicholas.

Ruben Roy, Analyst

Anirudh, I think you have answered just about every question there was. But I wanted to drill into the new customers on the digital design flow. Can you talk about the type of customers you're seeing? Is that competitive displacements for traditional semiconductor companies or non-traditional, a combination of both? Are you seeing a higher attach rate in either semiconductor companies or systems companies for hardware these days as you sign up new deals on digital design?

Anirudh Devgan, President and CEO

Hi Ruben, great points. In general, in terms of the digital business, I think it’s both, new customers and existing customers with market share gain. Cadence’s core EDA portfolio is performing excellently; it’s strong compared to before. I think what’s great about Cerebrus is, one, it does more automation of mundane tasks. It’s like having automatic driving versus manual driving; you don’t have to control all the knobs and tedious work. The tool does it for you. It also unifies the platform. We’ve been talking about unified synthesis, placement, and signoff since 2014 or 2015. Cerebrus unifies the entire platform by working across synthesis, place and route, and signoff. We have more than 40 new full flow wins in 2022, which helps our digital business. We see good growth in digital, just as we had last quarter. On the hardware side, that attach rate is strong in the large semi-companies. Still, a lot of hardware is also being employed by system companies designing semiconductors, as systems companies utilize more software, which necessitates emulation. We are pleased to see growth in hardware across both digital and hardware, monitoring it closely as we move forward. Thank you all for joining us this afternoon. We are excited about our business momentum and the tremendous market opportunities ahead. We are proud of the innovative and inclusive culture we have built at Cadence, and we are grateful for the recognition received over the years, including being named one of the world’s best workplaces for the seventh time by Fortune and Great Place to Work. We are also honored to be included in Investor’s Business Daily’s 100 Best ESG Companies for 2022, the fourth consecutive year achieving this recognition. On behalf of our employees and Board of Directors, we thank our customers, partners, and investors for your continued trust and confidence in Cadence. We look forward to speaking with you again on our Q4 2022 earnings call. Thank you, and have a great evening.

Operator, Operator

Thank you for participating in today’s Cadence third quarter 2022 earnings conference call. This concludes today’s call. You may now disconnect.