Earnings Call Transcript - CDNS Q1 2024

Operator, Operator

Good afternoon. My name is Regina and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence First 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.

Richard Gu, Vice President of Investor Relations

Thank you, operator. I'd like to welcome everyone to our First 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 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. I'm pleased to report that Cadence had a strong start to the year, delivering solid results for the first quarter of 2024. We came in at the upper end of our guidance range on all key financial metrics and are raising our financial outlook for the year. We exited Q1 with a better than expected record backlog of $6 billion, which sets us up nicely for the year and beyond. Long-term trends of hyperscale computing, autonomous driving, and 5G, all turbocharged by the AI super-cycle, are fueling strong broad-based design activity. We continue to execute our long-standing Intelligent System Design strategy as we systematically build out our portfolio to deliver differentiated end-to-end solutions to our growing customer base. Technology leadership is foundational to Cadence, and we are excited by the momentum of our product advancement over the last few years, and the promise of our newly unveiled products. Generative AI is reshaping the entire chip and system development process, and our Cadence.AI portfolio provides customers with the most comprehensive and impactful solutions for chip-to-systems intelligent design acceleration. Built upon AI-enhanced core design engines, our GenAI solution, boosted by foundational LLM co-pilot, is delivering unparalleled productivity, quality of results, and time to market benefits for our customers. Last week at CadenceLIVE Silicon Valley, several customers including Intel, Broadcom, Qualcomm, Juniper, and Arm shared their remarkable successes with solutions in our Cadence.AI portfolio. Last week, we launched our third-generation dynamic duo, the Palladium Z3 emulation and Protium X3 prototyping platform to address the insatiable demand for higher performance and increased capacity hardware accelerated verification solutions. Building upon the successes of the industry-leading Z2, X2 systems, this new platform sets a new standard of excellence, delivering more than twice the capacity and 50% higher performance per rack than the previous generation. Palladium Z3 is powered by our next generation custom processor and was designed with Cadence AI tools and IP. The Z3 system is future-proof with its massive 48 billion gate capacity, enabling emulation of the industry's largest design for the next several generations. The Z3 X3 systems have been deployed at select customers and were endorsed by Nvidia, Arm, and AMD at launch. We also introduced the Cadence Reality Digital Twin Platform which virtualizes the entire data center and uses AI, high-performance computing, and physics-based simulation to significantly improve data center energy efficiency by up to 30%. Additionally, Cadence's cloud-native molecular design platform Orion will be supercharged with Nvidia's BioNemo and Nvidia microservices for drug discovery to broaden therapeutic design capabilities and shorten time to trusted results. In Q1, we expanded our footprint at several top-tier customers and furthered our relationship with key ecosystem partners. We deepened our partnership with IBM across our core EDA and systems portfolio, including a broad proliferation of our digital, analog, and verification software and expansion of our 3D-IC packaging and system analysis solutions. We strengthened our collaboration with Global Foundry through a significant expansion of our EDA and system solutions that will enable GF to develop key digital-analog RF/MM-Wave and silicon photonics design for aerospace and defense IoT and automotive end-markets. We announced a collaboration with Arm to develop a chiplet-based reference design and software development platform to accelerate software-defined vehicle innovation. We also further extended our strategic partnership with Dassault Systems, integrating our AI-driven PCB solution with Dassault's 3DEXPERIENCE Works portfolio, enabling up to a 5x reduction in design turnaround time for solid work customers. Now let's talk about our key highlights for Q1. Increasing system complexity and growing hyperconvergence between the electrical, mechanical, and physical domain is driving the need for tightly integrated co-design and analysis solutions. Our System Design and Analysis business delivered steady growth as our AI-driven design optimization platforms integrated with our physics-based analysis solution continued delivering superior results across multiple end markets. Over the past six years, we have methodically built out our system analysis portfolio. And with the signing of the definitive agreement to acquire BETA CAE, we are now extending it to structural analysis, thereby unlocking a multi-billion dollar TAM opportunity. BETA CAE's leading solutions have a particularly strong footprint in the automotive and aerospace verticals, including customers such as Stellantis, General Motors, Renault, and Lockheed Martin. Our Millennium supercomputing platform, delivering phenomenal performance and scalability for high-fidelity simulation, is ramping up nicely. In Q1, a leading automaker expanded its production deployment of Millennium to multiple groups after a successful early access program in which it realized tremendous performance benefits. Allegro X continued its momentum and is now deployed at well over 300 customers. While Allegro X AI, the industry's first fully automated PCB design engine, is enabling customers to realize a significant 4 to 10 times productivity gain. Samsung used Celsius Studio to uncover early design and analysis insights for precise and rapid thermal simulation for 2.5D and 3D packages, attaining up to a 30% improvement in product development time. A leading Asian mobile chip company used optimality intelligence system explorer AI technology and Clarity 3D Solver to obtain more than 20 times design productivity improvement. Ever-increasing complexities in system verification and software bring-up continue to propel the demand for our functional verification products. With hardware accelerated verification now a must-have part of the customer design flow. On the heels of a record year, our hardware products continue to proliferate at existing customers while also gaining notable competitive wins, including at a leading networking company and at a major automotive semiconductor supplier. Demand for hardware was broad-based, with particular strengths seen at hyperscalers, and over 85% of the orders during the quarter included both platforms. Our Verisium platform that leverages big data and AI to optimize verification workloads, boost coverage, and accelerate root cause analysis of bugs saw accelerating customer adoption. At CadenceLIVE Silicon Valley, Qualcomm said that they used Verisium to increase total design coverage automatically while achieving up to a 20x reduction in verification workload runtime. Our Digital IC business had another solid quarter as our digital full flow continued to proliferate at the most advanced nodes. We had strong growth at hyperscalers, and over 50 customers have deployed our digital solutions on three nanometer and below design. Cadence Cerebrus, which leverages Gen.AI to intelligently optimize the digital full flow in a fully automatic manner, now has been used in well over 350 tapeouts, delivering best-in-class PPA and productivity benefits. It's fast becoming an integral part of the design flow at marquee customers, as well as in DTCO flows for new process nodes at multiple foundries. In custom IC business, Virtuoso Studio, delivering AI-powered layout automation and optimization, continued ramping strongly, and 18 of the top 20 semi have migrated to this new release in its first year. Our IP business continued to benefit from market opportunities offered by AI and multi-chiplet based architecture. We are seeing strong momentum in interface IPs that are essential to AI use cases, especially HBM, DDR, UCIe, and PCIe at leading-edge nodes. In Q1, we partnered with Intel Foundry to provide design software and leading IP solutions at multiple Intel-advanced nodes. Our TenSilica business reached a major milestone of 200 software partners in the Hi-Fi ecosystem, the de facto standard for automotive infotainment and home entertainment. We extended our partnership with one of the top hyperscalers in its custom silicon SOC design with our Xtensa NX controller. In summary, I'm pleased with our Q1 results and the continuing momentum of our business. The piling chip and system design complexity and the tremendous potential of AI-driven automation offer massive opportunities for our computational software to help customers realize these benefits. In addition to our strong business results, I'm proud of our high-performance inclusive culture and thrilled that Cadence was named by Fortune and Great Place to Work as one of the 100 best companies to work for in 2024, ranking number 9. Now I will turn it over to John to provide more details on the Q1 results and our updated 2024 outlook.

John Wall, Senior Vice President and CFO

Thanks, Anirudh, and good afternoon, everyone. I am pleased to report that Cadence delivered strong results for the first quarter of 2024. First quarter bookings were a record for Q1 and we achieved record Q1 backlog of approximately $6 billion. A good start to the year coupled with some impressive new product launches sets us up for strong growth momentum in the second half of 2024. Here are some of the financial highlights from the first quarter starting with the P&L. Total revenue was $1.009 billion. GAAP operating margin was 24.8%, and non-GAAP operating margin was 37.8%. GAAP EPS was $0.91, and non-GAAP EPS was $1.17. Next, turning to the balance sheet and cash flow, cash balance at quarter end was approximately $1.012 billion, while the principal value of debt outstanding was $650 million. Operating cash flow was $253 million. DSOs were 36 days, and we used $125 million to repurchase Cadence shares in Q1. Before I provide our updated outlook, I'd like to share some assumptions that are embedded in our outlook. Given the recent launch of our new hardware systems, we expect the shape of hardware revenue in 2024 to weigh more toward the second half, as our team works to build inventory for the new system. Our updated outlook does not include the impact of our pending BETA CAE acquisition, 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 fiscal 2024 is revenue in the range of $4.56 billion to $4.62 billion. GAAP operating margin in the range of 31% to 32%. Non-GAAP operating margin in the range of 42% to 43%. GAAP EPS in the range of $4.04 to $4.14. Non-GAAP EPS in the range of $5.88 to $5.98. Operating cash flow in the range of $1.35 billion to $1.45 billion. We expect to use at least 50% of our annual free cash flow to repurchase Cadence shares. With that in mind, for Q2 we expect revenue in the range of $1,030 million to $1,050 million. GAAP operating margin in the range of 26.5% to 27.5%. Non-GAAP operating margin in the range of 38.5% to 39.5%. GAAP EPS in the range of $0.73 to $0.77. Non-GAAP EPS in the range of $1.20 to $1.24. And as usual, we've published a CFO commentary document on our investor relations website, which includes our outlook for additional items, as well as further analysis and GAAP to non-GAAP reconciliations. In summary, Cadence continues to lead with innovation and is on track for a strong 2024 as we execute to our intelligent system design strategy. I'd like to close by thanking our customers, partners, and our employees for their continued support. And with that, operator, we will now take questions.

Operator, Operator

Your first question comes from the line of Joe Vruwink with Baird. Please go ahead.

Joe Vruwink, Analyst

Great. Hi everyone. Thanks for taking my questions. Maybe just to start with your outlook for the year. Can you perhaps provide maybe your second-half assumption before this quarter versus where it stands today in terms of just recalibrating around delivery schedules? And maybe a good way to frame it, I think in the past you gave a share of this year's revenue that was going to come from upfront products. Is that still the right range? But if it is the right range, you can obviously see more is going to end up landing in the second half. And so that kind of puts to your original views or how is that, I guess, skewed relative to what might have been the expectation a quarter ago?

John Wall, Senior Vice President and CFO

That's a great question, Joe. And I think you've hit on the main point there that upfront revenue is driving a lot of the quarter-over-quarter trends this year. When I look at last year, you recall that we had a large backlog of hardware orders and we dedicated 100% of the production, hardware production in Q1 to deliver that hardware in Q1 2023. As a result, in Q1 2023, 20% of our Q1 ‘23 revenue was from upfront revenue sources. That in contrast, Q1 this year, it's only 10% of the total revenue for this Q1 is coming from upfront revenue. But again, last year, and to reflect on where we thought we were this time last quarter, that we still expect that upfront revenue will probably be 15% to 20%. I mean, around the midpoint there is 17.5% in expectation for upfront revenue this year. And a midpoint of say 82.5% for recurring revenue. That's still the same as what we thought this time last quarter. That contrast with last year was, I think, 16% of our revenue was upfront last year. To put dollar terms on it, last year $650 million of our revenue was upfront. This year, we're expecting roughly $800 million to be upfront. But the first half versus first half, last year, we had $350 million in the first half and $300 million in the second half because we had prioritized all those shipments in hardware and it skewed the numbers toward the first half last year. So $350 million and $300 million ending with the $650 million of upfront revenue last year. This year, it looks more like $250 million and $550 million at the back end. But I know that's largely a result of, we had a record backlog, our record bookings quarter in Q1. We've got a substantial backlog in IP that we're scaling up to deliver; a lot of that revenue falls into the second half. We also launched these new hardware systems last week. Hardware revenue is expected to be more second-half weighted now, because based on what we've heard, and I'll let Anirudh chime in here on the technical aspects of the new hardware systems, we expect them to be so popular that a lot of demand will shift to those new hardware systems and we'll have to ramp up production to be able to deliver that demand. So it shifts some of the upfront revenue to the second half. So I think upfront revenue is really driving a lot of the skewed metrics. Anirudh, do you want to talk about Z3?

Anirudh Devgan, President and CEO

Yeah, absolutely. So we are very proud of the new systems we launched. As you know, we are a leader in hardware-based emulations with Z2 X2. The last time we launched them was in 2021. So that was like a six-year cycle. You know, Z1 X1 was 2015 and then Z2 X2 was 2021. So what I'm particularly pleased about is, we have a major refresh, you know, it's a game-changing product, but it was also developed in only three years. So in 2024, we have a new refresh, and it's a significant leap in terms of capacity. Even last week at our CadenceLIVE conference, Nvidia and Jensen talked about how they use Z2 to design their latest chip like Blackwell. It's also used by all the major silicon companies and system companies to design their chips. But what is truly exciting about Z3 and X3 is this a big leap; it’s like Z3 is 4 to 5 times more capacity than Z2. It's a much higher performance. So it sets us up nicely for the next several years to be able to design the several generations of the world's largest chips. The reason we can do it in three years versus six years is, we use our own design internally in Cadence for TSMC advanced nodes. We're using all our latest tools, all the latest AI tools, and all our IP. There's very good validation of our capabilities that we can accelerate our design process, but really sets up hardware verification and overall verification flow for using the new systems. Normally, there is a transition period when you have a new system, and we went through that twice already in the last 10 years. Customers will naturally transition to the new systems, and then we build them over the next one or two quarters. That is the right thing to do for the business long-term. It's crucial to accelerate the development of the next generation system to get ready for this coming AI wave for the next several years, and we are very well positioned. As a result, it does have some impact on quarter-to-quarter, but that's well worth it in the long run.

Joe Vruwink, Analyst

Thank you, that's very helpful. For my second question, I wanted to ask how some of the things you just mentioned, particularly AI, start to change the frequency of customer engagement with you and their approach to renewals. You mentioned how the Harbor platforms have evolved from the first generation to the next six years, leading to a three-year new product cycle. When I hear your customers talk about AI, it seems they're not just creating machine learning models that can be reused, but each iteration improves with prior feedback. It appears that AI itself not only fosters stickiness but might also incentivize broader deployment than customers would typically consider for new products. Does this imply that the average renewal run rates could significantly increase, impacting our backlog?

Anirudh Devgan, President and CEO

Yeah, that's the correct observation. As you know, AI has a lot of profound impacts on Cadence, and a lot of benefits to our customers. There are three main areas. One is the build-out of the AI infrastructure, whether it's Nvidia, AMD, or all the hyperscalers. We are fortunate to work with all the leading AI companies. That's the first part. In that, as they design bigger and bigger chips, the tools have to be more efficient; the hardware platforms must support that. That's why we have the new systems. The second part of AI is applying AI to our products, which is the Cadence.AI portfolio. As I mentioned earlier, several customers talked about their successes, including Intel, Broadcom, Qualcomm, Juniper, and Arm, and the results are significant. We are no longer in the trial phase of whether these things will work. We're now getting pretty significant improvements like MediaTek, which saw a 6% power improvement, and one of the hyperscale companies experienced an 8-10% power improvement. These are significant numbers leading to the deployment of our AI portfolio. The AI run rate on a trailing 12-month basis is up threefold. Design processes were already well automated, and EDA has a history of automating design over the last 30 years. Therefore, AI is in a unique position because you need the base processes to be somewhat automated to apply AI. The last piece of AI proliferation is new markets, which opens up things like data center design and our Millennium systems. These will take a little longer to ramp up but represent the third type of AI impact.

Joe Vruwink, Analyst

That's great. Thank you very much.

Operator, Operator

Your next question will come from the line at Charles Shi with Needham & Company. Please go ahead.

Charles Shi, Analyst

Thanks. Good afternoon. I just wanted to ask about the China revenue in Q1. It looks pretty light. I wonder whether that's part of the reason weighing on your Q2. I understand you mentioned that you're going through that second-gen to third-gen hardware transition right now. Maybe that's another factor, but from your geographical standpoint, what's the outlook for China for the rest of the year, and specifically Q2? Thanks.

John Wall, Senior Vice President and CFO

Hi Charles, that's a great observation. If you recall, this time last year, we were talking about a very strong Q1 for China for functional verification and for upfront revenue. I think those three things are often linked. You contracted with this year; China is down 12%. Upfront revenues are lower at 10% compared to 20%. Functional verification, of course, is lapping those tough comps when we dedicated our entire production to deliveries. What we're seeing in China is strong design activity. And while the percentage of revenue dropped to 12%, it aligns with a lower hardware, lower functional verification, and lower upfront revenue quarter which generally leads to a lower China percentage quarter. However, we have good geographical diversification. While China is coming down, we can see other Asia increasing, and our customer base is very mobile. That geographical mix of revenue is based on consumption and where the products are used. But as we do more upfront revenue in the second half, we'd expect the China percentage to increase.

Charles Shi, Analyst

Thanks. I want to ask another question about the upcoming ramp of the third-generation hardware. Where exactly is the nature of the demand? Is it replacement demand, like your customers replacing Z2 X2 with Z3 X3, or do you expect many more customers adopting Z3 X3? And importantly, I think you mentioned about 4 to 5 times capacity increase they can design larger chips with a lot more transistors. How much of an ASP uplift are you expecting from the Z3 X3 versus Z2 X2?

Anirudh Devgan, President and CEO

Charles, all good observations. In terms of your last point, normally if the system has more capacity like this one has, it can do more, increasing its value to our customers. Typically, newer systems are better that way for us and better for the customer. To give an example, we designed this advanced TSMC chip by ourselves, one of the biggest chips that TSMC makes. One rack will hold more than a hundred of these chips, and we can connect up to 16 racks together. That allows us to emulate very large systems efficiently. So even Z2, as Nvidia mentioned last week, even Blackwell, which is the biggest chip in the world right now with 200 billion transistors, was emulated on a few racks of Z2. With 16 racks of Z3, we can emulate chips five times larger than Blackwell. This provides our customers with considerable runway, as the capacity of the chips needed for AI is continually growing. It allows for emulating not just large chips, but multiple chips simultaneously, critical for AI workloads. I think this puts us in a very good position for all this AI boom that is happening, not just with our partners like Nvidia and AMD, but also all the hyperscalers. The primary demand will be for more capacity chips requiring more hardware, and then X3 will support that prototype in FPGAs. We have unique workload capabilities, good features for low power, and innovations for the mobile market. It's a combination of new customers, competitive wins, and continuing to lead in designing the largest chips required for AI processing now and in the coming years.

Charles Shi, Analyst

Thanks.

Operator, Operator

Your next question will come from the line of Lee Simpson with Morgan Stanley. Please go ahead.

Lee Simpson, Analyst

Great, thanks. And thanks very much for squeezing me on. Just wanted to go back to what you said last quarter, if I could. It did seem as though you were saying that there was an element of exclusivity around your partnership with Arm, your EDA partnership around Arm total design. I wondered how that was developing, if indeed you're collaborating to accelerate the development of custom SoCs using Neoverse. It looks as though it's pulled in quite a lot of work or continues to pull in quite a lot of work around functional verification. As we look at now third-generation tool sets for Palladium and Protium, leaving aside some of the rack-scale development that we're seeing out there, whether or not Arm’s total design development work is pulling in or is likely to pull in some of that second-half business. That means not just hyperscalers, but perhaps in AI PCs and beyond.

Anirudh Devgan, President and CEO

Yeah, thank you for the question. We are proud to have a very strong partnership with Arm and with our joint customers, Arm and Cadence customers. I think we have had a noteworthy partnership over the last 10 years, and it's getting better and better. Yes, we talked about our new partnership on Total Compute. Also, I think this quarter we talked about our partnership with HARMAN Automotive. It’s interesting to see that Arm continues to perform well in mobile, but also now in HPC server and automotive end markets. So we are pleased with that partnership, and they are also doing more subsystems and higher-order development, which requires more partnership with Cadence in terms of the backend, Innovus, Digital Flow, and verification with hardware platforms and other verification tools.

Lee Simpson, Analyst

Great, maybe just a quick follow up. We've seen quite a bit of M&A activity from yourselves of late, including the IP house acquisition of Invecas. You've had Rambus bought, and you've now acquired BETA in the computer-aided emulation space for the car. There's been speculation about the possibility of a transformative deal being done. Given that we have you on the mic here, maybe if you could share what type of business Cadence could look for. Would you look for a high value and contiguous vertical to what you already addressed, like automotive, or would it be something broader, a business spanning several verticals? Could that align with Cadence’s ambition given the silicon to systems opportunities emerging?

Anirudh Devgan, President and CEO

Thank you for the question. A lot of times there are many reports, and we normally don't comment on these reports. But what I would like to say is that our strategy hasn't changed; it's the same strategy from 2018. I want to make sure that we are focused on our core business, which is EDA and IP. Yes, I launched this initiative on systems, which is critical—chips from silicon to systems. But I would say our core business has become much more valuable because of AI. Our primary focus is on organic development, which is usually the best way forward. Alongside that, we have done some opportunistic M&A to add to our portfolio. It helped us in system analysis and in IP because we remain optimistic about IP growth this year. We talked about our new partnership with Intel Foundry in Q1. We also acquired Rambus IP assets, which are HBM. This is critical technology in AI, and we expect growth in HBM this year, with deliveries towards the second half of the year. In regard to BETA, it made sense because it is a good technology and right size for us. We focus on finishing that acquisition while integrating it, and this will take some time. Our primary focus in M&A remains the same since 2018: organic growth with synergistic computational software, mostly tuck-in acquisitions.

Lee Simpson, Analyst

That's great, thank you.

Operator, Operator

Your next question comes from the line of Ruben Roy with Stifel. Please go ahead.

Ruben Roy, Analyst

Thank you. Anirudh, I had a follow-up on the Z3 X3 commentary. One of the things I was thinking about, especially as you talked about the InfiniBand low-latency network across multiple racks of Z3; you mentioned that you're up to an 85% attach rate of both systems with Z2 X2. I would imagine that would continue to go up. Can you comment if the new systems incorporate InfiniBand across Z3 and X3, and do you expect that to be a selling point for your customers designing these big chips, which in many cases have software development attached to the design process? Do you think that the attach rates will continue to move higher for both systems?

Anirudh Devgan, President and CEO

Yes, absolutely. I think I started this in, I forget now, 2016, I think, with a Dynamic Duo—our custom processor for Palladium and using FPGA for Protium. This has become the right approach over the years. Customers are embracing both systems as they invariably do both chip and software development. A perfect example is Nvidia; they’ve moved beyond just chip development to a massive software stack. We see that trend continuing. We do use, you know, Nvidia's products like InfiniBand in our systems on Z3 because Z3 features a unique architecture that requires very high-speed interconnect. It's almost like a supercomputer, necessitating optical and InfiniBand for Z3. In contrast, X3 uses AMD FPGAs, which does not require that stiff interconnect speed. So InfiniBand plays a more critical role in Z3 compared to X3. Still, X3 is a dynamic system too. We're using the latest AMD FPGAs, providing an 8x higher capacity than X2, along with numerous software innovations. I'm confident that we have true leadership in both hardware platforms.

Ruben Roy, Analyst

That's helpful, thank you, Anirudh. Then for John. Anirudh mentioned the HBM IP business booked and shipping in the second half. I wanted to get a bigger picture update on how you're viewing IP in general in terms of bookings relative to the ramp of those IP sales. Should we think about the entire segment being second half weighted? Is it safe to say the second half will ramp heavier than the first half?

John Wall, Senior Vice President and CFO

Yes, thanks, Ruben. I mean, Q1 IP performance and bookings were ahead of our expectations. Everything remains on track there for a very strong growth year for 2024 for the IP business. Of course, the timing of revenue recognition depends on the timing of deliveries, but we had a tremendous bookings quarter in Q1, and we're preparing to scale for a number of deliveries of IP in the second half. We expect our IP business to experience a robust year. Overall, we're pleased with the business momentum but need to scale up headcounts to deliver on some larger backlog orders.

Anirudh Devgan, President and CEO

I want to highlight our partnership with Intel and IFS that was concluded in Q1. It's great to see Intel investing more in the foundry business and working more closely with us. That's a key contributor to IP, but we need to hire the right people and adapt our portfolio to the Intel process. This will take some time, and we expect it to become more evident towards the end of this year and into next year. We're pleased with this new partnership.

Ruben Roy, Analyst

Very helpful. Thanks, guys.

Operator, Operator

Your next question comes from the line of Jay Vleeschhouwer with Griffin Securities. Please go ahead.

Jay Vleeschhouwer, Analyst

Thank you. John, I want to refer back to a recent conversation we had. Can you share your insights on the health and dynamics of the EDA market regarding new or expansion business during intra-contract periods? Could you discuss what you're observing in this area beyond customer renewals? Additionally, how are you approaching pricing for this year? EDA generally has significantly better pricing capabilities compared to previous years. And then I have a follow-up for Anirudh.

John Wall, Senior Vice President and CFO

Sure, thanks, Jay. Great question. I think what you're getting at is what we would call add-ons. Typically, we have a very predictable software renewal business. And you'll see in the recurring revenue part of our business, I think we're at double-digit revenue growth. That has been in the low teens. We're seeing that a number of customers adopting AI tools are not purchasing add-ons as frequently, but right now we're focused on proliferating those AI tools into accounts. I think there's an opportunity to increase pricing but it may not be the right time. We have strong momentum on the upfront revenue business. We're preparing for scale into the second half there. Our focus is on proliferating AI tools and technology into accounts. Pricing is something we can focus on more intently in future years, but right now the focus is on proliferation.

Anirudh Devgan, President and CEO

No.

Jay Vleeschhouwer, Analyst

Okay, Anirudh, so piggybacking on your conference last week, particularly the Gen AI track. It was interesting to hear the adoption presentations by Renesas, Intel, and so forth. But what seemed to be taking place is a heavy focus on Cerebrus, which makes sense as it is the one longest end-market. So perhaps you could talk about how you are thinking about the adoption curve for the other brands aside from Cerebrus. Are there critical parts of the design flow that might not necessarily be amenable to AI enablement? We hear a lot about implementation, analog, verification, but we don't hear a lot about AI as being applicable to synthesis, for example. Could you talk about those areas where it makes a lot of sense and areas where that will remain more conventional technology?

Anirudh Devgan, President and CEO

Yes. Thanks, Jay, for the question. We have five major AI platforms, with Cerebrus and Digital implementation being the longest out. Cerebrus is performing quite well, as you noted. We've noted over 350 tapeouts with a lot of PPA improvement. However, all the other products are also doing well. Sometimes we have many products, and we don't talk enough about the others. For example, verification and products like Verisium are doing well. I mentioned Qualcomm discussed impressive results because verification is an exponential problem; as the chips get larger, verification tasks grow exponentially. The benefits to AI in verification will be significant, and you will see that grow in the next few quarters and years to have verification as important as implementation benefits of AI. Additionally, I want to highlight PCB and Allegro and Packaging, as that area hasn't seen as much automation. Allegro is the leading platform for PCB and packaging, and I'm proud of Allegro X AI. We talked about several customers, including Intel last week noting 4x to 10x improvement using X AI in PCB. Beyond Digital, I feel verification and Allegro and PCB will have a significant impact, but areas that haven't performed as well are design generation, which is a complex part of the design process. While LLM-based models show promise, there are challenges in applying this towards design generation.

Jay Vleeschhouwer, Analyst

Okay, very good. Thank you.

Operator, Operator

Your next question comes from the line of Gary Mobley with Wells Fargo Securities. Please go ahead.

Gary Mobley, Analyst

Hi guys. Thanks so much for taking my questions. John, I appreciate the fact that China revenue in the first quarter was down against a tough year-ago comp on the hardware verification side as you work on backlog. I assume you still expect China to be dilutive to overall company growth in the fiscal year. Could you speak to whether or not you are starting to see US export controls impact your ability to do business there, whether a function of restrictions around gate-all-around or certain China customers added to the entity list?

John Wall, Senior Vice President and CFO

Hi, Gary, thanks for the question. Just to clarify, I think last quarter I said I expected China revenue to be flat to down this year. I think we still expect that. That's because last year was strong, and there was an oversized portion of that hardware catch-up delivered to China. So it skewed the number higher. We're lapping tough comps, but the design activity in China remains strong. We have a lot of diversification. Strength in other parts of the world persists, but we're comfortable with the 2024 outlook and we factored in all the impact of geopolitical risk as best we can to reduce China risk.

Gary Mobley, Analyst

Okay. The follow-up, I want to ask about bookings trends for the balance of the year. You highlighted better than seasonal Q1 booking trends. How do you expect the bookings to play out for the balance of the year, and to what extent will Z3 and X3 factor into that for the balance of the year? Thank you.

John Wall, Senior Vice President and CFO

Yes, it's hard to predict in terms of Z3 and X3—we definitely need another quarter to see that. We expect strong demand and revenue growth. Overall, we are preparing for scale in the second half on the hardware side, but I don't like taking up the year until I see the pipeline in the summer. We are trying to be conservative about that. Overall, on the hardware side, yes, we expect strong demand.

Operator, Operator

Your next question comes from the line of Jason Celino with KeyBanc Capital Markets. Please go ahead.

Jason Celino, Analyst

Hi, thanks for having me. Anirudh, congrats to your R&D team. I'm impressed they reduced the cycle time while designing that among many factors, too. Just how many of the Z3 and X3 systems will become available in Q3? When can customers start placing orders?

Anirudh Devgan, President and CEO

Yes, first of all, thank you. Yes, they become available now but will ramp up in Q3 and Q4. We already have them running at several early customers. Normally when we announce something, all our lead partners have been running them for three months already, so they're stable. In general, it will be more Q3 and then Q4, as there is often a three to six-month overlap. We will continue selling Z2 X2 while moving to Z3 X3, which naturally contributes to quarter-to-quarter variation, but we expect Q3 to be larger followed by Q4.

John Wall, Senior Vice President and CFO

Yes, we try to reduce the guide with the assumption of strong demand for the new systems. We can also allocate older systems to the cloud, serving a large underserved community wanting to use our emulation capacity. Using them in the cloud would lead to ongoing revenues, while delivering them for on-prem use means we take revenue upfront.

Jason Celino, Analyst

Okay, because that's kind of what I was going to ask next. I think last time, in 2021, you had a six-month period where you were selling both. On that call, you were trying to clear inventory for the Z1 and X1. It doesn't sound like you'll be trying to do that again. When I think about this Q2 air pocket, is it a function of customers waiting for Z3 X3? Or might it be that they wouldn't want to purchase the older version?

John Wall, Senior Vice President and CFO

Well, we’ve reduced the guide with the assumption many customers might wait, but we intend to sell them side by side. To the extent customers wait, it could shift some hardware revenue into the second half, and we've anticipated that, so it's within the guide. If customers continue to buy Z2, then that will alter our revenue profile, but we expect strong demand for the new system.

Vivek Arya, Analyst

Thank you for taking my questions. I think you mentioned the second-half growth will be driven more by hardware. Will you see all the benefit of the hardware refresh this year? Will it carry on into 2025? A bigger question is that if I exclude the upfront benefit from last year and this year, your recurring business is expected to grow about 10%. I'm curious, Anirudh, is that in line with the recurring revenue growth you expect, or should we expect that moving forward along with periodic hardware refreshes? Or is interpreting your core recurring business this way incorrect?

Anirudh Devgan, President and CEO

Very good question. First, in non-recurring, it's not just hardware but also IP in the second half because we mentioned new IP business driven by HPM, AI and by Intel IFS. This also backends, along with hardware. Hardware normally takes one to two years fully to get ramped up, so even though we aren't commenting about the next year, I'd be surprised if we only experienced a six-month outlook this time. These systems are built to last for five to seven years. Regarding recurring revenue, the best way to assess is on a three-year CAGR basis to accommodate fluctuations. Overall, we're pleased with the recurring revenue growth.

John Wall, Senior Vice President and CFO

Yes, Vivek, I’d like to address part of Gary's question earlier that I don’t think I addressed. Q2 is our latest software renewals quarter for the year. We expect the booking to be about 40-60 for this year. The recurring revenue in the guide is over 10% now. In the past, it has been about 13%. We do not anticipate a large number of add-ons, but we expect growth above 10%. Any that comes through is upside to the guide. When we establish the guidance, we aim to mitigate known risks.

Vivek Arya, Analyst

Thank you. For my follow-up question on incremental EBIT margin. Do you think this greater mix of hardware is impacting the incremental EBIT margin? I think if I calculate it correctly, the new guidance is still below the 50% incremental margin, right, or right about there, which is lower than the level you've had the last two, three years. Is that the proper interpretation? And what can change that?

John Wall, Senior Vice President and CFO

Yes, Vivek, you're right in observing that for seven years now, we've achieved over 50% incremental margins, which is something we take pride in. We strive for that every year; we certainly hope to achieve it this year as well. It's probably in the high 40s, around 47% when looking at our guide currently. One of the challenges with the incremental margin calculations is the small tuck-in M&A—while we focus primarily on our organic development in EDA, we do minor M&A transactions. We don’t give up on the 50% incremental margin this year, though middle expectations will remain challenging.

Vivek Arya, Analyst

Thank you.

Operator, Operator

Your final question will come from the line of Harlan Sur with JPMorgan. Please go ahead.

Harlan Sur, Analyst

Good afternoon, thanks for taking my question. After a strong 2023, SDA is starting the year relatively flattish and down about 5% to 6% sequentially. I think it's an unusual starting point for SDA, especially given the drivers articulated. Is SDA expected to be more second-half loaded? Do you expect SDA to grow in line or faster than your overall corporate growth target for the full year?

John Wall, Senior Vice President and CFO

Yes, Harlan, that's a great question. Thanks for bringing that up. I think there's something funny going on with the rounding when you apply growth rates for SDA for Q1 over Q1, since the actual growth rate is probably high single digits Q1-over-Q1. That's compared to a year ago and, of course, those tough comps in Q1 '23. If you look on a two-year CAGR basis, I think it's up 17%. We expect strong SDA growth again this year, higher than the Cadence average.

Harlan Sur, Analyst

Great, thanks for that. Anirudh, many new accelerated compute AI SoC announcements come through these past few weeks, where we saw flagship Blackwell GPU announcement by one of your big customers Nvidia. Yet we've seen even more announcements from cloud and hyperscale customers bringing their own custom ASIC to market, including Google with TPU V5, Google with their Arm-based CPU ASIC; Meta unveiled their Gen 2 TPU AI classes of chips as well. Beyond that, their road maps seem to be accelerating. Can you give us an update on your systems and hyperscale customers? Are you seeing design activity accelerate within this customer base? Is the contribution mix from these customers rising above that roughly 45% level going forward?

Anirudh Devgan, President and CEO

Yeah, Harlan, that's very astute. The pace of AI innovation is increasing not just in the big semi companies but in the system companies. Several announcements have come out, including Meta's public discussion on designing silicon for AI, and obviously, Google and other hyperscalers. The huge design workloads for AI are increasing with hyperscalers and social media greatly influencing silicon designs. This trend will continue; we're involved with all major players here. We believe system companies will opt to design their own silicon due to customization needs, schedules, supply chain control, and cost benefits as their scales increase. Furthermore, the workload for AI indicates a gradual transition in the next few years as system companies develop their chips alongside semiconductor companies. While I don’t know if the percentage will shift from 45%, our business with system companies designing silicon is progressing faster than our average.

Harlan Sur, Analyst

Perfect. Thank you.

Anirudh Devgan, President and CEO

Thank you all for joining us this afternoon. It is an exciting time for Cadence as our broad portfolio and product leadership positions us to maximize the growing opportunities in the semiconductor and systems industry. On behalf of our employees and our Board of Directors, we thank our customers, partners, and investors for their continued trust and confidence in Cadence.

Operator, Operator

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