Synopsys Inc Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Synopsys Earnings Conference Call for the Second Quarter of Fiscal Year 2020. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session; instructions will be given at that time. Today's call will last one hour. Five minutes prior to the end of the call, we will announce the amount of time remaining in the conference. As a reminder, today's call is being recorded. At this time, I would like to turn the conference over to Lisa Ewbank, Vice President of Investor Relations. Please go ahead.

Thank you, Greg, and good afternoon, everyone. Hosting the call today are Aart de Geus, Chairman and co-CEO of Synopsys; and Trac Pham, Chief Financial Officer. Before we begin, I'd like to remind everyone that during the course of this conference call, Synopsys will discuss forecasts, targets, and other forward-looking statements regarding the Company and its financial results. While these statements represent our best current judgment about future results and performance as of today, our actual results and performance are subject to many risks and uncertainties that could cause actual results to differ materially from what we expect. In addition to any risks that we highlight during the call, important factors that may affect our future results are described in our most recent SEC reports and today's earnings press release. In addition, we will refer to non-GAAP financial measures during the discussion. Reconciliations to their most directly comparable GAAP financial measures and supplemental financial information can be found in the earnings press release, financial supplement, and 8-K that we released earlier today. All of these items, plus the most recent investor presentation, are available on our website at Synopsys.com. In addition, the prepared remarks will be posted on the site at the conclusion of the call. Finally, we are all participating from different locations today; please forgive any delays, technology glitches, or awkward handoffs in the Q&A session as we navigate this new virtual dynamic. With that, I'll turn the call over to Aart de Geus.

Good afternoon. I'm happy to report outstanding second quarter results with record orders, revenue, non-GAAP earnings per share and operating cash flow. We substantially exceeded all of our key guidance metrics. Revenue was $861 million, with GAAP earnings per share of $0.71 and non-GAAP earnings of $1.22. Orders were substantially greater than our internal plan, driven primarily by digital design software, and we continued to make good progress on our margin expansion goals. As a result of our first half strength and the resilience of our business, we are reaffirming our revenue and non-GAAP margin guidance for the year while raising our non-GAAP earnings and cash flow targets, which Trac will discuss in more detail. Before providing quarterly highlights, let me comment on the market landscape, which is, of course, dominated by the COVID-19 pandemic and its substantial recessionary pressure on the global economy. While in a matter of weeks, many companies around the world have adapted to widespread work-from-home, the semiconductor sector has stayed busy as electronic system and system design continues unabated. Driven by the sudden need for bandwidth and compute for home, be it for work, schooling, or entertainment, advanced chip design is not slowing down. We've seen this continuous design activity in previous downturns. Regardless of where a company or industry is in its business cycle, continuous investment in new technologies, be they AI and machine learning, 5G, IoT, automotive, or cloud end markets, is the best way to be ready when the economy turns up again. Synopsys is at the core of this enablement. Combining that with our time-based business model, a high level of recurring revenue, and a non-cancelable backlog of $4.8 billion, Synopsys is well-positioned to withstand the uncertainties of today's macro environment. With that context, let me provide some highlights from the quarter, beginning with EDA. Our unrelenting innovation push throughout our Fusion Design Platform is driving momentum in technical benchmark wins, increased competitive displacements, and new breakthrough products. In Q2, our hallmark Fusion Compiler product drove a doubling of the number of tape-outs, as well as significant business commitments by customers ranging from the world's largest microprocessor and consumer companies to mobile, networking, and automotive system designers. Key competitive wins included a leading Asian 5G edge computing chip supplier for next-generation 5-nanometer design, a prominent North American graphics company on advanced gaming GPUs, and expanding competitive displacement at some of the world's leading mobile semiconductor companies on multiple designs ranging from 12-nanometer to 5-nanometer. The Fusion concept, a revolutionary invention with impact that goes far beyond even the breakthrough Fusion Compiler solution, resonates very well with our customers and partners. This quarter, we expanded our collaboration with Broadcom, which is widely deploying our Fusion Design Platform to accelerate the delivery of its innovative 7-nanometer and 5-nanometer designs. And our innovation continues at a rapid pace. In March, we announced several exciting new products, including DSO.ai, the result of a multi-year initiative with leading industry partners. It includes learning engines that can automatically adjust and optimize throughout the design flow. The result is impressive productivity improvements in terms of project time as well as further optimizations in chip performance, power, and area. Using state-of-the-art AI and machine learning, as well as cloud-based burst computation, it enables design teams to tackle more projects, handle larger parts of a project, and let designers focus exclusively on high creativity and value-added tasks. Another seminal new product is 3D IC Compiler. Advanced designs are now so massive and complex that they require a brand new approach. 3D IC Compiler is a single environment that enables the combination of multiple dies together on a chip. This provides far better performance and capacity than conventional chip and package approaches for customers such as Samsung Electronics, who refer to it as an industry disruptor. 3D IC is also a great way to extend the power, performance, and density benefits of Moore's law, as it supports the high-speed parallelism and massive data needs of new AI architectures. This opens a new path to very powerful multi-die computational engines for years to come. Meanwhile, in Custom Design, our multi-year innovation push has resulted in a highly competitive product that is being used for the most advanced FinFET designs and driving ongoing full flow competitive displacements. For example, Alphawave replaced its legacy custom design tools with our Custom Design Platform for the development of high-speed connectivity IP. Here too, productivity was the reward, as our solution helped them meet aggressive design targets in a notably shorter timeframe. A major foundry in Asia expanded its internal deployment and now has more than 10 Custom Compiler projects underway. We also secured new deployments for memory, silicon IP, and microprocessor designs. Let me now move to our Verification Continuum platform where significant technology innovation continues to cement our market share leadership. In verification software, we're seeing notable expansions at influential hyperscaler companies, traditional semiconductor and systems companies, and global startups. Across the platform, our technology is strong. On the hardware side of our verification solution, which caters uniquely to unrelenting design complexity growth, demand for our products is also high. Competitively, our emulators and prototyping systems are differentiated by a raw feed, high reliability, easier installation and maintenance, and overall, lower cost of ownership. Just this quarter, 13 new customers purchased our hardware products, and we have more than 30 repeat orders. Here too, we're seeing good momentum with customers ranging from very large semiconductor and systems companies to hyperscalers and startups. While the timing of hardware deliveries creates a tough comparison with the first half of last year, we continue to gain momentum with both new and existing customers. Now to IP, where we are growing with solid momentum as the number one provider of interface, embedded memory, logic libraries, and foundry specific IP. We provide the broadest portfolio addressing the most complex requirements, accelerating time to market and lowering design risks. With more than 330 wins for foundry specific 7-nanometer IP, customers are clearly placing their trust in our leadership in high-performance cloud computing applications. Most recently, we achieved significant competitive wins, including a major internet services and AI company that adopted our production-proven IP subsystems and PCI Express 5.0, and a major Taiwanese fabless semiconductor company that licensed our silicon-proven HBM 2E for multiple networking customers. Our unrelenting focus on enabling advanced process designs continues. We announced the availability of the broadest portfolio of IP for TSMC's 5-nanometer process for high-performance computing SoCs. Our multinational technology giant in cloud services and AI selected our PCI Express 5.0, CXL, and foundation IP. And the leading e-commerce company chose our die-to-die HBI IP because of our performance, power, and area differentiation. Our product momentum for ARC processors also continued with the introduction of our first 64-bit processor IP. This is our highest performance ARC processor today, targeting high-end embedded applications such as storage, automotive control, and infotainment. Now to Software Integrity. This is one area of our business that felt more of an impact from COVID, as companies delayed business decisions while working to adapt to shelter-in-place mandates. While revenue growth improved sequentially, we did see a slowdown in orders that will moderate our revenue growth this year to the low-double-digit range before returning to higher growth long term. The breadth and roadmap of our portfolio are uniquely well suited to serve today's DevOps requirements. While providing high-value products, a great new platform, and strategic consulting services, we are well-positioned to help companies develop more secure, high-quality software for a very interconnected world. Industry recognition of our vision and product breadth has grown significantly over the past several years. Just a few weeks ago, Gartner updated its Magic Quadrant for Application Security Testing. We are pleased to note that Synopsys is again in the furthest top right position in the leader quadrant. We made progress during this quarter in several areas. We achieved multiple competitive displacements as customers embraced the benefits of our broad portfolio and integration onto the Polaris Software Integrity Platform. We saw a notable broadening of agreements as customers expanded the number of products they adopt. One example is a very large global electronics company that replaced the incumbent and significantly expanded its adoption to a broader set of our solutions. This quarter, our customer base continued to grow with new logos ranging from very well-known consumer electronics leaders to hyperscalers to industrial and financial services companies. Our next objective is to scale this business to reach $500 million to $1 billion in revenue over time. Before I hand it over to Tack, let me comment on our practical handling of the COVID-19 pandemic. I'll begin with a sincere thank you to the many selfless caregivers who keep us safe. I also want to thank our employees who have shown incredible commitment and agility over the past several months to execute on the dual objectives of health and business. I believe that our execution during this period has been stellar. In addition to the rapid actions we took to implement global shelter-in-place orders, we continued to partner with our peers, local governments, and health agencies to ensure a safe work environment for those returning to the office. Our IT, HR facilities, and operations teams have done an amazing job quickly adopting our infrastructure and systems to support work-from-home. Our R&D teams continue to execute very well and have effectively worked through some hardware supply chain and logical challenges. The large number of new products and excellent benchmark results give us strong confidence in our product pipeline. This also applies to our worldwide IP team, which had the foresight to rapidly enable remote development and delivery of high demand advanced titles. We are able to ship our products and provide our customer support from our application engineering teams. Last, as witnessed by the strongest orders quarter on record, our sales team also demonstrated stellar execution. As we now see a gradual opening of businesses in many countries and states, our leadership is planning a very gradual shift back to the office in coordination with local authorities and sensitive to our employees' well-being. In closing, Synopsys is executing well. We delivered outstanding second quarter results with record orders, revenue, non-GAAP earnings per share, and operating cash flow. Design activity remains strong and enduring. We continue to introduce innovative new products throughout our portfolio and are benchmarking strongly. Notwithstanding the extraordinary world circumstances, we continued to target high-single-digit revenue growth, substantial operating margin expansion, mid-teens non-GAAP earnings per share growth, and strong operating cash flow. Trac will now highlight the financial perspective.

Thanks, Aart. Good afternoon, everyone. Our record results are especially noteworthy in light of the considerable challenges faced by ourselves and our customers over the past few months. Given our history of strong execution, sometimes it's easy to forget how much hard work goes into delivering results like these. So I'd like to add my thanks to our employees for their dedication under these difficult circumstances. Complementing our excellent execution in the first half is our very solid business foundation, technology leadership, a diverse customer base, and nearly 90% recurring revenue. These elements position us well for periods of high demand as well as during times of greatest stress. This rare combination gives us the confidence to reaffirm our annual revenue and non-GAAP margin guidance and to increase our non-GAAP earnings and operating cash flow targets. Now to our second quarter results. All comparisons are year-over-year unless otherwise stated. Orders substantially exceeded our plan, driven in large part by EDA, particularly digital design. Ending backlog was $4.7 billion. We generated total revenue of $861.3 million, above our target range, driven by broad strength and some revenue that moved in from Q3. Semiconductor & System Design segment revenue amounted to $773 million. This strong growth in EDA software was moderated by tough hardware comparisons over a strong Q2 of last year. Excluding hardware, EDA software results remain within our long-term target range of mid to high single digits. A quick note on hardware: while COVID-19 has presented some minor HAPS-related supply chain challenges due to shelter-in-place mandates, we're managing through them well. Our contract manufacturing partners are gradually increasing capacity, and because our products are considered essential, they are top priorities. Software Integrity segment revenue was $88.3 million, 10% of total. Moving on to expenses. Total GAAP costs and expenses were $735 million, which includes approximately $30 million in restructuring costs associated with our previously communicated program to optimize resource allocation for sustainable long-term growth. These are not COVID-related. Total non-GAAP costs and expenses were $640 million, resulting in a non-GAAP operating margin of 25.7%. We are on track to generate approximately 2 percentage points of non-GAAP operating margin expansion for the year. Adjusted operating margin for the Semiconductor & System Design segment was 27.1%, while for the Software Integrity segment, it was 13.3%. Finally, GAAP earnings per share were $0.71, and non-GAAP earnings per share were $1.22, well above our target range due to excellent operational execution. Turning to cash, we generated a record $380 million in operating cash flow. We initiated a $100 million ASR and have now completed $200 million in buybacks year-to-date. We've repurchased $2 billion of our stock since 2015, approximately 75% of our free cash flow. Our capital allocation strategy has not changed. We'll continue to evaluate the best use of cash each quarter, and we will remain prudent as the global macro environment evolves. Our balance sheet is very strong. We ended the quarter with a cash balance of $856 million and total debt of $236 million, as we paid down $90 million of our revolver. Now to guidance, which continues to assume the current Entity List restrictions remain in place for the rest of the year. Consistent with our expectations, revenue is skewed to later in the year, due primarily to the scheduled timing of hardware and IP deliveries. For fiscal year 2020, our targets are revenue of $3.6 billion to $3.65 billion; total GAAP costs and expenses between $2.99 billion and $3.03 billion; total non-GAAP costs and expenses between $2.63 billion and $2.66 billion, resulting in a non-GAAP operating margin of approximately 27%; GAAP earnings of $3.74 to $3.90 per share; non-GAAP earnings of $5.21 to $5.28 per share; cash flow from operations of $815 million to $840 million; and capital expenditures of approximately $170 million; now to the targets for the third quarter, revenue between $875 million and $905 million; total GAAP costs and expenses between $721 million and $737 million; total non-GAAP costs and expenses between $640 million and $650 million; GAAP earnings of $1.12 to $1.22 per share; and non-GAAP earnings of $1.33 to $1.38 per share. In conclusion, despite the unprecedented challenges faced by our employees and customers around the globe, our focused execution, portfolio strength, and resilient business model enabled us to deliver a very strong quarter, reiterate our full-year revenue and non-GAAP margin guidance, and raise our non-GAAP earnings and cash flow targets. Our strong balance sheet and thoughtful approach to capital allocation position us well to navigate the current environment. And with that, I'll turn it over to the operator for questions.

Thank you so much. Before we begin the Q&A session, I would like to ask everyone to please limit yourself to two questions to allow us to accommodate all participants. If you have additional questions, please re-enter the queue, and we'll take as many as time permits.

Thank you, and congrats to the team on delivering very solid results in a challenging environment. First, just on the order commentary, I think you said you saw stronger than expected orders primarily in core EDA. I was wondering if you could give any color on sort of what drove that strength. And if you thought it was maybe timing-related, or if you think that was sort of a net increase in demand relative to your original plan?

Well, I think multiple things played in all at the same time. Obviously, in a time like this, we all pay a lot of attention to execution, so we will give some credit to just working hard at it. But I think the other thing that happened is that a number of the new products that we introduced last year, and some that we announced just recently, are very attractive and benchmark extremely well. And so the hunger for more sophisticated products continues because during the same timeframe, what we're seeing is that a number of the advanced customers are moving now from 7-nanometer to 5-nanometer. And so that has both implications on the IP that they're using and on the strength of tools that they want. And so the demand was absolutely there, and it was for us to make sure that we found a way to get at it.

And just one more on the SIG business. Could you say what the bookings were there? I know they were pretty good last quarter, despite the relatively modest revenue growth. And two, any progress on getting a business unit head there?

So we normally don't disclose the bookings for any subpart of the Company. We did communicate that they were lower this quarter than expected, and therefore that has some ramifications going forward. It's not completely a surprise because many of the interactions early on during COVID were affected by people essentially hustling for shelter from home. On the recruiting side, we have started a search, and we expect that in the next six months this will be fulfilled, and now we're looking at candidates.

Maybe first a question on the hardware business. At this point, is that completely outsourced? Or do you still do a final assembly and test in-house? And just curious if COVID was a bigger issue for your suppliers or for your own internal assembly and test?

It's an excellent question. We do a little bit of all of that. We outsource, obviously, as much as we possibly can. Depending on the status of the hardware, we assemble some of it ourselves. As you would expect, when you have a global disruption of all the markets initially, you have to watch out where all the parts are coming from and who is doing the assembly. The issues that we looked at initially were HAPS-related. I'm quite impressed by how quickly our team was on top of that. After that, the fact that this is essential equipment benefited us as the assembly people we work with gave us high priority. So I think the problem is mostly resolved at this point.

Okay, that's great to hear. And then Trac, when I look at the midpoint of guidance for the third quarter and the implied for the fourth quarter, pretty strong revenue growth, not a lot of model leverage off that revenue growth. So I'm curious if that's because it's more hardware-centric? Is it conservatism? Or is there something else going on?

It is a little bit of the hardware mix. You got COGS ramping up with expenses as well. The profile does have some additional expenses in terms of hiring, but I do expect that you'll see an improvement in operating margins from Q3 to Q4.

And apologies if this came up, I joined a little bit late, but just a current events question. I'm wondering if the recent proposals around new export restrictions have either impacted Synopsys in any way or maybe since the April quarter close caused some of your customers to reconsider certain spending decisions? Or just any impacts from the past couple of weeks and the news that has been coming out?

Well, the bottom line of the answer is no. The recent announcements were one or two weeks old, and while very complicated, we're able to get a good sense of it. Our conclusion is that it does not affect us beyond what is already prohibited in the entity. We have also not had any follow-on from customers that were worried in any form, so I think that interpretation has been fairly universal.

Okay, great. And then on Software Integrity, I guess, the qualitative commentary, just in terms of some of the buy-in to Polaris, and the fact that you're getting competitive displacements for Polaris at this point, that strikes me as pretty positive. So, I guess my question is, did it surprise you to have platform traction in a more difficult environment created by COVID? And does that give you maybe some optimism in thinking about bookings for the back half of your year?

You know, we live with optimism, and actually, this is a good example of it because the whole point of a platform is to get the benefit of multiple tools that work well together. And by the way, for the buyer, it has another benefit, especially for larger companies, they are trying to maintain an environment that is not overly complex with tools from many different vendors. So being able to bring multiple capabilities together in a structured fashion that over time will gain more and more value because things work well together is exactly the direction that we are counting on. The fact that the number of customers have actually bought Synopsys precisely for that reason is extremely encouraging.

Yes. I want to focus a bit here on the operating margin here. So the implied number, it looks like you guys are going to get to the high 20s exiting the year. So I really have two parts to my question. The first one is just, is that correct, you're going to kind of exit at 29%? And then secondly, does that imply that '21 should actually be better than your high 20s target? Because now, you guys kind of get the work-from-home dynamic; you don't have as much T&A expense. It's something we've heard that a lot of companies, particularly software coverage are able to do. So is there any way you guys are going to be able to squeeze extra basis points out of the OpEx line going forward?

Let me work backwards on your question, Mitch. You're right, we will be exiting in the high 20s for the year, but keep in mind that it's largely a profile of the revenue ramp. We remain committed to our long-term goals of driving margin expansion. But at this point, it's too early to talk about FY '21. We'll come on that later in the year. As far as savings from COVID, certainly, we're seeing some element of that flow through, which benefits flow through to the results. The results are largely driven by us executing the plan we set out for the year, which is to continue to focus on our spending, be more diligent about where we're investing, and drive a plan that's going to deliver good margin growth this year and over time.

And just one small one, if I could. I couldn't ask multiple questions there. So just, was there any revenue impact you guys could quantify in terms of what the hardware shipments would have been if you had any pushouts in terms of sales? I'm curious why the full-year guide didn't go above - how do you think that you'd be able to get to lease above towards the high-end, I guess, of the revenue guide? So was there any sort of pushout or anything related to COVID in the quarter?

No. Really, COVID had a really small or immaterial effect on the results. We mentioned we had some initial challenges with the supply chain when the shelter-in-place mandates went into effect, but we were able to overcome that and execute on the numbers for the quarter. Good execution in Q2, the results were strong on their own, but we did see some revenue move in from Q3 to Q2. At this point, we're providing our best view of the outlook for hardware, and it really reflects a profile of it growing in Q4. So far, we feel confident in our ability to execute; that's why we're reaffirming guidance.

Thanks for taking my questions, guys. The first one to Aart is a follow-up on some of the trade restrictions. You addressed, I think, the Entity List and Huawei; I guess tighter restrictions having already been factored in. But what about the military end-user or military end-use case control actions that were put out at the end of April? Do you expect any impact from that?

No, we don't. So fundamentally, the guidance that we have given you encompasses all of our interpretation of all of the various actions that have been taken over the last year and a half. We feel very solid in that interpretation at this point in time.

Okay, all right, great. Thank you, and then follow-up for Trac.

You're welcome.

Yes. For the most part, we haven't seen any meaningful impact from that or customers coming back and renegotiating terms. So far, that's been very positive. We're prepared for that kind of potential, but we haven't seen much of an impact. The strength in cash flow outlook is really confidence in the P&L and what we're guiding to. It's solid growth for the year, as well as good margin improvement. That's going to eventually translate to cash as a reflection of both strong collections and more effective disbursements, or lower disbursements.

The 7% sequential increase in backlog is commendable. And reading between the lines, I see that your average license duration has spiked quite significantly. Does that speak to the concentration of the record orders with perhaps one customer renewal? Or is there some more diverse overall bookings trends there?

It is the second. It's not the single customer at all; it’s multiple customers. I think in general, there are often variations in lengths of contracts. At this point in time, it is encouraging that the contracts have not become shorter, as in times of economic stress, people could be worried about it. That appears to not be the case at all. As I said the use and approach to design, we see no difference. If anything, a number of companies are now really accelerating as they hope to have good opportunities next year with new products. The technology advances are on track, and the business reflects that directly.

Gary, I would also add that it's nice to have that large backlog in an environment like this, in general, but particularly in an environment we grew it like this. Q2 bookings were not only a record in absolute numbers, but we also saw a very good run rate growth in the quarter. So, I'm pleased with that combination.

Okay. As my follow-up question: With the shelter-in-place largely still intact in the Bay Area and perhaps affecting access to your facilities and labs, is that a hindrance to completion of some IP deliverables? Is that perhaps an explanation why the fourth quarter may still be back-end loaded?

While initially there were several questions on how to best get access to labs, how to manage that, can we manage it? I think there too, we were able to find practical solutions pretty quickly. I'm actually pleasantly surprised at how well the IP group is executing as we continue to send chips to manufacturing and as we continue to deliver new cores. I think the distribution of revenue is more a function of the uptake from the customer than anything else.

And first on the Software Integrity business, I'm just wondering if you could elaborate on some of the delay in business decisions that you alluded to in the prepared remarks? And then what gives you the confidence in the low-double-digit growth target that you implied the business would grow this year? Secondly, how have your sales efforts been impacted by the shelter-in-place orders? And have your spending plans changed at all versus what they were last quarter?

Yes. Let me go backward on that. As working from home started to become a key action with many of our customers, it did slow interaction somewhat. We also saw some slowdown in our ability to hire quickly as we had planned. Those factors tend to impact the order rates we get. All in all, the reception through the types of capabilities we have has not diminished at all. The concern wave many customers had as they established work-from-home procedures raised security questions for their installations. While we hardly addressed that, it will lead to increased scrutiny on software security for future installations. So, our business opportunity remains healthy. Our execution can improve, and that's what we're focusing on. As for EDA industry broadly, the duplication of supply chain efforts leads to inefficiencies, which can actually benefit suppliers. We don't see much effort across the board yet. However, major macro discussions focus on the need to minimize dependency on a single country for semiconductor manufacturing. We'll see a dynamic evolution in the upcoming year. Given our connections with the involved parties, we intend to participate in their developments in a way that benefits our business.

And speakers, we have no further questions in queue.

Well, in that case, let me first thank you for attending. My assumption is that, if not all of you, most of you attend from home, so we hope that your home situations and family situations are also safe and sound. All the more do we appreciate hearing your voice and having your support on a quarterly basis through these earnings releases. Please take care of yourself and be well. Bye-bye.

And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T conferencing service. You may now disconnect.