Cadence Design Systems Q2 2006 Earnings Conference Call Transcript (CDNS)

Jul.27.06 | About: Cadence Design (CDNS)

Cadence Design Systems, (NASDAQ:CDNS)

Q2 2006 Earnings Conference Call

July 26, 2006, 5:00 p.m. EST

Executives:

Jennifer Jordan, Vice President, Investor Relations

Michael Fister, President and Chief Executive Officer

William Porter, EVP and Chief Financial Officer

Analysts:

Woojin Ho, Merrill Lynch

Harlan Sur, Morgan Stanley

Raj Seth, Cowen & Company, LLC

Tim Fox, Deutsche Bank Securities

Matt Petkun, DA Davidson

Sterling Auty, JP Morgan

Rohit Pandey, HSBC Securities

Stuart Muter, RBC Capital Markets

Vishal, Analyst

Operator

Good afternoon, my name is Brook and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Design Systems Second Quarter 2006 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. If you would like to ask a question during this time, simply press * then the number 1 on your telephone keypad. If you would like to withdraw your question, press the # key. I would now like to turn the call over to Ms. Jennifer Jordan, Corporate Vice President of Investor Relations for Cadence Design Systems. Thank you, Ms. Jordan, you may begin your conference.

Jennifer Jordan, VP, Investor Relations

Thank you, Brook, and welcome to our earnings conference call for the second quarter of 2006. The webcast of this call can be accessed through our website, www.cadence.com, and will be archived for one week. With me today is Mike Fister, President and CEO; and Bill Porter, Executive Vice President and CFO.

Please note that today's discussion will contain forward-looking statements and that our actual results may differ materially from those expectations. For information on the factors that could cause a difference in our results, please refer to our 10-K for the period ended December 31, 2005, and our 10-Q for the period ended April 1, 2006.

In addition to financial results prepared in accordance with Generally Accepted Accounting Principles, or GAAP, we will also present certain non-GAAP financial measures today. Cadence management believes that in addition to using GAAP results in evaluating our business, it can also be useful to measure results using certain non-GAAP financial measures. Please refer to our earnings press release for a discussion of non-GAAP measures and to both our earnings press release and our website for reconciliations of GAAP and non-GAAP financial measures used in today's discussion.

With that, here’s Mike Fister.

Michael Fister, President and Chief Executive Officer

Thanks, Jennifer. The second quarter was another good quarter for Cadence. Revenues grew 12% year over year, met by sales of our verification and digital platforms. Our business fundamentals and outlook for 2006 are unchanged. Now, I know many of you have some concern about the environment given the recent technology sell off. Let me give you some sense of how we try and go ahead on our business.

First, we look at the macro economy in the industry where the data as you know is the mix. Forecasts for semiconductor growth in 2006 span a wide range from 6% to 17%. The forecast for semiconductor R&D spending for 2006 remains in the high single digits. Design start forecasts are steady to slightly up with a number of design starts of 90 and 65 nanometers continue to grow. The consumer market will make up 54% of the $246 billion in chips that will be sold worldwide this year, according to the Semiconductor Industry Association.

Second, we take a deep dive in our booking business customer by customer. The customer-by-customer look is crucial because while some tech sectors may not be doing as well as others and competition everywhere is fierce, customers who hit their market window with the right product are having success. And third, it’s geography. In order to maximize our business opportunities and align our resources correctly with them, we need to know where our customers are investing, and we need to understand what new business models and strategies will best suit different regions.

Finally, the most interesting trend continues to be the emergence of both multinationals and local spending industry investments in China and India. In our core business, our Analog Mix Signal Kit is a key differentiator with customers and is fueling purchases of our other design platforms as well. We released our next generation Virtuoso platform to early adoptive partners on schedule in June. The initial feedback from these partners has just been excellent. We also completed the full production release of the Cadence ShapeBased router. STMicroelectronics uses Cadence ShapeBased router on its latest 65 nanometer mixed analog RF Digital design taken out in the third quarter 2006.

We’ve also upgraded our analog mixed single kit and announced our RF SiP methodology in ARM Functional Verification Kit with CDN Live in Europe about three weeks ago. Customers are adopting kits to target new vertical markets or design specs. And A2e Technology, which is a U.K. based company specializing in RF Design and manufacture, uses our AMS Kit in the Virtuoso platform to ramp a new design team quickly and save time and design cycles when attacking the new vertical market.

In digital IC we continue to develop innovative technology for managing the challenges of low-power design. We partnered with ARM to develop an automated digital flow for implementing their top line microprocessor, the Cortex-A8, to achieve the highest performance with the lowest power. And 10 companies led by Cadence formed the Power Forward Initiative to work on the refinement and promotion of a new specification of the common power format, which captures essential design intensive power and links to design, implementation, and verification demands to adjust obstacles to lower power design. SoC are now supported by the X technology of 65 nanometers and are geared based on the next design for the SoC 90 nanometer processors.

At Silicon Package Board we announced the industry’s first commercial SiP implementation solution. And to look at the verification changes, we enhanced our Incisive Enterprise solutions to enable architectural modeling to system validation, combining system level hardware and software for enterprise management. The combination of verification process automation with Enterprise Spectrum Simulator again drove the displacement of competitors’ simulation from a number of counts in the second quarter. Customers continue to see the value from a holistic approach to verification, and this holistic approach has had a similar impact in the hardware emulation where we clearly lead the market. Cadence is the only company delivering uniform emulation systems as a massive scale required to verify our leading customers’ most complex designs. These are systems capable of handling greater than 200 million gig. In the second quarter, we delivered our second such system.

In the design to manufacture ability adjacency, we are making steady progress with PVS where we completed seven phase outs, as well with Virtuoso SoC RET and Chip Optimizer. We continue to add forward-looking modeling technology such as chemical-mechanical polishing and…

Geographically, North America and Europe each had a great quarter while Japan did not. Hitachi entered into an agreement which includes joint flow creation, validation, and more comprehensive technical support, and consistent with flow seen across all our platforms, NEC extended its relationship with Cadence to improve verification technology and added Virtuoso technology for their business. We look forward to seeing at CDN Live in Silicon Valley on September 12th each and everyone, and now I will let Bill take you through the numbers.

William Porter, EVP and Chief Financial Officer

Thanks Mike. In the second quarter Cadence again demonstrated consistent executions and strong financial results. Total revenue was up 12% year-over-year. Non-GAAP operating margin improved 4 percentage points to 25%, compared to the second quarter of 2005, and we had another good cash flow quarter where we reported operating cash flow of $115 million.

GAAP earnings per share for the second quarter were $0.10, compared to breakeven in the same quarter last year. Non-GAAP earnings per share were $0.23 for the quarter, compared to $0.17 in the second quarter of 2005, a 35% increase. Total revenue for the second quarter was $359 million, compared to $321 million in the second quarter of 2005, up 12%. Product revenue was $232 million, maintenance revenue was $93 million, and services revenue was $33 million.

Revenue mix by geography in the second quarter was 48% North America, 24% Japan, 18% Europe, and 10% Asia, as we demonstrated balanced growth across all regions. One customer accounted for 13% of our second quarter revenue, and in the quarter approximately 76% of our product business was represented by licenses. Approximately, two-thirds of our product revenue was generated from backlog, and our contract life calculated on a dollar weighted average basis remained at approximately three years.

The second quarter total costs and expenses, on a non-GAAP basis, were $270 million, up from $262 million in the first quarter. Our non-GAAP operating margin in the second quarter was 25%, up from 21% in the second quarter of 2005, and we continue to look for a non-GAAP operating margin around 28% for 2006.

Headcount at the end of the second quarter was about 5100. The quality of receivables remained high in the second quarter with receivables 90 days past due at 1%, within our historical range of 1% to 3%. Total DSOs were 100 days, compared to 97 days in the first quarter. We still expect DSOs to settle into the mid-to-high 80s by the end of 2006.

The second quarter operating cash flow was $115 million. For 2006, we expect to generate operating cash flow of at least $425 million. Capital expenditures were $20 million for the second quarter and $35 million for the first half, keeping us on track to spend approximately $75 million for the year. We repurchased 5 million shares of common stock in the second quarter at a cost of $92 million. Cash and cash equivalents was to date $126 million at the end of the second quarter compared to $873 million in the first quarter. Stock-based compensation was $26 million for the second quarter, and for 2006 we continue to estimate stock-based compensation expense of approximately $100 million, and our non-GAAP measures exclude stock-based compensation expense.

Now, I'll turn to our outlook for the third quarter and the year 2006. For the third quarter we expect revenue to be in the range of $350 million to $360 million. GAAP EPS should be in the range of $0.12 to $0.14 and non-GAAP EPS in the range of $0.24 to $0.26. For the year 2006, we expect revenue to be in the range of $1.425 billion to $1.475 billion. GAAP EPS should be in the range of $0.45 to $0.53 and non-GAAP EPS in the range of $0.98 to $1.06. Other income expense for 2006 should be in the $43 million to $48 million range.

We’re working closely with our customers and watching the environment in which they operate carefully. In spite of the uncertainty in the environment I feel confident that we’ll make progress against our objectives to demonstrate growth, execute consistently, and achieve our operating targets. Operator, we’ll now take questions.

Question-and-Answer Session

Operator

At this time, I would like to remind everyone, if you would like to ask a question, press * then the number 1 on your telephone keypad. We’ll pause for just a moment to compile the Q&A roster. Your first question comes from Jay Vleeschhouwer with Merrill Lynch.

Woojin Ho, Merrill Lynch

Good afternoon, this is Woojin Ho for Jay. Mike, can you comment on the design requirement demands for markets other than consumer and mobile, for example automobile and imaging?

Michael Fister, President and Chief Executive Officer

Yeah, they are very similar. The mixed signal content is high, especially in automotive we have a lot of electromechanical devices. They’re also driven to value integration. They may not be the first always on the most advanced process because they are trying to improve the reliability, and reliability considerations are extremely aggressive, like literally zero defects per million. But it really is a much more a value to verification as it turns out, because what you’re trying to do is architect in the goodness, and that’s a very powerful approach when you do it correctly. So, both of those segments are very, very interesting to us and you may remember that we actually considered targets kits into the automotives, is declared vertical next year.

Woojin Ho, Merrill Lynch

Right, and in terms of the kits, are there one or two of the kits that you’ve introduced so far that you think might have especially stood out of the rest?

Michael Fister, President and Chief Executive Officer

Well, it’s a good question. What happens is some of the kits are methodology foundations like the analog mixed signal one. The ones that are probably particularly interesting — this is a journey and a not a destination — are the ones that are more vertically integrated. So, I’m very excited about the things that we’re doing with the RF Incorporation, we released RF SiP. The packaging in general is a good vertical integration. The way you can look at those if you’re not like me is look at ones that contain verification content, because that’s inclusion of planning through the implementation, and what we have on our roadmap I’m very excited about.

Woojin Ho, Merrill Lynch

Okay, now Cadence has released pieces of the suite thus far including Chip Optimizer, how have these done so far and what’s the schedule for the remaining pieces?

Michael Fister, President and Chief Executive Officer

We have been releasing it and as you know the FM strategy is very thoughtful and structured around big customer engagements, because you’re kind of comparing notes on what they know or what might be special to them with how we can help them solve those problems. The Chip Optimizer is an excellent evidence with IBM and API, and you’re right we did release the RET technology, we’ve got kind of a continuous stream of those coming out, and the PVS is an excellent foundation for being able to add and innovate technologies on top it. So, they kind of come and go and I don’t have anything to project for you. That is may be giving too much insight in some of the special customer engagements, but there are many and they are deep.

Woojin Ho, Merrill Lynch

Fair enough, and lastly what products if any underperformed, or generally speaking to which mature segments are you most exposed to?

Michael Fister, President and Chief Executive Officer

I don’t know. To tell you the truth, I don’t think we underperformed anywhere. Bill said it very nicely, across geographies and across product lines it looked good. The ones that are most mature are in our full custom analog mixed signal and primarily that’s the Virtuoso platform; that’s just marvelous to see what the teams have done with that and the customer response; and even something that would be considered relatively mundane like the package board for credit circuit boards, you can see we’ve taken our technology and innovated on top of it and brought in a semiconductor package. So, I think the technologies and the prices we have are excellent fundamentals and there isn’t any of it that isn’t capable of evolving and growing.

Woojin Ho, Merrill Lynch

Thanks a lot for taking my call.

Operator

Your next question comes from Harlan Sur with Morgan Stanley.

Harlan Sur, Morgan Stanley

Hi guys, good afternoon and congratulations on another well executed quarter. Question for Mike and Bill, you’ve talked about smoothing out the booking as it relates to renewals or large opportunities, and in speaking with some of your customers this quarter, we got the sense that several of those customers that placed large orders in the second half of last year are buying more this year. So, it seems like your strategy is working, maybe you can just give us your view on whether or not it’s working out the way that you envisioned.

William Porter, EVP and Chief Financial Officer

Harlan, this is Bill. I think we talked about what our strategy was and what we expected the results to be at analyst day. We were thinking we should see continued strong growth in verification. We should also see that trend continue where we’re continuing to come back and show strength in digital, particularly in the high end, and I think we’ll see steady growth in the custom business, and I think we’re seeing all three of those. So that tells us that, at least from the results we’re expecting, that is going according to plan. And as we’ve talked in the past, the key in the field really is trying to address the customer’s needs and when they need things, and so the ability to continue to work with them and to sell when they need it as opposed to trying to sell too much in big chunks in advance I think is getting good play with our customers. So that’s why we’re willing to be patient to get them what they need in particularly those three areas, and then we’re also continuing to work in what I’d say the more Greenfield areas, the kits and the segmentation, because those are still early days, but we are seeing some value there; it’s going to take a little time for those to really show themselves.

Harlan Sur, Morgan Stanley

Okay, it certainly seems like you guys are executing to that plan based on what we’re hearing from customers. Michael, a question for you based again on our channel checks in the quarter, we think you did particularly well with some of your large wireless semiconductor companies. So, my question there is, what trends are you seeing within this sector of the markets and where are these guys leaning heaving on Cadence for support, is it verification, is it digital, is it AMS or is it all of the above?

Michael Fister, President and Chief Executive Officer

That’s a good question, Harlan, and it is kind of all the above, particularly in the digital. You know, customers are doing very, very complex things. We have a strategy of demonstrating our digital technology and having it waterfall down that we debuted in most of the complex configurations as that’s a perfect target. And I think you have a very astute observation, that’s a good example of the whole through or across where digital and verification go kind of hand in glove, and these are the customers that who have microprocessor in big blocks as well as RF blocks, and they’re trying to make intelligent tradeoffs about how they structure those and balance that shift, which is a major system line shift, and those are the kind of customers that really value verification and it’s a pleasure to get to work with them on it.

Harlan Sur, Morgan Stanley

Thanks, and then last question for you, Bill; in terms of the guidance you’re expecting higher earnings on roughly comparable revenues in the third quarter, I’m just wondering where the leverage coming from on the expense side?

William Porter, EVP and Chief Financial Officer

Well, I think you’re always looking for a little bit of leverage, Harlan. I don’t think it’s in one particular area, and we are all watching where we’re investing. A lot of our growth is outside of the U.S., particularly these days in head count. So, I think we’re just going to continue to get that operational leverage as our customers move to lower cost areas, we’re going to get that kind of leverage, but that’s just the way the business has been playing itself out and that’s the way it has been planned. So, it’s not a particular area, it’s just across the board.

Harlan Sur, Morgan Stanley

Okay, thanks guys and again great job on the quarter.

Operator

Your next question comes from Raj Seth with Cowen & Company.

Raj Seth, Cowen & Company, LLC

Hi, thank you. Mike, just to follow up on Harlan’s line of questioning, you’re obviously executing well, you’ve been showing real good year-to-year growth, 12%, helped I guess a little bit in the beginning of the year by Verisity. Do you think you’re gaining meaningful share against your larger competitors, or do you think this reflects an overall market updraft relative to the last couple of years? And if you’re gaining share, where are the principle areas of share gain?

Michael Fister, President and Chief Executive Officer

We’re definitely gaining share. It’s a process element that we do. We’re gaining in digital and historically in common areas around simulation and verification, and I think we’ve even got an opportunity up in the synthesis. We’ve been trying to evidence that as much as we could in terms of testimonials and we lost count on how many designs that we’ve done with RSD sale. Those are elements but I think the biggest indicator for me, Raj, is that it’s an example of the holistic approach we’ve taken and the completeness approach, so that whole idea of moving up the scale and verification, interoptimizing it with some of those pieces is evidenced increasingly through our customers. Some of them are a just a little bit slower than others, because they got more historic incumbency maybe, and that’s a practical problem; as Bill said, we are going to be patient about that. But, between that kind of migration and the new projects that those customers are tackling across the board, they almost always see an opportunity to go and engage on a new project, and I think that amounts to a lot of kind of scale out that we can have as time moves along, and it’s a multipart strategy that felt good to us when we laid it out and has been feeling good to us in the last quarters, and I appreciate you noticed any execution.

William Porter, EVP and Chief Financial Officer

This is Bill, I’ll just add a little bit. I think we are seeing market expansion in verification. We are putting some technologies that people are using more of, so we are only getting share and that’s’ part of the expansion also at some point up into the systems area, but emulation continues to do well and people are finding new ways to use it. But to just to add a little color there, that market I think is growing probably faster than implementation, which in most cases I think is the share piece.

Raj Seth, Cowen & Company, LLC

If I could follow up a little bit, you’ve mentioned both in early June at our conference and today on this call that you’re seeing design starts slightly up, which is I think the first time in a number of years we’ve seen design starts pick up; sounds like around 90. Is it your sense that there is an actual EDA investment cycle going on, and I guess the question is will it end at some point, or does the run rate of business reflect you think something more like a new steady state for the industry post the impact of the down turn which lasted a couple of years, at least in this sector?

Michael Fister, President and Chief Executive Officer

From my perspective, it would be too early to tell. I think, Raj, and others talked about in the industry, there’s kind of a bifurcation around those customers that are rushing to the more advanced geometries and some of those who are staying more fixed, even up to 130 nanometer particularly around the analog, and certainly we could take it either way. The early evidence as everyone follows the industry leaders; maybe that’s a massive investment cycle. If it continues to stay bifurcated, then you better be able to sell across the whole continuum and that’s why that holistic approach that we have and kind of the whole segmentation of the conscious part of the strategy, because we could waterfall in from the top and take advanced technologies and methodologies and apply them in kind of what would have been a traditionally backward lay, you know, at 130 nanometers for power or die size. I think it should work well for us in any case and certainly if there’s a massive EDA investment cycle, then I think we may be leading it.

William Porter, EVP and Chief Financial Officer

Raj, this is Bill. I guess the color that I would add is a lot of the design starts continue to be around consumer electronics and wireless. I don’t know if it’s a trend, but clearly there’s a lot of activity there. So, I think that piece of the business looks like it’s going to be driven for a while as everyone tries to connect and build out that infrastructure, and as you know that plays pretty well in our mixed signal capability and our verification capabilities. So that’s in terms of the design starts and what we try to, as we peel the onion back, have at least to our business.

Raj Seth, Cowen & Company, LLC

Thanks Bill, and I’ve got one last one. You bought back near $100 million worth of stock, you’re generating a lot of cash now, what’s your buyback plan, are you going to try and take shares down, are you going to step by the buyback, how should I think about buyback as we move forward?

William Porter, EVP and Chief Financial Officer

I think as you know we had the authorization back in the first quarter, $400 or $500 million, and we have been taking that down really in the first quarter and second quarter, and we think clearly at this price it’s an opportunity to continue, because it’s a pretty good value. So, operationally, we’re going to keep going, generate the cash, and I think you should look to see us at these prices continue our program, because we think it’s an opportunity for us to get some value and use that cash.

Raj Seth, Cowen & Company, LLC

Thanks.

Operator

Your next question comes from Tim Fox with Deutsche Bank.

Tim Fox, Deutsche Bank Securities

Hi, thank you, good afternoon. Bill, I guess just slicing this a little bit differently on talking about the success around the top line, could you talk a little bit about you run rates and some of the efforts you have made in breaking some of the larger contracts up, are you seeing renewals coming at a meaningfully higher level than you expected, really what’s driving that strength in bookings?

William Porter, EVP and Chief Financial Officer

Tim, I think it starts with the technology and what we’re able to deliver to the customers. And as we’ve mentioned, I think we’re probably in the strongest position that we ever had with all the different pieces of the technology. So, customers now can add some verification that they may need or they haven’t use enough, so we see customers having that capability while we’re starting to evaluate some of our newer offerings in digital, and they would add that next. So, in many cases that I’m aware of, we have seen work particularly with the larger customers move into multiple sales engagements over a year and over a couple of years where we have active campaigns working with them and the patience and the ability to solve their problems when they need it. So, it’s that strategy that field has been working on; I think it is working well with customers; again the technology and the patience seem to be paying off.

Tim Fox, Deutsche Bank Securities

And not trying to get into specifics on a quarterly bookings, but should we still think about your overall bookings rate on an annual basis to relatively closely match revenue growth, is that the right way to think about that?

William Porter, EVP and Chief Financial Officer

I think its’ pretty close. As I’ve mentioned at the beginning of the year, our objective really is to try to improve our run rate with our customers. So, it’s not just to build back log. So, I’d be satisfied even if our back log was flat last year as long as we see those efficiencies of the business coming in the next year or year and a half as opposed to just trying to build bookings in advance of revenue. We’re trying to keep them pretty well balanced.

Tim Fox, Deutsche Bank Securities

Okay, and given the strength in top line and just looking at your cost structure, I guess we had modeled cost coming down a little bit and it just had been implied in your midpoint of guidance, which you sort of beat by a penny. I’m just wondering was there anything outside of say commissions that drove the cost structure to be a little bit higher than your implied guidance from last quarter?

William Porter, EVP and Chief Financial Officer

I think you’ll see a little bit of variability, Tim, as we do have some of the financing costs and some receivables. So that can have a tendency to move around a little bit and that drove a few million dollar increases from the first quarter. But other than that, it’s pretty steady as we go in terms of just the operational spending, and we do a lot of tradeoffs, we invest, and we’re always looking to where we really can see some efficiency.

Tim Fox, Deutsche Bank Securities

Thank you, one last actually if I could; you’ve been talking some time about segmentation in your kit strategy and hoping at some point you could give us a little bit of extra color or at least some metrics around how those are increasing your business. Are you at the point now where you’re getting a better sense of how those are being taken up in the market and whether a certain percentage of your business is being driven outside of your core strategic customers by the segmentation strategy?

William Porter, EVP and Chief Financial Officer

It’s something we are looking at, Tim. I’d say it’s still more anecdotal than it is in terms of data or trend driven, but I think the anecdotes are that for the segmentation as we would expected we’re seeing somewhere I would say in the mid teens in terms of the GXL range for digital line, which is the one that we have now out for two quarters, and probably a little bit, maybe less than that, on the L side, and the predominant part of the business continues to be XL, which has been the workforce for digital for us. So that seems to be where we’re going. We’ll need some more trend to see how that really plays out for us to through the rest of the product areas and through digital as we get better data. On the kits, again that’s probably a little bit early as well. In terms of the anecdotes, we are trying to track a few customers who are using the kits and really what kind of pull through we’re getting, because that’s where we’ll see the leverage. But based on looking at the geography data, which is this is one of the tools that our geo accounts will have, because it’s towards the mid small accounts for the most of part, we’re seeing continued very good strength in the geos. So, I think this tool, even though it’s early, will get some pickup there and as we get pull through I’ll share with you anecdotally…I’ll try to get some information together for CDN Live in September, but the data will probably be more towards as we look at 2007.

Tim Fox, Deutsche Bank Securities

That’s helpful, congratulations, thank you.

Operator

Your next question comes from Matt Petkun with DA Davidson and Company.

Matt Petkun, DA Davidson

Hi, good afternoon, a couple of questions. First, Bill, just looking at your guidance, you guys have put up through the most recent quarter eight straight quarters with year-over-year revenue growth in the double digits. The midpoint of your guidance for the third quarter would imply 5% year-over-year growth. If we’re trying to use the second derivative to kind of gauge the overall strength of this cycle, if there is a cycle, what should we read into that guidance?

William Porter, EVP and Chief Financial Officer

Matt, I don’t think I would try to read too much into it in terms of the mathematics. I think simply we had a good strong growth last year, and I think we just want to make sure that going into the environment we’re just a bit cautious from everything that we’re seeing out there. I don’t think that we’re expecting the business to slow down. On the other hand I don’t think we want to get ahead of ourselves.

Matt Petkun, DA Davidson

And then the upside that you guys delivered to, your previous guidance for the second quarter, is that maybe some of what’s pulling from your expectations for the third quarter, maybe the few deals renewed ahead of expectations?

William Porter, EVP and Chief Financial Officer

Well, I don’t think this is anything that would be moving in. If anything I think we’re just again trying to be conservative as we look at the business; that would be the outlook we took at the beginning of the year. I think particularly now as the market is trying to digest the economy and everything else, it’s just good for us to be steady and if the time is right with customers, maybe we’ll get a little extra business. If it’s not, we’ll be patient and get that extra value when it’s ready.

Matt Petkun, DA Davidson

Great, and then Mike, just a question; you were talking about some of the new business models that maybe emerging in EDA and it’s pretty clear, both from your offerings like PVS and a lot of the backend requirements in the industry as well as people looking at things like statistical timing for 45 nanometers, how do you see the environment for the actual CPU, the hardware that’s going to be running your software changing, and is there perhaps a new business model available for you to capture some of the new kind of system requirements that will be required to actually do all this work?

Michael Fister, President and Chief Executive Officer

Yeah, it’s a good insightful question. Our stuff is structured to run across many different processors, i.e., to take advantage of the scale out that happens with some of the server configurations. So, we’ve demonstrated a year ago at DAC scaling with a router across 20 different CPU servers at a time, so basically scale linearly. And that itself is thoughtful on our part, because we’re anticipating that the computing dynamics requirement and opportunity exists to be able to differentiate that way. The illusion that you have around some of the emerging geographies where maybe they want to have access to the stuff without owning is more of a capacity on demand environment. I’m very excited about trying that. We don’t necessarily have to do it ourselves, we could very well do that with a big partner or two that’s in the computing business, but the whole motivation there is to do it so that it makes it easier on our customers. If you consider an emerging environment…an engineer might be getting paid a fraction of what a U.S. engineer does, the problem with a $500,000 worth of tool is hard. But if they can pay kind as we go with the process, absorb the whole cost to start off with that’s a pretty exciting value proposition, and we needed to have some segmenting of our product line to really make that amenable and there’s an order to it, that’s why we segmented like the digital offering and such. So, I think we’re setting ourselves up to do that and is an essential element of our strategy, and we’ll just watch it go over time and see how it evolves.

Matt Petkun, DA Davidson

Okay, thanks Michael, final question; what should we be reading into your presence or lack of it at DAC this year, should we read into that, are you stepping away from the industry as a whole, and if so what’s that new direction you want to be headed in?

Michael Fister, President and Chief Executive Officer

Well, I would hate for you take that. We’re all over the DAC team and I was wondering around the show myself. We are prominent there and I particularly think that that conference has continued to focus itself more as a technology conference than a trade show extraordinaire, and many of our customers think about it. If one of big customers wants to have a conversation with me, he gets it. He doesn’t have to come to DAC to do that, and we are involved with the CDM Live and the technology on those events have been very, very well populated, extremely well responded to by the customers, because we get a focused time with them, and in the time of a day or maybe a day and a half they’d get everything, they see the executive base across the board, technologists and so on. So, I think that DAC continues to be a valuable technology gathering. We’re prominent there and we are going stay prominent there, and we are going to supplement our customer engagements with CDM Live, and we’ll just see how the industry continues to evolve.

Matt Petkun, DA Davidson

Okay, thanks a lot.

Operator

Your next question comes from Sterling Auty with JP Morgan.

Sterling Auty, JP Morgan

First, just two housekeeping ones; Bill, in the other income can you just give us some components, is it just higher interest rates that’s driving other income?

William Porter, EVP and Chief Financial Officer

Yes, Sterling, higher interest rates predominantly. We also did get a couple of million dollars from an investment sale that just happened for us, it was a long-term investment that just got changed. So, other than that it’s really interest income driving the majority of the increase over time.

Sterling Auty, JP Morgan

Were you seeing any long-term investments with a couple of million dollars, I’m not clear, was there something that was sold and matured?

William Porter, EVP and Chief Financial Officer

Something that was sold in the long-term investment area for a couple million dollars; that would be the only thing in the quarter that would not be interest income driven.

Sterling Auty, JP Morgan

Okay, as you talked about the operating expenses, operating margin targets, you mentioned G&A and the fluctuation around financing, but can you comment a little bit more specifically on the R&D expenses and control and how you are managing that, and also a little bit on sales and marketing in terms of what the plans might be to build out on the go-to-market strategy?

William Porter, EVP and Chief Financial Officer

In R&D, as Jim indicated last December, there were a number of programs that continue to improve our operational efficiency. Those have been ongoing and we’re been seeing benefits as simple as going through the operating engines. That’s not a simple task but it’s been ongoing for the first half of the year. We’re seeing those results in the second half. Those additional resources are being deployed back into new development, so we’re getting very good leverage from people who don’t have to do things that maybe are not the most efficient. We’re also seeing the continued migration in small pieces of customers through newer geographies, so you’re seeing some of our R&D resources being added in those newer geographies both through development and serve those customers, and that’s where a lot of our head count work has been, in particular Asia, in India. And there are other operational things that we’re continuing to do in R&D. The best where we’re getting leverage…and that’s continual and you’ll see some of that, and that’s why we can do more, and you’re not going to see the R&D expense number grow as fast or stay relatively flat, but we are adding people; we’re just doing it in an efficient way. I think the field is very much the same way. We’re seeing the field migrate for it’s customers, they’re also getting leverage from their programs in areas like sports and being able to leverage some of the benefits in R&D, so we don’t have to hold our customers hands as well as much, because this technology is stronger and we’re going to start to get some leverage from kits and still provide customers what they need when they need them. And in simple areas of services, that business is very well utilized and has being very steady and is developing the customer benefits without having to spend a lot of time in growing that. So, across the board, I think efficiencies we’re always looking at and making tradeoffs and that’s where we’re getting our operating leverage and…is the company.

Sterling Auty, JP Morgan

Okay, Mike, from a big picture model, custom IC digital, I mean they both seem to ebb and flow in terms of being good or not, but verification has been the kind of most stable contributor to the success over the last many quarters. Just from your sense in talking with the customers and looking forward, how much business can the verification rate have for Cadence?

Michael Fister, President and Chief Executive Officer

Yeah, two comments there; one, the ebb and the flow on a quarter basis across digital or custom is exactly the reason why we try to look at it on an annual basis, because they are both rolling nicely, especially the digital stuff, and I don’t think that’s all share gain, but it’s sure going through some share shift, and it’s capability. The verification, you’re right, the reason we commented on adjacency is because all computer designers know how important that that is, of being able to get it right before he implements it, at least because they correct by construction. Impacted architecturally you can make bigger and bigger gains and I think we’re just at the tip of the iceberg of what we can do. Now, that doesn’t mean that everyone who says they have something in verification shares the same passion of success that we do, because they could tend to have point technology in each of them, and if you can’t put those pieces together in a meaningful way at a minimum you’ll commoditize yourself and at a maximum you’ll ride the waver of the guidance and take the holistic view. I think we’ve taken a very thoughtful and structured approach to doing it. We waited out and the integration was risky, it was a very calculated thing. It behaved just like Bill and I told you, and I think there’s any awful lot of opportunity to move up that abstraction, and that will be a powerful contributor for our business, and we just have to wait it out now.

Sterling Auty, JP Morgan

Okay and then last question, last year with Synopsys with IC compliers this year it’s Magma some other new product introduction, can you just comment in terms of how you see the new competitive introductions from the product side relative to the other current products from Cadence?

Michael Fister, President and Chief Executive Officer

I haven’t seen anything that surprised us, but that’s good; I mean a thoughtful person is got a competitive intelligence, and our roadmap process is even more disciplined now than it was two years ago. Our features as we’ve been able to size it up are extraordinarily competitive from where we thought they would be, and our roadmap is rosy across all the different pieces of our business. So, I like our roadmap, it’s supported by excellent customer feedback, and in some of the small niche areas where maybe we could tune it up a little bit, they’re either in flight or we’ve taken the feedback and we’re concentrating on them. So, I think you can only really react to what the competitors do based on what you think is going to happen. That’s why we take such a structured and thoughtful notion about the roadmap, that’s what leadership companies do; we are the leadership company in our industry and I think I like our chances for continuing profits across all product areas.

Sterling Auty, JP Morgan

Thank you.

Operator

Your next question comes from Rohit Pandey with HSBC Securities.

Rohit Pandey, HSBC Securities

Thank you. Bill, you spoke about the uncertain environment, can you elaborate on that, like what uncertainty are you seeing from your customers outside the macro talk?

William Porter, EVP and Chief Financial Officer

Rohit, I think that’s why we indicated that there is uncertainty that the market is seeing in semiconductors and there are macro uncertainties that we’ve all looked at in terms of what may happen with interest rates and energy costs. But as we then take a closer look at our customers, we have been seeing steady increases in R&D spend, which is to me one of the most important indicators, and that seems steady at the high single digit rate So, we haven’t seen customers change behavior there. And then the other area as we look at design starts and just talking to customers, we haven’t seen them change their behavior in terms of those that need to move fast the new geometries are doing it, those that need to get products out quickly and competitively doing it. So I think what we’re counting is that the market is saying there’s a lot of uncertainty and we’re telling you we’re paying attention to that, and in particular we’re paying attention to our customers, but we haven’t seen anything that’s making us change our outlook, and our customers haven’t told us anything that’s going to change the way we behave and work with them.

Rohit Pandey, HSBC Securities

And going to the guidance actually, the midpoint of the annual guidance is a little below consensus, are you trying to be conservative or is it just uncertainty you’re trying to plan there?

William Porter, EVP and Chief Financial Officer

No, I think we’re trying to be conservative. As we do better, we expect that to flow through and we’re not reducing our second half outlook as we outperform. That’s something that we’re adding. So, I would take it conservative than an environment where the market tells us we should just be paying attention, but operationally things haven’t changed, the fundamentals are good, and we continue to plan to execute to our plans.

Rohit Pandey, HSBC Securities

You had some cash paid for business acquisition this quarter, what was that?

William Porter, EVP and Chief Financial Officer

We’ll always have some small activity that we just don’t talk about, because in some cases it’s payments on earn outs or prior acquisitions and in some cases it’s some innovative technology that is just under the radar, it’s not big enough to talk about probably. In many cases some of the smaller stuff is in the areas around the FM as people would expect. So, I guess that’s where I would say that the investment is happening, and when we have products to bring out that’s when we’ll talk about the technologies associated with those.

Rohit Pandey, HSBC Securities

But what we saw this quarter, was it acquisition or was it an earn out?

William Porter, EVP and Chief Financial Officer

I think we saw a mix across both, some technology that we acquired and some payments were earn out.

Rohit Pandey, HSBC Securities

Okay, and just the last one on the stock option expense, it was lower this quarter primarily, was it the lower stock price or something else?

William Porter, EVP and Chief Financial Officer

No, I think it’s been pretty consistent with what we expected in certain terms of the FAS 123R expense. We had indicated for the year we thought it would be around $100 million, and cumulatively I think we’re sitting right about that level. So, now it’s just pretty much as we had expected and we are managing of course carefully the amount that we give out, and I’ve told people we are trying to manage the 2% net and we’re just doing that very thoughtfully.

Rohit Pandey, HSBC Securities

Thank you.

Operator

Your next question comes from Stuart Muter with RBC Capital Markets.

Stuart Muter, RBC Capital Markets

Good afternoon, thanks for taking my questions. I guess first a question for Mike in terms of the mix by geography; Japan was strong this quarter, would you expect that to continue in the second half?

Michael Fister, President and Chief Executive Officer

Japan was a target for us. It is a very interesting place in the world because you have a lot of computer companies and not just semiconductor companies, so there are system designers, they relate very nicely to our segmentation and moving up into the verification adjacency. The team there is incredibly strong that we have and it makes for a wonderful combination of building on a base that we had and I think we’re continuing to do. It has not only been strong this quarter, it’s been strong for the last few quarters.

Stuart Muter, RBC Capital Markets

Okay that’s helpful, and then in terms of DFM there’s a lot of talk at DAC on DFM, at what point do you think DFM in terms of a percentage of revenues will kind of break out of that 8% or 9% level?

William Porter, EVP and Chief Financial Officer

That’s a good question. I think it could be a while and the intriguing part for you guys is that you may have companies whose total life projection is around EFM. In our case we’re a lot more integrated across our implementation flow, and I think the DFM stands for design and it’s a big D. So, you want to do it right the first time as opposed to getting all the way to the end of the manufacturing measure and see that you did a lousy job. So, our approach is very interoperable with the implementation flows that we have and that could mask itself a little bit. I think the third ting to watch for in the DFM is I don’t think it will be just a license descriptively. I believe there are going to be opportunities to participate in a risk reward proposition that customers do as they try to constantly increase yield. Certainly they should be able to…if that’s the case, probably requires a big mature entity to work with to have that global sophistication. We’re now trying it and it is a catalyst, almost a predisposition for it. And it will be harder to measure that, because you just won’t see how many products got sold by Thursday, but those are the three things that I would think about and it’s going to be a long maturing category because it is in the category now; a collection of points of life and it’s going to take someone to bring it together methodologically to really have a huge impact on the customer’s productivity and output.

Stuart Muter, RBC Capital Markets

Okay, thanks that’s helpful.

Michael Fister, President and Chief Executive Officer

Okay, we have time for one more question.

Operator

Your next question comes from Victor Smith.

Vishal, Analyst

Hi, Bill, this is Vishal. Two quick questions for you; first on the current portion of deferred revenues, can you talk about why there was a high single digit and what generally goes into that category, and how we should expect that to trend going forward? Then on the share count — correct me if I’m wrong — but the share count was still up quarter over quarter, was that primarily because the buybacks were tilted towards the latter part of the quarter and where should we see on a quarter end basis?

William Porter, EVP and Chief Financial Officer

Let me answer the second question first, Vishal. Yes, the timing, essentially what we saw in the quarter was exercises in the early part of the quarter and the stock buyback a little bit more weighted towards the end of the quarter, so that’s why the share count went up, it was just the waiting of what went in went in earlier, what came out came out later. In terms of the deferred revenue, now that is really a mix of different things. There are some customers, as we do more subscriptions, will pay for those in advance, so depending on the individual negotiation with customers we’ll see some increases in deferred revenue where we get payments in advance of revenue, and that’s something that we have been working for sometime. It’s just to encourage cash where it makes sense, and then we will continue to see some customers also in the area of maintenance payback and in some cases before the revenue gets taken. So, just as simple as that where we have payments in advance of taking revenue, and those are hard to predict because it doesn’t always go in a trend, so there could be some variability in deferred revenue. Generally my assumption is it’s pretty steady but slightly up based on just customers making payments with different operating schedules.

Vishal, Analyst

Okay, just a minor clarification on that, on what basis do you decide whether it goes into the current portion or the long-term portion?

William Porter, EVP and Chief Financial Officer

It’s expected to turn to revenue within one year or operating cycle; it goes into short term. If it’s something that’s going to be coming out greater than a year, it goes into long term.

Vishal, Analyst

Okay, so all things being equal, if it does trend up, it does add to your level of visibility coming into the quarter?

William Porter, EVP and Chief Financial Officer

Yes, slightly.

Vishal, Analyst

Thanks a lot.

Operator

Thank you, this concludes Cadence Design Systems second quarter earnings conference call. You may now disconnect.

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