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Mentor Graphics Corp. (NASDAQ:MENT)

F2Q10 Earnings Call

August 20, 2009; 5:00 pm ET

Executives

Walden Rhines - Chief Executive Officer & Chairman

Greg Hinckley - President

Joe Reinhart - Director of Investor Relations

Analysts

Matt Petkun - D.A. Davidson & Co.

Sterling Auty - JP Morgan

Rich Valera - Needham & Co.

Operator

Ladies and gentlemen, we thank you for standing by and welcome you to the Q2 ‘10 financial release of Mentor Graphics. At this time all participants are in a listen-only mode. Later we’ll conduct a question-and-answer session; instructions will be given at that time. (Operator Instructions)

I’d now like to turn the conference over to our host Director of Investor Relations Mr. Joe Reinhart. Please go ahead, sir.

Joe Reinhart

Thank you Pamela and good afternoon everyone. Welcome to Mentor Graphics second quarter conference call. As Pamela said I’m Joe Reinhart Director of Investor Relations Incorporated Development. This afternoon Walden Rhines, CEO and Chairman will open with a discussion of key trends in our business, Greg Hinckley our President will then discuss operational highlight, financial highlights and guidance.

Wally and Greg will then be available to take your questions. As a remainder this conference call contains forward-looking statements. While these statements reflect our best current judgment, they are subject to risks and uncertainties that could cause actual results to vary. In addition to the factors noted later, these risks factors could be found in our most recent 10-K, 10-Q and Annual Report.

For reconciliation from GAAP to non-GAAP measures used in this presentation, please refer to today’s financial release. This information is available online at the Mentor website. Wally.

Walden Rhines

Thanks Joe. The results for the second quarter significantly exceeded expectations with bookings growth of 15% an all time record for a second quarter, revenue of $182.6 million and $20 million of operating cash flow. While there’s still substantial caution in the business environment, the strength that was reported by semiconductor companies beginning late February continued during the quarter leading to increases in earnings guidance by almost all of our top customers.

Stronger than expected sales of Smartphones and personal computers raised the mood among our customer-based and layoffs by electronic companies decrease from more than 10,000 in January to less than 1500 in July. This is an automation conference are deck was also more positive than expected. Attendance increased 12% versus last year and 3% versus the year before helps by the return to San Francisco and full participation by all the major EDA companies.

Mentor had an excellent deck with strong interest in our low power and electronic system level or ESL product announcement as well as the inclusion of the Mentor complete design flow in TSMCs newly announced reference flow 10.0. In addition to improvements in the market environment, we also experienced some signs of bottoming in our own numbers for the quarter.

Number of new customers, which is decreasing for several quarters, turned up in Q2 with a 10% sequential gain. Customer renewals among our top ten customers showed a slight increase compared to their contracts of three years ago. Our base business, that is orders less than $1 million which constituted most of our weakness in the second half of last year and the first quarter of this year, stop declining and has even shown a slight up tick during the first weeks of Q3.

Our geographic or distribution bookings grew 45% sequentially during the quarter despite the general weakness reported by small EDA companies. Another positive early indicator is consulting. Mentors consulting bookings were very strong increasing 45% sequentially with particular strength in our yield enhancement, cabling and place-and-route services.

We also saw stabilization in the rates of decline of existing support contracts, which has been unusually high for the last four quarters. Bankruptcies which negatively impacted our first quarter revenue by over $10 million had no negative effect during the second quarter.

Finally, reflecting stabilization of the broader market, we were helped during Q2 by unexpected strength in our mechanical analysis division which handles flow term product line. This year has been a period of relatively intense pricing competition in the EDA industry highlighted by all-you-can-eat software contracts intended to displace competition and major additional discounts on existing software that are provided in trade for customer endorsement.

Mentor’s fundamental strategy places us in a more insulated position compared to our major competitors. While we are able to provide as complete a design flow as any of our competitors, we focus our efforts on the platforms where we have the number one market share and can provide irreplaceable technology as in physical verification, Design for Manufacturing, Design for Test and many more. This strategy makes us an invaluable part of the customer overall design flow, but focuses or interaction on benchmarking and support as specific product or design platform capability.

As a result, pricing for Mentor tends to be directly tied to products rather than all-you-can-eat contracts. We’re better able to price to value and we will achieve incremental revenue in the future if a customer’s requirements for copy of our software increases beyond their basic contract commitment. Average software access rates on our ten largest customer contracts actually increased this quarter, when compared to the access rates in prior contracts with the same customers.

Similarly for all of the customers that have provided a formal endorsement of a Mentor EDA competitor, both the access rate and total contract value of renewals have been increasing more than other overall average contract renewal. We believe this is a result of the fundamental difference in Mentor’s strategy and those of our major competitors. Competitors’ offers of all-you-can-eat contracts haven’t had an impact on Mentor. In fact the pricing data suggests that the reverse might be true.

An example of our strategic focus on products and platforms is seen in our LogicVision acquisition that was completed on Tuesday of this week. In Design for Test, Mentor already had more than twice the market share of our nearest competitor even before the LogicVision acquisition. Mentor’s strategy however, is to focus on areas of strength rather than areas of weakness.

BIST or built-in-self-test is one more unique piece in a complete array of Design for Test alternative. LogicVision has maintained the leading position in BIST for many years because of its focus. We believe the majority of the BIST market is still handled by in-house solution, because companies have been unwilling to out source this strategic difficult to replace technology to a small company.

Since the announcement of the acquisition of LogicVision, we’ve been approached by semiconductor companies seeking to out source their BIST activities or reactivating their use of LogicVision BIST. In addition, a complete DFT solution in the future requires both scan and BIST. This provides one more reason for customers to focus their testing needs on Mentor and to maintain their vendor flow and, of course the LogicVision acquisition is expected to be accretive to earnings during the first year.

Although I’m uncertainty still exists, there are concrete signs of stabilization in our market. As many of you have noted, when the upturn in EDA spending does occur, Mentor’s term business model will cause us to benefit from the upturn earlier than other companies. We are looking forward to that. Greg.

Greg Hinckley

Thanks Wally. On all the metrics we track, we are very pleased with our execution during a quarter of challenges including an economy that although improving is still very weak, opacity of renewals and the weakening of the US dollar. Because of new business from new products and new customers, bookings were up strongly, up 15% for the quarter and 20% year-to-date to an all-time second quarter record. That strength was brought based.

Integrated business designs, which includes our printed circuit board and field programmable gate arrays design software was up 20%. Design to Silicon, where we have our Calibre, and placed route products was up 45% and Scalable Verification, where we have our logic verification products was up 30%.

Only new and emerging was weak attributable to softness within automotive accounts and even there the success we were having with our consulting organization, bookings for transportation consulting was up 50% and included names like Honda, Goldstream and Hawker Beechcraft are used that momentum here is merely deferred and not winning.

Consulting in all up strongly sequentially was also up 5% year-over-year. Book-to-bill was significantly greater than parity and the strongest for the second quarter this decade. Revenue was flat $182.6 million with product up 10% and services including maintenance down 10%.

Encouragingly, the rate of decline of maintenance business has finally reached zero. So we think, we have reached the bottom here, and our consulting business is growing again. Obviously, we did far better than our revenue forecast of $165 million. Gross margin was 83.8%, slightly below that of the second quarter of last year caused by a higher mix of emulation revenue this quarter.

Operating expenses, we promised would drop both sequentially and year-over-year. We delivered on that promise. Non-GAAP operating expense was a $147 million, compared to $155 million in the first quarter of this year and a $153.7 million last year. Non-GAAP EPS was a $0.02 profit compared to our forecasted $0.10 loss in our actual $0.02 loss a year ago.

Expense control remains a Mentor priority. All natural expense categories, travel, facilities, and employee compensation and benefits continue under review. We abandoned or downsized facilities in five cities this quarter and began steps to consolidate one of our largest engineering locations in Europe with sales space that we can free up in a nearby community. Travel has been reduced by 25%. Salaries have been largely frozen and benefits cut.

Mentor is committed to delivering the most effective cost control program within the EDA industry. Cash flow from operations, as Wally said was $20 million, and we used those proceeds to retire fully our outstanding revolver credit debt. Factored receivables, was $4 million, well down from the $15 million of last year. We continued to have no difficulties factor in our receivables.

Capital expenditures are also down, a substantial 40% to $6 million. Now, for more of financial details; bookings were up 15% from the second quarter of last year. North America doubled. Pac Rim was up 20% while Europe was down 20% and Japanese activity was negligible.

Top ten accounts represented 60% of quarterly bookings compared to 50% last year and we had one account that was greater than 10%, but our average contract life remained at three years. Revenue as said were flat with strength in products offsetting weakness in servicing.

Bankruptcy proved not much of an issue this quarter. We reached a quarter prove contract with Spansion, received payment and recorded revenue. Lear invest the honor two other customers that filed for bankruptcy protection this quarter. We have been recording that revenue ratably and had bankruptcy proved our contracts to the extent possible, so effects from their filing are negligible.

Tellingly, our bad debt expense through six months of fiscal year ‘10 is less than $500,000, a net of reserves we have no receivables greater than 60 days. Revenue mix by geography was 50% North America, 30% Europe, 15% Pac Rim and 5% Japan. Ratable revenue was 50% of total, including maintenance, consulting and subscription revenue. Subscription revenue was 15% of total, perpetual 25%, and term 60%. Currency was unfavorable to revenue for about a million dollars.

New customers excluding PADS and Flomerics dropped about half in value and number, but saw a sequential up tick. Contract value renewals in the second quarter showed a slight gain, which while modest is vastly better than the 15% decline experienced last quarter and pricing is reflected in our access rate was up sharply, suggesting that so far we have not been affected by the pricing wars going on among the other large EDA companies.

Non-GAAP gross margin was 83.8%, 90.5% on product and 74.5% on services. OpEx non-GAAP was down 4% to $147 million. Currency was favorable to operating expense by about $8.5 million most of which came from currencies other than the Euro. GAAP OpEx and cost of good sold include $7.5 million of 123R our stock option in the like expense which is approximately 50% less than our principal competitors. Other income and expense was an expense of $4.2 million, up $1.6 million from last year.

Interest income was down $1.3 million because of fewer discounts received on forward contracts and less interest income on lower cash balances. Interest expense was higher due to balances outstanding on bank debt. Special charges of $4.2 million were related to expense cutting initiatives mostly severance and facility shut down cost and ongoing investment banking fees that arose from the Cadence offer. The non-GAAP tax rate remains at 17%.

Now to cash flow and the balance sheet, operating cash flow for the second quarter was $20 million. Cash and equivalence decrease sequentially to $76 million because during the quarter we repaid $20 million, the entire balance outstanding on our revolving credit and acquired Embedded Alley, a company specializing in Embedded Linux and Android applications.

Trade accounts receivable was $107 million down $2 million sequentially. Short term unbilled receivables were $152 million, up $10 million sequentially. Trade DSO were 53 days and increase at two days from last quarter and up 6 days since last year. Total DSO were 128 days, an increase of 11 days from last quarter and an increase of ten days from last year.

Factor receivable as said was $4 million in the second quarter. Capital expenditures were $6 million for the second quarter of this year compared with $5 million last quarter and $11 million in the second quarter of last year. Depreciation and amortization was $8 million for this second quarter compared to $9 million in the first quarter and $8 million in the second quarter of last year.

Now to guidance, we now expect revenues to again remain flat this time to the third quarter of last year at a total of about $183 million. I point out that if the economy is improving, our preference for fixed product term contracts that result in up front revenue recognition should allow us to accelerate revenues and earnings faster than the other companies within our industry.

With expenses down, we see non-GAAP earnings of about $0.01 per share and cash flow from operations of around $10 million. For the entire year, while we remain uncomfortable forecasting revenue and earnings, we see cash flow from operations in the range of $40 million to $50 million. Wally?

Walden Rhines

Thanks Greg. Mentors 15% bookings growth in the second quarter following a 25% growth in the first quarter is very encouraging in a weak overall economic environment. Leading indicators such as consulting bookings, number of new customers, and strength of distributor bookings suggest that we may have reached the bottom of the EDA cycle. With continued vigilance to control our cost, this recession can be a time of opportunity both to make strategic acquisitions like LogicVision and Embedded Alley, but also to increase cash flow and business competitiveness.

Now let’s take some questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matt Petkun - D.A. Davidson & Co.

Matt Petkun - D.A. Davidson & Co.

On the new and merging side Greg or Wally, I think Wally you had mentioned that the Flomerics’ business was starting to go kick in. Wouldn’t that have contributed to a better quarter in that segment?

Walden Rhines

It’s true, but new and emerging contains a lot of categories so the principal cause is, I’m sorry.

Greg Hinckley

It’s with our PCB product, Wally.

Walden Rhines

So, I answered the wrong question. Right, so the answer is true. The mechanical analysis products are included in integrated systems design. Let me also note as long as I was there that’s the new and emerging weakness side that you mentioned as Greg noted was primarily our automotive business.

Matt Petkun - D.A. Davidson & Co.

Your most recent 10-K had included the mechanical analysis business in emerging, but that makes sense and that’s helping to offset year-over-year weakness in PADS. Is that correct?

Walden Rhines

Yes, though our PADS stabilized and is looking better.

Matt Petkun - D.A. Davidson & Co.

One other comment you made was that and it does seem to be true that your pricing data suggest that you’re not being impacted for the most part by all-you-can-eat deals your competitors offer. Can you make a more specific reference though to how that pricing strategy is impacting your traction with the Olympus product line?

Walden Rhines

As I did mention earlier, we’re somewhat insulated, because fundamentally we focus on platforms or products and we go through benchmarking and we tend to end up with a contract with a customer that’s based upon the value of some portion of the total flow. Rarely, do we try to throw in everything in our flow and give the customer a lot of free software to go with the software we charge for. It’s sort a different methodology. Now, in the place in route, in general those are standalone evaluations.

The place in route software as you know, has relatively high listed prices, and so when we’re chosen, we tend to be selling a place in route flow and what that typically is going up against is a flow that includes a lot of other things with it that are thrown in either for free or at highly discounted prices. We’ve seem to been able to contain that and to get a comparable value for the more limited set of product we provide and to leave the opportunity open for upside.

Matt Petkun - D.A. Davidson & Co.

Just one other question product line, Wally, the press release contained some commentary about some traction in your Catapult C, even more chip level that you’re seeing. How will that translate, because I think that’s another potential adder for the new and emerging product category. What should we be thinking about in terms of the longer term revenue opportunity for that product category?

Walden Rhines

We certainly have seen a lot of momentum across the industry in high level synthesis, while there are a lot of small companies. Mentor right now, according to the market statistics has a little more than half of that total market and it’s growing and the overall ESL category is one of the few things has grown this decade going from about $50 million to $200 million. I don’t view that season, this is by itself is going to be $100 million plus category, but it’s substantial and the other pieces of ESL together certainly add up to bigger numbers.

Operator

Your next question comes from Sterling Auty - JP Morgan

Sterling Auty - JP Morgan

First question 15% bookings growth, how much of that was organic?

Greg Hinckley

It was about three quarters organic, Sterling.

Sterling Auty - JP Morgan

Two questions just for a clarification, you talked about the strong bookings, but if I look deferred revenue was down sequentially and while revenue was a big upside to your guidance, no doubt about that. It’s not the biggest revenue that you’ve done in this quarter and in the past. How do I reconcile the strong bookings in those two items?

Greg Hinckley

The sources of our deferred revenue Sterling, is virtually all maintenance contract related. So we typically renew our contracts late in the fourth quarter, early in the first quarter and then amortize those contracts and the deferred revenue that is created, when we recognize the contract perhaps to receive payment for the entire through the year, but haven’t performed service. So as we provide service over the following 12 months, the deferred revenue contract declines. It’s normal and customary here.

Sterling Auty - JP Morgan

Then on the product gross margin, I see they are down 500 basis points and down for the second quarter in a row sequentially. What’s happening there, because my immediate reaction would be, while you actually are seeing pricing pressure, which doesn’t fit with the comments? Is there something else going on in that part?

Greg Hinckley

Yes, there is. We had a strong emulation quarter.

Sterling Auty - JP Morgan

Last question is, we talked about your renewals getting better through the year, but very back end loaded. You’re flat sequentially here for the third quarter in terms your revenue guidance, which I would take it to mean that the strong renewals are awaited through the fourth quarter, would that be true?

Greg Hinckley

You got it.

Operator

Your next question comes from Rich Valera - Needham & Co.

Rich Valera - Needham & Co.

I was wondering if you can characterize, where the upside relative of your original guidance came from both in terms of product area and in terms of the type of business, because I know one thing that had fallen off pretty sharply was all of your non-renewal business sort of the turns that historically happened had fallen off very sharply during the hard of the downturn and I’m wondering if that came back some during the quarter?

Greg Hinckley

We’re seeing some improvement in our base business, but that wasn’t the cause for our strength this quarter. As I’ve tried to explain, business from new customers and new products both of which were very meaningful and they centered in the particular source of strength was in our Calibre platform.

Rich Valera - Needham & Co.

Those would typically though be renewals, wouldn’t they? Are you saying these are brand new customers that actually drove that upside?

Greg Hinckley

Brand new customer.

Rich Valera - Needham & Co.

I know you didn’t have a lot of renewals, but the ones you did have, can you talk about what the renewal run rate was like, flat, up, or down?

Greg Hinckley

The run rate, total value of the contract over the life of the contract, which I said Rich, remained at three years, it was slightly up and when I say slightly, I mean very modestly, but that’s a big improvement over what we saw in the first quarter, and we said that our access rates, which are what the lease rates that we charge, so it’s fees received on average over the life of the contract per year divided by the total value of the software delivered, those rates actually increased substantially. So we got better pricing for our software.

Rich Valera - Needham & Co.

Last quarter you cited some bankruptcies and customers divesting. Was there any of that in this quarter, any of those sort of adverse impacts?

Greg Hinckley

We mentioned that this quarter, we didn’t have any effects of bankruptcy. We had a couple of accounts busy on and Lear that did enter bankruptcy, but in those two cases, we had been dealing with the customers on a ratable basis. Anyway, because we were concerned about their credit and had been for the life of the contracts, and we think our contracts are well bankruptcy proved. So we’ll get back to receiving payment and recognizing revenue before the end of the year.

Rich Valera - Needham & Co.

Then last quarter you said you expected cash from operations, I think, better than I think it was like the $23 million number. In this quarter, you’re talking $40 million to $50 million, which is roughly double. I guess what you’d boost guided to last quarter. Can you talk about what has changed to increase your confidence in the cash from ops number?

Greg Hinckley

All there’s parts of it. It just has to do with our business is clearly much stronger than we anticipated, the fact that we were $17 million ahead on revenue, that helped. It helped in the earnings pace as well. The fact that we had strengthened emulation, we ended up reducing our inventory balances.

We agree with synopsis in their comments yesterday that we’re find in our payment conditions with our customers are a better than they were late last year and through the first quarter. So what we’re seeing is, improvements in our ability to manage our working capital has a lot to do with why we are forecasting $40 million to $50 million of cash flow for the year. I repeat for the year not for the next quarter.

Rich Valera - Needham & Co.

One final one if I could. I think I know the answer, but one of your competitors has a renewed effort to go after Calibre and has been quite vocal about that and has a product that sort of plug in replacement for Calibre. I’m just wondering what you’ve seen on the benchmark front or if you’ve seen any impact from that initiative from your competitor at this point?

Walden Rhines

The answer is we have seen absolutely nothing. We met a check to that and also the customer that was mentioned in that disclosure has requested an increase in the amount of Calibre they’re using. So I don’t believe it’s meaningful.

Operator

Your final question comes from Matt Petkun - D.A. Davidson & Co.

Matt Petkun - D.A. Davidson & Co.

Just a follow-up maybe Greg when it comes to the timing of when you’re seeing renewals, are you generally seeing your renewals happen on schedule? Are you starting to see customers maybe revert to their historic practice of renewing a little bit, before at the end of the contract? Are you seeing some renewals even delayed? I ask this most specifically in regards to what we should be expecting for back half of the year renewals this year?

Greg Hinckley

Matt, I said that payment terms have become much easier, much better than we’d experienced in the fourth quarter and the first quarter. We are beginning to see customers revert to renewing contracts again early. We saw some of that in the second quarter, which is why we hit such a strong book-to-bill.

Matt Petkun - D.A. Davidson & Co.

I want to ask this is indirectly as possible yet to be somewhat direct. This is our final chance to calibrate our models for Q4 before you provide formal guidance on your next conference call. I’m wondering if you think that the trends you’ve seen now year-over-year bookings growth in Q1 and Q2, if you think that continues throughout the rest of this year as you may be enjoying a better renewal cycle.

Greg Hinckley

I’d like to help, but we are not confident enough in the current business environment to help you.

Operator

Thank you and presenters, I have no further questions at this time. I’ll turn the call back to you.

Joe Reinhart

Pamela, thank you very much. Ladies and gentlemen, thank you for joining us this afternoon for a follow up calls both Greg and myself will be available. The best way to contact us is by calling Monte Koller at 503-685-1462 and she will make sure that either Greg or myself get back to you in a timely fashion. Operator if you could please give the replay information for those that want to dial-in at a future time and here is again.

Operator

Ladies and gentlemen this conference will be made available for replay after 4:00 pm today until August 27 at midnight. You may access the AT&T Executive playback service at anytime by dialing 1-800-475-6701 and entering the access code 111995. That number is 1-800-475-6701 with the access code 111995. International participants please dial 1-320-365-3844 and again 1-320-365-3844 for international with the access code 111995.

That does conclude our conference for today. We thank you for your participation as well as using AT&T Executive teleconference service. You may now disconnect.

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