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Executives

Lisa Ewbank - VP, IR

Aart de Geus - Co Founder, Chairman and Chief Executive Officer

Brian Beattie - Chief Financial Officer

Analysts

K.C. Rajkumar - RBC Capital Markets

Richard Valera - Needham & Company, LLC

Synopsys (SNPS) Q2 2010 Earnings Call May 19, 2010 5:00 PM ET

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Synopsys Inc. Earnings Conference Call for the Second Quarter of Fiscal Year 2010. [Operator Instructions] At this time, I would like to turn the conference over to Lisa Ewbank, Vice President of Investor Relations. Please go ahead.

Lisa Ewbank

Thank you, Lola. Good afternoon, everyone. With us today are Aart de Geus, Chairman and CEO of Synopsys; and Brian Beattie, Chief Financial Officer.

During the course of this conference call, Synopsys will make 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 quarterly report on Form 10-Q for the fiscal quarter ended January 31, 2010, and in our earnings release for the second quarter of fiscal year 2010 issued earlier today.

In addition, all financial information to be discussed on this conference call, as well as the reconciliation of the non-GAAP financial measures to their most directly comparable GAAP financial measures and supplemental financial information, can be found in the current report on Form 8-K that we filed today, our second quarter earnings release and our financial supplement. All of these items are currently available on our website at www.synopsys.com.

With that, I'll turn the call over to Aart de Geus.

Aart de Geus

Good afternoon. I am pleased to report that in Q2, we again delivered solid results with in-line revenue, good expense management, slightly above target earnings and strong cash generation. Moreover, we made good progress increasing our total available market for long-term growth.

Over the past several years, we have been executing on all fronts. R&D investment, global customer support and targeted acquisitions, all resulting in very solid financials, as we have emerged as a clear industry leader.

Let me first summarize last quarter's financial results. We met or exceeded all of our Q2 targets. We delivered non-GAAP earnings per share of $0.41, with revenue of $338 million. We carefully managed expenses and are on track to meet our ops margin target of 24% for the year, and we're heading towards meeting or beating our initial revenue, EPS and cash flow objectives for the year.

Before reporting on our strategy and execution, let me address the economic landscape that our customers are navigating and its impact on EDA [electronic design automation] and Synopsys. While the worldwide economy is gradually recovering, the semiconductor industry has experienced a rapid increase in demand. Companies are ramping up chip production as quickly as possible. Most of our customers have reported solid results, are seeing a strong six-month outlook, and in many cases, are reporting capacity shortages.

Simultaneously, they do remain cautious, as there is an ongoing focus on cost throughout the supply chain. Semiconductor executives continue to reassess every part of their business and are moving resources to the most value-added functions and projects. Although I would continue to characterize the EDA market as challenging overall, Synopsys is well-positioned to help customers, both in terms of cost and productivity focus and also with the need to accelerate innovation and differentiation.

Indeed, we continue to be the supplier of choice for many of these companies. And again in Q2, several customers chose us as their primary EDA partner, including Yamaha, a leader in audio and graphics chips. As companies look at increased differentiation though, through a combination of hardware and software, they find Synopsys a ready partner to drive this emerging quest forward.

Having said that, the implications of the customer landscape on near term EDA growth are mixed. On the challenging side of the ledger, we see cautious buyers, continued customer consolidation, considerable competitive pressures and core EDA budgets that are not growing.

On the positive side however, the adoption of 40-nanometer, 45-nanometer and below design nodes is accelerating. IP reuse-based design methodologies are growing, hardware/software co-verification is becoming a necessity and integrated design flows are demonstrating substantial productivity benefit.

For Synopsys, this is good news. We continue to lead the industry in advance designs all the way below 28-nanometer, and our highly-tuned product portfolio can handle the most difficult complexity challenges. Our IP is very strong. The interest in system solution is rapidly growing and our R&D engine continues to keep us in a strong technology position.

So notwithstanding the overall market challenges, we have been able to hold average run rates roughly flat and are focusing on near-term growth efforts towards the IP and systems adjacencies. Consequently, our strategy remains unchanged: One, maintain our technology momentum, increase our efficiency and expand our core EDA leadership; two, broaden our core EDA TAM by fielding adjacent products and capabilities; three, expand our TAM beyond core EDA by aggressively driving the emerging IP and systems space.

Let me begin with some highlights around core EDA. Our R&D investments continue to pay off. Not only have we made outstanding progress in providing leading solutions for the most advanced nodes, but we're also innovating in-house to optimize the design flows for substantial productivity improvements. Indeed, for the second year in a row, our Galaxy Design platform has won the EDN Magazine Innovation Award. The driver this year was IC Validator, which integrates physical verification with IC Compiler physical design.

With our In-Design technology, designers can now perform physical verification checks and repairs during design, thereby reducing late stage surprises and unnecessary iterations. Feedback from customers is strongly positive and adoption is progressing ahead of expectations. Driven by the integration of IC Validator and IC Compiler, one of the largest semiconductor companies in the world selected Synopsys to displace the incumbent.

In verification, our VCS simulator holds large lead in customer usage for advance designs. In addition, we're increasingly beating the competition in more mature process nodes, with two competitive displacements in Q2, based primarily on better performance and memory efficiency. In manufacturing, Renesas Adopts [Renesas Adopts Proteus OPC], our optical proximity correction for advanced 28-nanometer developments. By providing customers the best combination of accuracy and run-time performance, we can enable a shorter, more cost-effective development cycle.

Now to efforts to broaden our core EDA TAM. Our most notable focus has been the rapid maturing of Custom Designer, our analog/mixed-signal design tool. We now have not only a complete solution but also compelling differentiation, in terms of ease of use and open architecture and tight integration with other Synopsys tools. The quality and size of engagement opportunities have steadily increased, yielding several customer wins, including a competitive displacement at a company designing advanced network IPs.

In addition, from reprocess design kits (sic) [process design kits] or PDK support is growing for processes across the board from 180, all the way to 28-nanometer. Another new product, Yield Explorer, is also generating notable customer interest, as it accelerates yield ramp by diagnosing yield issues during design, where major semiconductor companies successfully use Yield Explorer for 90-nanometer and 40-nanometer design, and is now broadly deploying the solution through their organization.

And finally, let me address our efforts beyond the core, up into the IP and systems domain. This area is growing well, both organically and through acquisitions. Our strategic vision and investments of the last 10 years are coming together at exactly the right time. Today, IP and systems represent approximately 13% of our total revenue and is rapidly approaching $200 million in annual business for us.

IP had a very strong Q2, with many large semiconductor and systems firms making purchases. The drivers for this success are the following: Major [ph] buy decisions have accelerated, as customers stringently evaluates their cost structures and refocus their engineering on differentiation; in addition, post-recession time to market pressures have increased, forcing customers to quickly move to the new connectivity standards.

Since Synopsys not only provides a broad catalog of these IP titles, but also has a strong reputation for quality and performance, we're the natural choice to partner in this area.

One of those titles is USB 3.0, also called SuperSpeed USB, a rapidly growing new standards that provide 10x speed up over the previous generation. Synopsys was the first IP vendor to pass compliance and certification testing for SuperSpeed USB, and our product won the EDA Innovation Award for IP this year.

We are also seeing strong business in areas such as HDMI and DDR, on both the analog and digital side. During the quarter, we announced our new DDR multi-PHY, which supports multiple standards on a single physical core without sacrificing power or area. Our development importing engines are cranking with dozens of new versions released each quarter.

Synopsys is the second largest IP provider in the world, second only to ARM, and is the number one supplier of interface and analog IP.

Complementary to our IP focus is our systems strategy. In Q2, we bolstered our already strong offering in algorithmic design and virtual prototyping by closing acquisitions of VaST, a leading supplier of virtual prototypes for automotive and consumer; and CoWare, the industry's broadest and largest supplier of system level tools. The integration of both companies is proceeding with good customer feedback and engagements.

We've also further strengthened our portfolio with the introduction of our next-generation rapid prototyping. The new system doubled the size of designs that can be prototyped on a single board, while increasing prototyping speeds by 30%. Customer demand is very high, and we're selling these systems as fast as we can build them.

Synopsys has the most comprehensive set of solutions in the IP and systems space and is the clear leader in enabling our customers to accelerate software development, raise the level of design abstraction for efficient chip design and have access to a rich set of IP and model.

In summary, Q2 was a solid quarter for Synopsys. We maintained average run rates and made progress in our broadened core EDA TAM. We executed particularly well in IP. We substantially solidified our emerging systems offering. And last but not least, we delivered strong financial results and have a balance sheet that gives us many opportunities going forward.

With that, I'll turn the call over to Brian Beattie.

Brian Beattie

Well, thank you, Aart, and good afternoon, everyone. In my comments today, I will summarize our financial results for the quarter and provide you with our Q3 and 2010 guidance.

As a reminder, I'll be discussing certain GAAP and non-GAAP measures of our financial performance. We provided reconciliations in the press release and the financial supplement, which are posted on our website.

In my discussions, all of my comparisons will be year-over-year, unless I specify otherwise. Now as Aart highlighted, we delivered solid Q2 results, meeting or exceeding all of the quarterly financial targets that we provided in February. Additionally, we continued our stock repurchase program, closed three acquisitions and generated considerable operating cash flow.

Now let me provide some additional detail in our financials. Total revenue increased slightly to $338.1 million, at the high end of our target range, with greater than 90% of Q2 revenue coming from beginning of quarter backlog. Our IP and Systems business did very well this quarter, driven primarily by continued strength in our IP cores. One customer accounted for slightly more than 10% of second quarter revenue.

Turning to expenses, total GAAP costs and expenses were $293.1 million, which included $13.5 million of stock-based compensation, $11.8 million of amortization of intangible assets and $6.1 million of acquisition-related costs. Total non-GAAP costs and expenses were $257.3 million, an expected year-over-year and sequential increase and well within our target range. The year-over-year increase was due primarily to acquisitions, while the sequential increase was driven primarily by timing of quarterly expenses that we explained last quarter.

As a result, non-GAAP operating margin was 23.9% for the quarter and 25% for the first half of fiscal 2010. For all of 2010, we are well on track to achieving our non-GAAP operating margin target of approximately 24%.

Turning now to earnings. GAAP earnings were $0.26 per share. Non-GAAP earnings were $0.41 per share, slightly exceeding our target range. Our non-GAAP tax rate was approximately 27% for the quarter. And for modeling purposes, we think that a 27% non-GAAP tax rate is a reasonable estimate for the full year.

Greater than 90% of Q2 revenue came from beginning of quarter backlog, while upfront revenue was 4% of total, well within our target range of less than 10%. The average length of our renewable customer license commitments for the quarter was approximately 2.5 years, influenced by one large two-year contract.

This metric will fluctuate quarterly, depending on the mix of contracts signed, but we continue to expect average duration to be approximately three years.

Now turning to our cash and balance sheet items. Our balance sheet remains very strong, with approximately $1.08 billion in cash and short-term investments, which takes into account our stock buybacks and acquisitions during the quarter. Of our total cash balance, about 50% is held within the United States. We generated approximately $82 million in cash from operations in the quarter and we are raising our operating cash flow target for the year to $205 million to $225 million.

Capital expenditures were $6 million on the quarter and $14 million for the first half of fiscal 2010. For all of 2010, we expect capital spending to be in the range of $40 million to $45 million.

At this time, let me briefly outline our current cash strategy, which outlines the following elements: Maintain a high quality conservative risk profile for our cash portfolio; retain maximum financial flexibility; and prudently invest our cash to generate long-term shareholder value, including stock repurchases and disciplined M&A or a combination of both.

Now as you know, over the years, we've been active in both stock repurchases and acquisitions. We used approximately $370 million during fiscal '07 and '08 to repurchase over 15 million shares of Synopsys stock. We are not active in repurchasing stock in '09 based on the global economic environment.

Now each quarter, we evaluate the best uses of our cash. Our goal for the time being is to use stock repurchases to try to keep our share count roughly flat with first quarter levels, and then to continue to look for the right acquisitions to add to our company. During the quarter, we purchased approximately 1.1 million shares of Synopsys stock for $25 million and have approximately 450 million remaining on our current authorization.

We've also been very active on the M&A front, closing six acquisitions during the last 12 months. Now while we contemplated a number of acquisitions during the quarter, we closed three. CoWare, VaST and a small company in the smart verification space, all of which were initially funded from our U.S. cash balance.

Now continuing on with our balance sheet items. Q2 net accounts receivable totaled $149.7 million, and we maintained an industry-leading DSO of 40 days, reflecting the high quality of our current AR portfolio. Deferred revenue at the end of the quarter was $544 million and we ended Q2 with approximately 6,000 employees. While we have selectively grown our headcount, primarily through acquisitions, we continue to have more than a third of our total employees in lower-cost geographies.

Now let me address our third quarter and fiscal 2010 guidance. For the third quarter of FY '10, our targets are: Revenues between $330 million and $338 million; total GAAP costs and expenses between $275 million and $292 million, which includes approximately $14 million of stock-based compensation expense; total non-GAAP costs and expenses between $251 million and $261 million; other income and expense between zero and $3 million; a non-GAAP tax rate of approximately 27%; outstanding shares between $149 million and $154 million; GAAP earnings of $0.21 to $0.27 per share; and non-GAAP earnings of $0.36 to $0.38 per share. We expect greater than 90% of the quarter's revenue to come from backlog.

Now our current fiscal 2010 outlook. We're slightly raising our revenue range with our new target between $1.34 billion and $1.355 billion . At this time, we expect revenue from our second quarter acquisitions to be very modest, primarily reflecting the purchase accounting haircut that is applied to deferred revenue.

Other income and expense between $4 million and $8 million, a non-GAAP tax rate of approximately 27%, outstanding shares between $149 million and $154 million, GAAP earnings between $1.56 and $1.75 per share, which includes the impact of approximately $58 million in stock-based compensation expense, non-GAAP earnings of $1.52 to $1.62 per share, and we're maintaining our guidance range, even taking into account the small amount of dilution from our recent acquisitions.

Now as I mentioned earlier, we're targeting cash flow from operations of $205 million to $225 million.

To conclude, we are pleased with another quarter of consistent execution. In addition to delivering solid financial results, we are investing in new and exciting areas that we believe will help drive the next growth cycle for Synopsys. And with that, I'll turn it over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And first we'll go to the line of Rich Valera with Needham & Company.

Richard Valera - Needham & Company, LLC

Aart, you mentioned a number of challenging factors in the customer environment, but could you talk about how it compares with one quarter ago or maybe two quarters ago, has it roughly stabled, sort of unchanged or has anything changed to be more challenging in that time period?

Aart de Geus

I would say that in general, it's become more positive. No question about that, in terms of the outlook from our customers. Now they are all reporting the same thing, which is a lack of capacity, thus pricing going up and all in all, that doesn't feel bad for them. Having said that, their sale are maintaining, their watchfulness on the cost side of the equation. And I think that as more money becomes available from an R&D point of view, that money will go on those areas where there can be more differentiation. One key [ph] of evidence for that would be the very fact that we've seen some of these -- the number of designs in 40-nanometer actually tweak up. So that's not a surprise, because last year actually, it sort of slowed down, and now people are catching up. So all in all, I would say it's a better environment.

Richard Valera - Needham & Company, LLC

Would you consider the competitive environment similar to a quarter ago? And how would you say pricing has averted? An anecdotal account of at least one large renewal where there was apparently some very aggressive pricing to try to take share. Can you characterize the competitive environment?

Aart de Geus

Sure. Well I think it finally hasn't changed all that much. I think companies are either trying to survive or trying to grow. Typically, if you have a market that overall is not changing all that much, that makes for a very competitive market. But then you know, I mean they can't be all thinking that it's always been very competitive and that the rate for technology keeps going, and over time, that's what determine how well the company does. I don't know about any specific deal that you're referring to, but I can only communicate that on the large things we been doing. We've been able to maintain essentially a flattish run rate of slightly positive, so far so good for us.

Richard Valera - Needham & Company, LLC

So would you characterize bookings as on track for the year, relative to expectation?

Aart de Geus

Absolutely.

Richard Valera - Needham & Company, LLC

Brian, with respect to the acquisitions, can you give us a little more sense of the revenue contribution? I mean, can we assume that your base revenue as a sense for guidance was essentially unchanged and that the incremental addition is from the acquisitions? And also on the dilution front, can you give us any sense of how many EPS of dilution there might have been?

Brian Beattie

Yes, absolutely. When you look at our guidance for the year, we have factored in the three new acquisitions into that guidance, and effectively tightened our range and raised that slightly to reflect that. The core business itself, all of the existing business is right on track for the year as well. So we've raised it, just really to reflect the acquisitions in there. As you know, with software purchase accounting, there's very significant haircuts that come in, and we indicated that while the expenses fully come in as the employees come on board, we did reflect about a half a quarter of expenses in the base. So it becomes slowly diluted for the year, as what we indicated. And not withstanding that, held on to the total EPS guidance that we issued earlier. And then looking out to next year, clearly, we'd expect still some impact from that haircut, from the deferred revenues that we acquire, but clearly, that will be built into our revenue guidance that we projected in December for FY '11.

Richard Valera - Needham & Company, LLC

Do you think they could be neutral or accretive next year?

Brian Beattie

Well, typically again, these are smaller type deals. They're typically dilutive for the first 12 months. So I think we'd start to see a positive contribution from those in FY '11.

Operator

[Operator Instructions] And next, we'll go to the line of K.C. Rajkumar with RBC Capital Markets.

K.C. Rajkumar - RBC Capital Markets

With half the year behind you guys, what's your sense for next year? In particular, what would you say is the basis order of contract expiry into fiscal '11? Is it more first half loaded or is it more like second half loaded?

Aart de Geus

Obviously, we'll give more precise guidelines at the beginning of the year. But I don't think that there's anything that is out of the ordinary in terms of more or less renewals. And one of the positives of course of our model is that it is extremely stable, and that we managed the backlog in such a fashion that we have an ongoing good cash flow and good profitability level. On the other hand, it's also true that we will gradually come out of the recession because the contracts are very stable. And once that is the case, then there's an opportunity to work with customers, say, what else do you need, and have you grown your R&D expenses?. So we are really preparing for that late in the year '11.

K.C. Rajkumar - RBC Capital Markets

Have you folks seen any change in the year-over-year from your customers based out of Europe?

Aart de Geus

Not really. As a matter of fact, we've done reasonably well in Europe, given the situation that the entire continent is facing. I think the question mark, that's the macro question mark, not just for us but in general, is going to be what are the currency fluctuations that come out of the fact that Europe is now going through the realigning of some of its issues, but that has nothing to do with us. And so overall, in Europe, we've done quite well and that includes by the way, good efforts on the Custom Designer side, where we've had some very active and very successful customers with it.

K.C. Rajkumar - RBC Capital Markets

Which leads me to ask Brian, are you guys adequately hedged to currency fluctuations?

Brian Beattie

Yes, we are. The company has a full hedging program, and I'd just lay it out for a second for you. All of our revenue currencies, our U.S. dollars, except for the yen, and we effectively hedged on a rolling basis going forward for revenues. So we're already as you'd imagine, halfway covered through FY '11 on the hedge for revenues. In the other currencies in the countries we operate, where local currencies come into effect, we have all the major currencies hedged and we have a rolling forecast of those hedges. So again, no surprises as we approach the year. We'd anticipate having 60%, 70%, 80% even, of all our expenses fully hedged, both expenses and revenues, for a matter of fact. So we'd be very good shape and very predictable.

K.C. Rajkumar - RBC Capital Markets

And lastly from my side, would you have any comments as sort as to your IP for systems concerned, with regards to the recent acquisition by Cadence of Denali?

Aart de Geus

Well, I don't think it changes much, in terms of the overall landscape. We clearly have invested in this area now for a long period of time, and have built a, not only a great portfolio but also a great business model and a great ability to deliver high quality. Now in parallel to that, we, as you have seen recently, have increased our efforts to also provide the systems of verification and design solution, and the CoWare and VaST acquisitions were just recent manifestations of that. But obviously, in the last two years before that, we have already invested there. And so as we're looking at this picture, it is only our believers that turned amount of the, or a substantial amount of the functionality is moving from the chips to the System-on-Chip, and the System-on-Chip, by virtue of its terminology, includes those software and hardware. And as a matter of fact, most semiconductor vendors have more than half of their engineers on the software. And so our business really is in three dimensions, that is the systems dimension, the RTL and its physical dimension, and all three are quite well aligned for that.

Operator

And I'd now like to turn it back for closing remarks.

Aart de Geus

Well, that was quick. I assume that, that means that our comments were what you were looking for. As usual, we are available for questions afterwards, and we appreciate the time you've spent with us. Have a good rest of the day.

Operator

Ladies and gentlemen, that does conclude your conference for today. Thank you, for your participation and for using AT&T Executive Teleconference. You may now disconnect.

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