Synopsys F4Q06 (Qtr End 10/31/06) Earnings Call Transcript

Nov.29.06 | About: Synopsys, Inc. (SNPS)

Synopsys, Inc. (NASDAQ:SNPS)

F4Q06 Earnings Call

November 29, 2006 5:00 pm ET

Executives

Lisa Ewbank - VP, IR

Aart de Geus - Chairman, CEO

Brian Beattie - CFO

Analysts

Stuart Muter - RBC Capital Markets

Raj Seth - Cowen & Co.

Harlan Sur - Morgan Stanley

Dennis Wassung - Canaccord Adams

Matt Petkun - D.A. Davidson

Jay Vleeschhouwer - Merrill Lynch

Vashal Soluwa – Soleil

Sterling Auty - JP Morgan

Operator

Welcome to the Synopsys Inc. earnings conference call for the fourth quarter and fiscal year 2006. (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

During the course of this conference call, we may discuss forecasts, targets and make other forward-looking statements regarding Synopsys and its financial results. While these statements represent our best current estimates of our future results and performance, the company's actual results and performance are subject to significant risks and uncertainties that could cause actual results to differ materially from those that may be projected.

In addition to any risks that we highlight during this call, important factors that may affect our future results are described in our quarterly report on Form 10-Q for the third quarter and in our fourth quarter 2006 earnings release. 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, can be found in our fourth quarter earnings release and financial supplement. Our earnings release, financial supplement and quarterly report on Form 10-Q for the third quarter are all currently available on our website at Synopsys.com.

With us today we have Aart de Geus, Chairman and CEO; and Brian Beattie, CFO. With that, I'll turn the call over to Aart.

Aart de Geus

Good afternoon. Today’s call comes at a good time for Synopsys. We not only had a strong quarter and a very successful year, but we are also eager to share our expectations for top and bottom line growth with you, and how we are moving the company to the next level. Q4 fiscal 2006 was excellent for Synopsys. We delivered strong revenue and earnings growth, solid cash flow and overall business results that were notably above plan.

On the product side, our technology initiatives are clearly improved with accelerating momentum in customer adoptions and strong new product rollouts. Let me briefly summarize our financial highlights.

Revenue for the year grew 10.4% to approximately $1.1 billion. Q4 revenues were $283 million, an 11% increase over last year. We continued to manage expenses very well. Overall non-GAAP expenses for the year grew just 2% as we offset acquisitions and compensation increases with targeted cost reductions.

For the quarter, we came in at $242 million, at the low end of our target range. Non-GAAP operating margin was 14.1% for the year and 14.5% for the quarter. Both were nearly double the same period last year and higher than beginning of year guidance, even after factoring in several acquisitions.

Non-GAAP earnings were $0.77 per share for the year and $0.21 for the quarter; again, nearly double the same period last year. During the year, backlog grew to an industry high $2 billion which provides unprecedented stability and visibility. Looking forward, we plan to pass the 20% operating margin mark during the second half of fiscal '07. Beyond '07, in the next several years, we will drive to a mid to high 20s target as the next milestone.

Before I describe our strategy to achieve these objectives, let me comment on the overall environment and provide some technology highlights.

Looking at semiconductors, we hear some level of caution as the industry settles into a high single-digit growth rate for the year. Longer term, the semiconductor industry appears quite stable. The growing wave of video and consumer applications will increase the demand for processing power, bandwidth and storage. Although our customers remain quite sensitive to their product cost, especially for the consumer segment, the technology race is clearly on. The move to slower geometry certainly shows no signs of slowing down. Spending on EDA appears to be improving as our industry has an impact on both product differentiation and manufacturing costs. As the leader in advanced IC technologies, Synopsys is particularly well-positioned.

Moving on to our technology, business for the full year was strong across every product line. In Q4, IP as well as analog digital verification were especially strong. Starting with core EDA, Galaxy, our implementation platform had another strong orders quarter and hit a number of major milestones.

As mentioned last quarter, our field force has completed its migration to IC Compiler support. Innovations and adoptions have accelerated and the product ramp is right on track. In Q4, we passed the $100 million mark in IC Compiler orders. The tape account is mounting rapidly with recent successes at companies like Toshiba. Many more tape-outs are in the pipeline.

Customers are indeed seeing promised improvements in performance and time to results. During the quarter, we displaced the competition at four companies. At several more, we gained entry into a competitor’s domain. The technology in our latest Synthesis release is very strong as well. The resulting adoption of our high end Design Compiler Ultra accelerated in Q4. In fact, we displaced competitors at four companies and doubled our position at a fifth company, one that had previously experimented with another Synthesis tool.

Now, to Discovery, our analog and digital verification platform. Discovery did extremely well, both in Q4 and throughout the full year. The move to smaller geometries and higher complexity chips has accelerated the demand for verification tools. In fact, Q4 was our largest ever quarter for VCF, our core digital solution. The migration to System Verilog accelerated as well. The maturity of the tools and the efficiency of the language are now clearly proven. For example, Enterasys, a provider of security-enabled network infrastructure, chose Synopsys after an extensive competitive evaluation. The move to System Verilog with VCF doubled their verification productivity. With this kind of performance differentiation we are winning business from our major competitors.

During the quarter, Freescale, a global leader in the design and manufacture of embedded semiconductors signed an agreement to continue deployment of Discovery for System Verilog based verification.

In analog mixed signal verification, Q4 business was also well above plan. We continue to be the clear choice for mixed signal verification with superior performance and productivity. For example, Virage Logic adopted H5 as it's global simulator for it's 90 nanometer and below AFAT logic library.

Turning now to our high growth adjacencies, let's look first at manufacturing. Our strategy is to grow a powerful position in all key technologies in the design to manufacturing chain, and to link them together by bringing data from the fab up into the design process. This is especially important as customers move to 65 nanometer and below. During Q4, we shipped the first orders of Prime Yield, our first product that integrates advanced manufacturing data into design. Last month, we announced yet another linked product family called process aware DFM. Targeted at custom and analog design for 45 nanometer and below, these new solutions integrate TCAD derived manufacturing data into physical design tools. The impact is better results and fewer resends.

On the lithography side we announced a collaboration with Nikon to develop and deliver next generation manufacturing aware models for 45 nanometers. We're also leveraging advanced 3D lithography simulation from our recent acquisition of Sigma C.

Moving up to our other adjacency, system level design, we are realizing the benefits of our investments in connectivity IP more and more. With momentum in both digital and mixed signal cores, customers are committing to buying our off-the-shelf high quality IP to accelerate their time to market. In fact, Q4 was the largest quarter ever for designware cores. This success was led by our standards-based IP, especially USB , wireless USB and PCI express cores.

In particular, our analog mixed signal cores are doing very well. With speed requirements increasing, analog design has become much more difficult at smaller geometries. PCI express and SATA are good examples of this growing technical challenge. Our investments in this direction are now paying off. Synopsys delivers very reliable and differentiated mixed signal IP for this complex protocols.

Turning to systems, we completed the integration of Virtuo and are sharing a compelling road map with our customers. With our virtual platform, software engineers can develop and validate their software up to a year before the hardware is actually available. Our vision is not only to drive incremental growth in system level design, but also to streamline a complete system to design to manufacturing flow. This flow will reduce risk, power consumption and time to market and will yield higher performance for our customers.

Finally, let me briefly outline our overall strategy to move the company to the next level. We are now building on a very solid foundation after completing a set of major changes over the past several years:

  1. We have evolved Synopsys from tools to complete solutions to integrated platforms. Stronger products are now rolling out steadily, all benefiting from the architecture and power of the Galaxy and Discovery platforms.
  2. We have increased our addressable market substantially with major positions in two adjacent growth markets, down to manufacturing and up to IP and system level design.
  3. Through our ratable license model, we now have one of the most predictable software businesses in the world, supported by $2 billion in contracted backlog.
  4. We've instituted a culture of operating margin discipline. We delivered many improvements in ‘06 and are executing to deliver more margin expansion going forward.
  5. In Q4, we realigned our organization to better drive profitable growth. We have new sales leadership in place and launched our '07 plan earlier this month. We have combined services and support under one leader and we have brought all marketing and business development into one organization.
  6. Lastly, we have sharpened our business unit structure to better focus on the broad set of opportunities around us.

With all these changes completed, our focus is now squarely aimed at getting more value for what we provide. Our priorities for '07 and beyond are:

  1. To improve our go-to-market strategy through sharpened segmentation, better packaging and pricing, and clear advocacy on the value we deliver.
  2. To expand our technology leadership position further into the mainstream design market with new products, marketing vehicles, and a refreshed channel strategy.
  3. To improve our return on investment through sharpened internal investment decisions and disciplined product development processes.

You'll hear more about these initiatives in the next several months. The organizational changes, our technology strength and the momentum in our results have energized the entire Synopsys team. We feel that we have entered a new phase of the company and we are strongly focused on capturing value and share and expanding our business reach. With that, I'll turn the call over to Brian who will provide more detail on the financials.

Brian Beattie

Thanks, Aart. As a reminder, I'll be discussing certain GAAP and non-GAAP measures of our financial performance. We have provided a full reconciliation of our GAAP to non-GAAP results in the press release and financial supplement posted on our website.

Our results in Q4 and the full fiscal year were excellent. Q4 revenue was up 11% year over year to $283.4 million. Non-GAAP operating margin nearly doubled to 14.5% and earnings per share were $0.21, all beating our internal targets.

For the full year, revenue was up 10.4% to approximately $1.1 billion, while at the same time, we increased backlog by $100 million to a record $2 billion with a book to bill ratio of greater than one. We also generated more than $200 million in operating cash flow.

Now as Aart mentioned, the changes we've made over the last couple of years not only allows us to function more efficiently but also to focus on new ways to grow our business. We're already seeing the benefits. Let me provide some additional financial details.

We continue to have excellent visibility, approximately 93% of Q4 revenue came from beginning of quarter backlog and more than 80% of FY '07 revenue is already in hand. GAAP earnings per share were $0.07 in Q4 and $0.17 for the full year. COGS and expenses totaled $273 million in Q4 and $1.067 billion for the full year. For the year, GAAP results included $120 million of amortization of intangible assets, in process R&D and stock-based compensation.

Non-GAAP earnings per share were $0.21 in Q4, more than double the same period last year, and we earned $0.77 for the full year. In Q4, we held non-GAAP expenses to $242 million, even factoring in an expected increase due to acquisitions and one-time items such as severance and increased variable compensation. We successfully offset much of this upward pressure with a reduction in our expense base from the headcount actions and expense management. As a result, we enter FY '07 with a lower base expense run rate than we did in '06.

For the year, we held our non-GAAP expenses to $941 million as we offset increases due to acquisitions, inflation, and severance by cutting expenses by offshoring and a broad cost discipline.

Non-GAAP operating margin increased to 14.5% in Q4, an increase of 7 percentage points over last year. For the full year, it was 14.1%. The non-GAAP tax rate was 31% in Q4 and 32% for the full year. We continue to have a stable contract mix with 95% of Q4 product orders booked as time-based licenses and 5% booked as upfront. For the full year, 6% were booked as upfront, well within our target range of less than 10%.

One customer accounted for more than 10% of revenue in the fourth quarter and for the year.

The average length of our renewable customer license commitments remains healthy at approximately three years. We're seeing the benefits of our ratable model in a couple of ways. First, excellent visibility and also in our customer engagements. It gives us the flexibility to continue to work with a customer on an agreement and not feel forced to close it before the end of the quarter. Q4 was a good example. We have continued negotiating several deals that started in Q4 so that we could increase the value for both parties. We did so and we're still able to exceed our target for the quarter.

Turning now to cash. Operating cash flow was $100 million in Q4 and $206 million for the full year which was above our target. Capital expenditures were $14 million in the quarter and $48 million for the full year. Cash, short-term investments increased $61 million to $573 million. Now, that strong cash balance was achieved even with a very active stock repurchase program during the year.

In Q4, we purchased 1.6 million shares for $30 million. For the full year, we spent $200 million purchasing more than 10 million shares of our stock and have approximately $237 million left on our authorization. Primarily as a result of this repurchase program, Q4 diluted share count decreased 2 million shares sequentially and 5 million shares compared to Q4 of '05. As always, we will continue to evaluate the best uses of our cash each quarter including company operations, investments and stock repurchases.

Q4 net accounts receivable, totaled $123 million and our DSO's remained very healthy at 39 days. Deferred revenue at the end of the quarter was $499 million, a slight increase sequentially. We expect this to increase again in Q1 similar to last year 's pattern due to a large customer scheduled to pay a year in advance.

At the end of Q4, we had approximately 5,100 employees. This was a slight drop sequentially as we reduced our North American workforce by more than 2%, offset by hiring elsewhere. We also renewed our credit facility in Q4 and increased it to $300 million, also at much better terms. This revolver provides excellent flexibility in our business operations.

In addition to the changes that Aart talked about, I'd like to give you just a few examples of the changes we made during the past year on the expense front. First, every function cut back on planned hiring in 2006.

Second, we've streamlined some of our infrastructure operations, outsourcing certain non-core functions and offshoring others. For example, we outsourced our entire procure to pay process to a best in class service provider that works with seven of the top ten Fortune 500 companies. Once this is fully implemented, we expect to save between $2 million and $5 million per year.

We have continued our redeployment of certain functions. For example, some IT support was moved to some lower cost locations. We now have 30% of our employees in low cost regions, ahead of our plan. Not only does this provide us cost savings of approximately $4 million per year, but it moves us closer to our customers, allowing us to better meet their needs.

Third, we completed a thorough review of our international operations and tax structure. As a result of some structural changes we've made, we expect our non-GAAP tax rate to drop from 32% in 2006 to between 28% and 29%. We're certainly not done. We'll continue to update you throughout the year on further changes we are making to improve our earnings power.

Turning now to our financial targets in FY '07 and beyond; first some general commentary. Almost two years ago, we committed to passing a 20% operating margin during FY '07. We're confident that we'll reach this goal in the second half of this year. We expect revenue growth of between 8% and 10% in FY '07 with less than 10% of our business coming from up front orders. We expect to hold expenses down to just a slight increase in FY '07. As a result of cost controls and actions we've taken, we're almost entirely offset the upward pressure on expenses due to acquisitions, inflation and an extra fiscal week that occurs for us every seven years and that happens in Q1.

Regarding our long-term operating model, as Aart mentioned, beyond '07 our next operating margin is in the mid to high 20s which we'll work to reach through a combination of sustainable revenue growth and expense control. Our goal is to limit expense growth to less than half of our revenue growth and this philosophy will allow us to both increase our profitability and provide future technology and business growth. As we increase our earnings power we'll grow our cash flow to higher levels as well.

Now on to the guidance. For the first quarter of FY '07, our targets are:

  • Revenue between $292 million and $300 million.
  • Total GAAP costs and expenses between $267 million and $283 million which includes approximately $16 million of stock compensation expense.
  • Total non-GAAP costs and expenses between $241 million and $251 million reflecting the extra fiscal week. Excluding this extra week, our Q1 expenses will be notably lower than Q4. We expect our expense levels to decline considerably in Q2.
  • Other income and expense between zero and $4 million.
  • A non-GAAP tax rate between 28% and 29%.
  • Outstanding shares between 141 million and 147 million.
  • GAAP earnings of $0.10 to $0.15 per share and non-GAAP earnings of $0.26 to $0.28 per share.
  • We expect more than 90% of the quarter's revenue to come from backlog.

For fiscal 2007, our targets are:

  • Revenues between $1.18 billion and $1.205 billion.
  • A book to bill greater than 1.0.
  • A non-GAAP tax rate between 28% and 29%.
  • Outstanding shares between 142 million and 148 million.
  • GAAP earnings per share between $0.60 and $0.73, which includes the impact of approximately $65 million in stock-based compensation expense; non-GAAP earnings per share between $1.20 and $1.28.
  • We expect cash from operations to be greater than $275 million.
  • Over the next four quarters, we expect approximately $980 million of our beginning of quarter backlog to turn to revenue and that means we already have greater than 80% of 2000 revenue in hand.

In summary, we had an excellent Q4 and fiscal 2006 and I'm really looking forward to the next year. With that, I'll turn the call over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Stuart Muter - RBC Capital Markets.

Stuart Muter - RBC Capital Markets

Good afternoon and congratulations on some nice numbers and guidance. First, in terms of business conditions, a question for Aart. We're hearing about a substantial slowdown in 65 nanometer wafer starts but there seems to be a fair bit of design activity. Could you talk a little bit about what you're hearing from your customers on 65 nanometers?

Aart de Geus

Sure. I think there is absolutely a difference between wafer starts and design activity largely because the design activity simply starts about two years before major wafer starts. I can tell you that if you look at the 65 nanometer designs that we're watching, it went up again considerably from last quarter. Last quarter, I think I reported that we were watching 243 designs, this quarter it's 282 and if you want to look at the tape-out account it went from 80 to 109 so that's moving forward actually quite well. By the way, we see exactly the same trend in 45 nanometer, of course on smaller numbers.

So, I've been watching this carefully now for a number of years and I'm very positive that on all of the advanced designs, the clock for new generation happens to be exactly two years and so there's no slowdown from that perspective.

Stuart Muter - RBC Capital Markets

Okay, that's helpful. With the 45 nanometer activity that you see now, I'm sure it's pretty limited, but are you seeing the same kinds of demands? Is power a major driver or is there a new theme emerging on 45 nanometer?

Aart de Geus

Well, power became a fairly big issue at 90 nanometer, a bigger issue at 65 and a bigger issue at 45 and it's just accompanied with now an increased focus on yield variations in the design. We're getting closer and closer to physical phenomenon that before were negligible. I expect that to continue and as a matter of fact, we're already starting to track the first 32 nanometer designs which shows that the span of the most advanced developments is quite broad, and there will just be more of that.

But you're absolutely right. Power is important. The other reason power is important of course, which is that the drive of consumer products is very, very strong in many of these advanced technologies and consumer products want to be portable.

Stuart Muter - RBC Capital Markets

Excellent. If I can, a couple of questions for Brian. What do you think the expense guidance would be without that extra week? I mean, should I just do the math in terms of the percentage or would it be a little bit different?

Brian Beattie

Yes. You can do the math just based on the guidance for revenues and margins and the EPS numbers we gave you.

Stuart Muter - RBC Capital Markets

Okay. The share count guidance, it's kind of ticking up. Is there anything going on there?

Brian Beattie

Well, our share count includes of course the impact of the 10 million shares we bought back in the year, but it's also a factor of looking at the numbers, we've bought back more than double the amount of new options or new stock issued during the year and we expect to continue that trend going forward. Another factor that comes in as well is as the price of the stock goes up, clearly there are more shares using the treasury stock method that are included in the denominator.

Stuart Muter - RBC Capital Markets

Okay, excellent. Thank you.

Operator

Your next question comes from Raj Seth - Cowen & Co.

Raj Seth - Cowen & Co.

Thanks, Aart, a couple questions for you. First, a follow-up on Stuart's question about the strength in EDA. You talked about in your prepared remarks, I think you said EDA appears to be improving. Is this in your view something that really is indeed sustainable, or is this a cyclical trend around some of the node transitions we've just gone through? 65, 90 becoming mainstream, or is this EDA growing again consistent with R&D spending?

Aart de Geus

Well, I think it's probably fundamentally consistent with R&D spending; however, the node transitions have been coming across like clockwork in the last four or five years, so that I expect to continue. I think the definition of EDA has been broadening gradually because we're definitely spending much more attention to all the things that touch manufacturing, and you can view DSM as a subsegment, or you can say some of that is directly reflected in the core EDA.

Be it as it may, there's no way to do the advanced chips with some of the older tools at this point in time that don't take into account various forms of signal integrity and variation and DSM and this and that. So I expect that the investment level will have to continue for all the people that want to play.

Raj Seth - Cowen & Co.

So more of a secular trend there than something cyclical?

Aart de Geus

I would think so. I've never been a strong advocate of cyclicality when you deal with design flow evolutions and design cycles that are much longer than the ups and downs of the semiconductor industry. Secondly, in addition to that we have a business model that is very much I would say three-year centric and so that makes for a very stable, steady industry.

Raj Seth - Cowen & Co.

You mentioned in terms of your priorities for next year, you said something about sharpening segmentation, mentioned pricing and a move into the mainstream. Can you elaborate a little bit on what your objectives are there? What is it you're trying to do and maybe a bit about what you plan to do?

Aart de Geus

Sure. There's one common word to all of this, it's the word value . I think that we are strongly back into a position where on many fronts we're quite differentiated and our objective is to make sure that this differentiation gets translated in something that's both measurable and appreciated by the customers as helping them differentiate themselves.

One way to do that is to know better what are the concerns of the customer and the other aspect is to know better what are the differentiations that you have internally and match the two. From that perspective, the increased focus on the centralized marketing will be one of the mechanisms to do that.

I think following up on that, we will then tune the sales approach, the go to market approach to be reflective of it. We feel that we have a lot of strong technology and we can probably do better at getting value for it.

Raj Seth - Cowen & Co.

Do you expect, or should we expect that you'll tier your products in the way that Cadence has? Good, better, best? Is that the direction you're headed?

Aart de Geus

We've sort of always thought that all of our products were best but I understand what you're saying. The reality is that we have always had a tiering of products. There's always been Design Compiler and Design Compiler Ultra and in many products, there are additional ways to get additional functionality which is a form of tiering that is both a form of pricing and packaging but it's also a way of meeting the needs of those people that are at the very high end or are more in the mainstream.

Having said that, I think we can do better. A lot of this has been an almost 20-year-long evolution step by step and this is a good time to rethink entirely how we want to do it. I don't think that it is quite as simple as just saying well, there's a low, medium, and high end. I think it has to be understood more in terms of the needs of particular constituencies.

Raj Seth - Cowen & Co.

Sure, that's helpful. Thanks, nice results.

Operator

Your next question comes from Harlan Sur - Morgan Stanley.

Harlan Sur - Morgan Stanley

Great job on the financial results. You talked about mixed fundamentals within the semiconductor industry. I think one of the near term bright spots has been the memory sector -- DRAM especially -- so maybe you can just refresh us as to how Synopsys has leveraged memory design activity and maybe some of the trends you're seeing in this segment of the market space.

Aart de Geus

Sure. Well, first, I think it's clear one of the reasons that memory is doing well is by the time you start looking at most content becoming video, you've just multiplied dramatically the amount of data, and I expect that to massively continue. It's interesting that I now see many of the semiconductor executives spend a great deal of attention on what happens with YouTube and why are these guys so interested in this? I think they are all smelling the fact that the video content is just an enormous driver.

Now, memory is sort of the obvious thing of which you have never enough and interestingly enough we actually do quite a bit of business in the memory segment. First and foremost, through our simulation and very fast simulation and now increasingly also through the DSM side of the equation and so this is a good example of a segment, if you can call it that, that may have very direct needs in terms of the products that we can provide and that we'll pay more attention to going forward.

Harlan Sur - Morgan Stanley

Okay, great. As you see obviously more 65 nanometer design activity here in digital, where are your customers seeing the challenges as they tackle these complex designs? Is it timing closure related? Is it process variability? Multi node, multi corner analysis? Is it power? How would you rank those priorities?

Aart de Geus

Well, I'm tempted to just say yes. They are all sort of at max demand, partially because if they were not, immediately people would say well, why can I not do better? I'm increasingly of the mind that project length is almost fixed and then you just do the best you can with that.

Having said that, the center of gravity of all electronic design to date is timing, has been for the last 15 years because it brings together all of these phenomenon and all of these other things are almost like perturbations that you have to work through and so you will try to achieve your timing and then minimize the power, optimize as much as possible for the profit variation, the multi corner analysis, and others, all techniques that are used to achieve that. So design is definitely more complex, but people will always push this envelope of timing. For consumer designs, there is a high emphasis on cost and therefore, the area will remain key as people still try to push more and more onto fewer chips.

Harlan Sur - Morgan Stanley

Along those same lines as you speak with your customers that are working on these 65 nanometer and 45 nanometer designs, is the percentage of silicon success going up or down relative to prior generations of technology?

Aart de Geus

It's a difficult question because the chips are substantially more complex and I think there are fewer of them, but all in all, the move to 55 nanometer has gone quite well because many people feel that the transition 90 to 65 was rather well executed from a manufacturing point of view. I think a transition to 45 will probably bring some tougher challenges as we are now talking about things like emersion and photolithography, et cetera. So there are a number of customers that have been working at 130 that have barely touched 90 and are essentially saying, can I go straight for 65? That's I think why this tempo is being kept up so well in terms of going to new generations.

Harlan Sur - Morgan Stanley

Okay, great. Thank you, Aart.

Operator

Your next question comes from Dennis Wassung - Canaccord Adams.

Dennis Wassung - Canaccord Adams

A few quick questions on some of the segments of the business here. First, if you look at the segment breakouts, and you actually had very strong growth across the Discovery platform, the IP, and DFM areas, but the Galaxy side of the business was only up about 2.5% year-over-year. Just any commentary you can give us on that side of the business? As you look forward, do you expect to see that line return to a more solid growth rate? Do you see IC Compiler driving that or is that just a market that has just been tough on the pricing and in terms of competition that's going to be hard to just maintain?

Aart de Geus

Well, we think it's the first, meaning that as IC Compiler starts to become a larger portion of the existing large technology pools that are in these deals, it will start driving Galaxy forward. Typically there's some delay between a major product and seeing the impact of it. We are expecting that in '07 you will therefore see a high growth rate on Galaxy because IC Compiler is doing very well.

Dennis Wassung - Canaccord Adams

In past quarters you've talked about the transition of your customer base to IC Compiler. I think you mentioned that you've got over $100 million of bookings so far to date. Anything else you can give us in terms of quantification, how far along in terms of converting the installed base? Is there any metric you're working toward at this point?

Aart de Geus

Well, I think we told you about a year ago, even a little bit more, that we expected 80% conversion over a three-year period. We think that we're quite well on track with that, and so I think that we are going to see an acceleration now and the reason is that many of the people that are reporting good results with IC Compiler took 18 months to go through a complete design cycle. As they've done some sophisticated chips as the product simultaneously has matured substantially, they are now saying okay, this thing is ready for broader deployment, not just for the fighter pilots inside of a company. From that perspective, I think we're now entering the acceleration phase of adoption.

Dennis Wassung - Canaccord Adams

Okay, and then when you look at some of the other segments of the business, the DFM side obviously has been a nice growth driver for you. I'm curious how that revenue kind of parses out. I know you don't break it out but I'm wondering if you're seeing a broadening of that revenue base across multiple areas and OPC is obviously a big driver, TCAD and some others but how would you classify that revenue picture today and how do you see it migrating over the next year?

Aart de Geus

Well, the very fact that we are so broadly and well represented in all of these segments is very helpful because at the limit, some of them do overlap and it's precisely that overlap that ultimately we think is a major asset for us as we link the complete loop from manufacturing back into design and vice versa. So our own thinking is that we have been able over the last few years to carve a position into the manufacturing area almost independently of the DFM, the design flow manufacturing, which is really the linkage, and we plan to push on both, the manufacturing and the DFM connection. Not independently, but with certainly interesting financial objectives in both.

Dennis Wassung - Canaccord Adams

Okay and then the last question for me. You've alluded to pricing a couple of times and you talked about it in your prepared remarks, improving the pricing and being more diligent on pricing as you move forward. Any comments on the environment for pricing? Has it been the same as it has been over the last year or so and as you move toward this value methodology or further along that line, how do you plan to keep the pricing in place or improve pricing?

Aart de Geus

Well, I think all in all, the pricing has not materially changed one way or another and it's a little bit of the same story which is, if you had differentiation you can hold your pricing if you don't, then it becomes a cost equation. Having said, that I think that we have substantially increased our differentiation in the last 18 months, now we need to learn how to advocate the value that we are providing.

I do think that we're not the only ones in the EDA industry that are realizing that the value we do provide to the overall semiconductor industry is quite substantial and so I have good hopes that as an industry, we use the word value more often and set this into the right direction.

Dennis Wassung - Canaccord Adams

Thank you.

Operator

Your next question comes from Matt Petkun - D.A. Davidson & Company.

Matt Petkun - D.A. Davidson

Hi, good afternoon. Couple of questions. First, Brian, I just wanted to clarify. You said that there were a few deals that you were able to hold off at the end of Q4 and continue working on now here in Q1. Then you also said in your commentary that you exceeded your target for Q4. I just wanted to clarify, did you exceed your internal bookings target for Q4?

Brian Beattie

Yes, we did.

Matt Petkun - D.A. Davidson

Okay. And then also to clarify, you said you expect a book-to-bill above 1 for 2007?

Brian Beattie

That's correct too, yes.

Matt Petkun - D.A. Davidson

Okay. A question for Aart then, just in terms of the strength that you're seeing, not just in terms of growth but also competitively in the verification space. Aart, what would you really point to in terms of your own internal technology there? Is it maybe better support for System Verilog, superior test bench technology, verification IP, why are you winning with VCS and with Discovery in general?

Aart de Geus

For the last 25 years it's been one word, speed. Now, speed is becoming more complex meaning that it's speed of many aspects but fundamentally, if you can verify a design faster than somebody else, given that there's almost no end to the needs in verification, that is how you win; and in many, many situations, we can actually demonstrate a 4X to 5X improvement over other solutions.

Now, having said that, we have simultaneously in the last couple of years invested substantially in the notion of debugging. So in the broader term that says well, if there are problems how do you find them? It's not just raw cranking through vectors. It is what you do with them, how do you analyze it, how do you find out the issues, and there are things such as much stronger language such as System Verilog but also many of the debugging mechanisms that have been built into the platform of high value, but at the end of the day, it's a little bit the horsepower of the car is where everything starts.

Matt Petkun - D.A. Davidson

Last quarter, you announced Joe Logan heading up sales. I wonder if there is any changes you guys have made or are looking to make maybe internally in terms of sales and perhaps marketing and how maybe from a strategic perspective you've changed things? Or has Joe just basically taken over the new role of sales but not a lot of other strategic changes to how you guys are approaching global deals?

Aart de Geus

Sure. Joe has been very quick to align his organization and the yearly boundary is actually a very effective moment to do that because then you have all of the old quota that get finished for the past year and then you start fresh going forward.

I think that has been actually very electrifying to the sales team and as these changes now percolate through the organization, we're actually in the process of rolling out our plans for '07 and I think that's going quite well.

At the same time, you alluded to marketing and I mentioned that we had pulled out all the marketing out of all the BU's in the entire company, put it under one leader and there clearly the objective is to articulate our value more in terms of solutions given that from an engineering point of view, we have been working for now quite a while in making the things work well together, and we are seeing the technical benefits of that. We need to articulate the value that comes with it.

Finally putting the two together, John Shelton who runs marketing and Joe Logan in sales are aimed to be joined at the hip in making this happen in practice and there of course how we work with our customers, how we articulate better and deliver better the values at the essence of creating good growth.

Matt Petkun - D.A. Davidson

Okay, great. Thanks so much and congratulations.

Operator

Your next question comes from Jay Vleeschhouwer - Merrill Lynch.

Jay Vleeschhouwer - Merrill Lynch

Thanks, good afternoon. Aart, I'd like to ask you about the connection between the technology evolution you've undergone in the last few years towards more integrated platforms and your bookings profile. In other words, is the integration of multiple products biasing deal sizes larger? When you look back over 2006, for example, and the range of deal sizes which you had once described at an analyst meeting, are you in fact seeing more large deals on average as a result of technology completeness, let's say?

Aart de Geus

I would think so because the completeness takes at a minimum two forms. One is that we actually have more capability than the sales force in back meaning that we go further into DFM, that we have additional capabilities around optimization and the other that we actually can demonstrate higher value, higher quality of results with the integration that we have done. As you all know, the integration was actually a fairly painful, long investment but it was more than integration. We've created a platform that is better set up for optimization of many different things from timing to area to power to DFM to test all at the same time. I think we're now starting to see a rapidly increasing body of evidence that the quality of results is indeed better and that the overall effort to get there is reduced. Those are the two angles that really help the salespeople articulate the value.

Jay Vleeschhouwer - Merrill Lynch

When you look at the business in the last year by product segment or with respect to your expectations for the next year, in which product areas or specific products did you see the most increase in net capacity or where might you see large increases in net capacity? Would it be IC Compiler or was that just a swap out of PC and Astro or are there other areas in which you are in fact seeing increases in licenses?

Aart de Geus

It's actually fairly across-the-board but there are areas that really stand out. Maybe the best example is actually verification because the complexity of the chips being built makes verification almost impossible, which sounds strange because chips still come out working pretty well. One of the reasons is because the amount of verification that's being done has grown incredibly in the last few years. Now, partially because the verification tools, the simulators have improved significantly, but partially also because of the number of simulators being used on large compute forms has grown substantially.

So that's a good example where you can clearly see the number of tools growing. And things like IC Compiler, it's too early to tell because we're in this replacement of PC Astro and then we'll see where that leads afterwards while simultaneously, the depth of the product is much higher, so there it's more of the advanced guys are now jumping on it and then we'll see how it percolates through the company.

Jay Vleeschhouwer - Merrill Lynch

Following up on the earlier question with regard to segmentation, that might suggest more specialty or niche-type applications. Would that perhaps result in some smaller deals on average or are you targeting the segmented products like Cadence towards perhaps smaller design shops, fabless customers and the like, not necessarily the majors?

Aart de Geus

Not really. As much as it's desirable to go to all of the smaller shops, by the time you add it up, that's nothing compared to being able to make the difference on some of the medium or larger companies and really highlight better the value. So when we talk about value, we really want to put it in terms of how our customers differentiate. So if you can reduce the area of a chip by 10%, 15% and this happens to be a reasonably high volume chip, you have had a major impact on the cost, right? The same is true on any percentage change in manufacturing yield which is still a little harder to measure but we'll get there over the next few years.

It is stating those value propositions against how the customers view their own differentiation that I think we want to hone more and then make sure that we are really aligned in terms of presenting well what we have and listening well to what the customers need.

Operator

Your next question comes from Vashal Soluwa - Soleil.

Vashal Soluwa – Soleil

Hi, thanks for taking my question. Aart, could you please give us a preview of you’re your product flow in '07 might look like? Brian, on the issue of working some deals in Q4 and having them slip, can you give a sense of your level of confidence around ultimately being able to close those deals, hopefully at higher values?

Aart de Geus

Regarding the product flow, of course we don't communicate products that we aren't ready to announce, but the best way maybe to respond is to look at how the landscape will shift in terms of the design starts that utilize many tools, and so there's no doubt in my mind that in '07, we're going to now see a substantial increase in 65 nanometer designs and we're going to see a substantial increase of work around 45 nanometer. When I say work, there's a lot of people that are doing the initial cores on 45 and are tuning their 45 nanometer rolls and libraries and all of this is preparing for then ultimately going there with full production.

So if you look at 65 and 45, the word power absolutely comes to mind over and over again, but so does the word yield and therefore the connection to DFM will start to increase in importance as it manifests itself in our tools.

Brian Beattie

Relative to the deal flow, we're very confident that the deals we're working at the end of the year will get closed. We're aiming hard to get those closed specifically in this quarter. Again, it's really used as a highlight of our ratable business model that the fact that we had 95% of that business coming from backlog this quarter, it tells you when you get to the end of the quarter, in our case, the end of the year that the pressure to close the deal for the quarter, having minimal impact on revenues, allows both parties to get the most value from the agreement and so in that case, we just keep working this one through and are very confident we're going to close it in the short-term.

Vashal Soluwa – Soleil

Thanks a lot. Great quarter.

Operator

We currently have five minutes left in the conference. Would you like to entertain one more question?

Aart de Geus

Give us one more question.

Operator

Your next question comes from Sterling Auty - JP Morgan.

Sterling Auty - JP Morgan

Brian, in terms of the margin improvement that you look at through '07, should that progress linearly through the year or do you think you get a step function in the second quarter and then you hit the 20% goal in the third quarter?

Brian Beattie

Yes. We indicated the 20% exceed number is in the second half of 2007, so it's something that we've given specific guidance for the Q1 and expect to be over 20% in the second half and track upward from there.

Sterling Auty - JP Morgan

Okay, but again, you made some comment about a significant step down in expenses in the second quarter; is that correct ?

Brian Beattie

Yes, that's right.

Sterling Auty - JP Morgan

What do you expect for CapEx in '07?

Brian Beattie

Well, in our case, it's about flat year-over-year, so this year we came in at about $48 million.

Sterling Auty - JP Morgan

As you look at the business that you did in '06, how much of that would you of classify as taking the renewals or existing customers and selling more seats into existing projects or teams? How much of that would you say was further expansion and gaining presence within those customers?

Aart de Geus

Well, by definition, the world of customers is actually reasonably well defined, although there are still new companies popping up. Financially, they don't hit the radar scope very quickly. It just takes time for them to grow, if they do. Having said that, therefore, most of the business is coming from existing customers and I think the expansion is both in the core EDA largely because our main engines, the Synthesis and the verification are all doing quite well, but then there's also the expansion down towards the DFM which is new for a number of customers and by the way also up into the IP.

IP I think will be one of those steady growers because people need more and more IP blocks that become harder and harder to build which doesn't mean that some can't build them themselves but for many buy versus build, they are so much better off buying if they can trust the IP and I think we have high reliability, high quality IP today.

So that's how I see this developing and I think the good relationships that we have with many customers are very conducive to be able to introduce them to new technologies.

Sterling Auty - JP Morgan

So the growth is more than just hiring on to teams that are already using Synopsys tools. You're saying it's expansion of some of the new tools and the new areas and garnering more seats in other areas of those customers?

Aart de Geus

Absolutely, yes.

Sterling Auty - JP Morgan

Okay, thanks.

Operator

With that I'll turn the conference back over to you for any closing comments you may have.

Aart de Geus

Sure. Well, I appreciate your time as usual. I think we're looking back on a strong year '06 that in many ways concludes somewhat one phase of the company. As a little aside highlight, in a couple of weeks we will have our 20th anniversary and for fun, I tracked where we were in technology 20 years ago and we have literally gone through ten generations of Moore's Law which is 1,000X in complexity. While I'm a little hesitant to say let's go for the next 1,000X, we hope to have you on calls in the future. Thank you very much for your support over all these years.

Operator

Ladies and gentlemen, this conference will be available for replay after 5:30 pm Pacific time today and going through December 13, at midnight. You may access the AT&T replay service by dialing 1-800-475-6701, and using the access code 847573. International callers may dial area code 320-365-3844. That does conclude our conference for today.

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