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Mentor Graphics Corporation (NASDAQ:MENT)

F2Q2011 Earnings Call Transcript

August 19, 2010 5:00 pm ET

Executives

Joe Reinhart – Director, IR and Corporate Development

Walden Rhines – CEO and Chairman

Greg Hinckley – President

Analysts

Rich Valera – Needham & Company

Tom Diffely – D.A. Davidson & Co.

Operator

Ladies and gentlemen, thank you for standing by; and welcome to the Mentor Graphics second quarter conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to our host, Mr. Joe Reinhart. Please go ahead.

Joe Reinhart

Good afternoon, everyone; and thank you, Cathy. Welcome to Mentor Graphics fiscal second quarter 2011 conference call. I am Joe Reinhart, Director of Investor Relations and Corporate 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 provide operational and financial highlights, along with guidance. Wally and Greg will then take your questions.

As a reminder, 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 risk factors can be found in our most recent 10-Q, 10-K, and Annual Report.

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

Wally?

Walden Rhines

Thanks, Joe. The fiscal Q2 2011 revenue of $187.9 million and non-GAAP earnings per share of $0.01 exceeded guidance and provide positive indicators of future growth. As Greg will cover in detail, all of our leading indicators of future business were strongly positive, and we are therefore raising our outlook for revenue and earnings for the current fiscal year.

Growth of annualized revenue for the contract renewals in our top 10 bookings was exceptionally strong. After two quarters of 25% growth, the renewals in Q2 grew 45%. This indicator of renewal growth has steadily strengthened over the last five quarters, and indicate that customers are anticipating substantially increased use of EDA software in the coming three years.

We have also experienced strong performance from the acquisitions we made a year or two ago, especially Flomerics and LogicVision, both of which have substantially exceeded our expectations, and both of which have expanded their business with significant new customers.

Fundamental to the strength we have seen this year, is the growth of non-traditional EDA business in adjacent markets. Like others, we expect the growth of traditional EDA software revenue will lag behind any semiconductor recovery, as electronics companies bring R&D back in line with revenue. And Mentor's approach provides growth that is independent of that semiconductor recovery. Our strategy focuses upon developing number one market positions, particularly in newly emerging markets, where application of EDA technology can provide new capabilities and reduce costs. For Mentor, the best example of this has been in the area of system design.

Our mainstream integrated system design business grew well this quarter at 10%. But the biggest impact continues to be in the rapidly growing new application of EDA to the transportation market, particularly automotive and commercial aviation. In the first quarter of this year, our total automotive business grew 80%. Second-quarter, it was 95%.

There are several major trends that are fueling Mentor's growth in system design for the transportation industry. First, there is a ramp-up of the use of EDA software among transportation companies that have been integrating EDA into their design processes for many years. Major automotive orders this quarter included companies like Hyundai Kia, Mitsubishi, Fiat, Chrysler, and Mazda. Hyundai Kia is a typical example. They are the sixth largest automotive manufacturer in the world, and the second largest in the Japan and Korea region, behind Toyota. They made a corporate enterprise software decision three years ago to adopt the Mentor cable and wire harness methodology called CHS throughout their design and manufacturing process. All their new vehicle designs are based upon Mentor automotive software, and they have increased their usage with their first large term contract order this quarter. The significant share of the hundreds of suppliers to Hyundai must have CHS software to develop and test their subassemblies.

Similarly, four commercial aircraft companies have committed to CHS enterprise software during the past year. This quarter, one of the leading suppliers of business jets made significant purchases of CHS software as they roll out their automated design methodology. Like the automotive companies, aircraft companies have broad supply chains and must keep their design processes in step with their customers, like purchasing the same automation software.

The second trend in the system's business is the growth of the Chinese market, with system design automation software. While China has been slow to grow the domestic semiconductor industry, other than the wafer fabs and the operations of multinational companies, they are aggressively growing a domestic automotive and aerospace industry using the latest technology. This quarter, Mentor received our first author from FAW, securing the top three Chinese auto companies as users of Mentor automotive software. Another eight China-based automotive companies use Mentor automotive design software. Similarly, seven Chinese aircraft companies are using Mentor's system design software.

The third trend, Mentor's strength in system design, along with our acquisitions like Valor and Flomerics, is diversifying the base of customers we serve. Our traditional business with industrial equipment companies like General Electric and Emerson, is now being called limited by new names, like Sumi Motherson of India and Everlite Electronics in Taiwan. Our automotive customer list, that includes most of the leading automotive OEMs in the world now expanding to names like Dongfang Motor Corp in China and McLaren Group in the U.K. Our automotive component customer list, of companies like DENSO and Bosch is being extended to new names like Magnetti Marelli and Parker Hannifin. And contract manufacturing customers like Foxconn, Flextronics, and Jabil are being complemented by companies like RH Electronics of Israel and Panda Electronics of China. Many of these companies come to us simply because they traditionally used Valor or Flomerics products, but many others, like Caterpillar in heavy equipment, JDS Uniphase in test and measurement, or Hypercom in point-of-sale terminals, are finding that traditional EDA products from Mentor can be used to solve problems in new areas of system design.

Proof of our base of new system design customers and products provides Mentor a large opportunity for new applications of EDA in the future. When combined with the strength we saw in our largest contract renewals in our traditional business at 45%, our optimism about the future continues to increase.

Greg?

Greg Hinckley

Thanks, Wally. The second quarter of fiscal year 2011 was a very satisfactory quarter. Bookings were strong over many of our product lines, but particularly anything transportation or system-related. Book-to-bill was an all time second-quarter record, as is our backlog. Revenues, paced by upsides in services and support, exceeded our guidance by $8 million, and with stringent cost controls in place, about 60% of incremental revenue dropped down to non-GAAP operating income. Earnings per share, non-GAAP, was $0.01, compared to our guidance of break-even to a nickel loss. This quarter was our sixth consecutive quarter of meeting or exceeding guidance.

All of the metrics that Wally and I use to track the health of the business were strongly positive in the quarter. Support reinstatements, for example, were up 30% from the second quarter a year ago, while declines dropped in half. Consulting and training revenues were up more than 10%. New customers, excluding PADS, were up 5% in number, and 35% in value. Base business, terms transactions less than $1 million, was up a significant 15%. Most importantly, as Wally said, the value of our top renewals grew 45%, returning to the high end of the 25% to 45% range that we were accustomed to reporting prior to the calendar 2008 recession.

Expense control remains a Mentor priority. Despite adding 290 employees from seven acquisitions last year, total headcount was up only 191 people, and non-GAAP OpEx increased at a lesser rate year-over-year than headcount. Next month, we will occupy a building in Fremont, California that we purchased earlier this year at a steep discount to traditional Silicon Valley real estate prices. Relocation to that space will result in $3 million of annual savings.

During the quarter, we began a program to consolidate 24 distributed data centers in Europe and North America to two sites in Shannon, Ireland and Wilsonville, Oregon. Scheduled for completion in calendar 2012, consolidation will reduce costs by about $5 million a year. Also in the quarter, we extended (inaudible) to several more of our sales offices to reduce facility costs and took action to reduce the cost of equity-linked employee benefits.

Now, for more financial detail. Bookings were up 2%, slightly better than flat for product, and up 10% for services. New and emerging was particularly strong, tripling the bookings for our transportation products. Integrated systems design, which now includes the Valor line of PCB manufacturing products, was up 10%. Designed silicon was down 10%, but that was in comparison to a quarter last year that was up 45% as foundries purchased quantities of resolution enhancement technology products to ramp their 45 nm production. Finally, scalable verification was down 5%, while consulting and training was up 10%.

By geography, Japan more than doubled, Pac Rim almost doubled, Europe was flat, and North America was down 30%. Bookings were 55% term, 15% subscription, 30% perpetual, compared to 60%, 50%, and 25% last year. As said before, both book to bill, which was obviously greater than 1.0 and backlog were and are at Q2 record levels.

Revenue was $187.9 million, up $8 million from guidance. Product revenue was down 3% from last year, offset by services, up 11%. Services benefited particularly from a shop drop off in maintenance declines, accompanied by increased reinstatements, but also by the addition of about $2.5 million of Valor support revenue.

Revenue mix by geography was 40% North America, 25% Europe and for Pac Rim, and 10% Japan. Ratable revenue was 55% of the total, comparable to last year, and reduced from 60% in the first quarter.

Top 10 customers represented 50% of bookings for the second quarter this year, compared to 60% last year. Currency, all attributable to the yen, was favorable to revenue by $1 million.

Non-GAAP gross margin was 85%, comparable to the first quarter, but up 1.4% from last year due to a change in product mix, more software and less hardware revenue. In the second quarter, operating expenses non-GAAP increased $9 million or 6%, due to the acquisition of LogicVision and Valor, which were running $10 million of operating expense, a quarter prior to their acquisition. Headcount is up $191 million year-over-year, and down $20 million sequentially. Currency was unfavorable to OpEx by $1.5 million.

Other income, non-GAAP, was an expense of $3.6 million, a decline of $600,000 from last year, reflecting capitalization of interest expense for construction in progress at our Fremont facility. Special charges were $3.2 million, and related to cost reduction initiatives, both facilities and employment and fees that were caused by the (inaudible) offer. Obligations for those fees expire this quarter. The non-GAAP tax rate remains at 17%.

Now on to cash flow and the balance sheet. Operating cash flow for the quarter was a $13 million use, as we accelerated payment of dollar-based receivables by non-U.S. customers lapsed with the weakening of the U.S. dollar. Cash and equivalents decreased a similar amount, $10 million sequentially, to a total of $89 million. Trade accounts receivable was $89 million, up $2 million sequentially. Short term unbilled receivables were $183 million, up $80 million sequentially.

Trade DSOs were 42 days, down 1 day from last quarter and down 11 days since last year. Total DSOs were 130 days, flat with last quarter, and an increase of two days from last year. Quality of receivables remains excellent, with no receivables net of reserves greater than 60 days past due. Factor of receivables were $13 million in the second quarter, compared to $16 million last quarter and $4 million last year.

Capital expenditures were $11 million for the second quarter, compared with $8 million last quarter, and $6 million last year. The increase in capital expenditures for the quarter was payments related to the opening of our new Fremont facility. Depreciation and amortization was $8 million, the same this quarter and the same for the same quarter last year.

Let me now give you some detail on our recent legal action against EVE. For emulation technologies, Mentor has over 100 patents issued, and 40 more pending. These patents represent a significant investment by the company and an important asset of our shareholders. We have a net obligation to defend our investment in this intellectual property and to receive fair value for it. We offered to license our emulation patent portfolio to EVE, including U.S. patent number 6876962, an offer they declined.

We have, therefore, commenced two actions against them. First, we filed a claim with the Japanese Customs Office. The Japanese Customs Office will review the claim, and if they find for us, will bar the importation of EVE products into Japan. We also filed a patent infringement suit in U.S. Federal Court in Oregon. The suit seeks damages and to bar their products manufacture and sale in the U.S.

Turning to guidance, with strength in all our leading business indicators, in particular, the robust 45% growth in our second quarter renewals, as well as recognition of the level of our present backlog, today, we are raising both revenue and earnings guidance for our 2011 fiscal year. For the entire year, we are now forecasting revenues of $880 million, an increase of $10 million from prior guidance. And are changing our non-GAAP EPS guidance from a range of $0.60 to $0.65 to a point estimate of $0.65.

For the third quarter, we are forecasting revenue of $220 million and non-GAAP EPS of $0.15. That represents a $13 million increase in non-GAAP operating income on a $30 million increase in revenue from the third quarter of last year. Increased revenue in this third quarter is expected to include significant hardware revenue, with hardware cost of goods sold and Valor revenue that includes costs that were not dilutive or not yet materially accretive. In addition, with success this year, we are forecasting higher levels of incentive pay and commissions.

For the fourth quarter, we are forecasting revenue of $290 million, and non-GAAP EPS of $0.51. For this quarter, expiring contracts at historical value, backlog, and scheduled service revenue represents more than 75% of our revenue forecast. Let me repeat that. For the fourth quarter, expiring contracts at historical value, backlog, and scheduled service revenue represent more than 75% of our revenue forecast.

The $0.65 of non-GAAP EPS will deliver a 45% increase in operating income on an annualized 10% increase in revenue.

Revenue guidance of $220 million is a third quarter record for Mentor Graphics, and that is by a lot, $30 million. The third quarter, coupled with the $290 million revenue guidance for the fourth quarter, also a record, and our second quarter 45% renewal growth, all show momentum in our business is building.

Wally?

Walden Rhines

Thanks, Greg. Strong bookings, positive leading indicators, and a 45% growth in the annualized revenue from contract renewals of our largest orders provides positive momentum in a strengthening business environment. New applications of EDA, particularly in transportation, are diversifying our revenue base, and opening up markets with higher growth rates than traditional EDA markets. Our long-term strategy provides the opportunity to grow faster than the overall market, and with ongoing cost controls, to continue the steady increase in earnings. Now, let us take some questions. Cathy?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We do have a question from the line of Rich Valera. Your line is open with Needham & Company. Please go ahead.

Rich Valera – Needham & Company

Thank you. Good afternoon, gentlemen. Obviously, very nice renewal run rate percentage increase there, up at the high end of historical range. And then in your commentary, I guess, in the fourth quarter guidance, you mentioned that, you know, when you were factoring in the 75%, I guess, of your revenue number, you are talking about renewals at historical levels. So, just wondering what you are actually baking into your guidance? Obviously, something I would think higher than historical levels, but are we, you know, can you give us a sense of what the ranges you would expect for renewal run rates for that fourth quarter?

Greg Hinckley

Rich, Greg. We are not prepared to describe that. We have a variety of sources to deal with the remaining 25%, part of which is new contracts, part of it is growth in our base business, which grew very healthily this last quarter, and then exactly what you point out increases in their renewal amounts. What we have in that 75% number, when we talk about historical values, is the value that the contract was recorded at several years ago. And as I say typically before this recession, we would have our renewals grow by anywhere between 25% and 45%.

Rich Valera – Needham & Company

Understood. I have a question on new and emerging – I am not sure, did you actually give a number for what percentage new and emerging bookings increased year-over-year?

Greg Hinckley

50%.

Rich Valera – Needham & Company

50%. Okay, that is great. And then, Greg, I think you mentioned that auto had tripled. Can you give us a sense of what the comparison was we were dealing with there? Was Q2 of last year an unusually weak quarter? Or was it a sort of normal quarter? Just to get a sense of how impressive that tripling is.

Greg Hinckley

That tripling is impressive, Rich. A year ago, it was a – this is a lighter business that has been growing pretty steadily for us. Every now and then, we get a very enlarged order from one of our customers, but there is nothing unusual about last year and this year, it was just a – it is a part of the business that is progressing very, very nicely.

Rich Valera – Needham & Company

Okay, that is helpful. Can you give us any sense of sort of what you think the growth rate is of that auto business on a more normalized basis? You know, I am presuming you are not expecting a sort of tripling every quarter, but it sounds like it is obviously way above a normal EDA growth rate. Is there any kind of range you could give on what you think the growth rate is of that business?

Greg Hinckley

We are still – it is too early into the program. We do have some quarters where the total transportation related bookings are as much as 15% of our total. These are large companies that we do business with, and the orders have the prospects of being very large, and as a result, the business is lumpy, up and down a bunch.

Rich Valera – Needham & Company

Understood. And then to the annual guidance, nice to see you taking up the revenue range there. Just want to understand why the high end of the EPS did not go up. Was that the higher incentive commissions? Or was there something else in there as well, that would have kept that EPS from bumping up a little?

Greg Hinckley

There is a variety. So, one of it is the – incentive pay. What we have is, as we don’t accrue incentive pay until it is earned, and given the nature of our business, and the big spike that we have in the fourth quarter, and the fact that this year, we are forecasting that $0.51 of our $0.65 worth of earnings happened in the fourth quarter, the preponderant of our incentive pay is earned in the fourth quarter. It also reflects that our hardware business is becoming a bigger portion of our revenue, and the hardware has hardware cost of goods sold, and so revenue doesn’t count the same kind of dropdown in terms of margin and profits as does software.

Rich Valera – Needham & Company

Sure. Understood. And one final one, if I could, on the EVE litigation. You know, back when you guys were engaged in litigation with, I guess, Quickturn, that was a fairly lengthy and quite expensive process. I mean, do you have any sense of what type of legal expenses we might expect to incur as this plays out over the next few quarters?

Greg Hinckley

The expenses over the next few quarters will be immaterial.

Rich Valera – Needham & Company

Okay. Great. That is it from me. Thank you very much.

Greg Hinckley

Thanks, Rich.

Operator

(Operator Instructions) Our next question is from the line of Benjamin Papas. Your line is open, sir. And he is with D.A. Davidson. Please go ahead.

Tom Diffely – D.A. Davidson & Co.

This is Tom Diffely. Quick questions on the expenses. If we continue to see some strong momentum both in the core EDA and these new markets into next year, how do you look at expense expansion? Is there a point when we need to start adding back some of the expenses that we have taken out over the last year?

Greg Hinckley

You will be seeing, and you see it already, in this year's forecast. We have, certainly, incentive pay is at a higher rate this year than it has been in the past. We have also been very careful on employee wages and benefits. And you know, if the business continues to improve, like we are reasonably optimistic that it could, we will need to take a look at compensation benefits and incentive pay.

Tom Diffely – D.A. Davidson & Co.

Okay. So there aren't necessarily any of the temporary cost reduction measures that come back into play then?

Greg Hinckley

That is correct. So far, what you see in terms of the increase in year-over-year running expenses is really all acquisition related. So, it all has to do with headcount adds, and in fact, as I said in my commentary, Tom, the increase in headcount, percentage-wise, was greater than the increase in the dollar-based expense. So, we continue to be tight on expenses.

Tom Diffely – D.A. Davidson & Co.

All right. And when you look at the core products being up 45% this time, was that a factor of competitive wins? Or was it really just the customers adding more this time around?

Walden Rhines

No, the 45% is a calculation of the annualized rate of the contract renewals compared to the annualized rate of the previous contract three years before. All of that 45% is a growth in the dollars of the renewals compared to what people paid per year on the previous contract.

Tom Diffely – D.A. Davidson & Co.

Yes, I just thought part of it could be that they give you a bigger portion of the overall spend.

Walden Rhines

That is certainly quite possible. In fact, that is certainly true in many, if not most of the cases. In one case, moving from 50% to 90% of their total spending. But in general, it is the natural growth that occurs when people move forward, designs become more complex, they need more copies of the software to get things done, and it leads to an increase in the amount of usage per year.

Tom Diffely – D.A. Davidson & Co.

Okay. So have you seen a meaningful shift in or increase in R&D budgets for EDA over the last couple quarters then?

Walden Rhines

We didn't actually do a calculation this quarter to see where it was at, but I have to believe that it is picking up some just based on the reports of some companies. The dynamic we have talked about that we have seen in recoveries from previous recessions is when we are going into the recession, the semiconductor companies in particular, but all electronics companies in general tend to cut all expenses, except their design activity, which they will trim some and they will cut the resented program, but it cuts back very little. So the result in the bottom of the recession there, R&D as a percent of revenue rises to levels that they feel should not be sustainable, and so they try to hold back as long as they can on increasing that R&D until it comes in line with their new revenue. With the semiconductor industry clearly going to break the $300 billion barrier this year, we shouldn't be too far away from them easing up and bringing the R&D in line, and that should help us.

Tom Diffely – D.A. Davidson & Co.

Yes. Okay, great. Thank you.

Operator

(Operator Instructions) Gentlemen, there are no further questions. Please go ahead.

Joe Reinhart

Cathy, thank you very much. Ladies and gentlemen, thank you for participating in this call this afternoon. For follow-up calls, both Greg and I will be available. The best way to reach us is by calling Monte Koller at 503-685-1462 and she will make sure that either Greg or myself can get back to you in a timely fashion. Cathy, if you could please provide the replay information for our listeners.

Operator

Thank you. Ladies and gentlemen, this conference will be available for replay after 3 PM today until August 26, 2010 at Midnight. You may access the AT&T Executive Playback Service at anytime by dialing 1-800-475-6701 and entering the access code of 167842. International participants may dial 1-320-365-3844. Again, those numbers are 1-800-475-6701 and entering the access code of 167842. And once again, for international participants, they may dial 1-320-365-3844. That does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.

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