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Cadence Design Systems (NASDAQ:CDNS)

Q4 2006 Earnings Call

January 31, 2007 5:00 pm ET

Executives

Jennifer Jordan - Corporate VP of IR

Mike Fister - President and CEO

Bill Porter - EVP and CFO

Analysts

Jay Vleeschhouwer - Merrill Lynch

Harlan Sur - Morgan Stanley

Tim Fox - Deutsche Bank

Rich Valera - Needham & Company

Raj Seth - Cowen and Company

Mahesh Sanganeria - RBC Capital

Matt Petkun - D.A. Davidson and Company

Vishal Saluja - Seligman

Presentation

Operator

Good afternoon, my name is Melissa, and I will be your conference operator today. At this time I would like to welcome everyone to the Cadence Design Systems Fourth Quarter 2006 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. (Operator Instructions).

At this time, I would like to introduce Ms. Jennifer Jordan, Corporate Vice President of Investor Relations for Cadence Design Systems. Thank you. Ms. Jordan, you may begin your conference.

Jennifer Jordan

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

Please note that today's discussion will contain forward-looking statements, and that our actual results may differ materially from those expectations. For information on the factors that could cause a difference in our results, please refer to our 10-K for the period ended December 31st, 2005 and our 10-Q for the period ended September 30th, 2006.

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

Now I will turn the call over to Mike Fister.

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Mike Fister

Thanks Jennifer. Q3 was a fantastic quarter for Cadence. Revenue grew 14% over the prior year period. And for fiscal 2006, revenue grew 12% over fiscal year 2005 led by 20% of better year-over-year growth in verification and custom IC. Before I get in to details of the quarter and the year, let me give you some sense of what we see in the environment.

Now there are lot changes in our customer's environment. Design activity remained study. Industry forecast for semiconductor growth in 2007 span from 2% to 10% with an average around 8.4%. The fastest growing segments continue to be consumered around 11% and wire and automotive each about 14%.

Analysts' estimate semiconductor R&D spending growth in the high single-digits for 2007, and activity at the 65 nanometer process now is picking up and many analog customers are moving directly to 65 nanometers. In addition, leading edge customers are already working at 45 nanometers. Most recent evidence, as this was in last week's news article about Intel, IBM, and TI's advanced activities around the 45 nanometer nodes. Still there are more nodes in production today than at any other time in the history of the semiconductor industry, reflecting the breadth and depth of the semi market and the challenges of managing the economics of timing, volume and demand.

Now for a few details. During 2006, we introduced a significant upgrade of our custom IC platform, continue to bring differentiation to our verification in digital platforms, and we completed the segmentation of all our products platforms. Since the last time I talked to you, we have introduced cross platform capability such as the low power and logic design theme solutions. Which help customers manage the vectors of Time To Market complexity and productivity. Both these solutions emerged from Torino, which is our next generation implementation technology.

Cadence Low-power solution is the first combined design verification and implementation flow for low power. The industry's growing in to Low-power design is an important opportunity for Cadence. Because more power design crosses several engineering domains, with our breadth of technology we are uniquely positioned to offering integrated end-to-end solutions that supports the multiple design teams working on a single low-power IC.

Cadence low-power solution is the first complete system to capture low-power design intent and manage it seamlessly from architecture to manufacturing. Because we believe standard data formats will accelerate the adoption of low-power design methods in the industry, we have also contributed a key piece of technology, the so called the Common Power Format or CPS. It’s a larger industry standards movement; in this case, the Silicon Integration Initiative or Si2. This fulfills the commitment we made last summer. Early adopters of the Cadence low-power solution have already saved significant time and expense. Anecdotally, our solution identified major architectural challenges required for the success of low-power design much earlier than they would have been found using other method.

The Logic Design Team Solution combines technology from our Incisive verification and Encounter digital design platforms into an integrated front-end environment for logic designs. Today mostly in logic designs have to content with the portfolio of tools from multiple vendors. We believe that looking to streamline their design environment and increase the predictability of the product development process. An increasingly our ability to deliver this complete solution has become a significant differentiator for our customers and money business for that case. For example, on the fourth quarter, NEC electronics significantly expanded its use for the Encounter and low-power digital flow.

As we had anticipated functional verification was the fastest growing segment of our business in the full year, driven by our segmented incisive verification solutions. No one else in the industry offers his complete, and robust solution for verification management from planning to closure.

In the fourth quarter, we released our enterprise system-level or ESL verification capability. ESL combined automated hardware, software co-verification system like closure management and high performance SystemC simulation in hardware engines.

Another step-up this stack in terms of helping hardware, software and systems engineering teams to manage the risk caused by system complexity.

We achieved the major milestone with respect to the SystemVerilog adoption which indicates this customer base. Over 150 customers are now using our SystemVerilog solution with Incisive design team and Enterprise offering up from the 40 early adopters about a year ago.

Many of these customers appoint a mixed language environment leveraging e, SystemC, and SystemVerilog to meet the full breadth of demand for verification across the organizations.

And we also extended our lead in emulation by improving the ease of use performance and integration with the release of Xtreme III and Palladium III in the fourth quarter. Taking advantage of this improved capability, a leading Graphic Processor Company adopted Palladium III in the period.

The custom IC, we saw a strong year-over-year performance. A very successful early adaptive program for our new Virtuoso platform helps exceed the demand, which continued following the general release in October. As I have mentioned before this is the most significant upgrade to the custom product line in many years and it clearly helps us to expand our business at a number of customers in the fourth quarter.

As an example Qualcomm selected the new Virtuoso platform because it recognize the success at 45 nanometers and below we will require a better technology and a level of integration that only OpenAccess and Cadence could provide. Only this is a nice hardware gap for the customer upgrade cycle this year.

Custom simulation added over 80 new logos in 2006 reflecting an increase in customer demand driven by smaller geometries. More wireless design starts and increase mixed-signal content. We delivered great digital technology during 2006 putting us in a position to have a much greater differentiation in 2007. Mostly solutions like Logic Design Team that came with low power solution and the integration of our Catena technology to encounter GXL. There are various successful entries into the timing signoff market with the Encounter Timing System or ETS. The number of customers and the speed at which they are integrating ETS and new design flows are is very encouraging. During the fourth quarter Renesas adapt their RTL Compiler for it's customer's ASIC Designs at 90 nanometers and beyond.

Hitachi began consolidating its digital Encounter platform. And IBM that is already, excuse me, has announced that it has incorporated RTL Compiler in Encounter Test technology into the IBM 65 nanometer ASIC design kit.

Design for manufacture ability our strategy of tight integration in the design environment I sometime see a big deal in DSM remains on track. Consistent with this we have integrated ship optimizer into Encounter GXL and the space based router into Virtuoso GXL. Focus on kit this year was primarily in the wireless market with small mid size customer seeking to speed up their adoption in technology and design methods. However, kits are not limited to small customers.

Freescale Semiconductor has deployed the AMS Methodology Kit across its design centers worldwide. Freescale anticipates that the verified methodologies within the kit will help it more rapidly to document and deploy this leading edge mixed-signal design flows reducing flow development time by up to 20%. The Silicon-Package-Board business we had a strong performance through the quarter and the year. We advanced IC packaging in market segment we continue to increase our market segment share in position.

Xylon Semiconductor, a Communication Company selected Cadence's SiP solution and RF SiP Methodology Kit, recognizing the D solutions to quickly raise the skill level there in higher teen. In addition, the industries top four assembly and test providers worldwide are standardized on Cadence.

Overall I am extremely pleased with the result of the fourth quarter and for the full year 2006. I look forward to sharing what we have planned with you what we have planned in 2007 on our Analyst Day in New York City on February 28.

And now let Bill take you through some numbers.

Bill Porter

Thanks Mike. Cadence completed another successful year with strong financial results. For the year total revenue was up 12% non-GAAP, operating margin improved 300 basis points to 27% and operating cash flow was $421 million. Book-to-bill exceeded one for the year, and backlog grew to $1.9 billion. We expect backlog to grow again in 2007. For Q4, GAAP earnings per share were $0.16, compared to $0.8 in the same quarter last year. For the full year 2006, GAAP earnings per share were $0.46 compared to the $0.16 earned in 2005. Non-GAAP earnings per share were $0.38 for the quarter compared to $0.29 in the same quarter last year, up 31% year-over-year. For the year, non-GAAP earnings per share increased 30% to $1.8 from $0.83 for 2005.

Total revenue for the fourth quarter was $431 million compared to $378 million in Q4 of 2005, up 14%. Product revenue was $298 million, maintenance revenue was $98 million, and services revenue was $35 million. Revenue for the year totaled $1.48 billion, up 12% from $1.33 billion in 2005. Revenue mix by geography in Q4 was 60% for North America, 19% for Europe, 10% for Japan, and 11% for Asia. Business levels exceeded plan across all geographies for Q4 and 2006. One customer in North America accounted for 28% of revenue in Q4. Approximately two-thirds of the revenue for this customer was upfront, and one-third from backlog. No customer accounted for 10% or more of revenue for the full year.

In the quarter, approximately 83% of our product business was represented by ratable licenses and 74% for the full year. Approximately two-thirds of product revenue was generated from backlog for 2006, a trend we expect to continue in 2007. Contract life calculated on a dollar weighted average basis was approximately three years. In Q4, total costs and expenses on a non-GAAP basis were $290 million, up $25 million from $265 million in Q3. The increase was primarily due to higher commissions and incentive compensation, driven by our strong operating results.

The non-GAAP operating margin in Q4 was 33% and 27% for the full year 2006. For the full year 2007, we are looking for another 300 basis point improvement to approximately 30%. Year-end headcount was approximately 5200. Total DSOs for Q4 were 81 days better than our target of mid-80s. The quality of receivables remained high with receivables 90 days past due at 1%, the low end of our historical range of 1% to 3%.

Operating cash flow for Q4 was $205 million, compared to $177 in the fourth quarter of 2005. For the year we generated $421 million in operating cash flow. For 2007, we expect to generate operating cash flow of approximately $450 million. This year we are beginning the construction of a new state-of-the-art engineering building in our San Jose campus. Re-enforcing our commitment to the San Jose community and allowing us to consolidate on a single location. The building will take approximately two years to complete and is funded by the sales of a portion of our San Jose campus. The sale closed last week for $47 million.

Capital expenditures for 2006 were $68 million, yielding free cash flow of $353 million. For 2007, we are targeting normal capital expenditures in the $75 million range plus $22 million for work on the new engineering buildings. Cadence repurchased 12.9 million shares of stock in Q4 at a cost of $236 million, including 5.9 million shares repurchased in connection with our $500 million convertible bond offerings in December. Approximately $528 million remain under our current stock repurchase authorizations at year-end. We intend to use the $100 million that remains from the net proceeds of the convertible notes issues to repurchase stock.

In conjunction with the new convertible bond offering, we also repurchased approximately 45% of our convertible bonds due in 2023, which removes 12.1 million shares from the diluted share count beginning in Q1. The weighted average diluted share count for Q1 should be in the range of 290 to 294 million shares. Cash and cash equivalents were $934 million at year-end.

Now I will turn to our outlook for Q1 in the year 2007. For Q1 we expect revenue to be in the range of $355 million to $365 million reflecting the normal seasonal decline from Q4. GAAP EPS should be in the range of $0.10 to $0.12 and non-GAAP EPS in the range of $0.23 to $0.25. For the year 2007 we expect revenue to be in the range of $1.575 billion or $1.625 billion. GAAP EPS should be in the range of $0.69 to $0.77 and non-GAAP EPS in the range of $1.26 to $1.34.

With the seasonal pattern in 2007, we expect to generate 22% to 23% of annual revenue in Q1, 22% to 25% in Q2, 23% to 26% in Q3 and 28% to 31% in Q4. Other income and expense for 2007 should be in the range of $28 million to $32 million.

As I look back at 2006, and forward to 2007, I am pleased with the growing strength of our technology, and our track record of achieving our operating goals. Looking beyond 2007, I believe we will be able to continue to grow our business while expanding operating margins beyond 30%.

Operator, we will now take questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Jay Vleeschhouwer with Merrill Lynch.

Jay Vleeschhouwer - Merrill Lynch

Bill, could you comment more on the one large customer in the quarter, 28% of revenues is unusual both as a proportion so in terms of the absolute amount, the upfront portion of that also seems unusual getting the targeted model anyway. We saw something similar in Q3 of course with the below nominal model range for subscription business. So, just help us understand why this is not an ongoing divergence from the model as welcome, it might be to have a large customer with this much business with you? And I have some follow-ups.

Bill Porter

Sure Jay. Well I think the thing that I focus on is that we are making real good progress in demonstrating and the differentiation in the value of our solutions at a number of our largest customers. I think you saw that in the past in Q4 and I think you have seen it this year. So, I think that's the plus point as we are having good success with some of the larger customers in the industry. The other point that I would make is that there was a portion of this particular customer's revenue that was upfront two-thirds of it as well as the third was coming from backlog. And as we look at the model we traditionally will have about two-thirds of our revenue coming from backlog, and we will have about a third that is generated in the quarter. And we are still staying comfortably within that model. And as you saw based on our total bookings which you can imply from the backlog growth as well as our revenue growth, that we had a banner year as well as keeping our model with 83% of our bookings in the fourth quarter being ratable. So, we are right within our target range and for the year our ratable percentage was 74%. So, I think the model is holding real well. I think what you are seeing is occasionally we will have success with a big customer and that's welcome because we hope to have success in the future with other large customers and still operate within the model that we have been working for the last three years.

Jay Vleeschhouwer - Merrill Lynch

What's your forecast for the backlog increment for '07, do you think you can grow it again by at least another $100 million. And Mike when you look back at 2006 in entirety at the components of growth, how would you distinguish the contribution from either additional license capacity just more SiP's and users versus pricing, packaging, incremental payment of a new technology?

Bill Porter

Jay let me just start off on your question on just total business growth for 2007. I think one of the things that we try to do is plan conservatively, so we are not going to go out and try to get too big of a stretch you could see in our revenue range for 2007. That it's going to be in -- the mid point is around 8%. And we do that consciously because we think the planning model gives room for our team to evaluate opportunities with customers and take the business at the right time. So I do expect we will grow our backlog next year, I am not going to put a specific number on it, because I think it allows us like we did this year to work with customers to find the right time we think we will win. But its better to plan conservatively, hit our model and then have the opportunity to overachieve if we see that is ready for us and I think you have seen that we can do that.

Mike Fister

Yeah Jay when I look back in 2006, it occurred that what Bill said, when you do these consolidations every once in a while you land a monster and those things are going to come and go as we do. And in the biggest companies that -- those are very significant and it's not just seat expansion its expansion of the business. Sometimes it’s a market segment share ship position for us. But once that are -- I think the most telling the way the industry is going go are the progress that we made in expanding the universe, and the whole verification segment was that way. What we are doing with analog and moving it into the RF and the Microwave region is that way. And I don’t think we get any credit for it, but what we are doing down to the manufacturability of the chips and the pro-action in the design environment is that way. So, here is a core component of business that we have, Bill and I have constantly pointed out, that fairly link to the average, new R&D spending, and that’s going along nicely. But we are growing faster than that, constantly through last year, and then all through my time here and I think we’ve just scratched the surface of where we can go.

Jay Vleeschhouwer - Merrill Lynch

And then lastly, what’s going on in Japan that was a fairly low percentage of total revenue this last couple of quarters?

Bill Porter

Yeah, Jay. I will just comment. And as I talked about the geographies, India and Japan in particular, we beat our plan across all geographies in 2006, and quite frankly in Japan, it’s the highest business level we’ve ever achieved. So, the business is going very well, and as you know we are focused primarily, directly with the top 11 customers and we are continuing to have very good success also with our geographic base there. We will see the normal seasonality with large customer contracts and so there is some volatility between regions as well as sometimes between product lines. Well I think that’s really what we are seeing in Japan. Good traction across the board with the Japanese customers.

Mike Fister

Few testimonials from Hitachi and NEC bode very nicely for us. I am super excited of what we have done in there. And that part of the world is expanding Jay as kind of a percentage of large numbers for the quarter was huge and it’s a relative piece of the business. That's the fraction that Bill was pointing out banner year in Japan. Its going to happen again next year as far as I am concerned.

Jay Vleeschhouwer - Merrill Lynch

Thanks very much.

Operator

Your next question comes from Harlan Sur with Morgan Stanley

Harlan Sur - Morgan Stanley

Hi, good afternoon, good job on the fourth quarter execution. Mike, any updates as to the adoption rate of your next generation Virtuoso platform, and maybe your views in terms of the total upgrade opportunity and over what period of time. It seems that activity for customer is accelerating pretty significantly, we've got aggressive node shrinks by the memory suppliers and aggressive digital to analog integration with your logic customers. So any updates on next-gen Virtuoso be great?

Mike Fister

Well we certainly have done very well. We did a very deliberate [EDA CD] program and Early Adopter Program. It led to a -- not only early release of the product there I was quite pleased with, but the uptake through Q4 was spectacular, shows up in the numbers as Bill said. And I think it worked very nicely for us for upgrade, some of the base or large part of the base in to next year. I don't know how long it will take us to drive the cost of the whole base, and quite frankly what we are doing is engaging the most ready customers first and sooner or later they will all move, as is my confidence. Its strength of the technology, and as you say Harlan, the features that we have across that are just required as people move along the process or migration, whether its a memory designer or a full custom person or a mixed signal person. So I am super excited about what the team did there. The early customer's feedback is nothing but growing, and I think it bodes very nicely for us this year and for a couple of years to come.

Harlan Sur - Morgan Stanley

Good to hear. And then, as it relates to the full year outlook, just your thoughts at a high level on what are going to be the key top line drivers for the year. Should we anticipate continued strong growth in digital and verification and that we also get some accelerated contributions from your custom mixed signal segment as well.

Mike Fister

Well certainly to the conversation we were just having, mixed signal is going to be and customers going to be a significant piece of it. I think we just scratched the surface of what we do can is verification and steadily announcing new capabilities and kind of moving up that stack. And as I said before the things like Low-Power and Logic Design Team are fore bearers of the strength when you consider that in a holistic fashion. The digital are very well positioned with doing all the hardest designs in the world, and I think that gives us a run way to be able to proliferate down and have had this success throughout the year for the segmented products coming in at the entry level to ensure on the customer seamless just cross that. So there is no week part. We are going to announce it in the -- just something in middle of the year of revolution and what we have done in the Printed Circuit Board packaging business from a technology standpoint. So I think I am quite excited about doing it and I see a lot of the feedback from the customers. That’s encouraging just to keep hitting our stride in the business is going to come forward.

Harlan Sur - Morgan Stanley

Great. And then my last question as it relates to one of the company's new initiatives with which is your Kits strategy and so obviously we saw the Freescale announcement on the adoption of the AMS Kit. I am just wondering is this a product which has being adopted across the entire Freescale organization?

Mike Fister

Certainly what we have done has allowed Freescale which is globally divergent in the design team that is they are located all over the place that use that as a methodology kind of kick start integrating some of their best practices and deploy it very uniformly, its kind of what you read in the announcement. I think that is an opportunity in other big companies too and we just don’t have them testimony of Cadence and certainly for small company, who may not even be globally diverse, its best method integrated into their design process and that’s exactly why we do it. Let me keep doing that instead of unlimited how high up or fast we can go or, or what we can do that's only limited by our imagination and workforce to be able to gather those best methods in the packaging. So, again I am kind of super optimistic about that strategy I think the IT industry teaches us to do that and we are going to keep doing it.

Harlan Sur - Morgan Stanley

Great, thank you. Good job on the quarter guys.

Mike Fister

Well, thank you.

Bill Porter

Thanks.

Operator

Your next question comes from Tim Fox with Deutsche Bank.

Tim Fox - Deutsche Bank

Hi, thank you, good afternoon. Bill, just one quick question on the deal push out from last quarter that you had tried to work into the fourth quarter, obviously your mix came in right on target. Could you just talk a little bit about whether those deals that you did push out in the fourth quarter to work harder. Did they all closed and if you just comment generally about how the pricing came in after reworking those contracts?

Bill Porter

Sure, Tim. I think Q3 was a bit of anomaly, because I think as we, generally we will see some business that we always continue to work between quarters. It just so happened in Q3, we got more of them which was unusual and that's why we chose to vote them, and not try to close that business and try to keep that secondary metric inline with lower practices and we were confident that if we did have the time it would comeback and half would be where we expect it which you did, so, just to punctuate that point 74% for the year and really strong for the half. We did, just take a little bit more time we close the business that we were targeting and I think that's just really it shows up in the great results we have in Q4. So, we were able to close that and we work on top of it and number of other pieces of business that were just happen to be ready for the quarter.

Tim Fox - Deutsche Bank

Okay. And second question, Bill maintenance jumped pretty dramatically quarter-over-quarter and year-over-year, its actually one of the highest ranges sometime, is that due to the maintenance associated with the upfront portion of that large deal?

Bill Porter

It was a little higher than normal Tim, it's not necessarily with the upfront portion. I would -- on a go forward basis I think its going to come down a couple of million where there was a little bit of back maintenance that came in, in the fourth quarter which gave us a pop.

Tim Fox - Deutsche Bank

Okay. Actually one more if you Bill, sorry. Your cash flow from operations guidance for '07 up about $450 million, I think you said it's up about 8% year-over-year. Could you talk about why that's not going to track with earnings growth?

Bill Porter

Yeah, I think Tim, that we are seeing a little bit of a need to have some working capital in the business. So, I thrown that back just a bit, we will continue to see cash flow growth and there is just some working capital items that we are going to have to take care of in the next couple of years. So you will see it grow with the business it just may not grow as fast as earnings but you will see good growth.

Tim Fox - Deutsche Bank

Okay, and Mike this one for you. Talking about some new products in the digital area obviously and digital was a little bit more disappointing in '06 than you had planned. Looking at into '07 this is arguably the most competitive space from a pricing perspective, could you just comment on the competitive environment there and do you expect digital to out grow your '06 space?

Mike Fister

Well I think not even arguably it is the most commoditized element of the EDA core. Some of the reasons that we segmented that technology first, because that allowed us to stratify or draw some lines in the sand about what would be valuable, and kind of project the technology fit along either a node or a time basis. I don’t even know that it was, it certainly wasn’t disappointing to me I think it's another large numbers we just had fantastic results in verification and analog. And I can say, Tim, I continue to like our position kind of taking a very conscious strategy feeding in from the top, doing all the cost stuff as far as I can get it from customers, that great pull-through across the analog and digital because the products are optimized and worked between each other and I am showing you how the verification products and digital are linked than optimized work between each other. And I think it was very nicely for us to grow that present and grow the value of the digital offering. That maybe the more important, because some of the element of commoditization either by maturity or time leads to some wild competitive practices, and that I think our value's degenerating. And so a lot of our focus is to show a customer how we can help them differentiate their business in time or productivity or complexity management and demonstrate some value and that’s the one that we are pursuing.

Bill Porter

Tim this is Bill. I guess just to add on, because that’s one of the areas as you know with our segmentation that we've spend some time, and that is a multi-year aspect where we are changing packaging and pricing strategy particularly in digital, which is the most competitive space. But I think we have seen some good results so far. For example as we shift through the numbers and we’ll spend a little bit more time at Analyst Day. We are seeing that technology differentiation is helping us to improve pricing in our GXL line in digital. We are also seeing that having the ability to have the L, the lower end version is helping us preserve value in competitive situations. So, these things will take, again years to play out, but those foundation of the product and packaging along with the strength of the technology will help us as we continue to take that journey. So, we will spend a little bit more time, it 's just that it's harder to see the appearance of it in digital right now. Because this is just a little bit more commoditized or competitive.

Tim Fox - Deutsche Bank

That’s fair. Thank you both and nice quarter.

Bill Porter

Thank you.

Operator

Your next question comes from Rich Valera with Needham & Company.

Rich Valera - Needham & Company

Thank you and congratulations on a nice finish to the year. Mike just wondering if you can talk about the business environment that you are looking at in ‘07. From your comments, it sounded like you are viewing it as largely unchanged relative to ‘06. Just wondering what would you -- should need to see in your customer base to make it more cautious or more optimistic, it sounds like there has been some sort of cautionary notes among some of the semi companies, just want to get your take on that?

Mike Fister

It's kind of a mix I guess is the word that everyone uses, and a lot of consolidation moving in and around the semiconductor guys. Lot of small companies growing up to be bigger, faster and in generally the way that I think about it is, we are looking at the vertical segments by a breakdown finer than standard industry code and so wireless as a category, consumer as a category, automotive application as category and all double-digit growth. So those bode nicely for mixed signal and the verification kind of technologies that we bring, and some of them require extremely complex Digital Logic Design.

And so I think where -- we can see the growth where we are very focused on those to demonstrate value and I think that's some of the reason that we've run faster than the market in the last year and if possibly there continuing that kind torrid pace moving into it. As Bill said, I think very well, the thing in kind of conditioning the market or reconditioning is to really be thoughtful about trying to show that value and differentiation of the customer, maybe as a contrasting with the competitor, but more so that those companies can evolve. So I really see us at the heart of that semiconductor evolution. And if we do that well, not only will we be very valuable and continue to grow our business by market segment shift, but we will grow the total available universe that we can participate in.

And that's what we are all, Bill and I are always, we got lots of different ways of looking at it. Certainly we are both optimistic about not only at the close of '06 and '07, but I think for the future. And we just don’t know how fast are we more optimistic on that market expansion, than just kind of letting it gestate for a little while. As Bill said it before, as some of these things are multiple year journey, and there is no instant event on the positive that you want to see. Because I do think it's an evolution of the industry.

Bill Porter

Rich the thing that I also look at is. As we have been seeing consumers becoming a bigger piece of semiconductor consumption, as that is requiring more activity faster and I think that’s a trend that's here for a while. I don’t think that’s going to change quickly even though some of those markets move up and down if the need to get products faster and faster in those markets I think it is going to continue. And as we look at R&D expense growth rate, they still see missing at the high single-digit. So that seems to be a pretty good indicator for more activity faster and the spend is going to be there to see that happening.

Rich Valera - Needham & Company

Great. And Bill looking at your three major product segments. Relative to the midpoint of your revenue target growth of 8%, can you say which of the three segments you expect to sort of grow above, below or sort of in line with that rate, and if any of them would require sort of have market share gains in your estimations to achieve those rates.

Bill Porter

Yeah that’s -- I would just could have categorized them the way that Mike was talking Rich. I think with custom which is pretty much going to be rolling out that new product-line, that’s not going to require any share shifts, its going to be just a nice pickup. It will be over a several years, which you can see that there is a lot of demand for our customers for that new technology. As you can see the first full quarter production release and grew over 30%. So, I think that will probably be number one mile stock. I think we are going to see the functional verification continue to grow and I think it will grow double-digits and then I think the wildcard for me has been trying to predict digital. As in Analyst Day last year, I thought that was going to grow double-digits and as it turned out custom, outperformed. So there is a little bit of variability in trying to make these predictions. But I think that’s kind of -- I think because we have a very strong portfolio, we are going to see a little add-in flow amongst the three. But the demand from customers is there and I think between the three, yes that gets us to that growth rate that we’ve got out there. And it also allows us the opportunity to do better than that when the opportunity presents itself.

I wouldn't think that the system interconnect even though it has a very, very good quarter. Yeah that is still a smaller piece of the business and we are not going to see that growing at 20% again next year, I don’t think it. It has the ability to probably grow double-digits, but traditionally it’s a slower growing market. So, I think we can do great things there and set them a pack the, the team has done a great job. But I don’t think that’s going to be a big driver for our growth. And quite frankly I think the DFM is still, we’ve got some work to grow to show that number growing, but its really the -- we are having great traction in our implementation and that will pull overtime into what is defined today is DFM.

Rich Valera - Needham & Company

Great that's helpful. Thanks guys.

Operator

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

Raj Seth - Cowen and Company

Hi. Thank you very much. Bill you have I think in the past you talked about your perspective at design starts that picked up, I think important around the consumer activity, I am just curious if you think that this is something that is sustainable or do you think that this is driven by the no transitions and investments around 65 and I guess 90. In other words do you think that design starts were up sustainably?

Bill Porter

Raj I haven't seen new data but I do think what I was mentioning to Rich is I think that trend is continuing. We are seeing more design activity because there just are more consumer applications. I think that's what driving more of the design starts, but again that was the last data we saw. And the other thing that we were seeing was some of the high bandwidth requirements was driving customers to the very small process nodes. But that's probably the extent of my vision into…

Raj Seth - Cowen and Company

Forgive me if you discussed this already, I just jumped in. Maybe one more if I could, for either you or Mike. Mike you talked in the past about potentially exploring some alternative business models maybe royalty base models around acts or some of the other stuff you are coming out, is it still something that you are interested in, is it something that we should expect overtime or as your appetite for those kinds of models cooled for some reason?

Mike Fister

No, my appetite hasn't cooled because in some of these parts of the development process especially in the manufacture ability thing that's the only way to make real money. I think even now some of the -- our colleagues who pursue DFM as a category are seeing that and we had said for the last few years that we were successful in taking some revenue with customers. That way it requires a progressive customer relationship, it bodes well for us in the consolidated relationships and I believe that, that will continue to happen. So in some respects it was also a demonstration of sharing risk and reward, which in my experience has not been traditional in EDA. And so I think this is another one I think it takes a while to do, with the X technology we did try that because it was a very good demonstrable of causality that is what it did produced a result and we're still out there for organize a little bit, but nothing new to report. And as those technologies become mature like we actually can see that we -- sooner or later we will integrate it in for preference in some of the products like the high end of the digital platform. So you can never be static about it, but I remained convinced that's not only interesting, but a necessary element of either demonstrating risk reward sharing with the customer, which they need to do to evolve and penetrating some of the market segments for a financial effect.

Raj Seth - Cowen and Company

So given that context and I realize it takes a while, how long would those kinds of business models to take within Cadence to sort of make a material impact to your financial or contribute materially I guess?

Mike Fister

It's a good question. I don't know. Let Bill will do some more with (Alberto) and think about it. The way that we that Bill and I characterize is we try to do it by product or by segments, and some of us say as the DFM penetration strategy. And in that case if it is, I think that there is another two year's (inaudible) on DFM or maybe that will be the basis to do it. But nothing new to report on that, let us think about it. Back to you.

Bill Porter

Roger, I think at this stage what I would say is we are open and we do quietly do some experimentation where it seems to be a good balance within the core, but I wouldn’t try to project it as a meaningful part of the business in the core at this stage. So, I cannot leave at that. We are still looking at it, well I think we cracked the code on variable pricing models at this stage.

Raj Seth - Cowen and Company

Got it, appreciate your perceptive.

Operator

Your next question comes from Mahesh Sanganeria

Mahesh Sanganeria - RBC Capital

Yes, thank you very much. So, I wonder if you can help me understand this booking fluctuation. You had, if I do a quick calculation you had this big customer booking close to 200 million, and you had a, looks like maybe a record booking quarter. Say if I move that 200 million back to September that probably becomes more normalized rate. Is that a correct way to look at it?

Bill Porter

Well, I think if you go ahead and look in total at the full year, and as many of you know I don’t get into a lot of specifics on bookings. But I think once a year, we do talk about business levels, because we talk about backlog. And just some of the building blocks. Since we grew the top line for the year about 12%, and then you could see that we grew our backlog a 100 million, you can see that the total when you look at it on a percentage basis is in the high teens. So, I don't think that is a generally sustainable way that we are going to grow our business, because its and probably twice the growth rate of the industry, but I think we do take advantage of opportunities. And I think it put us in good stead as we go forward, because we do have the opportunity to over achieve. But I think that just gives you the way we look at the total business for the year, and it's driven by the real strong technology that we've had across in 2006, primarily punctual verification and then also custom, and I think it sets us up well in digital which -- the business did well, but it didn't show that same level of growth.

Mahesh Sanganeria - RBC Capital

So, just one more clarification. When I look at your backlog is it of the backlog, is it proportional to individual numbers, for example say product revenue and service revenue, are they in the right proportion in the backlog or one is higher than other?

Mike Fister

Yeah. Actually I don't get into that level of specifics on backlog. The level is about two-thirds of our business in 2007. We will come out of backlog, and I think that's probably the right level to think about as oppose to trying to figure out individual component, because I wouldn’t try to get tied up.

Mahesh Sanganeria - RBC Capital

Okay, thank you.

Mike Fister

You are welcome.

Operator

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

Matt Petkun - D.A. Davidson and Company

Hi, good afternoon, most of my questions have been answered, but Mike I was wondering if you could be a little bit more specific in terms of perhaps new competition you are seeing both in your emulation market and then from a broader perspective in the custom analog, mixed-signal market.

Mike Fister

Yeah in the -- we really enjoy a great market segment share position in the analog. And as matter, to me analog or full customers, custom analog, mixed-signal, memory, RF, RF moving to micro and so it’s a lot of different things. So that exposes, I suppose, niche positions for some of the companies that you see coming along. It's -- to me its one of the reasons that we made such a big conduct to do out of the Virtuoso launch last year, because we are not giving up anything there. That’s a strong position we have now build up for many, many years, and it's hard for someone to penetrate that with any real breadth because its complicated stuff and its integrated into a lost a little pieces. But if you analyze any of that competitive offering that we did, you will find it incredibly strong. And so beyond a few niche positions, that may be geographic or some kind of a unique product focus like TFT is in Taiwan, I don’t feel lot of exposure there.

On the emulation business there, we do have a big competitor there. I don’t know that I think of it as just the emulation business, we think it of it as the verification. And there is a reason why, I know probably it's hard. Some people dismiss it as my philosophical approach but its not, it’s -- the real value it adds to a customers when you can bundle the emulation, the simulation, the verification process method that you do in that stack of stock. And that’s the way we've segmented the business. We are certainly getting great pull across those, and with the addition of the Extreme to the product-line, we are very seamless by the construction of what we've done from acceleration all the way through emulation. So, I really like our position there. We have got in a lot of great collaboration from customers and once again, the way that we do it is we set roadmaps and we try to execute to our roadmaps and if we do, then we are pretty confident that we are going to succeed in our goal. It's always a competitive analysis, but we are not looking over our shoulder at anybody. We are just setting our targets and trying to hit them. So, I guess that that would be my comment on those two areas.

Matt Petkun - D.A. Davidson and Company

Okay. And then I was wondering if Bill, maybe you guys could be any more specific in terms of how you are looking for competition plans, maybe to change next year, especially in the sales and marketing part of the business or if you feel like you guys are well positioned there in terms of how you are executing the plan. And maybe more specifically on this issue from just percentage of revenue basis, marketing and sales did not see a ton of leverage in the most recent quarter. So, I am wondering if you can kind of address that?

Bill Porter

Sure, Matt. I think the -- at the highest level, I think our plans are constructed very well, and so I don’t see any fundamental changes and how we've been constructing our compensation arrangements. So, I think that works well. I think what you saw quite frankly in the fourth quarter was we had such a strong business performance that the teams earned some very good incentive compensation, and as we were talking a little bit about the level of business, that is very well rewarded for a great performance both on the product side as well as on the delivery of it. So, generally, if you can take it for the year, I don't think it's that big, but I think you just saw the impact in the fourth quarter because it was a master quarter.

And my true sense is, I think we have demonstrated great scale on the sales, application engineering, and associated marketing. We've grown the business in my time a couple of hundred million dollars and not materially grown the size of the company. Those people men and women are working hard demonstrating and taking great productivity goals. We will talk about it at the Analyst Day, but it's something like 11% productivity in that channel and well I think we've got some more scale to go. So the fact that we are holding the line relatively on the number of employees in the company continue to grow the business, I think bodes very nicely to the kind of capability we have for scale.

Mike Fister

And Matt, I just would follow-on to that. Occasionally, I get a question well can the business continue to scale, passed the next target we have for 2007 of 38% operating margin, and I think it can one of the big reason as we do have great leverage in the channel as Mike was explaining. We are pretty well, where we need to be. We have great people in the field. So a lot of what we bring to the top line comes right down from a channel perspective.

Matt Petkun - D.A. Davidson and Company

Okay, great. And then just one more final question Bill. You had mentioned earlier the need perhaps to expand your working capital requirements next year. Can you be a little bit more specific in terms of what you might be funding?

Bill Porter

No Matt, I am not going to be more specific. I think as I said, we'll grow our cash flow from operations, but there is just some working capital that we just need to take care of. I think having something that’s at the 450 level is very good results, we are not seeing anyone in the industry putting anywhere near those kind of numbers. And so we are very happy with that and we will just continue to make progress growing it, but at a little bit of a slower pace.

Matt Petkun - D.A. Davidson and Company

Okay. Thanks a lot.

Bill Porter

Sure.

Operator

Your next question comes from Vishal Saluja with Seligman.

Vishal Saluja - Seligman

Hi, thanks for taking my question, and Bill great backlog number. I think you have conditioned us for a flattish backlog. So that’s nice to see. I just had a question on operating margins for '07 and beyond. I think you've mentioned that there was still room for improvement, but maybe you can just give us a sense of what level of improvement we can expect in '08 and beyond. So, that’s one. And then can you just walk us through the new convert structure in terms of when exactly does -- at what share price, does the convert become dilutive? Thanks and I have one follow-up.

Bill Porter

Sure Vishal. In terms of the operating margin progress, I think there having an increase of 300 basis points in '07 and then continuing to progress like that beyond into the next few years I think is very possible for us. I don’t see anything structural that would change that. So getting into the mid 30s over 2 to 3 years is something that I think is very possible. We will look to see as we are continuing to grow the business, particularly in the areas of the adjacencies. At some point maybe to make some trade off's between accelerating growth and margin expansion. And that would be the -- I think a nice trade off and we expect to have that trade off. But, I think for the next few years being able to expand margins 200 to 300 basis points beyond '07, I think it is a reasonable goal. We work hard at it, we do a lot of prioritization. But if we could see growth we will fund it even at the expense of maybe slowing down some of that growth and operating margin, but we do see the ability to get to the mid 30s as the next I think target range. And then in terms of the convertible, let me just take that one off, because I think that information is in the press release, but basically if you look throughout the $30 stock price, we start to get solutions. I don’t have the specifics with me right here.

Vishal Saluja - Seligman

Okay. And then last question just for Mike. You know the verification franchise has been the tailwind for overall growth. Can you just give us some sort of qualitative assessment of why you think that you can sustain that over the next 12 to 18 months?

Mike Fister

Well there is two simple reasons. One, it’s an expansion of the total universe that we participate in. Most simply characterized by appealing to people who are software designers or system designers, and its 10 to a 100 times more people who do that, and are the number of people who design chips in the world. Strange to say, but it's absolutely a fact. And I think that’s the goal and the leverage that we see with Kits and holism and all those kinds of fancy words that we use that are semi-technical I suppose. The second is that, companies that are specifying ITs have an exposure to even a supplier if they don’t get a very good molding in the minds on the specification, and that’s the process of verification and not validation. Validation is a semiconductor would have been proven in logic design for the chip goodness. So this verification becomes an architectural tenant and that’s why Bausch was such an interesting testimonial to last a couple of times last year to us. And it bodes very nicely for verticals like automotive or industrial applications.

And that holism makes that melding in my minds even more complete. I believe it’s got a lot of value embedded in it, certainly cement of what a broader customer relationships, sometimes I call it the customer, where a customer becomes valuable. And those combinations of things make it a very fruitful place to go put a lot of effort. So thing that is unique for us is that we bind that market drive to the implementation in the core digital, analog, packaging, very seamlessly until it makes the melding even more complete all the way down. And I think over time, we will demonstrate the manufacturability of its shift. And so I really don’t say this lightly as a philosopher. I say this with some experience because I haven’t done it for 20 something years in my life. And the resonance of that either with my or some of our collective experiences with the progressive customer is just I think a lot of reason for the tailwind. So we are going to keep going and I am anticipating some very nice results to show in the future.

Vishal Saluja - Seligman

Thank you.

Mike Fister

Yeah, sure.

Operator

This concludes the Cadence’s fourth quarter and fiscal year 2006 earnings conference call. Thank you for participating. You may now disconnect.

Bill Porter

Thanks operator.

Operator

Thank you.

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