Mentor Graphics' CEO Discusses Q1 2012 Results - Earnings Call Transcript

Transcripts

Mentor Graphics (MENT) Q1 2012 Earnings Call May 27, 2011 8:30 AM ET

Executives

Gregory Hinckley - President, Chief Operating Officer, Chief Financial Officer, Principal Accounting Officer and Executive Director
Joseph Reinhart -
Walden Rhines - Chairman of the Board and Chief Executive Officer

Analysts

Saket Kalia - JP Morgan Chase & Co
Paul Thomas - Roth Capital Partners LLC
Thomas Diffely - D.A. Davidson & Co.
Richard Valera - Needham & Company, LLC
Jay Vleeschhouwer - Merrill Lynch

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Q1 earnings release for Mentor Graphics. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Joe Reinhart. Please go ahead.

Joseph Reinhart

Thank you, Greg, and good morning, everyone. Welcome to Mentor Graphics Fiscal First Quarter 2012 Conference Call. I'm Joe Reinhart, Director of Investor Relations and Corporate Development at Mentor Graphics. This morning, Walden Rhines, CEO and Chairman, will open with a discussion of key trends in our business. Greg Hinckley, our President, will then provide some 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 the actual results to vary. In addition to factors noted later, these risk factors can be found in our most recent 10-K, 10-Q and annual report. For a reconciliation from GAAP to non-GAAP measures used in this presentation, please refer to today's financial release. This information is available online at the Mentor website.

Wally?

Walden Rhines

Thanks, Joe. Well, fiscal Q1 2012 set an all-time Mentor revenue record for our first quarter at $230 million, the 10th consecutive quarter that Mentor has met or exceeded guidance. Revenue grew 27% versus last year. Growth of bookings from the contract renewals among our 10 largest orders grew 35% in annualized run rate. This 35% growth in run rate exceeded our very high average of 25% for all of last year and 25% for the first quarter of last year. Overall bookings grew more than 5%.

We continue to have confidence in our revenue and profit growth for the year, and we're very close to the 45%/55% distribution of revenue in the first versus the second half of the year that we previously forecasted.

Traditional leading indicators were positive. New customers, not including our PADS business, which almost always provides large numbers of new customers, grew 20% in number and 40% in dollars. And services bookings grew 85% versus the same quarter last year.

Our strategy is to focus on the areas where we can be number 1. Last year, 87% of our revenue came from products where we already have the number 1 market share or are the primary contender for the number 1 position. This strategy requires us to focus on one or more or more of the following 3 approaches: number 1, building upon product positions where we already have the number 1 market share; number 2, being prepared for technical discontinuities that require major architectural changes in existing tools and therefore, may displace an incumbent de facto design tool; and number three, being first with new and emerging technologies or the application of EDA to new problems or to customers who haven't previously used EDA.

The strength this quarter came from the first and the third approaches. System Applications, where Mentor already has a #1 market share position and totally new applications of EDA, provided most of the growth, although helped by bookings growth of 15% in our Scalable Verification segment. Weakness in the physical verification part of our Design-to-Silicon segment, where we also have the #1 position, was caused by the lumpiness of major contract renewals, which this year, will be concentrated in the latter part of the year. We expect a strong second half for this business.

As seen last year, the Integrated System Design continues to be a highlight, with 45% growth in bookings this quarter after a year of 40% growth last year, growing from our already-strong #1 position. Our very profitable PCB business now represents 50% market share for last year, as reported by the EDA Market Statistics. New and emerging products grew almost as fast as Integrated System Design, with 40% year-over-year growth in bookings. These products are examples of the third strategic approach I mentioned. The Capital Wiring Harness product line is an example of the application of EDA to totally new markets like automotive and aerospace. Electronic system level design is an emerging technology for traditional chip and system design, and embedded software is a non-traditional market for EDA where application of our technology brings new or improved capabilities. All 3 of these areas grew strongly in the quarter.

The third strategic approach of bringing EDA capabilities to the automotive and aerospace industries continues to provide growth with new applications and totally new customers. Capital family bookings for electrical system and wire harness tools were particularly strong during the quarter as they were last year.

As we develop these new applications and customers, we also have the opportunity to achieve #1 positions in emerging specialties within the application areas. Examples of these specialties include: one, electrical systems for trucks, where many of the leading OEMs use Mentor's Capital products. Examples include Daimler Truck Group, where initial deployments at Mercedes-Benz and Mitsubishi Fuso are now spreading to multiple sites globally. Paccar, where production orders have just been received. Isuzu in Japan, Foton in China, Eicher in India and Iveco in Europe. Number two, Chinese transportation companies where 9 automotive companies, including 3 of the 4 largest, and 7 aircraft manufacturers, have chosen Mentor's automotive wirings or networking products. Another specialty application of EDA within system design has been Mentor's thermal analysis tools, where we have the largest market share by quite a large margin. Once again, the strategy of growing an existing #1 market position has proved very productive. This past quarter, our newest FloTHERM product was 1 of 2 design products that won Design News Magazine's Golden Mousetrap Award for the year. New applications continued to emerge in this business, driving about a 35% growth rate. New business deals contributed 75% of our thermal analysis bookings.

The number of new customers nearly doubled versus last year. One of the fastest-growing parts of this business is the family of products used for thermal analysis of light emitting diodes. This business grew 50% and it is riding the wave of growth of LEDs for lighting applications, helped by regulatory requirements that have set deadlines for the use of incandescent lighting.

Finally, following our strategy of applying EDA technology to new problems with new users, our sustained investment in embedded software is showing strong results in the quarter, growing 55%. Mentor's System Analyzer product won the Best of Show product award at this year's Embedded Systems Conference.

Building upon the base of Nucleus, which has the largest number of copies in use of any embedded realtime operating system, the Development Tools business has shown excellent strength. This strength is driven by the challenges of developing and debugging multi-core embedded applications, the growth of applications for cost-effective 32-bit microcontrollers in the move of semiconductor companies like Freescale and NetLogic to provide Mentor products to their users as their preferred provider for embedded software tools for their new microprocessors.

In summary, Q1 of fiscal 2012 set a Mentor all-time revenue and non-GAAP earnings-per-share record for Q1. Growth of the annualized run rate of our top renewals was exceptionally strong at 35%. Leading indicators, such as new customers and service bookings, were also strong.

Now at the May 12 Shareholder Meeting, 3 new directors were added to the Mentor Graphics Board: Jose Maria Alapont, Gary Meyers and David Schechter. Since the Shareholder Meeting, we've had one telephonic Board call and have confident of the Board's commitment to field value for all of our shareholders. Consistent with past practices, we will not discuss specifics of Board deliberations.

Greg?

Gregory Hinckley

Thanks, Wally. I'll start with a overview. Given what Mentor had for scheduled renewals to work with in the first quarter, results were meaningfully stronger than were provided in our guidance on February 24. Recall our discussion for the first quarter fiscal year 2011. I then said that in a strong renewal quarter such as a typical third or fourth quarter, scheduled renewals could represent as much as 2/3 of forecasted bookings and that in a weak scheduled renewal quarter, as typical in our first and second quarters, these can represent as little as 10% of forecasted bookings. This Q1 was pretty typical of a first quarter. That said, bookings were up about 20% from what was embedded in our guidance and more than 5% ahead of last year. Revenue was up 27% to a record $230 million, $5 million ahead of guidance. Non-GAAP EPS was $0.20 compared to guidance of $0.15 and the prior-year loss of $0.02. Approximately 60% of year-on-year incremental revenue growth fell through to operating income, which, as a percentage of total revenues, reached 14%, well ahead of the 11% that was embedded in our guidance.

With revenue up 27% and headcount up only 0.8%, operating expenses were up less than 5%, and all of that increase was either Valor or currency-related. SG&A non-GAAP, net of the front-line credit, was 40.3% of revenues compared to 50.7% last year. R&D was 29.5% of revenues compared to 34.2% last year. We are making progress in reducing our sales and administrative costs through targeted programs affecting headcount, commission structure and facilities. We remain committed to delivering value to our shareholders.

Now for more detail. Bookings were up more than 5% from the first quarter of last year with PacRim, Europe and Japan up 15%, 5% and 5%, respectively and North America flat to last year. Services, including consulting and training, increased 85%. This growth is driven in part by our recent acquisitions of Embedded Alley and CodeSourcery. By product category, Integrated Systems Design, which includes our Printed Circuit Board and Field Programmable Gate Array [FPGA] Design businesses, grew 45%. New and emerging, which includes our embedded software and our automotive- and transportation-related products, grew 40%. And scalable verification, where we include our simulation and emulation tools, were up 15%. Design-to-Silicon, as expected, lacking meaningful renewals, fell down 45%.

Bookings were 40% term, 20% subscription and 40%

[Audio Gap]

identical to last year. Strong perpetual bookings are evidence of the strength of our emulation product line. Book-to-bill was less than 1.0% as we shipped backlog booked in the prior quarter. Top 10 customers were 45% of bookings compared to 50% the prior year. Average deal length for these customers was approximately 3 years. Average value of term renewals, as Wally mentioned, was up 35%, well ahead of the 25% we reported last year.

Revenue mix by geography was 40% for North America and 20% for each of Europe, PacRim and Japan. Support revenue was up more than 5%, with reinstatements up strongly. Support declines, however, increased for the first time since early calendar 2009. Base business, which is turns business less than $1 million, was also soft, growing only 1%. But I note encouragingly that Base business is up 12% in count and 38% in value through the first 4 weeks of this second quarter. Currency, principally the yen, was favorable to revenue by about $3 million. Gross margin non-GAAP was 84%, down 1.6% from the prior year, reflecting a much higher proportion of emulation shipments in the quarter's revenue mix.

OpEx non-GAAP declined to 69.8% of revenues from 84.8% of revenues last year. Currency was unfavorable to expenses by about $2.5 million. Interest expense non-GAAP was $4.8 million, up from $4.3 million last quarter, resulting from interest overlapping on both the 6.25% and 4% debentures during the 20-day call period. Interest expense GAAP was $17.4 million, which included not only non-GAAP interest expense, but accelerated amortization of debt discount and issuance costs for the 6.25% debentures, as well as a $3.5 million call premium. Special charges were $4.5 million, including $3 million for proxy advisors and $1.5 million arising from employee and facility cost reduction initiatives. Our non-GAAP tax provision remained at 17%.

Now onto the balance sheet and cash flow.

Cash and equivalents decreased $17 million to $116 million at quarter end. Operating cash flow for Q1 was a $9 million outflow, due largely as a result of commissions and variable compensation payments for last year. Trade accounts receivable was $139 million, down $15 million sequentially. The decrease in trade accounts receivable is due to normal first quarter collections and improvements in past due receivables. Short-term unbilled receivables were $182 million, down $11 million sequentially. Trade DSOs, or days sales outstanding, were 54 days, an increase of 9 days from last quarter and 11 days since last year. Total DSOs were 126 days, an increase of 24 days from year-end and an increase of 4 days from last year.

The quality of receivables remains excellent, with no receivables greater than 60 days outstanding. Factored receivables were $12 million in the first quarter compared to $16 million last year. Capital expenditures were $6 million for the first quarter compared to $10 million last quarter and $8 million last year. Depreciation and amortization was $8 million for the first quarter 2012, the same as last quarter and last year.

Now for guidance. Last quarter in Q&A during our conference call, I volunteered that our revenue split for the year would be about 45%/55% for the first half and second half. Historically, we run that range between 43% and 46%. Consensus among the analysts is now 46%. Our guidance today, based upon a detailed look at our opportunities, suggests the year to be slightly more back ended than we had earlier predicted. In this case, a 44%/56% split. That said, we are forecasting revenue up 12% for the second quarter to a total of $210 million. Currency, weakness of the dollar and strength of the euro and the pound are again pressuring our operating expenses. We forecast non-GAAP OpEx to be up about 7% from a year ago, with 75% of that increase in OpEx currency-related. SG&A will grow around 4%, again, almost all currency-related, and R&D will grow about 12%. Second quarter non-GAAP operating margin will be about 4.5%, up from 2.4% last year. EPS non-GAAP, we expect to be $0.05 compared to $0.01 last year. And again, thankfully, the euro is weakening. For the entire year, we are raising guidance revenue by $4 million to a total of $1,004,000,000, and EPS to $1.01.

Second quarter cash flow from operations is expected to be approximately $25 million. For fiscal year 2012, we expect cash flow from operations to be about $100 million, up from $82 million in fiscal year '11. Capital expenditures for fiscal year '12 are projected to be on the order of $50 million as we make investments to consolidate our IT infrastructure. Once complete, this is expected to yield solid operating savings over a number of years.

Wally?

Walden Rhines

Thanks, Greg. The first quarter was an all-time record in revenue and non-GAAP earnings for our first quarter. Strength in our Integrated System Design in our New and Emerging segments provided the momentum. Leading indicators are strong, and we're confident in our plan, which we are raising modestly to $1.004 billion of revenue and $1.01 of non-GAAP earnings per share.

Let's take some questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Paul Thomas from Bank of America.

Paul Thomas - Roth Capital Partners LLC

Maybe first off on the 2Q guidance, just so I understand, it's basically just lumpiness in renewals and there's no change in Emulation and New and Emerging products, those should still be accelerating from 1Q to 2Q or is there anything else going on there?

Gregory Hinckley

There's absolutely nothing going on. We have a pattern of our business where we have a much larger proportion of our renewals in the second half of the year than we do in the first half. We typically have 10% of our opportunities in the first quarter, 10% in the second quarter and then we have the third and fourth representing 80% of the Renewal business. We can balance off some of that occasionally with strong bookings in the fourth quarter, which leads the backlog that we then ship early through the first and the second quarter. But the renewal opportunities are much dampened in the first and second quarter. I pointed out the growth of the renewals that we had to work with was what we thought was strong, and we were pleased with that, up 35%. Our Emulation business, as I mentioned, was strong during the first quarter. Our New and Emerging business was up 40%. All that is very good, Paul.

Paul Thomas - Roth Capital Partners LLC

Okay, and thanks for that. Because I guess one of your competitors mentioned some competitive displacement going on, on physical verification last quarter, so have you seen any change in the competitive environment there?

Walden Rhines

No. As a matter of fact we've actually seen the reverse. We have some long-term holdouts who seemed to be finally coming around. So I'd say, from a customer pervasion point of view, Calibre is getting stronger, not weaker.

Paul Thomas - Roth Capital Partners LLC

Okay. Maybe one last thing on the expenses in fiscal 1Q. Your operating margin, 14%, was a couple of points better, and you talked about expense reductions, a couple of other items on the last call that you guys were going to enact on travel and IT. How much of that was affected in 1Q?

Gregory Hinckley

We had that programs as expected. The single biggest thing is that the leverage on incremental revenue in our business is really pretty impressive. So on the $5 million of incremental revenue, we gave guidance, you recall, Paul, of $225 million. We passed through more than 80% of incremental revenues through incremental earnings. So we have a very fixed cost in the short-term cost structure.

Operator

Your next question comes from the line of Rich Valera from Needham & Company.

Richard Valera - Needham & Company, LLC

Greg, I was just trying to reconcile the comments that it sounds like bookings were actually 20% ahead of plan, but yet it sounds like the year is slightly more back-half weighted than we would have expected. What is it that changed in your outlook, given you actually had better-than-expected bookings, which led you to that somewhat more back-half weighted outlook?

Gregory Hinckley

We didn't view it as a change in outlook. So I said at the last quarter that the split would be about 45%/55% this year, and we're getting more linear. Prior year was like 40%/60%. We are now forecasting 44%/56%, which I think is pretty close to 45%/55% and if anything, maybe there's a lesson here that I need to be more precise in communication. I can assure you it has nothing to do with the strength in the business. As said, the first quarter, second quarter, we have limited renewals. With the limited renewals that we had, we had strong growth on. And so we had bookings up 20%, not ahead of plan, but really ahead of forecast. And we booked, actually pretty similar to what was even better than our plan. It was just when we start going down through the very detailed account-by-account, geography-by-geography of the sales force as we put together the guidance for the subsequent quarter, we get more detail.

Richard Valera - Needham & Company, LLC

Okay, fair enough. On Calibre Design-to-Silicon, sounds like you expected a soft quarter. But can you talk about your thoughts for the year for Calibre? Do you expect that, that business would grow in bookings this year?

Walden Rhines

Yes, Rich, this is Wally. The renewal profile is heavily loaded in the third and especially the fourth quarter. So when you look at total year, answer is yes, modest growth.

Richard Valera - Needham & Company, LLC

Great. And then just want to get an update on Emulation. Obviously, you guys had very strong Emulation bookings in the second half of last year that drove a strong first quarter on the revenue front. Can you talk about the demand for Emulation and how has bookings been in the first quarter and thus far in the second quarter for Emulation?

Walden Rhines

So as we had last year very strong emulation, we had a strong number as well this year. It appears that what's happening is actually a broadening of the potential customer base. The explanation we've attached is as we talk to people, there as they get the larger and more complex single chips, they need to do a final full chip verification and simply can't do it with Simulation anymore. So people who used to get by with the Simulation for full chip verification now are acquiring Emulation, and they're doing it even for the large blocks in their design. So I'd expect that to be a trend to continue. And the other thing is, we have a lot of software developers who work on the emulator doing the debug of the embedded software. And with our strong base in embedded software development tools, that's been a plus in making the job easier for those people.

Richard Valera - Needham & Company, LLC

I just wanted to clarify, did you suggest that Emulation bookings were strong in the first quarter?

Gregory Hinckley

Absolutely, and that's continuing into the second quarter.

Richard Valera - Needham & Company, LLC

Excellent. And one final one if I could. Wally, in your remarks, I think you mentioned that two of your leading indicators were actually a bit weak; I think it was maintenance renewals and turns business. Could you just comment on that a little bit more and tell us why you don't think we should be concerned about that?

Walden Rhines

Well, the ones that we use as leading indicators are new customers and service bookings. And the reason is that if you look at the business cycle, when things turn down, then you stop seeing the new customers coming in and people start pulling work inside to use their own employees to avoid redundancies in the employment. And as you come out, the way they buffer that is to use outside services, and the small companies that are usually cash-strapped, start buying and that contributes a share of the new customer bookings. On the other side...

Gregory Hinckley

Actually, maintenance reinstatements, Rich, were up strongly. What we had for the first time in several years was we had more customers declining maintenance, then it's the first time we'd seen growth in that since really somewhere around 2008, 2009. The reinstatements were stronger, so I’d describe that as a mixed effect. The fact that our base business, million-dollar deals, that book and bill in the same quarter were soft in the first quarter. Early indication in the second quarter is they're moving along smartly. But it's a little more mixed than it was during portions of the more strong recovery last year and into the first, but things are still looking pretty decent.

Operator

Your next question comes from the line of Jay Vleeschhouwer from Griffin Securities.

Jay Vleeschhouwer - Merrill Lynch

First, like to ask if you are expecting a positive book-to-bill for the year as whole in terms of product bookings, and then ask follow-up questions.

Gregory Hinckley

We're not expecting a positive book-to-bill, Jay, for the entire year.

Jay Vleeschhouwer - Merrill Lynch

Okay. In terms of product profitability, would it be fair to say that the large majority of profitability comes from both Calibre and PCB business together and the remaining products have far less contribution to profitability?

Gregory Hinckley

You can say that. So what we end up with, it is, historically, that the product lines where we had the highest market share are among the most profitable. We've made the statements in the past that as market share goes up after you have leading market share, that profitability goes up exponentially. So a product category, for example, which is much smaller than either our PCB, our Calibre product, is our DFT product, which is highly profitable. So the PCB is very profitable, Calibre's very profitable and we have others.

Jay Vleeschhouwer - Merrill Lynch

So when you look at the rest of this year and into next year, could you say or rank which of the smaller or emerging categories you think might become most incrementally profitable for you?

Gregory Hinckley

No, I won't do that, Jay.

Jay Vleeschhouwer - Merrill Lynch

All right. Going back to the point about Calibre bookings, Rich asked about this is, I'd like to ask about it as well. I understand the point about timing of renewals. But you mentioned that bookings in Design-to-Silicon were down 45%. In the year ago quarter, bookings have been down 35%, so it wasn't a particularly difficult comparison. And in dollar terms, correct me if my math is wrong, looks like Q1 in absolute dollars for DTS bookings was the lowest quarter in 5 years, not just first quarter, but any quarter and you're expecting, however, that there's going to be a steep ramp in bookings for the remainder of the year to give you what you call, "the modest growth" in that area for the year.

Gregory Hinckley

So I'll just add, Jay that your arithmetic is very precise, and then I'll let Wally explain why we think things are fine.

Walden Rhines

So it's absolutely right, Jay. First quarter of last year was weak as well due to lack of significant renewals. We only had 2 renewals in that quarter, and they were not extremely large ones. One of the trends here is when the resolution enhancement deals renew, and they tend to be larger single events than the general Calibre renewals that are quite broad and cover a wide range of customers and companies. But the major dynamic you're seeing here, now that we're approaching close to 1,000 different company logos that are buying Calibre, the chance that somebody comes in who has never bought Calibre before and isn't doing a renewal gets less and less. And so it's a more and more renewal-dependent business, and you can simply see by looking at which quarter renewals come in, you can pretty well look at the profile. And so I view it as one of the more predicable parts of our business, and that's how I get the prediction that says third and fourth quarter would be quite strong.

Gregory Hinckley

And we're looking at -- it's when we move to a new process note, so the last one was the kind of 40, sub-40 nanometer process node. To the extent that people are announcing sub-30, there is requirements to upgrade physical verification, RET and DFM, and so all that's coming up shortly. So we're expecting really strong results, Jay.

Jay Vleeschhouwer - Merrill Lynch

Okay. And then just to finish up with more of a broad market question. For Wally, could you talk about your business and your outlook in terms of the major category by customer type? First, in terms of what's left of the IDMs, maybe talk about some of the recent genetic engineering, let's call it, that’s taken place among some of the companies, the fabless customer base and then finally, the foundries.

Walden Rhines

Well, we don't break it out that way. But I think we sort of track the general health of the EDA industry. The IDMs are still a very meaningful part of the business, partly because IDMs include a lot of memory companies that, they’re process-sensitive and use resolution enhancement software, but also because if you look at market shares, despite combinations that have occurred in the industry, the actual market share of the top 5, top 10, top 100 has actually continued to decline, so we still have new companies coming into the business. Fabless startups are down. They've picked up a little in terms of the number, and of course, most of those fabless startups have to buy at least Calibre and many of them become candidates for our simulation products as well. And then the other miscellaneous categories of foundries and others have been particularly healthy this past year. And while the number has decreased, the magnitude of what we do with the leaders has increased as well. So I don't know if that addresses what you're looking for or not.

Operator

Your next question comes from the line of Tom Diffely from D.A. Davidson.