Synopsys F1Q07 (Qtr End 1/31/07) Earnings Call Transcript

| About: Synopsys, Inc. (SNPS)
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Synopsys Inc. (NASDAQ:SNPS)

F1Q07 Earnings Call

February 21, 2007 5:00 pm ET

Executives

Aart de Geus - Chairman, CEO

Brian Beattie - CFO

Lisa Ewbank - VP, IR

Analysts

Harlan Sur - Morgan Stanley

Rich Valera - Needham & Company

Jay Vleeschhouwer - Merrill Lynch

Terence Whalen - Citigroup

Raj Seth - Cowen & Company

Matt Petkun - D.A. Davidson & Company

Mahesh Sanganeria - RBC Capital Markets

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to Synopsys Inc. Earnings Call for the First Quarter of Fiscal Year 2007. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions). Today's call will last one hour. Five minutes prior to the end of the call, I will announce the amount of time remaining in the conference. As a reminder, today's call is being recorded. At this time I would like to turn the conference over to Lisa Ewbank, Vice President of Investor Relations. Please go ahead.

Lisa Ewbank

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

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

In addition to any risks that we highlight during this call, important factors that may affect our future results are described in our annual report on Form 10-K for fiscal 2006 and in our first quarter fiscal year 2007 earnings release.

In addition, all financial information to be discussed on this conference call, as well as the reconciliation of the non-GAAP financial measures disclosed to their most directly comparable GAAP financial measures, can be found in our first quarter earnings release and financial supplement. All of these items are currently available on our website at Synopsys.com.

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

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Aart de Geus

Good afternoon. I am happy to report that after a very successful 2006, we continued our excellent execution with a strong first quarter of 2007. In Q1, we delivered excellent revenue and earnings growth, solid cash flow and strong business across the board. On the product side, momentum continued with technology advances, competitive wins, and customer adoptions.

Let me briefly summarize our financial highlights. Business was strong across all product lines. Revenue for the quarter was $300.2 million, a 15% increase over the same period last year. Non-GAAP expenses for the quarter came in at $247.1 million, well within our target range. We made excellent progress, on increasing our earnings power. Non-GAAP operating margin was 17.7% for the quarter, significantly strengthening our confidence in reaching our target of 20 plus percent during the second-half of the year. Non-GAAP earnings in Q1 were $0.30 per share, a 65% increase over the same period, last year.

The reason for our continued strong results stems from our clear focus in recent years. One, implementing the most predictable and transparent business model in the industry. Two, systematically growing a culture of cost management. Three, delivering important core products, around a well integrated set of platforms. And four, building strong positions in adjacent growth markets.

Starting with the operational efficiency of the company, let me highlight some specific improvements. We have streamlined many of our infrastructure operations, including outsourcing procurement and accounts payable. We have organized some of our field operations to serve our customers in a more cost effective way. We've increasingly started projects in low cost regions when appropriate, and we are systematically tuning our internal processes in search of additional cost efficiencies.

For the foreseeable future, we will keep expense growth of less than half the rate of revenue growth, to drive towards the post '07 objective of mid to high 20's operating margin. With cost control now clearly part of our culture, our focus has turned to revenue growth through technology innovation and new go-to-market strategies.

As a backdrop for our opportunities, let me give you a sense of the market environment. The semiconductor industry continues to evolve. The market feels quite solid, as consumer hunger for electronics continues unabated. Consumer demand creates many opportunities for our customers of course, but also tough technical and economic challenges. Take the latest mobile products; a phone now also contains a music player and a camera, and a video display and GPS and Wi-Fi access, all in a small package with a long battery life.

The challenges are tremendous, huge amounts of constantly increasing functionalities, top flow power requirements for mobile battery use and heat minimization, high cost sensitivity accelerated by demand in global markets and tight market windows demanding faultless product scheduling and delivery. These challenges are opportunities for Synopsys. We've always been leaders in optimizing speed, power and area, with our design and verification platforms.

Our design for manufacturing solutions, predictably and safely move designs into the complex phase of high volume manufacturing. Simultaneously, our IP and system tools, squarely attack the productivity challenges of very complex designs.

A good example of our differentiation success is Wolfson Microelectronics, a global leader in mixed-signal chips. After an extensive evaluation of competitive solution, Wolfson selected Synopsys for their high performance analog mixed-signal chip, because of our complete implementation, verification and IP Solution, which brings me to the products highlights for the quarter.

Starting with Core EDA; Galaxy, our implementation platform, had another strong quarter. The productivity benefits of an integrated platform are increasingly visible, as the three components of Galaxy, synthesis, physical design, and sign-off, melt seamlessly in to the highest performing digital design flow.

Nowhere is this more tangible, than with the number one design problem, low power. Synopsys today delivers the most complete solution on the market and our service and support chains are highly qualified to assist customers in advanced low power designs. As an example, Cypress Semiconductor used our complete integrated Galaxy Low Power Solution to tape-out the complex 3G/3.5G mobile phone chip.

One reason for our strong results is our continued commitment to technical innovation. In Design Compiler Ultra, for example, we have the industry's only topographical synthesis technology. It lets our synthesizer predict what the downstream physical design will look like, thus eliminating many costly design iterations.

As an example, FP has deployed DC Ultra in its 90 and 65 nanometer ASIC design flow, to speed up the design cycle for both its internal design groups and for external customers.

In Q1, DC Ultra won literally all benchmarks, resulting in multiple competitive displacements.

In physical design, IC Compiler had another excellent quarter as well. The product ramp is right on-track with evaluation, tape-out and production adoptions all increasing. Designers continued to report 40% to 50% faster time-to-result and 8% to 10% better quality of results. These statistics are compelling customers to choose Synopsys for physical design.

For example, after a detailed competitive review, Silicon Optix selected IC Compiler for its 90 nanometer video processor design. Progate, one of the largest design service providers in Taiwan used IC compilers to tape-out an advanced mobile communications chip ahead of schedule.

Let me now move to Discovery, our analog and digital verification platform, which also did very well. As we've highlighted for the past year, the demand for verification is exploding, as massive chip complexity requires faster and more comprehensive bug finding. We foresaw and in fact led the movement towards a speedier verification language, System Verilog. Simultaneously, we invested in a much faster verification solution, VCS, our core digital simulator.

We're now seeing the return on these investments, as VCS is driving excellent business for us. Renesas is a good example. It's one of the largest semiconductor companies in the world, focused on mobile, automotive and audio/visual markets. Renesas adopted VCS for its next generation of advanced chips, in networking, peripheral and consumer applications.

Demand for analog mixed-signal verification also continues to grow. Here too, we are innovating and Synopsys remains the clear choice for superior performance and productivity. As a result, we delivered another very strong quarter for analog mixed-signal verification.

Turning now to our high-growth adjacency, let's look first at design for manufacturing. The physics of smaller geometries, especially, in 65 and 45 nanometers are causing unavoidable problems. To guarantee good yield and thus good profitability for advanced products, DFM is now mandatory. Our investments in the recent years have put us in leadership position. We've grown strong positions on both the design and the manufacturing side and are now systematically linking the two.

We are the only company with true end-to-end visibility. We're deeply engaged with the design community, with the mask shops, the process development teams and with the fabs doing the manufacturing. By bringing data from the fab up into the design process, we can anticipate and mitigate potential manufacturing issues, during design, and thus improve the resulting yield.

On the design side of DFM, our new franchise sign-off solution, successfully modeled variability and manufacturing. We're now seeing the first real chips using a variation-aware PrimeTime VX.

PrimeYield, our integrated design-to-manufacturing solution, is moving through its maturation process and its connection to IC Compiler is driving business for both. For example, a large Japanese semiconductor company adopted PrimeYield for 65 nanometer, driven in large part by its link to IC Compiler.

On the manufacturing side, there's good progress as well. Customer reaction to our new process-aware DFM Solutions, has been excellent and our TCAD continues to perform very well. We displaced a competitor at a major foundry in China, as we consolidated their TCAD business on Synopsys.

On the lithography side, we won a key competitive benchmark on the 65 nanometer design due to better accuracy and speed. We're also seeing success with our new advanced 3D lithography simulation tools; in one case, displacing the competition at a large wireless chip supplier.

Moving up to our other adjacency system level design, our investments in IP are bearing fruit.

Today, Synopsys is the clear leader in analog and digital connectivity IP. Our products span all the key standards such as USB, wireless USB, PCI Express and others.

For our customers, make or buy decisions for IP are increasingly contemplated, as a time-to-market benefit, as well as the risk and cost advantages are more and more evident. Selection of an IP partner is based mainly on the performance and the quality of the available IP. Our years of systematic investments in very high quality IP, are now really paying off. Our analog USB cores for example, are in more than 200 million chips, primarily in consumer electronics.

Let me now turn to our key objectives going forward. One, we are continuing our strong operational cost management. Two, we are increasing our focus on technology innovation. And three, we are reenergizing our go-to-market approach with a clear objective of revenue growth.

Towards this end, we made substantial organizational changes last year, which we completed in Q1 with the appointment of Wolfgang Fichtner, as head of the Silicon Engineering Group. We now have five energized business groups with strong leaders, including a new analog mixed-signal business unit. We have centralized all marketing functions. We have combined the design services and support, and we have new sales leadership in place with a strong commitment to driving growth. Again, the uniquely high visibility business outlook and with renewed vitality in our team, our objectives for this year is to completely revisit our go-to-market strategy.

Clearly, we and the rest of the EDA industry are delivering essential value to our customers. With fresh thinking ranging from better advocacy to creative segmentation and packaging to innovative product development, our goal overtime is to increase the return that we get for the value we deliver. We look forward to sharing with you some details on our progress at our Investor Day in late March.

In conclusion, Q1 started 2007 with great execution. We delivered strong financial results in terms of revenue, earnings growth, solid cash flow and very good business across the board. We're seeing excellent technology in product momentum and we're making progress on our new initiatives to drive increased value.

With that, I'll turn the call over to Brian, who will provide for detail on the financials.

Brian Beattie

Well, thanks Aart. As a reminder, I'll be discussing certain GAAP and non-GAAP measures of our financial performance. We provided a full reconciliation of GAAP to non-GAAP results in the press release and financial supplement posted on our website. Q1 was another strong quarter for Synopsys. We continued to execute well against our financial targets and expand our earnings power. Revenue increased 15% year-over-year. Non-GAAP operating margin, rose almost 300 basis points sequentially to 17.7%. And earnings per share were $0.30, an increase of 65% over last year.

Now let me provide some additional details. As a reminder Q1 included an extra fiscal week that occurs every seven years. Total revenue was $300.2 million, up 6% sequentially and up 15% year-over-year. Compared to last year, core EDA, which composed of Galaxy Design and Discovery Verification, grew more than 12%. Our high growth adjacencies, DFM and IP, grew 27% and 39% respectively. Professional Services grew 8%. One customer accounted for more than 10% of our Q1 revenue. GAAP earnings per share were $0.16 in Q1 with costs and expenses totaling $280 million. This included $30 million of amortization of intangible assets and stock-based compensation.

Non-GAAP earnings per share were $0.30 in Q1 above our targets due to strong execution and the lower than expected tax rate. Non-GAAP expenses were $247.1 million, an expected increase, due mainly to the extra fiscal week. Excluding this extra week, our expenses would have been lower than Q4, of 2006. Non-GAAP operating margin increased 17.7% in Q1 and we're well on track to reaching 20% plus in the second half of this year.

The non-GAAP tax rate was 23% in Q1, eight percentage points lower than last quarter. Now about half of the draft was from optimizing our international operations and the remainder was due to a one time R&D tax credit. As a result, we are able to lower our annual tax-rate guidance as well.

We continue to have one of the most transparent and predictable business models in software. With 95% of Q1 product orders booked as time-based licenses and 5% booked as upfront. The average length of our renewable customer license commitments remained healthy at approximately three years.

Turning now to cash. Our operating cash flow was $56 million in Q1. Capital expenditures were $12 million in the quarter. Our cash and short-term investments increased $107 million sequentially to $680 million. This increase was driven by increased option exercises and in annual payment made by one large customer.

In Q1, we purchased 700,000 shares of our stock for $18 million and have approximately $219 million left on our authorization. Our diluted share count increased 6 million shares during Q1, primarily as a result of a higher stock price. Q1 net accounts receivable totaled $141 million and DSO's were 46 days well within our historical range.

Deferred revenue at the end of the quarter was $584 million and expected increase to the large annual payment that I just mentioned. And as we've seen in the last several years, we expect deferred revenues to decline through the year and this payment rolls in the revenue.

At the end of Q1, we had approximately 5,100 employees a slight drop sequentially. In a second quarter in a row we reduced our headcount, as we continue to tightly manage our resources. From a broader perspective we continue to drive cost control initiatives throughout the company.

As we mentioned last quarter we have outsourced our entire procure-to-pay function and off shored a number of IT functions as well. We have also begun studying virtually all of our policies, everything from travel to cell phones to consulting fees, all designs control expenses and you will have to reallocate those resources to drive our new growth initiatives.

Now for the guidance. For the second quarter of FY '07 our targets are revenue between $285 million and $295 million. Total GAAP costs and expenses between $255 million and $276 million, which includes approximately $16 million of stock compensation expense. Total non-GAAP costs and expenses between $230 million and $245 million. Other income and expense items between 0 and $5 million. A non-GAAP tax rate between 27% and 28%. Outstanding shares are expected to be between $145 million and $151 million. GAAP earnings of $0.11 to $0.17 per share and non-GAAP earnings of $0.26 to $0.29 per share.

We expect more than 90% of the quarter's revenue to come from backlog. For fiscal 2007, we're raising a bottom end of our revenue range with our new target between $1.185 billion and $1.205 billion. A non-GAAP tax rate between 26% and 27% an improvement of 200 basic points from our previous guidance due to the R&D tax credits we mentioned earlier. Outstanding shares between $145 million and $151 million. GAAP earnings per share between $0.64 and $0.77, which includes the impact of approximately $70 million of stock based compensation expense. We are increasing our non-GAAP earnings per share range by $0.03 with the new target of between $1.23 and $1.31.

We continue to expect to hold our non-GAAP expenses down to just a slight increase in FY ’07. Over the next four quarters we expect approximately $980 million of our beginning of quarter backlog to turn to revenues. We expect cash flow from operations to be greater than $275 million. In summary we continue to execute well in Q1. With strong results I am looking forward to the rest of the year. And with that I will turn it over to the operator for questions.

Question-and-Answer Session

Operator

Thank you, (Operator Instructions). And first we will go to the line of Harlan Sur of Morgan Stanley.

Harlan Sur - Morgan Stanley

Hi, good afternoon. Good job on the quarter, Aart despite a mixed environment for many of your customers I think the move to 65 nanometers appears to be in full force. And with many of these customers having a step up to R&D spend fairly significantly. First, can you just maybe update us on the number of 65 nanometer design starts and tape-outs you are track in the first quarter. And then secondly as it relates to the step up in the R&D spend I am seeing with your customers I am just wondering how much of that is related to EDA product spend in your view versus just larger design teams, higher mask tooling costs, etcetera?

Aart de Geus

Sure, first of all regarding the design tape-outs we continue to track those and so for 65, you are absolutely right. The numbers are growing now quite rapidly, we are tracking 373 active designs and 151 tape-outs so far. And by the way, we're seeing pretty rapid growth from 45 nanometers as well, with 47 active designs and several tape-outs. And so that's moving along just fine. You may have noticed also that a number of semiconductor vendors are literally looking at how to reallocate their R&D spending, because as some of them have decided to the more fab light, it's undoubtedly because they're now looking at differentiating more on the design side. And so I would not be surprised if we saw gradually the EDA portion grow, because after all EDA is what allows you to differentiate on the design side. My guess is that the entire EDA industry is already feeling some of that. We certainly did very well, based on being close to the leading-edge design.

Harlan Sur - Morgan Stanley

So Aart, sounds right, so you said 373 cumulative design starts?

Aart de Geus

Yeah. Active designs. We track all the active designs that go to --

Harlan Sur - Morgan Stanley

That's a big jump up from the previous quarter. I think a 30% jump up.

Aart de Geus

32% actually.

Harlan Sur - Morgan Stanley

Yeah. Okay. So activity is pretty robust, it seems like.

Aart de Geus

Yes, it is.

Harlan Sur - Morgan Stanley

My next question is, as the industry moves more towards the fabless business model, what is the longer term impact as it relates to your DFM business. The manufacturing base is clearly shrinking. I'm just wondering, does it have a positive, neutral or negative impact as it relates to the DFM opportunity in your view?

Aart de Geus

Well clearly, it's the realization that developing new technology is not an easy thing. And that will bring about more utilization of the DFM tools, especially at an age where the DFM simulation capabilities are now some of the economically rivaling well, what it would cost to go through experimentation. But in other words, anytime that you can take a process or a device and simulate it, rather than test and build it, you can save a lot of money. So that's good for us.

Secondly, I do think that we will see gradually a consolidation around certain number of centers of excellence that we already work with. But many of our customers are going to rely more and more on us to help them have a safe bridge into manufacturing, so to speak. But in other words, where we provide the mechanisms and the data coming from manufacturing that allows them to, if not predict, at a minimum, optimize the yield. And so in that sense I think we're very well anchored at that place.

Harlan Sur - Morgan Stanley

Okay, great Aart, thanks. And then one last question for you, Brian. I know that the team was still working on a few deals exiting Q4, so I guess did you close those deals and did you get the economics you were looking for in the first quarter?

Brian Beattie

Yeah, we did. There were a number of deals that were on the table at the end of the quarter. And those closed the first quarter or so in good shape.

Harlan Sur - Morgan Stanley

Great, all right. Thank you very much.

Aart de Geus

You're welcome.

Operator

Thank you. And next we'll go to the line of Rich Valera of Needham & Company.

Rich Valera - Needham & Company

Thank you, good afternoon. Aart, I was just wondering if you could talk about the competitive dynamics in the fast SPICE simulation market. I am sure you know Magma has a new product in that area. And it's an area that you're very strong in, through a couple of different product areas. Can you just talk about how you see that market in general and how significant it is, and if there is any change in the competitive landscape there?

Aart de Geus

Sure. Well, I think in general, verification has clearly grown more rapidly in terms of need, as anything else because it follows a sharper curve than Moore's Law. And that applies certainly also to the analog, and analog mixed-signal arena. I don't think that I've ever heard of Magma having anything in that area. I knew they had purchased something, I believe, but the main competitors really, are clearly Cadence and Mentor for us. But in verification, we do very, very well. And we see a broad set of applications ranging from the very high definition accuracy spikes, that solution all the way to the very fast spikes, all of those have been growing well for us. And our areas that we continue to invest in from an innovation point of view, so I would say that's an area to stay tuned on.

Rich Valera - Needham & Company

All right, and then just with respect to Galaxy, it had been pretty modest growth in the last couple of quarters of last year and it looks like you saw some decent year-over-year growth this quarter. Is that what you would expect of for the balance of the year you expect to see Galaxy continue to grow at a pretty decent clip as you get that IC Compiler rolling out over the course of the year?

Aart de Geus

Yes. We had said all along that IC Compiler had been doing pretty well. It takes time until you see that in the numbers when you have a multiyear business model. And of course at times it competes a little bit directly with our verification that often is bought at the same time that customers buy all of our core EDA tools. But IC Compiler having done very well, it will help Galaxy and I believe you're starting to see that through the numbers this year already higher than certainly last year.

Rich Valera - Needham & Company

Brian, how should we think about the longer term tax rate? Should we think about it more like your second quarter guided tax rate than your full-year tax rate here because you have hit that one-time R&D?

Brian Beattie

Yeah, that's right. Clearly the impact of the first quarter does translate the benefits for our full-year tax rate and that's what we've factored into our guidance. I think on an ongoing basis, we say that 27% to 28% for the second quarter is appropriate for us. And it should stay in that range over the next three years. Something in the next, the high 20s, let's say, is the range that we're going to be aiming at. That's really there as a result of the work we did in restructuring some of our international operations and also getting this R&D tax credit approved by the government at the end of 2006, I think was November. So that has allowed us to capture that impact for all of '06 and get factored into the Q1 numbers. So the overall year it's pretty significant improvement from that 32% that we saw effectively in place for all of 2006. So now it's a 4% or 5% improvement ongoing.

Rich Valera - Needham & Company

Great, one more just quick one if I could. With respect to the share count, you saw the big jump this quarter as the stock moved up. Assuming the stock was level let's say for the next quarter, would you expect to be in there buying shares and maybe bring that share count down a bit again back towards the mid 140s level?

Brian Beattie

Yeah. Rich, as I mentioned, the impact this quarter really was primarily related to the price. So therefore with our treasury stock method, we have more shares that we have more options that we count in that fully diluted basis. So going forward again, we are very committed to a buyback program. We've been very active with our buyback over the past few years, very high percentage of our cash flow being dedicated to that. So we're still committed to buybacks. Again we'll do what we can to minimize those shares outstanding and provide those return to shareholder that we expect.

Rich Valera - Needham & Company

Great, thank you.

Operator

Thank you. And next we'll go to the line of Jay Vleeschhouwer of Merrill lynch.

Jay Vleeschhouwer - Merrill Lynch

Thanks, good afternoon. Aart, could you elaborate on what you mean by fresh thinking about the go-to-market model and your focus on revenue growth? I guess the multipart question is. What do you think your organic growth can or should be? As backdrop, you've probably seen that we've calculated for the top three vendors in the group, Synopsys from 2000 to 2006 appears to have had the slowest compound average growth in book-ins in the low single digits. Your next 12-month revenue backlog was flat sequentially at 980, and according to your 10-K, your largest customer modestly reduced its spending with you, 2006 versus 2005. Maybe that's anomaly, given how big they are. I guess the point is, what, what kind of an uplift you think you can or should achieve given the last six years or so of average history?

Aart de Geus

Well, commenting on your editorial. Clearly, the objective for us is to take advantage of the, the positive news we see out of all of our technology investments. For the last four or five years we've made many changes to the Company. Obviously, the most profound one is the business model from the financial side, but from a technology point of view, we have not only invested in complete platforms and new tools within it, that I think are doing quite well right now. We've also broadened our position to adjacent markets. Much of that has been investment very much from the technology side. And we've realized that the value that we provide to many of our customers is quite substantial. And so that begs the question, can we do better in how we roll out these technologies going forward? And we have dedicated this year to try to reanalyze how do we do business? How can we be better at getting return for that? Now, in many of the areas that we have invested in, actually or business is up. And at the end of the day, the only metric of success is the revenue. And for this year, I think, so far we've done certainly very well and last year we did quite well. So I expect that we will be able to continue on that track.

Jay Vleeschhouwer - Merrill Lynch

Brian, could you comment on your book to bill in the quarter? Was it above one or below one?

Brian Beattie

Yes. We're not commenting on specifically in the quarter. It was a good quarter. We're very happy with the performance and the way that came through. Also, to clarify on your point of the next four quarters, we said we had $980 million of revenue already booked for the quarter. That also, as you must know, excludes that extra week we had in the first quarter, right. So, the number is the same but you really have an extra week in the first number, so the 980 does really represent a nice increase over the next four quarters, about 8% there. The other thing, again, keeping in mind our book to bill for 2007, we've already indicated that that will be a positive number and, therefore, you can see that the bookings are expected to be pretty strong with a nice growth on a year-over-year basis.

Jay Vleeschhouwer - Merrill Lynch

And then lastly, over the years, you've made obviously a number of acquisitions besides Avanti, Numerical and Silicon, what was left of Monterey and so forth, Vertio, any way you could describe the of return you think you've gotten in the aggregate, Aart, from all those various investments in terms of returns, market share, revenue, et cetera?

Aart de Geus

Sure, absolutely. I think many of these acquisitions made it possible for us to build strong positions in adjacent markets. And probably the best example of that is actually the DFM arena, because that's an area that has grown very rapidly, is very complex. And I think, today we have by far the most complete solution there in terms of touching all of the pieces and now having the opportunity to close the loop there. And of course on one hand, we want to maximally invest internally. At the same time, sometimes new technologies do emerge at other places and we're certainly not hesitant to use M&A as appropriate.

Jay Vleeschhouwer - Merrill Lynch

Thanks, Aart. Thanks, Brian.

Aart de Geus

You're welcome.

Operator

Thank you. And next we'll go to Terence Whalen of Citigroup.

Terence Whalen - Citigroup

Great. Thanks for taking my question. My question relates to; in December, we had a meeting, introducing new heads of sales in marketing. In that meeting you mentioned that you would take more of a portfolio oriented approach in managing product development. And I just wanted to know if there were any preliminary conclusions in doing that product portfolio analysis? And I have a follow-up?

Aart de Geus

Yes in many ways this also attaches a little bit to Jay's question of the whole go-to market approach. I think we're becoming increasingly sensitized that by looking at our own product portfolio, there are probably many ways to package and price things better. Roll them out more appropriately for certain segments that have specific needs. And potentially expand a little bit more away from not doing only the top ends, which we catered to very, very well, but gradually also to a little bit more of what some people would call the mainstream. So, all of these things are in fairly rapid evolution. It's a little bit one of those, once you put your attention to it, you learn more every time you look more. And in that sense, it feels like we're really changing the company.

I do think that it will take this year to become much more proficient on that, but it's a good time, because it's a time where the entire EDA industry has an opportunity to almost become more conscious of the value that it provides. And so that's a good time to rethink.

Terence Whalen - Citigroup

Thanks, Aart. And then I have a follow-up for Brian. Brian, you made some nice progress on the operating margin side this year. Clearly, the 20% for fiscal '07 for the second half looks very achievable. I was hoping a comment, looking beyond that, you have a goal of above 25% mid-to-high 20s. Is that goal for fiscal '08 specifically, or is it simply beyond fiscal '07? Thank you.

Brian Beattie

Yeah, you are welcome Terence. It is a target for us, which is our next target. So as you recall, we've set the greater than 20% earlier and we're on track for that as we mention in '07. And then for the targets for our next area, we'll be in the mid-to-high 20s that we set. So specifically, it's not 2008 targeted, something that's beyond '07, that's what the whole company is focused on driving for.

Terence Whalen - Citigroup

Great, thank you.

Operator

Thank you. And next we'll go to the line of Raj Seth of Cowen & Company.

Raj Seth - Cowen & Company

Hi, thanks, just a couple of quick ones. Aart, you've talked a lot about value, getting better value for products, etcetera. You seem to want to avoid the word price. I'm just curious if, do you feel like you're getting better pricing. Is pricing improving in this industry?

Aart de Geus

Yes, I think there's always price pressure because of course there is competition and they provide a lot of value as well. Maybe the reason that I like to emphasize the word value more than price is that if you only talk about price, you end up very quickly within a stuck budget, where the customer has one primary objective, which is lower is better. Whereas, if you talk about value, you can start thinking about what are all the things that we do that really increase the differentiation, could reduce their costs downstream, for example, could reduce their costs sideways in other groups, etcetera. And I'm just surprised myself that as we start to do this more and more, how little we've done of it in the past. And partially maybe it's because we're coming out of a long period of time, literally, multiple decades where just, faster tools, or slightly better tools was always the right next step. And I think right now, we should take a more economic look at how our customers can do well. And if we can engage with them on that basis, our opportunity, our tam, clearly can increase.

Raj Seth - Cowen & Company

A couple others if I might. You mentioned strength in 65 nanometer starts and tape-outs and then 45 was beginning. In general, is the infrastructure there for most of your customers to do design at 45 or is that another wave of investment that starts? And if so, when does that start for the mainstream?

Aart de Geus

Sure. Well, clearly, for most people, 45 nanometer is one bridge too far. And today, many people are just getting into 65. The fact that there's so many designs, means that those that really need it, and they tend to be people doing very advanced chips and chips that are very high volume. They have really race car driving designers. So, with the [rest] it follows a little later. So, 65 is really now the wave that is moving into production, I would say. 45 from my perspective is at least another 18 months out before you see broad production. But you can never generalize from the total to an individual customer, because some people really are trying to differentiate. And by the way, we're already engaged and working with a number of people at 32 nanometer. So there's a spread among the customers. But I would say the move from 90 to 65 is really where the bulk of the action is today.

Raj Seth - Cowen & Company

And so, if tape-outs start 18 months from now, you used a different word than tape-outs. But at 45 does that imply, given design cycles of around a year that within six, nine months, people need to begin to put in the capability to do design at 45, and that drives a little bit of a cycle in EDA or am I reading that wrong?

Aart de Geus

No, you're reading it right. What it means is that the people that will need it first already started about 6 months ago. And so we're already well involved with many, many libraries, with many, many design rules for 45 nanometer for quite a while. I think at the same time for those people that are aiming towards, let's say production in 18 months, they are really starting to become serious about it. I would say this summer and fall. And so you see, again, this spread out the most advanced people being always the ones that will also invest first in some of the technology-specific needs.

Raj Seth - Cowen & Company

Right. Last one for Brian. Brian, you've talked a little bit about buybacks, etcetera. How do you think about the appropriate capital structure for a company like this? Now that margins are getting back to where they've been, you're starting to gush cash. How much cash do you need to run a business like this? It doesn't seem like you'd need $600 million.

Brian Beattie

Yes, we continue to look at that and try to optimize our capital structure. It is very, very strong balance sheet right now, with no debt, with a very strong position on cash flows being generated. So we're in a very good position. I'd highlight as well, though, as I said, if you looked on a percentage of cash flow generated, we are one of the highest companies in the area related to the amount of buyback we do as a ratio to that amount of operating cash flow we generate. So we are already up there. And as you know, we bought $200 million worth of stock last year and that was over 10 million shares, which is more than twice the amount that we issued through the programs of option grants or stock units and so on. So that has been our approach over the last year and we continue to focus in on that. But, we're going to continue to look at all the different opportunities for us and positive use of that cash, whether it's for investments in our operations, our buyback is really strong, or whether that required for M&A, all of it again focused on how we can support the growth for the Company.

Raj Seth - Cowen & Company

Would you ever consider taking on some debt and buying back a lot of stock? Cadence has got, obviously a different structure here, where net cash is lower, and it seems to be a trend in a lot of companies, especially those that have cash generation profiles like yours. Is that something you'd ever consider, even more aggressive buybacks and maybe taking on some debt to do that, or no?

Brian Beattie

We, of course, are approached by a lot of people with the offering. There's a lot of capabilities available to do that. And all of those are at our use, and our discretion, if and when we decide to use it. So I think we're in pretty good shape. We'll continue to valuate those best uses of our cash.

Raj Seth - Cowen & Company

Thanks, appreciate it.

Brian Beattie

All right.

Operator

Thank you. And next we'll go to the line of Matt Petkun of D.A. Davidson & Company. Please go ahead.

Matt Petkun - D.A. Davidson & Company

Hi there, Aart. Just as a follow-on to your conversation with Raj, about the transition to 45 and what you're seeing at 65, would it be fair to say, our is it perhaps too soon to say that the transition from 65 to 45 should be a little bit easier than the transition from 90 to 65 has been?

Aart de Geus

I don't think so. I think that the transition from 90 to 65, although challenging, went reasonably well, and as a matter of fact, we've even seen some customers go straight from 130 to 65 because they really like what they heard about 65. I think 45 is a different kettle of fish. I think, now we're talking about the geometries that have a lot of physical side effects that have high degree of valuability, and it remains to be seen exactly what the power issues are going to be. You may have heard that there's been some interesting new announcements around new materials to reduce leakage. But these announcements on top of what is already a very big leakage problem. And so, I think that 45 will be quite challenging. But the good news is now we have already taped out the chips so, as usual, so far, we're the enabler to Moore's Law.

Matt Petkun - D.A. Davidson & Company

Okay. And then, of on your earlier comments, and another caller asked about the payback that you've been getting in M&A. How successful do you think the M&A in your IP business has been in terms of return on investment? And we've seen a little bit of a flatline in that line item over the last couple of quarters. Should we expect more M&A to fuel future growth in that business? Do you need to achieve more critical mass? Or do you feel pretty comfortable where you are in that business?

Aart de Geus

So, I think that our IP strategy actually has been very successful including a number of small acquisitions that we have done there. Because we've been able to systematically bring these acquisitions up in terms of the quality. Most of these companies that sell IP fail all on the same thing, which is they sell very cheap something that's of poor quality and the customer pays a momentous price afterwards. We have really changed that. So today, we've been able to build the second largest IP business behind ARM, which is of course very specialized on processor cores. And I think that this position will be very valuable to keep growing with. As a matter of fact, over a longer period of time, we actually have seen our IP grow quite well.

Matt Petkun - D.A. Davidson & Company

How successful do you think, I know ARMs a partner but, how successful do you think they've been with their physical library?

Aart de Geus

Well, it added an angle to their business that was really beyond what the processors had done. They've been able to focus on a few areas, especially by the way, working with Synopsys on low power, specifically, that have been quite interesting. It's not for me to comment, really, on their sub-businesses, overall ARM is very strong partner of Synopsys and the company that we certainly admire for what they've been able to do overall.

Matt Petkun - D.A. Davidson & Company

Okay. And then last question, Brian, just of looking at your guidance for next quarter, it implies of at the midpoint a flattish operating margin. Maybe a little bit down but relatively flattish. I'm wondering, which line items you might expect to see a reduction in expenses in? Should we see R&D flattish or down on an absolute basis, or is there going to be more leverage in sales and marketing?

Brian Beattie

I'd characterize when you take all the elements of our Q2 guidance into alignment that you've got to recognize that there's one week less of revenues, one week less of expenses. And as a result, you might see a little bit of downward pressure from Q1 just associated with that extra week in the accounting process.

Matt Petkun - D.A. Davidson & Company

You don't get a week less of revenue?

Brian Beattie

You do, yes. A week less revenue and a week less of expenses than the first quarter. So, considering revenues are greater than expenses that generally translates into a little bit lower guidance that we provided for Q2. We're seeing 26 to 29 compared to the 30 that we did in the first quarter. That's only related to the week. If you really look at the expenses, and get into the details of it, taking into that account, the mid point of our expense range is quite a bit lower than the first quarter. So, therefore, you see the impact of all these programs that we're talking about relative to getting that cost down and keeping the expenses tight. And continuing on track to be greater than 20% operating margin in the second half of this year.

Matt Petkun - D.A. Davidson & Company

Okay. Thank you.

Brian Beattie

Okay.

Operator

Thank you. (Operator Instructions). And next we'll go to the line of Mahesh Sanganeria of RBC Capital Market.

Mahesh Sanganeria - RBC Capital Markets

Thank you. Just to follow up on that operating margin question. Sir, would you be able to get 20% operating margin by keeping the expenses flat for to second half or do you have to cut the costs to get to the 20% operating margin or better than 20%?

Brian Beattie

Yes, I'd say again, our impact on spending in 2007, we're holding everything to a very slight increase compared to 2006. And that's even with this extra week if you want to be picky as an extra 2% of spending on a year-over-year basis. So we're keeping it very tight year-to-year. And of course then when you combine that with the revenue growth that we provided for guidance, obviously, drive revenue up, drive costs down, all of it drives it's greater than 20% margin very significant impact on a year-over-year basis.

Mahesh Sanganeria - RBC Capital Markets

And then the question for Aart, in your IP strategy, are you considering any to enter into the new market in the connectivity arena like HDMI for the consumer product? Is that something we should look to?

Aart de Geus

We are always looking at all of the new markets as they appear. And it's invariably slightly tricky question to know exactly when to jump and when not. Because, on one hand you want a standard to be sufficiently standard so that we can actually sell many copies. On the other hand, you want to be early enough to be the chosen one that can really grow the position first. And so, I think at this point of time we have a pretty well honed engine of continually looking at a portfolio of IP that we have plus the portfolio of potential IP, and then invest just in time, so to speak, to make sure that we have very high quality IP. And that is really the most important consideration. And so as an example of that, last year we diagnosed that there was a high likelihood that wireless USB was going to be important, and yes, indeed, I think it's starting to now really appear and the interest is growing, and we're employees with both the digital analog side with a high quality solution. So that's how we go about it. So absolutely portfolio approach.

Mahesh Sanganeria - RBC Capital Markets

But can you give me some more insight into how do you think about HDMI, because it's so widely adopted and it's pretty much of that in any consumer applications. So, is that something you think you will enter soon? Any color you can provide, that would be helpful?

Aart de Geus

This is one of those situations where I wish you ask me a question on synthesis because I'm a lot more confident on that than our IP direction. For more detailed questions on some of those IP maybe we can connect you with the people working on it. I don't think that we have any announcements on HDMI at this point in time, but I concur with you that the whole, the whole video area is of very high interest going forward.

Mahesh Sanganeria - RBC Capital Markets

So, let me ask, give it a try on the synthesis side. Not a technical question. Just, how are you using your market share in synthesis to win verification market? Is that something, are you able to put some hooks into your synthesis platform, that enables your verification platform, or that motivates the customer to choose your verification platform as opposed to your competitions platform?

Aart de Geus

Well, let me give you a good example. We have been certainly one of the key leaders in bringing about System Verilog on the market. And we have to realize more and more that, as much as one can have a great solution around the language or so, unless one has a complete solution, the customers really even more stock, like introducing a great new car and the only thing that is still missing are the tires. You still have nothing to drive in. And this is true throughout EDA, meaning that, if you want to drive a leading solution, you need to be able to go through all of the tools. And so System Verilog was a good example where the initial need came absolutely from the verification side. But customers were somewhat reluctant until it was also really good synthesis, really good form of verification for it, et cetera. Of course we have that today. And I think that is a good example where the sideway leverage is very much by providing a really reliable and complete solution. Power is a good other example of that. The unified power format is now well entrenched, and these are the type of thing that really bring all the tools together, in many cases also from multiple vendors. And we certainly are very much driving open standards around these things.

Mahesh Sanganeria - RBC Capital Markets

Okay. Thank you very much.

Aart de Geus

You're welcome.

Operator

Thank you. And we have a follow-up from the line of Terence Whalen of Citigroup.

Terence Whalen - Citigroup

Thanks, I have two quick product related questions. The first, there's a competitive offering to PrimeTime out in the market now, and was wondering if you had seen that at all competitively, and if you would like to comment on what you're seeing there?

Aart de Geus

Well there have always been many timing verifiers, and many different tools use different things. At the same time, at the end of the day, there's a gold standard against which you make sure that your chip actually will work. And so, in technology just as in everything else, it's all about trust, and so PrimeTime is clearly the tool that is trusted to verify the timing of the chips. And by the way, PrimeTime itself is evolving continually at a very, very rapid pace, where today already we have variation aware capabilities in it, for example. So, from that perspective, I don't think things have changed much in the last decade. There will continually be other products seeking to do the same, and our objective and job is to make sure that we have the best product.

Terence Whalen - Citigroup

Great. And then a quick follow-up, Aart, to your comment on the common power format. I think a competitor of yours surprised people by rather quickly integrating their CPS into their digital design, is common power format actually integrated into your digital tools now, and what's a timeline that we can expect for that?

Aart de Geus

We're actually talking about unified power formats, and there are many tools that are being aligned on that including many tools outside of Synopsys. This is a much broader industry coalition that is working in that direction, which is necessary. Because one should not underestimate the amount of work that people have to do that put together libraries, for example. And one should not underestimate the necessity to have a vary degree of accuracy and be able to measure things. So from that perspective, the success of all of these things, and this is not any different than library formats many years ago or language standards, such as system analog, they are often predicated on the success of many people to work really well together.

Terence Whalen - Citigroup

Thank you.

Aart de Geus

You're welcome.

Operator

Thank you. And we have no further questions at this time. Speakers, I'll turn it back to you.

Aart de Geus

In that case, we appreciate your time spent with us. We think that we just concluded a very strong quarter and that we are well set for this year. As usual, Brian and team are available for questions after the earnings call. And we hope you have a good rest of the day, bye-bye.

Operator

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

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