Synopsys F2Q07 (Qtr End 4/30/07) Earnings Call Transcript

May.23.07 | About: Synopsys, Inc. (SNPS)
TRANSCRIPT SPONSOR
Cornerstone OnDemand Logo
Click to enlarge

Synopsys, Inc. (NASDAQ:SNPS)

F2Q07 Earnings Call

May 23, 2007 5:00 pm ET

Executives

Lisa Ewbank - VP of IR

Aart de Geus - Chairman & CEO

Brian Beattie - CFO

Analysts

Harlan Sur - Morgan Stanley

Rich Valera - Needham & Company

Raj Seth - Cowen & Company

Jay Vleeschhouwer - Merrill Lynch

Terence Whalen - Citigroup

Dennis Wassung - Canaccord Adam

Matt Petkun - D.A. Davidson & Company

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to Synopsys Incorporated Earnings Conference Call for the Second Quarter Of Fiscal Year 2007. At this time, all participants are in a listen-only mode. Later we'll conduct a question-and-answer session and instructions will be given at that time (Operator Instructions).

As a reminder, today's call is being recorded. At this time, I'd like to turn the conference over to Lisa Ewbank, Vice President of Investor Relations. Please go ahead.

Lisa Ewbank

Thank you, Pamela. 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 as of today, 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, our quarterly report on Form 10-Q for our first fiscal quarter, and in our earnings release for the second quarter.

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

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

TRANSCRIPT SPONSOR

Cornerstone OnDemand Logo

Want to understand the future of human resources software?

Cornerstone OnDemand is the leading provider of SaaS solutions for integrated talent management, covering the human capital life cycle from hire to retire.

We offer over 30,000 online training titles and performance tools for compliance and analytics to help companies maximize workforce productivity and achieve organizational excellence.

Learn about talent management and our industry leading products for learning management, corporate social networking, onboarding, compensation, compliance, employee performance management and succession planning at CornerstoneOndemand.com.

To sponsor a Seeking Alpha transcript click here.

Click to enlarge

Aart de Geus

Good afternoon. I'm pleased to report that Synopsys had another very strong quarter, which further solidifies our outlook for the fiscal year. We continued our excellent business execution with strong revenue and earnings growth, solid cash flow, and our very predictable business model.

In technology, we see momentum. With new product introductions and customer adopting our complete platforms. We also continue to evolve our go-to-market approach for value capture and simultaneously invest in future growth.

Let me begin with some financial highlights. In Q2, we delivered excellent earnings growth. Non-GAAP earnings were $0.35 per share, more than double the same period last year. As a result, we are raising our earnings guidance for the year. Revenue in the quarter grew 7% year-over-year to $293 million. We managed costs well. Non-GAAP expenses were $229 million.

Our plan is to take a portion of these savings and invest in growth initiatives while holding total expenses for the year to a slight increase as we had planned. With our revenue and expense performance, we met our 2007 operating margin target ahead of schedule. It was 22% in Q2. We anticipate the full year operating margin to be approximately 20% as we drive towards our mid to high 20s target over the coming years.

Before delving into technology highlights, let me comment on the overall semiconductor landscape. Interacting with our customers we see a broad spectrum of challenges and expectations. Whereas some companies are doing very well, with solid results and expectations, others are reporting tappet results. While it's difficult predict short-term fluctuations, we are optimistic about the industry's long-term growth prospect.

Technology drivers, such as, VoIP, Internet video and consumer electronics in general, all provide a solid basis for sustained growth in semiconductors. Our view is supported by continued growth in advance design starts, driven by the demand for complex multi-faceted consumer devices. In fact, in the last six months, the active 65-nanometer designs we track have increased more than 50% to 441.

Even at 45-nanometer, we already track more than 50 designs and 9 tape-outs, virtually all relying heavily on Synopsys. The migration to 65 and 45 nanometer is visible, not only in logic SoC design, but in the memory sector, as well.

At the same time, customer budget pressures are intense. Technology development and capacity costs are making customers rethink how they differentiate. Recent announcements show a shift by some IDMs to a fab-lite business model. Some are also forming manufacturing consortium as a way to share costs.

Synopsys is well positioned to help customer meet their new requirements. During Q2, we saw a number of companies increase their commitment to Synopsys. In fact, we expect business for the year to be stronger than our initial plan.

STMicroelectronics, who present a great example of how we help customers, solved the competing challenges of extremely demanding technology with the need to minimize the cost of high volume. In fact, ST achieved first silicon success for a complex 65-nanometer consumer chip by using Synopsys throughout the entire flow, from IP, to implementation, to verification and final signoff.

Complex chips especially benefit from using our complete flow. Only powerful integrated platforms can truly tackle the maze of interrelated design objectives. Our investments in these kinds of platforms over the last few years are paying off.

This brings me to the product highlights for the quarter. Let me begin with our Galaxy implementation platform. Galaxy integrates the industry's de-facto standards in both synthesis and sign-off with state of the art physical design.

In synthesis where we have a clear market lead, our new topographical technology is having major impact. It has an uncanny ability to accurately predict and avoid downstream place and route issues. This capability, which I like to refer to as Clairvoyant synthesis, substantially reduces costly physical iterations.

Design Compiler topographical is not only consistently winning benchmarks, but customers, such as Hisilicon and Cypress Semiconductor are seeing great improvement in correlation and performance.

STMicroelectronics is adopting DC topographical in their 90 and 65 nanometer ASIC design flow for both internal design groups and external customers.

In physical design, IC Compiler is performing well. Our upgrade ramp is right on track, with more than 100 engagements, and many tape-outs and active designs all the way down to 45-nanometer. As an example, after carefully evaluating all options Renesas chose IC compiler for their production IC design flow. Our product had better quality results through multi-mode optimization, much faster turnaround time, and overall ease of use.

In sign-off, we continue to enhance our gold standard technology by integrating features, such as, low power and variation aware design. Fujitsu standardized on PrimeTime and Star-RCXT as their sign-off solution for their 65-nanometer design flows.

Meanwhile, Synopsys is the leader in advanced low power designs. Thanks to a comprehensive end-to-end solution that optimizes for powering every phase of the design flow. In Q2, Synopsys and ARM announced an IT compiler base joint flow for high performance low power applications on advance design.

Another key challenge at the most advanced technology nodes is yield. The latest consumer products are all built on the latest technology nodes. Companies are forced to quickly ramp production of hundreds of thousands or even millions of devices to satisfy channel demands.

Fortunately, we anticipated this a number of years ago, and began to assemble key technologies in both the design and the manufacturing domains. We have integrated the two domains to enhance yield at 65-nanometer and especially at 45-nanometer and below.

Today, our design for manufacturing strategy is bearing fruit with DFM revenue growing in the double digits. Our first integrated product was PrimeYield, which links data directly from the fab into the designs.

During Q2, we announced several technology advances; ease of use and performance enhancements to PrimeYield, a single user interface for physical verification PrimeYield, Mask Synthesis and TCAD, and we linked our Proteus lithography technology with our mask data prep. This linkage reduces run time by 20-30%.

During the quarter, we also announced the availability of an advanced Hercules physical verification suite. This suite supports the latest release of 65-nanometer design kits from IBM.

Now to discovery, our verification platform, which is also doing very well. A number of years ago, we made four predictions; one, verification needs would grow faster than Moore's Law; two, next generation verification and debugging had to be broader, more integrated and faster; three, support for the System Verilog language would be key; and four, smaller geometries would bring a greater need for analog and analog/mixed-signal verification.

We systematically developed our technology around these predictions. Our recent business successes with double digit growth are evidence of our vision and our momentum. In digital, the rapid migration to System Verilog supported by the raw speed advantage of our verification solution accentuates our differentiation.

Today, Synopsys is by far the leader in System Verilog Solutions. In analog/mixed-signal, we've had great technical end market progress, as well. In Q2, we introduced AMS 2007, which allows users to easily balance accuracy and performance. Past solutions were either more accurate, such as, HSPICE or faster, such as, NanoSim and HSIM. With our new technology, customers can have both. In addition, with AMS 2007, we improved the links between our analog and VCS based digital verification.

Moving now up to systems and IP. We've had good momentum as well. This adjacency is growing at about 20%. We're both participating in and benefiting from a rapidly evolving IP industry, as more and more large customers are outsourcing their IP needs.

Internally developed IP, unless it is highly differentiated, is no longer economically viable. Instead, companies, such as, Synopsys become the partners of choice, especially in standard space IP. The keys to the IP business are reused competence, quality, and long-term trust in the supplier. We do well on all three count and have spent years developing a strong portfolio. Today, we are one of the top IP companies in the world and number one in the connectivity IP with standards such as USB and PCI Express.

Over the past several quarters, our analog connectivity IP has been especially successful. In fact, we were recognized this quarter by Analog Zone, a premier source of information for design engineers as having "The Best Connectivity IP." We received this recognition for our analog mixed signal IP course for the PCI Express, SATA and XAUI standards.

Against this backdrop of excellent financial results and technology momentum, we are tuning our go-to-market approach to capture more value for what we provide. That includes expanding our products and focus to better address new markets, such as, mature technology nodes of 130-nanometer and above. Connecting better to customers by segmenting their needs, and offering them solutions optimized for those needs, and improving our communication of the value we deliver to customers.

As part of our strategy, we just introduced a new product. IC Compiler Express targeted to the more mature technology nodes. We have long been viewed as the leader for the most complex designs. We believe this new target will expand our addressable market. IC Compiler Express is currently in limited availability, and we already have our first customers.

In addition, we are refining our sales approach to demonstrate the value of our complete platforms, and get fair compensation for the critical role we play in getting chips to market on spec and on time.

To wrap up, all around us we see encouraging indicators of momentum. Synopsys won the prestigious IBM Beacon Award for "its complete EDA solution that supports and complements our advanced process technologies, and enables our clients to meet their manufacturing needs." It was the first Beacon Award ever for the IBM Samsung chartered Common Platform ecosystem.

In the first half of the year, we are seeing record attendance at our User Group Meetings across the globe. In fact, we have to move our San Jose venue to accommodate more than 1,500 engineers, a 20% increase over 2006.

Finally, our expertise in advanced designs and DFM is cementing Synopsys as the trusted advisor while semiconductor companies tackle the intricacies of migrating to 45 nanometer designs.

Summarizing Q2, it was all about strong execution. We delivered strong earnings growth and cash flow, and we are moving into the second half of the year with greater confidence in executing our plans and commitments.

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

Brian Beattie

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

Q2 was another quarter of solid execution for Synopsys with strong revenue, earnings and cash flow. More than two years ago, we committed to improving our operating margin to greater than 20% during fiscal 2007.

In Q2, we've reached that goal ahead of schedule, achieving 22% operating margin, a sequential increase of more than 400 basis points. While some of these increases are due to timing of expenses, I'm nonetheless extremely pleased with our expense discipline and our ability to meet this operating margin objective early.

Let me now provide some additional detail on our financials. As a reminder, our fiscal first quarter included an extra week that occurs every seven years; Q2 obviously did not include that extra week.

Total revenue was $293 million, up 7% year-over-year and down slightly compared to Q1 as expected due to that extra week last quarter. One customer accounted for more than 10% of our Q2 revenue.

GAAP earnings per share were $0.28 in Q2 with costs and expenses totaling $255.6 million. This included a $26.2 million amortization of intangible assets and stock-based compensation. Also included in our GAAP earnings is $12.5 million of other income related to the legal settlement with Magma.

Non-GAAP earnings per share were $0.35 in Q2, above our target and more than double the same period last year. This overachievement is due to both the timing of expenses through the year and a very good expense and tax management. As a result, we are raising our annual earnings guidance.

Continuing with expenses, non-GAAP expenses were $228.6 million for the quarter, a sequential decrease of 7%. R&D was $85.3 million, sales and marketing $75 million and G&A came in at $20.3 million, all of which were down sequentially. This was mainly due to the extra fiscal week last quarter as well as normal quarterly expense fluctuations.

However, as Aart mentioned, we also had some expense savings in Q2, which we will be able to reinvest in targeted business initiatives while keeping our annual expense target unchanged at a very modest 2% to 3% growth. As a result, our non-GAAP operating margin increased to 22% in Q2.

For the full year, we now expect our operating margin to be approximately 20%, an increase of about 600 basis points over last year. As expenses fluctuate from quarter-to-quarter, we expect our operating margin to dip a little in Q3 and then increase again in Q4.

The non-GAAP tax rate was 24.1% in Q2, reflecting our restructuring of international operations and resulting in an improvement to our annual tax rate for FY '07.

Turning now to bookings, 93% of Q2 product orders were booked as time based licenses with only 7% upfront. We continue to have one of the most transparent and predictable business models in software.

The average length of our renewable customer license commitments in Q2 was 2.6 years, which is within our historical range. Regionally, Asia Pacific had the strongest quarter, thanks to excellent execution from the team.

Turning now to cash. Cash and short-term investments increased $88 million sequentially to $768 million. Our operating cash flow was also $88 million in Q2, which includes $12.5 million related to the settlement with Magma.

In Q2, capital expenditures were $13 million and we repurchased 2.4 million shares of our stock for $63 million. As we announced during the quarter, our Board increased our buyback authorization to $500 million.

Our diluted share count increased slightly to 150 million shares due to a combination of higher stock price and the timing of share issuance and buybacks. Q2 net accounts receivable totaled $167 million and DSOs were 52 days, which is within our historical range. Deferred revenue at the end of the quarter was $606 million.

At the end of Q2, we had approximately 5,100 employees, a slight drop sequentially and the third quarter in a row in a row we reduced our head count. On a year-over-year basis, our head count is flat, as we have offset acquisitions and growth in low-cost regions with reductions in some of the higher cost areas.

For the third quarter of FY '07 our targets are: revenue between $295 million and $305 million. Total GAAP costs and expenses between $268 million and $284 million, which includes approximately $16 million of stock compensation expense. Total non-GAAP costs and expenses between $243 million and $253 million, an increase due to timing of expenses through the year.

Other income and expense between $3 million and $6 million, a non-GAAP tax rate between 26% and 27%, outstanding shares between 146 million and 151 million, GAAP earnings of $0.13 to $0.20 per share, and non-GAAP earnings of $0.28 to$0.31 per share, and we expect more than 90% of the quarter's revenue to come from backlog.

Now looking at the total year of 2007, we're raising the bottom end of our revenue range with our new target between $1.19 billion and $1.205 billion, non-GAAP expenses to be between 2% to 3% higher than FY '06, on a non-GAAP tax rate between 25% and 26%, an improvement of 6 to 7 points over last year.

Outstanding shares between 146 million and 151 million, GAAP earnings per share between $0.78 and $0.89, which includes the impact of approximately $69 million in stock-based compensation expense, non-GAAP earnings per share of $1.27 to $1.33. We've increased the low end of our guidance range by $0.04 and the top end by $0.02, and this of course is up from $0.77 in 2006.

Operating margin for the year of approximately 20% and over the next four quarters, we expect approximately $970 million of our beginning of quarter backlog to turn to revenue. We expect cash flow from operations to be greater than $275 million.

And with that, I'll turn the call over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) First we'll go to the line of Harlan Sur with Morgan Stanley.

Harlan Sur - Morgan Stanley

Hi, good afternoon. Good job on the quarter. Aart, first question for you. I know you started off by providing us with an update on 65 and 45 nanometer design starts. Still pretty strong, I think it was up about 18% sequentially for 65. Can you also give us the 65-nanometer tape-outs you tracked in Q2?

Aart de Geus

Sure. 194 tape-outs for Q2. And yeah, I think it is up quite strongly. As a matter of fact, we of course have also the data for 90 nanometer. And it tracks; it's virtually identical to 90-nanometer delayed by eight quarters. And 45 is identical again delayed by eight quarters. So far the advance nodes are moving along just fine.

Harlan Sur - Morgan Stanley

Great. And the environment for your customers as you mentioned in your opening remarks as well, continues to be mixed and in some cases fairly challenging. So is the team seeing any signs of softness out there within your customer base as it relates to tool spend?

Aart de Geus

I don't think so. I think that people are cautious because it's a turbulent sea. At the same time, its a little bit winners’ take-all type of market where you have to bet otherwise you can't play. And so the advance designs demands a lot of tools, a lot of technology, and that's of course where we are primarily in and advance designs by definition is part of the winners' crew.

In general, though, I think we'll see some up and downs for some of the customers. And we will be careful to invest especially in those people that we see as winners.

Harlan Sur - Morgan Stanley

Okay. Great. And on the Galaxy platform, there's been, recently there have been a few very high visibility bake-offs or evals for physical implementation at 65 or below. And I think Synopsys and competitors are right now involved in a pretty big bake-off as one of the biggest founders of semi companies in the world. So question for you, Aart, is how has IC Compiler faired in some of these recent evals?

Aart de Geus

Well, IC Compiler is doing great right now. I'm not sure which eval you're referring to, but in general we never comment on individual customers anyway. Their evals is sort of this continuing effort. And frankly there are a number of customers that sometime call an eval just finishing their chip. And more often than not, we've seen that somebody has had challenges in getting closure with a competitor and then under the guidance of an eval, they ask us. Hey. So what can you do?

Harlan Sur - Morgan Stanley

Right.

Aart de Geus

We partially like those, partially feel that it's a little bit overusing our good will. But what is always clear though, is that the most difficult chips we can finish and we are finishing many, especially the ones where there is a combination of timing challenges and low power. And that's absolutely where our strength is.

Harlan Sur - Morgan Stanley

Okay. Great. And quick question for you, Brian; nice job on the team for controlling expenses in Q2, but for Q3, the expenses are growing at twice the rate versus revenues. Then it does look like op margins will probably drop below 20% as you said. So maybe a little bit more color from the team in terms of, I think you mentioned investments in growth initiatives. What sort of programs are we talking about here?

Brian Beattie

Well, I put all of that in context of good expense management through the quarter. And leading into Q3 and the rest of the year, our total year guidance as we said is with revenues growing in the range of 8.5% to 10%. We committed pretty early on to limiting the growth for all of '07 to 2% to 3%. And in fact, to highlight that point, 2% of that is due to the extra week we have in 2007, compared to last year.

So you've got to look at us holding expenses flat for the year while driving up the revenue growth of 8% to 10%. You're going to get some fluctuations from one quarter to the next, just based on timing of expenses, how they come through and their profile for the quarter. So I'd really kind of focus on the trends and the expense management to show our continued focus on the op margin improvements.

Harlan Sur - Morgan Stanley

Okay. And just any color on growth initiatives maybe from either you or Aart?

Aart de Geus

Well the growth initiatives are, well, I think the main focus for is clearly been that putting together tools in more coherent flows and platforms is absolutely starting to pay off. And so as we can illustrate to customers that by using a more complete solution from Synopsys, they cannot only significantly reduce their time to market risk, but in many situations get better results. That is a great way of moving us forward from a business perspective.

The other thing that we're doing in this tuning of our sales force to the market is to get a much better understanding of what are really the key concerns of the customers. And although very often they formulated as technical concerns, very, often it is business concerns and business direction. And that ties to my earlier comment of seeing fairly choppy waters in the semiconductor market. And the more we can be responsive to the needs of those customers as they decide where to go, the better.

Harlan Sur - Morgan Stanley

Okay. Great. Thank you very much.

Aart de Geus

You're welcome.

Operator

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

Rich Valera - Needham & Company

Thank you Aart. Good afternoon, gentlemen. Aart, in your prepared remarks, you referred to a new analog mixed signal product, which I think you said combined sort of the best of HSPICE NanoSim, sort of the accuracy of HSPICE with the speed of. NanoSim. Can you go into a little more detail on that product? Is that a combination of these two products? Or is that a completely new product?

Aart de Geus

Val it good its right you've highlighted. Because my comments were rather simplified compared to the technology on need base. What we're referring to here is what we call the XA option to a number of tools that allows them to dial up or down accuracy versus speed in a much more continuum fashion, between the HSPICE we won, which is very, very precise, to the NanoSim or HSIM, which is very, very fast.

And a number of customers have always had this wish of well, you know, I would be willing to give up a little bit on accuracy if I could just get a lot more speed. And being able to navigate that space in a continuous fashion is what this capability offers. And we have decided to offer it as an additional option to these existing products because that's the best way to get a quick return on the value that we provide.

Rich Valera - Needham & Company

So, it is actually sort of both products essentially, and you have a way of sort of seamlessly switching between the two to trade off speed and accuracy?

Aart de Geus

Yeah, it is more set of algorithm that have been implemented in those products and allow one of the products to take over a couple more capabilities of the another that’s maybe the best way of thinking about it.

Rich Valera - Needham & Company

Understood. And Aart, you mentioned that IC Compiler was doing well and that Galaxy was, but that segment was only up about a 1% year-over-year it looks like, which is pretty modest growth relative to the rest of your business.

Should we expect that to, you know, I thought sort of once IC Compiler got sort of going on the upgrade cycle that we might see better growth out of that. Is this just sort of a lumpy quarter? And should we expect to see that growing at a higher rate for the balance of the year?

Aart de Geus

Well, two comments. First, you're correct about the quarter, although, if you look at the trailing 12 months, it's already pretty excess. And the other thing is if you look core EDA, which actually combines with the verification, it's about 9.5 or so percent. So the reason I'm saying that is because very often in the larger deals, the products tradeoff within a pool of technology.

And at times that makes our own general managers unhappy because who deserves the credit and it's not always completely to reveal to allocate in those polls. However, all in all, IC Compiler's are actually doing very well. And we also see that by the rate of adoption in production and the still very high degree of support. I think most of our physical support has now entirely switched from DC Ultra to IC Compiler.

Rich Valera - Needham & Company

Is the modest revenue growth to do with pricing? Is the pricing continuing to be quite aggressive in the digital implementation area?

Aart de Geus

I think that pricing in any form of large deals will absolutely stay aggressive. That is precisely one of the reasons, of course, why we're investing in adjacency that leverage off of the core EDA. Although core EDA this year is doing better than it was in the last few years and largely due to the fact of having both technology, strength and implementation, IC Compiler but also synthesis and Synopsys and a very strong verification offering.

So I think that's the way to look at it is that core EDA tends to be more linked to the existing budgets of the customer migrating gradually whereas all of the adjacencies are our opportunity to sell on top of those budgets.

Rich Valera - Needham & Company

Okay. Just one final one, if I could. You guys nicely provide this metric of bookings turning to revenue over the next 12 months and that had been sort of going up for several quarters and it sort of flattened and actually ticked down for this quarter. Is there anything to read into that metric?

Aart de Geus

No. As a matter of fact, the thing to understand is that as we are completely or right at the end of our move to a ratable model, you sort of get the gradual balance between the two. And secondly, I think we'll see reasonably large fluctuations quarter-to-quarter just as a function of what’s the, deals are that come in the second quarter.

Let's assume you have some very large deal. Well for the next six to eight to ten quarters after that by definition, the bookings ratio will be down. And that is just fine as long as we our run rate with these accounts. And that is really the thing that we’re focusing on. And I'm absolutely on the side that one should not pay too much attention to the bookings number, much more to how we grow the revenue over time.

Rich Valera - Needham & Company

Fair enough. Thank you very much.

Aart de Geus

You're welcome.

Operator

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

Raj Seth - Cowen & Company

Hi, thank you. I just had one quick one. Brian, you've got just under 800 million in cash. You talked about buyback being refilled this last quarter. I'm curious when you think about this business, how much cash do you need to run the business? And if you might think about, it certainly seems like have the opportunity to more aggressively buyback and still leave plenty of cash on the balance sheet given the cash generation characteristics here. How do you think about that? Cadence is obviously is a little bit more levered up? Is that something you would consider? How does the thought process work?

Aart de Geus

Yeah, I think, we're in really good shape in terms of the cash flow. It's just a critical asset to the company and getting close to 800 million it’s an excellent credit to all of the hard work we put into it.

We're always looking at the capital structure to determine how we can best use the cash, which of course includes M&A activities, the buyback levels, which we recently increased to bring that back up to $500 million. So, it shows that we plan to be aggressive and I think the Q2 activity also reflects that we were aggressive in the second quarter spending that amount back buying back our stock.

Another part is again looking at funding the ongoing operations. Also you look at where the cash is, how much is in the U.S. and how much is internationally and balance that to the overall use of those same things. Is M&A going to be local? Is it going to be offshore? And how do we leverage up the cash assets?

So continue to look at all those, so we have been aggressive, we continue to be one of the largest in the industry in terms of using our cash flow to acquire our stock back. And of course all the operations focuses on continuing to drive good strong cash inflow to the company. We're holding our commitment at bringing in more than 275 million of cash this year. So it's really a good focus and continues to buy those assets.

Raj Seth - Cowen & Company

So, Brian, do you think you need this level of cash, obviously you're spending a lot of what you generate, but this level of cash would seem to be even despite the commentary on potential M&A etcetera, would seem to be in excess of what you need to run this business. Do you disagree?

Brian Beattie

Well, I'd say it's a real strong position. It's way more than the minimum amount of cash you need to just get by. But again having that flexibility to invest in M&A in the right opportunities new growth initiatives inside the company, I think are an excellent asset for the to give you that level of flexibility and timing to invest when you need to.

Raj Seth - Cowen & Company

Any update on the pending IRS dispute? You're not holding cash for that potential outcome are you? And when would you expect a resolution?

Brian Beattie

Yeah, we're have had, again, as you know this takes quite a while getting addressed, but we have had some movement over this past quarter and that the appeals process began in April. And we don't believe there'll be a settlement of that during FY07, but in our initial meetings, I think both sides feel good about moving fairly quickly to a positive conclusion for everybody. So again, the cash is not related to the tax issue, we believe we're adequately provided for on that basis in any case.

Raj Seth - Cowen & Company

Okay. Thanks very much.

Brian Beattie

Okay.

Operator

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

Jay Vleeschhouwer - Merrill Lynch

Thanks. Aart, I'd like to follow-up on an initiative you mentioned at the analyst meeting in which you did again today. Let's call it run rate compiler. And could you be a little more specific as to the early results you're seeing as to the focus on run rate? And the ways you're going to be able to substantiate that is in fact occurring that you're growing the business organically as you're aiming to do?

Aart de Geus

Well, there's only one substantiation, which is called the revenue and our job is to keep growing revenue. Actually, I would argue our job is more importantly to keep growing earnings. And so obviously the earnings can grow by both growing the revenue or improving the ops margin. Right now we're doing both.

I think the fact that we are a bit ahead on our ops margin is very positive, because it allows us to put some of that into the earnings, some into investments for future growth. Having said that, when you have a ratable business model, it's fairly complex to compute how the deals impact the long-term outlook, but I think we're well on top of that.

And quarter-by-quarter we're absolutely tracking how we are growing the run rate with individual accounts where transactions are done. And by the way, our sales this year more compensated for that than they were in previous years. And so, all of these things are heading in the right direction.

Jay Vleeschhouwer - Merrill Lynch

Given the comment you just made about ops margins being at least as important as revenue growth. And when you tie that into the concept of run rate, is the profitability by customer at all a meaningful or a measurable part of the business?

Aart de Geus

I think that's an excellent question, because I think it is meaningful, it is partially measurable, and it is an opportunity for us over time to improve our operations. I don't want to give the impression that today that is something that is managed very, very precisely.

However, I think we are increasingly aware that, if we could improve the profitability by customer that that is yet another opportunity to improve our overall business operating model or to achieve other things with customers. And so, I think it's a good question for which I hope that in the next few quarters I'll have a gradually better and better answer because we're definitely looking at that.

Jay Vleeschhouwer - Merrill Lynch

Okay. Brian, you mentioned the duration was only 2.6 years. And you're right, that is within the range we've seen, but it is nevertheless the lowest in three years. Was there something anomalous in the quarter that resulted in it being at least somewhat lower than we've seen in the last 10-12 quarters?

Brian Beattie

Yeah, Jay, I wouldn't read anything into any of the trends. It does fluctuate from quarter-to-quarter. In particular this quarter, we had a couple of our deals had a shorter term to them than some of the other quarters than we've had. So it came in at 2.6 and anticipate for the rest of the year it gets up again. It was just based on the mix of the actual orders closed in the quarter. So

Jay Vleeschhouwer - Merrill Lynch

Okay.

Brian Beattie

I wouldn't read anything else into it.

Jay Vleeschhouwer - Merrill Lynch

Lastly, Aart, you highlighted consumer electronics a number of times. Could you talk about what your positioning is for other important or incrementally important verticals? Wireless, of course it could ties into your AMS comments. But automotive, imaging, other sorts of technology sectors where the electronics demand seem to be accelerating, as well?

Aart de Geus

Well, sure it's interesting you mention wireless, because some people would now readily put wireless in the consumer segment, right, given that how powerful the cell phone is and how much the cell phone is becoming sort of the ultimate communication, play machine and everything.

At the same time, it is clear that in a number of other segments we are doing well, memory would be a good other example that in the past we didn't pay as much attention to, automotive has been an okay segment for us. It is not our primary focus because it tends to be very analog mixed signal centric, where we have strong simulation and some very good system tools. But it's not our center of gravity.

The type of segmentation that we prefer is segmentation that goes by very fundamental need. And the fundamental needs tend to be, needs such as very high volume, therefore, you need to make sure that the yield is there and that the chip has been absolutely minimized in area, typically there was very high volume tend to be also very advanced, and functionality, therefore, there's a lot of verification that’s there. And so our value formulation is very much in solving a set of five or six macro problems and trying to be at best there and then transcends a different traditional vertical.

Jay Vleeschhouwer - Merrill Lynch

Thanks, Aart.

Aart de Geus

You're welcome.

Operator

Thank you. And next we'll go to the line of Terence Whalen with Citi.

Terence Whalen - Citigroup

Thanks for taking my question. This question is for Brian. Brian, you mentioned that there were some quarter-to-quarter changes in expense timing? And `was hoping to get a little bit more color on that.

And then in addition, was hoping to get a little bit of a longer-term view of the opportunity for expense saving. What inning are we in, in terms of keeping expenses at only one or two points growth? Could that actually be sustained for one to two years to come?

Brian Beattie

Good question, yeah, Terence. We're looking again really clearly at each one of our line of expenses. Both going from the first quarter to the second quarter and very significant drop that we're able to put in place and the actions in the quarter continue to be under spending relative to our plans keeping the headcount and having it come down slightly in the quarter. All of this again is focused on margins and earnings improvement as we go forward.

So while we're again proud of achieving a target we set some two years ago and increasing our margin numbers for '07 by 600 basis points, we're not stopping there. And you heard Aart say that committed to continue to drive to mid to high 20s in margin. So clearly that requires spending the growth significantly less than revenue growth. So, we're focused on that element and optimizing the resources we do have in various areas.

So, again, as you look at the drops from Q2 to Q1, primarily they're due to the extra week we also had a gain on some sale of some land, which is a few million dollars in the second quarter. And then as you look forward to Q3 and Q4, again, keeping that expense commitment in place at the 2% to 3% is what we're committed to doing. And again this is also to highlight a point that our business is stronger in 2007 than we anticipated at the beginning of the year.

So again the expense that there is higher business being completed we've also have an expense accruals to put in place for that as we go through the year plus the full-year impacts of acquisitions, foreign exchange costs, and other things, all that saying still flat year-over-year in 2007. So, again, attributed to the team for a lot of hard work in making that come through. And the trends going forward in '08 and beyond are focused on continuing to improve operating margins.

Terence Whalen - Citigroup

Great. And then a follow-up if I could for Aart. Aart, you mentioned IC Compiler express initial reception has been quite positive. Can you also kind of expand on whether segmentation is just for digital design? Or is that an area that could also or strategy rather that could be proliferated on into have verification, as well? Thank you.

Aart de Geus

Sure. Well, let me start right away with the second one, which is verification, absolutely can be stratified into different segments. And we see today that there are very different behaviors in different customer categories.

If you take, for example, the processor, the VSP, the graphics guys, they use an immense amount of verification, largely because their products are very complex, are going in broad distribution and are expected to be flawless.

At the same time, you look at people that are let's say in the wireless communication segment, their verification is growing rapidly, but I think there's a long way to go before they can assure the same degree of coverage of the first group that I mentioned. If you then look at the segment I mentioned earlier, which is memory, you see that there again there's a big change because traditionally memory has been very level verification.

And now the complexity of the memories is bringing about a surrounding of digital control that is great for us because not only are we very, very strong in digital, but we're also very strong in analog mix signal, meaning that the combination of digital and analog. And so each of one of those sort of talks their own language when they talk about verification. And the same is true for the vast majority of our products. I think the forays into the less advanced technologies, forays may not be the right term, spending a little bit more attention is primarily a broadening of our potential addressable market that in the past we just didn't pay all that much attention to.

And so we may, as well, leveraged all the technology that we've built by making it easier to use somewhat simplified and the right cost point for people that are maybe less demanding.

Terence Whalen - Citigroup

Thank you.

Aart de Geus

You're welcome.

Operator

Thank you. And next we'll go to the line of Dennis Wassung with Canaccord Adam.

Dennis Wassung - Canaccord Adam

Thank you. Good afternoon. I guess first a quick follow-up on the operating expenses. I know you had a couple of questions on this. But, you talked about the new initiatives, released more cost are coming back into the model here. And I was just curious; I think this was asked, I didn't really catch an answer.

Do you expect to see a lot of that I guess resurgence and expense coming on the R&D line? Just a new product development efforts or specific R&D efforts or is there a sales and marketing push expansion in specific areas that we should look for, as well? Just trying to understand the dynamic there.

Brian Beattie

Okay. Well, Aart, maybe over…

Aart de Geus

Well, let me start in general. Just to be crystal clear, we have committed a number of years ago to keep improving the ops margin. We are continuing to do that. At the same time, we gave our self a timetable that I think we have rigorously met, and we are exceeding now. The way we're looking at that is to say, hey, there's opportunities to invest some of that in future growth. And simultaneously stay ahead of schedule.

And so I think that's good news in both, what goes to the bottom line as well as what we can invest for the future.

Now, when we look at our investment, it's absolutely clear that fundamentally have two groups that you want to invest in either R&D development or new things or fields. It's typically not the third one, which is infrastructure that you want to keep either flat or optimize more on. And so there the decision has to be whatever gives us the best chance of growing our footprint and our success rate with the customers.

And in some cases, it's clearly an R&D because it's infinite new projects possible there. But in some cases it is also go for a different approach with the customer, take over more of some of the things they do and evolve our overall solution with them. And so we have now have the luxury to look a bit at both of those things. And we'll decide on ROI evaluation basis.

Dennis Wassung - Canaccord Adam

Okay. That helps, thank you. And secondly, the DFM and yield side of the equation, you made some comments about some of your products becoming more of a common interface.

I'm just wondering if you look at your DFM group in general, it had a nice steady growth past year, I'm wondering where the strength is, if there's a specific area or is it strong across the Board? Is OPC a big driver for that? Is PrimeYield taking a bigger piece of this pie. Could you just maybe talk about what's driving that growth at this point?

Aart de Geus

Well, fundamentally if you look at DFM, obviously it means different things, different people because they are at both the D wares and the M wares, right. And so let me start actually with the M side which is if you look at T cap, that is obviously deep inside of the manufacturing chain, be and so focused on either process development or device development or manufacturing optimization.

And so those are sort of the key areas to focus on. Then the second grouping is everything that has to do with masks. And there we have the various forms of radical enhancement technologies and of fracturing and a variety of verification things.

The third one has to do with the whole yield measure test chip etcetera area. And the fourth one, which is where really the design word comes back in, is how do you close the loop with all this information into design? And that's where PrimeYield over the years will hopefully become what PrimeTime is today in timing.

And a number of years ago, we obviously pioneered the ability to predict timing in such a fashion that you could rely on it and design towards it. We are heading in the same direction towards predicting yield and designing towards it. And so those are the centers of gravity and then from quarter-to-quarter, there's big fluctuations as to which one happens to have big deals. But it is really the aggregate picture that we're after.

Dennis Wassung - Canaccord Adam

As you look at your total suite of offerings in this area, do you feel like you have the complete picture at this point? Or is there a specific technology that you're missing? Or can I get the feel that you have an accurate and adequate offering at this point for 65 and 45 nanometers and below?

Aart de Geus

Well, we know that we have an adequate offerings for 65 and 45, because we have a number of customers that do their entire flow with us and are doing very well with this. On the other hand, whenever you talk about emerging technologies the word complete has never applied in the 20 years that we've had Synopsys. So there's always new investments and new opportunities, although I must say I think that EDA is in a very different phase in that we have much more complete solutions today and whenever possible we like to amend them ourselves or then acquire technology that fits in, but all in all, I think we are as complete as anybody on the market today.

Dennis Wassung - Canaccord Adam

Thank you.

Aart de Geus

You're welcome.

Operator

Thank you. We are now five minutes prior to the conclusion of our conference. So we'll take our final question from the line of Matt Petkun with D.A. Davidson & Company

Matt Petkun - D.A. Davidson & Company

Hi, thanks for taking my question. Just to follow-up on Dennis's question. To be a little bit more specific. So when we look to sequential changes and expenses from Q2 to Q3, you're talking about investing in R&D. Should it be the R&D line item on a non-GAAP basis that grows more rapidly sequentially than the SG&A line item?

Aart de Geus

Well, I think, don't overemphasize too much these changes from quarter-to-quarter. I'm sure Brian will give you a more refined answer here. But from my perspective, the only numbers that really matter is sort of the rolling 12-month averages because from one quarter to another, the way some of these things fall in one quarter or another can change radically the actual distribution.

Now having said that, clearly if we make additional investments, they tend to be in the R&D and potentially in some aspects of the field rather than anywhere else in the company. And we're very careful with making these additional commitments to be much sharper about what's the reach on an investment on each one of those. You want to add anything, Brian?

Brian Beattie

Yes, I'd say as you look specific on the line-by-line basis that from Q2 to Q3 we'll see an increase recognizing a several million dollar gain on sale of that land that was in the G&A area. So that will be an increase from Q2 to Q3 on G&A.

From sales and marketing perspective, again, as the business continues to grow, there'll be expenses there associated with higher commission activity and higher business and that continues to go up as the business grows. But again, all in all, keeping in line with that 2% to 3% growth for the year and then the R&D as Aart said is really focused specifically on getting more development, more capacity and capability while driving efficiency through the team and obviously leveraging lower cost areas to the extent we can. And so again, that's the message on each one of the lines for the operating expense.

Matt Petkun - D.A. Davidson & Company

Okay. And then Aart, I was hoping you could give us a bit of an update on what you are seeing in the world of system level design and ESL specifically kind of noting the fact that about a year ago that you acquired Video to do some more kind of embedded software platform development debugging.

So I am wondering kind of what's going on there? Has that market really developed and what do you expect from it going forward?

Aart de Geus

Sure. Well, we are engaged quite a number of places with Virtio and I think that's a direct reflection of the fact that increasingly people developing software would like to have some degree of modeling of the hardware before the hardware is fully developed or even built.

And so the level of interest is high and the number of engagements is high. I think it will take a little bit of time for the market to develop. But there's one other angle that one should not forget, which is the whole angle of IP as actually in my opinion the much more important ESL success factor today.

Because a lot of people have thought about ESL why don't you just create designs from a higher level? Well, the way you create designs from a higher level is start with much higher-level building blocks.

And we are absolutely seeing that that vision is materializing more and more literally quarter-by-quarter because in the whole wave of companies looking at their cost structure and by the way quite a number doing that by virtue of being investigated by private equity opportunities.

They are all coming to the conclusion that a lot of these design activities on the individual blocks have completely no return on investment for them and are not differentiated. And for those companies being able to come to us and say can you develop the basic building blocks and provide them to us is a very promising approach for them to save money and of course for us to grow our business.

And now tying this back to virtue, the reason I am enthusiastic about that is because I think that the content of software in these building blocks is growing and by the way also the verification aspect of these building blocks because verification is by far the largest consumer of EDA software period.

And so I think there are great opportunities as these things come together. And so that's the vision we're pursuing.

Matt Petkun - D.A. Davidson & Company

Okay. Thanks so much.

Aart de Geus

You're welcome. Well with that that concludes our earnings release, we really appreciate the time you spent with us. We think that we're coming off a very strong quarter and definitely feel momentum in both the technology direction and the business direction.

And so from that perspective feel that the year is in very good shape. If you have further comments or questions, as usual Brian, Lisa, and I will be available after the call. Thank you very much for spending an hour with us.

Operator

Thank you. And ladies and gentlemen, that does conclude our conference for today. We thank you for your participation and for using the AT&T Executive Teleconference Service. You may now disconnect.

TRANSCRIPT SPONSOR

Cornerstone OnDemand Logo

Want to understand the future of human resources software?

Cornerstone OnDemand is the leading provider of SaaS solutions for integrated talent management, covering the human capital life cycle from hire to retire.

We offer over 30,000 online training titles and performance tools for compliance and analytics to help companies maximize workforce productivity and achieve organizational excellence.

Learn about talent management and our industry leading products for learning management, corporate social networking, onboarding, compensation, compliance, employee performance management and succession planning at CornerstoneOndemand.com.

To sponsor a Seeking Alpha transcript click here.

Click to enlarge

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!