Mentor Graphics' CEO Discusses Q4 2012 Results - Earnings Call Transcript

Executives

Joseph L. Reinhart - Vice President of Corporate Development and Investor Relations

Walden C. Rhines - Chairman of the Board and Chief Executive Officer

Gregory K. Hinckley - President, Chief Operating Officer, Chief Financial Officer and Executive Director

Analysts

Richard Valera - Needham & Company, LLC, Research Division

Krish Sankar - BofA Merrill Lynch, Research Division

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

Thomas Diffely - D.A. Davidson & Co., Research Division

Saket Kalia - JP Morgan Chase & Co, Research Division

Mentor Graphics (MENT) Q4 2012 Earnings Call February 28, 2012 8:30 AM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Q4 '12 Earnings Release Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Joe Reinhart. Please go ahead.

Joseph L. Reinhart

Yes, thank you, Greg. Good morning, everyone. Welcome to Mentor Graphics' Fiscal Fourth Quarter 2012 Conference Call. I'm Joe Reinhart, Vice President, Corporate Development and Investor Relations. This morning, Walden Rhines, CEO and Chairman, who will open with the discussion of key trends in our business; Greg Hinckley, our President, will then provide operational and financial highlights, along with the guidance. Wally and Greg will then take your questions.

As a reminder, this conference call contains forward-looking statements. While these statements reflect our best current judgment, they are subject to risks and uncertainties that could cause actual results to vary. In addition to factors noted later, these risk factors can be found in our most recent 10-K, 10-Q and annual report. For a reconciliation from GAAP to non-GAAP measures used in this discussion, please refer to today's financial release. This information is available online at the Mentor website. Wally?

Walden C. Rhines

Thanks, Joe. Well, Mentor Graphics set all-time record across a wide range of operating parameters for our business in fourth quarter, including exceeding $1 billion of revenue for the year for the first time, and more importantly, achieving record earnings. Bookings growth of 15% for the quarter and for the year, as well as growth in the annualized run rate of our largest contract renewals, at 20% for the quarter and 29% for the year, reflect the strong momentum we see as we move into fiscal 2013.

Why the record-breaking momentum for Mentor? Well, 2 reasons predominate. First, adoption of 28- and 20-nanometer technology is driving extremely strong growth in functional verification and physical verification and leading to some fundamental changes in the way chips are designed. Second, Mentor's diversification into new applications has provided new businesses that are growing at 2 to 3 times the rate of the EDA industry. Now, as Greg will discuss in detail, bookings for Scalable Verification and Design-to-Silicon subflows both grew 15%, reflecting the importance of both physical and functional verification in ever more complex chip designs. Physical verification is not a surprise because the complexity of 28- and 20-nanometer design node is growing exponentially, and verification has been extended to design for reliability, as well as design for manufacturing. Resolution enhancement technology continues to be a strong contributor to growth, as the rollout of 28- and 20-nanometer processes, along with the development of 14-nanometer ones, demands increasing amounts of Calibre software. And this growth in usage will continue to increase even with the eventual adoption of new forms of optical lithography like extreme UV.

Also, our functional verification grew partly because of the Mentor's early lead in SystemVerilog, OEM and UVM for simulation, the largest growth came from the emerging transition of the industry to emulation for an increasing share of the verification to 28-nanometer chips required.

For leading edge designs at 28 nanometers and below, simulation could be used to verify design blocks for the verification of the entire chip, including the embedded and application software, increasingly requires emulation. The multi-million dollar customer list for emulation reflects the who's who of semiconductor industry, and more recently, of the systems companies too. Half of the emulation orders this quarter came from systems companies. What used to be a technology limited to the developers of graphics chips has become widespread among the 28-nanometer design crowd. And the verification cost of emulation has decreased, so this -- it's now about 2 orders of magnitude less expensive than simulation on a cost-per-verification-cycle basis and 3 orders of magnitude lower power.

The other area contributing strongly to Mentor's records this year is the rapid growth of new EDA applications, such as design of system electronics and interconnect or automotive and aerospace applications, development and verification of embedded software and the software required for manufacturing automation. Bookings in need areas grew at almost double our overall bookings growth rate. Embedded software bookings grew strongly, fueled by the growing need of chip design and system companies to provide development, compilation and debug environment of software developers using their chips and systems.

Mentor's acquisition of Valor in fiscal 2011 extended our complete solution for system development from design to design for manufacturing, and software to set up, automate and monitor equipment on the factory floor. And one of the fastest-growing parts of Mentor's Systems business is in thermal analysis of electronic systems, which continues to reveal new opportunities with high-growth potential, like the characterization of light emitting diode-based systems and the thermal analysis of electronic packages.

Growth of Mentor's core EDA business, the diversification to adjacencies, such as embedded software, automotive and aerospace, and new applications in system design, such as thermal analysis, all point to continuing momentum in the future.

Confidence in the continuing momentum of our business motivated the Board of Mentor Graphics yesterday to increase the share repurchase authorization from the original $150 million plan, of which $90 million has already been purchased, to a total of $200 million. Greg?

Gregory K. Hinckley

Thank you, Wally. As Wally said, the fourth quarter of fiscal year 2012 was a quarter of records that kept a year of records. Bookings were up 15% for the quarter and 15% for the year. Revenue was up 4.2% for the quarter, $4 million ahead of guidance, to a total of $320.4 million. We surpassed $1 billion in revenue for the first time in the company's history, closing the year at $1,014,638,000 in total revenue, obviously, a record for both the quarter and the year. Book-to-bill, paced by exceptional strength in Scalable Verification, design-to-Silicon and Services, was a record, greater than 1 for the quarter, for the entire year and for 3 of the 4 quarters this year.

Earnings per share non-GAAP was $0.58 compared to $0.48 last year and guidance of $0.50. The fourth quarter of fiscal year 2012 was the 12th consecutive quarter that Mentor has exceeded guidance for both non-GAAP EPS and revenue. Non-GAAP operating margin was 25.4% for the quarter compared to 22.7% last quarter last year, and was 16.5% of revenue for the year compared to 11.9% for all of last year and was again a record. Fourth quarter non-GAAP gross margin was 86.8% up, albeit modestly from last year, despite an increasing proportion of lower-margin hardware and services and support in the revenue mix.

Non-GAAP OpEx was up less than 0.01% or $157,000 to $196.6 million, which led to earnings exceeding guidance by $9 million or $0.08 per share on a $4 million increase in revenue. Foreign exchange, FX, including the euro, the rupee and the Israeli shekel, was a principal contributor to reduced OpEx, together with headcount, that net of the acquisitions, those of Flowmaster and Calypto, was down 101 people from the beginning of the year. Total non-GAAP OpEx was up only 3% for the year, Mentor continues to monitor and control expenses rigorously.

All leading indicators remain positive. Emulation was strong for the year, and in the fourth quarter, was exceptionally strong. Consulting bookings were up 50% for the quarter and 75% for the year. New customers were up 25% in number and 5% in value. Average contract renewals were up 20%, and base business turns business less than $1 million was up 20% in value. Support declines were flat.

During the quarter, we repurchased $20 million of stock at an average price of $12.98. Over the year, we repurchased $90 million of stock, 6.8 million shares or about 5% of capitalization of a just increased authorization of $200 million. We expect to complete this authorization over the next 2 years.

In December, Mentor acquired Flowmaster, a U.K.-based developer of one-dimensional computational fluid dynamics simulation software, marketed principally to the automotive and aerospace industries. Mentor already had a presence within fluid analysis as a result of our fiscal year 2009 acquisition of Flomerics. Flowmaster had prior year revenue of about $10 million and was purchased for a price of about $15 million. The product will be integrated with our Mechanical Analysis Division, which reports within our integrated system design sub-flow.

Now for more financial details. Bookings were up 15%, with product up 15% and services up 20%. Design-to-Silicon was again very strong, up 50% for the quarter and 25% for the year, as 7 of our top 10 accounts for the quarter were leading semiconductor companies. Also strong was Scalable Verification, up 50% for the quarter and 30% for the year, as we saw strength in both analog and functional simulation, as well as emulation. Integrated System Design was down 35% for the quarter and 10% for the year. Please recall that fiscal year 2011 was a phenomenal growth year for Integrated System Design, as many of our mil-aero and telecom accounts renewed that year. Fiscal year 2012 for Integrated System Design, though down, was still up 30% over fiscal year 2010 and several sub-product lines such as pay adds and design for manufacturing showed double-digit growth.

New and Emerging was down 40% in the quarter but up 15% for the year. The fourth quarter softness in New and Emerging was largely confined to our electronic system-level design products. This decline could be attributed to the spinoff of our Catapult C product line into Calypto Design Systems, which uses a ratable model. We expect improvement as the integration and revenue model trends transition is completed.

Geographically, North America, Europe and Pac Rim all showed strong double-digit growth. North America was up 25% for the quarter and 20% for the year. Europe was up 20% for the quarter and 10% for the year. Pac Rim was up 15% for the quarter and 40% for the year. Japan was down 20% for both the quarter and the year. In recent years, Japan's global semiconductor market share has declined about 100 basis points per year as the Pac Rim has descended.

Bookings were 70% term, 25% perpetual and 5% subscription against 80% term, 15% perpetual and 5% subscription last year. As said before, our emulation product was very strong this quarter, and this product is usually sold by us through the meanings of our perpetual license.

Top 10 deals were a strong 60% of total bookings compared to 55% last year. The weighted average growth of annualized run rate in our renewals in our top 10 contracts was 20%. Average deal length was 3.1 years compared to 3.5 years last year. Recall that our fiscal year 2011 contracts included a large proportion of mil-aero accounts in the renewal mix, and that our mil-aero contracts are typically 4 years of life. This fourth quarter, our top 10 accounts were concentrated in the IC industry, where we typically extend 3-year licenses.

Revenue mix by geography was 35%, North America; 25%, Europe; 5%, Japan; and 35%, Pac Rim. Support revenue was up 7% for the quarter and 6% for the year. Currency was unfavorable to revenue guidance by about $1 million. Gross margin, non-GAAP, was 86.8%, essentially flat to last year despite increased hardware and services in the revenue mix. For the full year, gross margin was 84%, down modestly from 84.5% the prior year.

Fourth quarter OpEx, non-GAAP, was 61.4% compared to 63.9% last year. Full year non-GAAP OpEx was 67.4% versus 72.6% in fiscal year '11. GAAP SG&A was 35.1% of revenues compared to 36.7% the prior year, as revenues increased 11% for the year and SG&A-related headcount climbed. For the entire year, GAAP SG&A was 39.4% of revenues, down from 42.8% the prior year. Our analysis suggests that at less than 40%, Mentor ranks well below the median SG&A ratio of 45% for the technical software industry. Other income and expense, non-GAAP, was a $3.8 million expense, essentially interest expense net of interest income. Special charges were $5.8 million and were largely related to cost reduction initiatives. Ending headcount, after given effect to additions from Flowmaster and Calypto, declined by 2%.

Non-GAAP tax provision remained at 17%. The GAAP tax rate includes a release of tax reserves related to reduced foreign exposures causing the tax benefit for the year.

Now the balance sheet. Cash and equivalents increased $35 million to $146 million at quarter end, as net stock repurchases of $6 million, acquisitions of $14 million and capital expenditures of $16 million were funded by $69 million of cash flow from operations. For the year, cash flow from operations was $104 million, up from $82 million the prior year. Trade DSO were 38 days, a decrease of 3 days from last quarter and 7 days since last year. Total DSO were 93 days, a decrease of 12 days on the quarter and 9 days on the year. The quality of receivables remains excellent, with no receivables net of reserves greater than 60 days outstanding. Factored receivables were $1 million in the fourth quarter compared to $17 million in the third quarter and $13 million last year. We periodically also factor in markets and continue to find no difficulty in selling receivables.

Capital expenditures were $16 million for the fourth quarter 2012 compared to $8 million last quarter and $10 million last year. Depreciation was unchanged at $8 million. During the quarter, we repurchased $20 million of stock, increasing the amount purchased to $90 million for the year. On a weighted -- on a non-weighted basis, ending basic shares declined to 109 million shares from 111 million shares at the end of fiscal year '11, as share repurchases more than offset stock issuance.

Guidance. For the first quarter of fiscal year 2013, we are forecasting revenue of approximately $255 million, an increase of $25 million or 11% from the $230 million reported a year ago. EPS, non-GAAP, will be about $0.25, up 25% from the $0.20 reported last year. We are optimistic about the outlook for the EDA industry in general, and for Mentor Graphics specifically. Our EDA product line is as competitive as it ever has been, and our thrust in manufacturing emulation and invent software are performing exceedingly well, outpacing the overall company.

For the entire year, fiscal year 2013, we are forecasting revenues growing 8.4% to $1.1 billion. We expect operating income to improve to 18% of revenues as we continue to manage costs vigorously and grow revenue, leading 2014 to a targeted 20%. EPS, non-GAAP, we forecast to increase 17% to $1.32. Relative to linearity of our business through the fiscal year, we expect about 45% of our revenues in the first half of the year and 55% in the second half. This represents modest improvement over fiscal year '12, when we were 44-56, in solid progress versus fiscal year '11, when we were 40-60. With cash flow from operations increasing proportionally to earnings, we intend to shrink our share capitalization, returning value to our shareholders. Wally?

Walden C. Rhines

Thanks, Greg. Accelerating the option of 28- and 20-nanometer technology, coupled with growth of new applications, has propelled Mentor through the billion-dollar revenue level and provided the basis for another strong year in fiscal 2013. Over the next 2 years, we expect to continue to increase our non-GAAP operating margin from 16.5% to 20% while continuing to grow, on average, faster than the EDA industry, license and maintenance revenue.

So let’s take some questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Rich Valera from Needham & Company.

Richard Valera - Needham & Company, LLC, Research Division

First, just with respect to the backlog, are you willing to give, one, the specific backlog number or discuss when you built backlog last year?

Gregory K. Hinckley

Rich, we certainly built backlog for the year, where our book-to-bill was greater than 1, which means that our bookings were greater than our billings, and we will be disclosing our backlog when we file our 10-K in the next couple of weeks.

Richard Valera - Needham & Company, LLC, Research Division

Okay. And then with Integrated System Design, you noted that it had very tough comps last year and that was the reason it was down. What do you think about the potential for growth in ISP in this coming year?

Walden C. Rhines

So Rich, if you look at the overall trend, going back several years, the Integrated System Design has been on a steady growth path. And it's actually aided by the acquisitions we've done and the continuing growth in the total flow that we provide. So we would expect it to be a consistent growth part of the business, and the deviation was simply because of that large set of mil-aero renewals late last year.

Richard Valera - Needham & Company, LLC, Research Division

Great. And then I guess sort of similarly on New and Emerging, it sounds like the comps there are distorted because you've undergone a model transition, so I guess you're -- the business run under you was done more on a term type of basis. Is that correct, Greg? And then you're switching that to a ratable, and that's really what's causing that compression?

Gregory K. Hinckley

That's most of it. We are also -- since we didn't control the entity, Rich, I mean, we -- it is independent financial organization. We are reporting their results on a one-quarter lag, and they do have a strong fourth quarter and their strong fourth quarter will be reported in our first. So it's a combination of ratability together with whatever seasonal effects they have yet reported one quarter later as they're consolidated within our results.

Richard Valera - Needham & Company, LLC, Research Division

And then the final one for me. This is sort of your second year of emulation. I guess last year was really your second half. That was very strong this year. Just completed with strong across the board, the entire year and obviously, some key enter this year with some momentum there so just, Wally, I wonder if you can comment on whether the EBITDA can continue to grow. It's gone fairly well above historical trends in terms of growth rate, and I think in terms of the magnitude of the entire market if you look at the other players. So just wanted to get your sense on the potential medium to longer term for the emulation markets to keep growing?

Walden C. Rhines

Yes, Rich, glad you highlighted that because there seems to be no limits to the ongoing growth. We keep seeing new customers enter emulation. I mentioned that system companies, as well as semiconductor, as you noted earlier, the growth in backlog is partly because our manufacturing lags, our bookings and the bookings have been strong late in the year, so we're still moving to catch up with the production. And the thing that actually has caused the biggest shift is that people are doing total verification, including debugging their embedded software -- in some cases, even application software at the emulator level because it becomes so cost effective to do so and because it has such flexibility. And I see no end in sight. They were talking orders of magnitude, more users of emulators as we move into the broader base of system verification.

Operator

Your next question comes from the line of Krish Sankar from Bank of America.

Krish Sankar - BofA Merrill Lynch, Research Division

I had a few of them. Wally or Greg, in terms of your full year guidance, can you provide some color on how it breaks out between New and Emerging products and the boat to the consistent segment?

Gregory K. Hinckley

We're not yet in the position to do that, and frankly, we really don't do those splits, but the strongest part of the business we would expect this year to be the New and Emerging product line, as well as Scalable Verification. As Wally mentioned, as did I, our portions of the business that are doing very well are manufacturing for us, emulation and embedded software. Embedded software, we describe as part of New and Emerging. Emulation is part of our Scalable Verification product line. And the trends that we saw this year, we expect to continue into fiscal year 2013.

Krish Sankar - BofA Merrill Lynch, Research Division

Got it. And then in terms of your OpEx, you guys have done a pretty good job in improving your OpEx. You're guiding to about 18% now. Looking ahead to get to 20%, what are the levels you have left and what kind of revenue level do you think you need to get to the -- your 20% up margin?

Gregory K. Hinckley

Growth, we figure that our growth rate of kind of high single digits can get us there, combined with a better gross margins on our hardware business, which we delivered this last year. And then rigorous attention to our operating expense, we can get there comfortably in the fiscal year 2014, Krishna.

Krish Sankar - BofA Merrill Lynch, Research Division

Got it. And then just a final question from my end. Now, in terms from a macro standpoint, have you seen any change in your customers' sentiment in the last few months? Or do you think that pretty much business is tracking as you'd expected in the past?

Walden C. Rhines

Krishna, I would say that it has been a level of enthusiasm was apparent towards the end of the year, so if anything, it was positive. But overall, as you look at the matters of performance, as Greg mentioned, it's been record-setting almost every quarter, so it's a consistent type of strength, I would say.

Gregory K. Hinckley

Yes, and we, Krishna -- we use what we describe as leading indicators as indications of what is going on in the market. In prior periods, what we would see is our emulation business or consulting business would go soft during downturns, and that they would strengthen as the business was progressively getting better. We had an exceptionally strong emulation booking here. And as I mentioned, consulting bookings were up 50%, so that's really exceptional performance, and it suggests that our customers, quantitatively, are prepared to spend. So we're very optimistic.

Operator

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

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

Wally, Greg, I'd like to start by asking about customer concentration. Through the first 3 quarters of fiscal '12, you had one customer that accounted for 13% of revenue, which was unusually high percent for several quarters at a time in your case. Could you talk about the contribution from that customer in fourth quarter or what you think might occur in fiscal '13 in terms of the comps from that particular customer spending or continuity of that customer spending? And then a couple of follow-ups next.

Gregory K. Hinckley

We continue to do follow-on business with that customer, but I think it is fair to say that for over the course of the year, we had -- we may have had one customer that was 10% of revenue but not much greater than 10% of revenue.

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

Okay. Also Greg, you touched on a question I was going to ask about your hardware profitability. In your case and as well in cadences, the hardware gross margin would seem to be somewhere in the range of, let's say, 50% to 60%. Yours seems be somewhat lower than cadences as far as scale. Could you talk about where you think you could realistically get the gross margin on that hardware business as it continues to grow with the momentum you've talked about?

Gregory K. Hinckley

I think that we will do results that are similar to what others in the industry are obtaining, Jay. I'm -- I have difficulty talking about pricing when I have competitors listening in on the same telephone call.

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

Okay, understood. Also with respect to Design-to-Silicon, a couple of questions there. In the past, you've said you've expected that the consumption of Calibre licenses would increase per design, particularly the most advanced nodes. And I'm wondering if, in fact, you're seeing that, particularly in your comment about 20 and 28. And do you think that there's a realistic prospect of your seeing much share gain in the implementation side of the market with, for example, your in-route product in light of the recent structural change in implementation with Synopsys and Magma.

Walden C. Rhines

Yes, Jay, this is Wally, and you're right. The Design-to-Silicon, as we said in previous calls, was extremely strong in fourth quarter, close to 45% of revenue. And it was in fact license growth. A big part of it is the number of licenses required to do manufacturing. That drives up the resolution enhancements and the number of licenses in verification. So it drives on renewals a substantial growth in the dollars that people commit to in their multiyear contracts, as well as additional purchases. With regard to gaining share, 2 aspects. One is we have continued the migration of top 25 semiconductor companies to Calibre. The few remaining, that continues this year with 2 new ones. And then in addition, as you say, it's rolling up the whole physical implementation space for reevaluation. It gives opportunity for new growth, particularly in implementation, place and route, or as you know, within route, the integrated place and route and verification.

Jay Vleeschhouwer - Griffin Securities, Inc., Research Division

All right. The last, if I could just ask about the auto electronics market at CES last month, we heard -- that we've heard in confidence before about the connected car and telematics and so forth about the intelligence being built into cars, do you think your current portfolio addressing auto electronics is complete for all the functionality that companies like Daimler and others are talking about, or do you think there needs to be some further investment or diversification of your auto electronics portfolio?

Walden C. Rhines

Okay. Well, Jay, as we've noted, it's been an area of investment for a long period of time, and you can never invest enough in a market that's growing that rapidly. But in fact, the -- and as we said earlier, the automotive bookings have grown, and the leading-edge things you're talking about that people refer to come in the entertainment sector. As we noted this quarter, we have people heavily involved in the standards. Part of that, GENIVI, a member of the board there, Indian AUTOSAR, the emergence of the new standard for design, which has in fact allowed us to be first to market with a full AUTOSAR 4 implication, that's really sort of the hottest software thing going on in that car of the future. And so we've got an early lead there. And sure, we'd like to invest more, but we're doing awfully well in that business.

Gregory K. Hinckley

We're at a point, Jay, where it's about 15% of bookings for last year, and the product line is profitable.

Operator

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