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Cadence Design Systems (NASDAQ:CDNS)

Q2 2007 Earnings Call

July 25, 2007 5:00 pm ET

Executives

Jennifer Jordan - Corporate VP of IR

Mike Fister - President and CEO

Bill Porter - EVP and CFO

Analysts

Jay Vleeschhouwer - Merrill Lynch

Mahesh Sanganeria - RBC Capital

Terence Whalen - Citigroup

Harlan Sur - Morgan Stanley

Tim Fox - Deutsche Bank

Matt Petkun - D.A. Davidson

Saket - JP Morgan

Raj Seth - Cowen & Company

Rich Valera - Needham & Company

Erach Desai - America's Growth Capital

Presentation

Operator

Good afternoon, my name is Gillette and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Design Systems Second Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.

I will now turn the call over to Ms. Jennifer Jordan, Corporate Vice President of Investor Relations for Cadence Design Systems.

Jennifer Jordan

Thank you Gillette. And welcome to our earnings conference call for the second quarter of 2007. The webcast of this call can be accessed through our website, www.cadence.com and will be archived for one week.

With me today are Mike Fister, President and CEO and Bill Porter, Executive Vice President and CFO.

Please note that today's discussion will contain forward-looking statements, and that our actual results may differ materially from those expectations. For information on the factors that could cause a difference in our results, please refer to our 10-K for the period ended December 30, 2006 and our 10-Q for the period ended March 31, 2007.

In addition to financial results prepared in accordance with Generally Accepted Accounting Principles or GAAP, we will also present certain non-GAAP financial measures today.

Cadence management believes that in addition to using GAAP results in evaluating our business, it can also be useful to measure results using certain non-GAAP financial measures. Please refer to our earnings press release for a discussion of non-GAAP measures and to both our earnings press release and our website for reconciliations of GAAP and non-GAAP financial measures used in today's discussions.

Now, I will turn the call over to Mr. Fister.

Mike Fister.

Thanks, Jennifer. Our results for Q2 again collaborate our technologies, and strategies continue to be in line with our customers needs. Revenue grew 9% over the same period in 2006 and non-GAAP EPS was up 30% on the same basis.

In a semiconductor environment, which I will continue to characterize as mixed, we saw good underlying design activity and accelerating movement to more advanced process geometries. And continue to execute to our strategy of growing our core business while expanding into the systems and manufacturing adjacencies.

To illustrate our continued progress, let me focus on some of our achievements this quarter. Functional verification again delivered excellent results in the period. We are leading the market segment with solutions that improve our customers' productivity while helping to manage the verification challenge across teams and at higher levels of abstraction.

Customers who are working at the stack with advanced verification capability rely on Cadence Incisive Enterprise to get their design done on time and functionally correct.

UK based Imagination Technologies had great success delivering SoC IP platforms and the consumer graphics and multimedia systems for major semiconductor companies and systems OEMs. These platforms required advanced verification solutions that can be easily integrated into existing design flow and across multiple engineering teams.

Already a user of Incisive Enterprise from the front-end designs test and simulations, Imagination Technologies expanded its usage of both Incisive Enterprise and Incisive Formal Verification to ensure overall quality and time to delivery.

Another aspect of improving our customers' productivity is facilitating the adoption of new methodologies. Soon as IT solutions and services saw an advantage in choosing Cadence's System Verilog solutions because they were the easiest to adopt and most practical for the logic design and verification teams.

Our acceleration and emulation solutions also improve our customers' productivity when it comes to hardware and software co-design and co-verification. Sun Microsystems use Incisive Xtreme, cut by roughly half. The development cycle on the design on the 32 bit processor, UltraSPARC T1. Xtreme's ability to swap simulation between software and hardware environment greatly reduces Sun's times to bring up and allow them to boot the Solaris operating system on the UltraSPARC design before committing at the silicon.

During the second quarter, we released the design with verification component for our logic design team solution. The integration of verification of logic design capabilities is resonating with customers. For example, G2 Microsystems, a firm designing ultra low-power Wi-Fi chips, adopted the complete logic design team and input Cadence Low-Power Solution to maximize their design as productivity.

Moving to 65 nanometer digital designs accelerated in Q2 with strong demand for low-power flows and some leading edge customers already driving the 45 nanometers.

Our particular strength in low-power advance are fueling our competitive success at both these nodes where numerous customers have taped out designs using Cadence Low-Power Solutions.

TSMC now supports the Cadence Low-Power Solution Encounter GXL technologies for their 45 nanometer reference flow. Cadence expanded its IC digital implementation capability by adopting Encounter GXL, including low-power capability. And we deliver the industry's first low-power kit in the second quarter, providing end-to-end methodology with an ARM-based reference design and IP covering larger design, functional verification and physical implementation.

In addition, the number of customers adopting the Encounter Timing Systems doubled in only the second full quarter of availability. ETS allows customers to complete their design entirely within a Cadence digital flow.

Our custom IC business continues to track according to the plan. It help drive our excellent performance in the Asia-Pacific region this quarter, where we had great success with memory companies.

As you may recall, memory is one of the five drivers of the Virtuoso platform, the others being wireless, analog, mixed-signal and RF. The advanced demand of leading-edge memory design resulted in the expansion of Virtuoso technology at several leading memory in electronics companies in Taiwan and Korea and a significant competitive win in North America. A leading US memory company has chosen to move its custom design flow to Cadence due to the advanced capabilities that new Virtuoso has.

We also collaborated with TSMC to deliver 65-nanometer RF where we have process design capability in Virtuoso platform. The combination of TSMC process technology and libraries with the Cadence design flow provides an end-to-end solution for designers of wireless expertise.

A key trend of our RDFM strategy is enabling the creation of process-friendly designs by building yield awareness into both Encounter and Virtuoso flows. TSMC's 45-nanometer reference flow drives on several Cadence DFM technologies, including QRC extraction, the first extraction tool qualified to 45-nanometers as well CMP predictor in chip optimize or maximize yields.

Additionally, we worked to start the research consortium for the Japanese semiconductor market to develop a design flow that addresses the most pressing 65 nanometer DFM challenges.

The purchase of Invarium this month, Cadence gains the next-generation technology to address litho, etch, metallurgy in manufacturability requirements at 45 nanometers and below.

In June, we delivered on schedule, a major upgrade of Allegro, our silicon-package-board platform. This upgrade includes highly automated board planning and routing technology and new RF capabilities.

In the quarter, Allegro won a PCB competitive replacement at a major North American systems company and we also had several good IC packaging and system and package wins as our SIP solutions continue to gain momentum.

In conclusion, we had another great quarter and I am very pleased with the progress and now I will turn it over to Bill.

Bill Porter

Thanks Mike. The results of the company's key operating metrics for Q2 were total revenue up 9% year-over-year, non-GAAP operating margin of 28% improving 300 basis points from Q2 of 2006, and operating cash flow was $101 million.

GAAP earnings per share for Q2 of 2007 were $0.20, compared to $0.10 in Q2 of 2006. Non-GAAP earnings per share were $0.30 for the quarter, compared to $0.23 in Q2 of 2006, up 30% year-over-year.

Total revenue for the second quarter was $391 million, compared to $359 million in Q2 of 2006. Product revenue was $264 million, maintenance revenue was $94 million, and services revenue was $33 million.

Revenue mix by geography in Q2 was 52% for North America, 17% for Europe, 17% for Asia, and 14% for Japan. We saw particular strength in our broad base accounts. During the quarter one customer accounted for 18% of revenue.

In the quarter, approximately 75% of our product business was represented by ratable licenses. Estimated contract life on a dollar weighted average basis was approximately three years.

Total costs and expenses, on a non-GAAP basis for Q2 were $280 million, compared to $277 million in Q1. Our non-GAAP operating margin in Q2 was 28% compared to 25% in Q2 of 2006. We are on target to achieve a 30% operating margin for the full year 2007.

Quarter-end headcount was approximately 5,200. Total DSOs in Q2 were 102 days compared to 100 days in Q2 of 2006. We expect DSOs to be in the mid to high 80s at year end. The quality of receivables remained high with receivables 90 days past due at 1% within our historical range of 1% to 3%.

Operating cash flow for Q2 was $101 million compared to $115 million in the second quarter of 2006. For 2007, we expect to generate operating cash flow of approximately $450 million.

Capital expenditures in Q2 were $18 million. For 2007, we're targeting normal capital expenditures in the $75 million range plus $22 million for work on the new engineering building.

Cadence did not repurchase any common stock in Q2. Approximately $406 million remains under our current stock repurchase authorization. Cash and cash equivalents were $1.129 billion at quarter end.

Now I'll turn to our outlook for Q3 and the year 2007. For Q3, we expect revenue to be in the range of $395 million to $405 million. GAAP EPS should be in the range of $0.20 to $0.22 and non-GAAP EPS in the range of $0.31 to $0.33. For the year 2007, we expect revenue to be in the range of $1.585 billion to $1.635 billion.

GAAP EPS should be in the range of $0.85 to $0.93 and non-GAAP EPS in the range of $1.28 to $1.36. Other income and expense for 2007 should be in the range of $40 million to $45 million.

I see 2007 progressing as planned, and I expect that we will attain our growth, profitability and cash flow goals for the year. Looking beyond this year, we should be able to grow the business profitably, while expanding our operating margins above 30%.

Operator, we will now take questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line Jay Vleeschhouwer with Merrill Lynch.

Jay Vleeschhouwer - Merrill Lynch

Thanks, good afternoon. Mike I would like to ask you a somewhat broad question about how changes among your semiconductor customers might affect EDA and you. We have seen in just the last few days and weeks a new relationship between ST and IBM. ST also seems to be doing some work with Freescale. There were some reports out of Japan yesterday about some of the Japanese semiconductor companies perhaps pulling some of their R&D resources and the like and so as any role of that plays out how do you think that could affect EDA?

Mike Fister

Jay, it's not unanticipated the kind of things that have been happening and lot of it is around new process technology generation, some around more efficient use of outsource possibility. In any case, I think EDA was one of the first things that is disaggregating, not too lately followed by semiconductor equipment and even IP blocks. And so I think for those of us, who can invest money and provide valuable solutions we become extremely valuable. And it gives us even more targeted opportunities as it consolidates. The customers when they do that aren’t just softening our cost but also focusing where they grow and its typically been around systems kind of things, platform design, software integration and verification resources, because these chips are amazingly complex. And that's right in the sweet spot where we end our adjacency penetration and where we are achieving extremely nice growth. So I think it bodes well for us, both in the alignment of our technologies and the direction of the company and to make possible transition for our customers as they evolve to be a little bit more system or platform centric.

Jay Vleeschhouwer - Merrill Lynch

A technology question for you. I appreciate what the company has been saying for a number of months. Now regarding you're somewhat different view of DFM than perhaps the way it has been described to date elsewhere in the industry and you have made some small acquisitions. The question is as reported your DFM revenue is still a very small percentage of the total, but its apparent that it’s a very real problem, I mean you just have to go to the [day or dark] shows to see that or otherwise talk to the customers. At what point do you think that you run the risk of in some way falling behind necessitating either a redoubling of efforts on the internal R&D side or more to the point something along the line that what you did five or six years ago on the digital side, you just go out have to buy something's to get your portfolio to where it really needs to be?

Mike Fister

Yeah, I think it's confusing because as you know, I and Lee we are very passionate about the way that the world evolves and the world evolves from a physical sign off which is where most report their DFM revenue, including us. And that's a historical artifact to broadening it to include a kind of a correct by construction or I am going to say the big D in DFM, that's a design pro-action for manufacture ability.

The growth in our digital business or our full custom business is representative progress in DFM, because those are technologies that we embed into the high-end strata of our Encounter Virtuoso platforms. And so, we are making nice progress there. I don't know if we are any credit for it.

The completer or additions that we've done either with partnerships and sometimes with acquisitions. Our completer technologies that really fell out, the componentized approach that we are taking and that's both allowing us to do that up the stack in design pro-action and down into manufacturing signoff.

And I think that the testimony that you saw today, you head about today from Bill and I in the memory spaces our great collaboration of just how much progress we are making there. People are adopting full custom they are doing that in anticipation of the DFM stuff or because they are doing it up the stack, there is a 45 and 50 nanometer process technology and it bodes very nicely for the progress we are making for some big digital customers at the same kind of targets.

So, I am not unhappy with exactly what we are doing and I think that the development teams are right on par to change the world in DFM as it continues to move down the process curves.

Jay Vleeschhouwer - Merrill Lynch

Okay, one final one for Bill. This quarter too you had a large customer account for a substantial portion of your revenue which we've seen in a number of quarters now over the last year. Is this embedded now, do you think and the way the business comes in that there is just going to be as a matter of course every quarter, a substantial percentage of revenues coming from a single customer. And between now and at the end of the year for example, we know that there is three or four customers coming up for substantial renewal representing together anywhere around $1.5 billion of bookings, so are you anticipating that over the next two to three quarters, we are going to see substantial amount of upfront revenue or reported revenue coming from the small number of customers?

Bill Porter

Yeah Jay, as you know our customer profile and we have been pretty exclusive. We have 35% of the business, it comes from around 15 accounts, so what you are seeing is the success we are having with some of the large global customers, its just an indication of the strength in the breadth of our technology. And I do expect that we will continue to have this kind of success going forward but the thing I just emphasize is the success isn't just isolated to large customers. As I mentioned in my prepared remarks, we are seeing really good results across the broad base of accounts, so I think it's a combination with the large customers we are having success, you see that as the occasional 10% plus customer and it is happening frequently because we are having good success there. But we are also having good success in our broad base of geographic accounts. So I think that nice portfolio of large and small customers just like we have the success with the portfolio of our technologies.

Jay Vleeschhouwer - Merrill Lynch

Thank you

Operator

Your next question comes from the line of Mahesh Sanganeria with RBC Capital.

Mahesh Sanganeria - RBC Capital

Thank you very much. Mike, I just want to follow-up on something you mentioned in your prepared remark about the low-power, can you help us understand the low-power design the point tools little better? Are you selling mostly that with the digital flow and with your platform or that goes even with the Synopsys Platform, and basically, given idea of what the market size is and probably this one is growing much faster than the other segment, so a lot more color on that will be helpful?

Mike Fister

Yeah, I am an old digital designer and work is going to change the world and evolve just like we did, when the world was totally a vertical by looking at a homogenous or what I would call holistic flow that approaches the hard problems like power.

What that does as it preserves the intention of the designer all the way through the process from synthesis, logic design, circuit design, test and back and forth. And that's the way we approach low-power.

Kind of testimonials that are in the remarks that we had and we are seeing in the industry every week, are people taking advantage of that holistic or homogenous flow and then applying it and seeing huge impacts on power and that's because its not just some circuit design trick or a logic design trick. It's a consistency of all those things additively improving the power.

We did that by not only saying but by integrating that across all facets of our tool chain and that's Encounter digital, that's a Virtuoso, that's a verification technologies, it's into what we call DFM and that's what allows it to happen. And I think other people will try to emulate that.

I believe to tell you from 30 years we're doing this it's going to be very darning and difficult, because we had to change sourced fundamental pieces of the code across every one of this tools and architected into do that. I often describe that or my colleagues in the development side as optimizing between the pieces and we get amazing results. I mean we see 40% power reductions in OnCore integrated IC's just by using the tools and we've just only scratched the surface for what we can do. So it's not a point tool where we got some kind of a trick for like multiple thresholds or the [multi-DVD] or something. Of course we got that, but is by allowing all those pieces to work and not have one trick undo another trick. That's the kind of cleverness that's involved in a holistic flow.

As you know power is one of the bigger barriers now for either building big chips or building chips that have to run on a battery. And so we just use this as one of the first demonstration places to show the power from, and no pun intended, of looking at the problem and/or as a holistic mass.

So in the market segment side I think, I don't know. To me what it does is it continues to drive the value of the total offering as a company. It is interesting in consolidating customer situations. Even in ones that don't use Cadence its interesting and people who without our whole digital flow or people who adopt our logic design theme, which is a front-end plus verification. And so they can adopt some pieces of it with some success, but the real big wins are when people adopt the flow homogeneously. Does that help you?

Mahesh Sanganeria - RBC Capital

Yeah, that's very helpful. And just have a question for Bill. Your R&D expenses went up in the quarter can you even describe that little bit?

Bill Porter

Sure it did, I think that would be just the normal increase that we would see in the second quarter from adding a little bit of account and that’s when we have our myriad increase which comes in Q2.

Mahesh Sanganeria - RBC Capital

And so going forward we should expect that to that remains flattish?

Bill Porter

Yes it should. And as you know we are managing our costs and expenses on a total basis. And we do continue to expect to get very good leverage in our operating margins. So costs are going to be growing at that lower rate and then we will see the leverage in the model.

Mahesh Sanganeria - RBC Capital

So, it looks like you took some expense out of SG&A and increased the R&D so that’s how you are going to manage it?

Bill Porter

Yes, again the expenses aren’t going to grow significantly through out the year. Those are all relatively constant, there is going to be small ebbs and flows depending on the different line items. But in total, relatively modest growth and that’s how we are investing in the business, we can get good leverage both in the field and good efficiencies in our R&D teams with better [OpEx].

Mahesh Sanganeria - RBC Capital

Okay. Thank you.

Operator

Your next question comes from the line Terence Whalen with Citigroup.

Terence Whalen - Citigroup

Thanks, a quick one for Bill. Bill it seems like the stock buyback went down this quarter. Can you explain to us and also give us your outlook for stock buyback and your considerations going forward? Thanks.

Bill Porter.

Sure, Terence. We pick our times to be in the market and this I've described to many of you. Our objective for the use of our free cash remains to make investment that will help us grow in the adjacencies. And also to repurchase shares, and as you have seen from some of our announcements, we are active in making some select investments particularly in the DFM areas in Q2 and then also this quarter. So, we keep ourselves busy in both fronts, but our objectives remain the same. And I think you will be seeing us active on both fronts, but we don't telegraph that in advance.

Terence Whalen - Citigroup

Sure, and then a quick follow-up regarding acquisition. It looks like the cash outlay for Invarium was pretty modest. You have also made another DFM acquisition. And then outside of Cadence, we have seen a couple other acquisitions from the other top players. Is there any change in perspective, do you think for either the industry or for Cadence regarding acquisitions within EDA? Thank you.

Bill Porter

So, Terence, let me just to be clear, we announced Invarium after the quarter closed, okay. So that just you don't have the wrong impression on what was closed during the quarter. In terms of our acquisitions in the quarter again and we have been pretty consistent that most of our dollars are going to be going to funding growth in the adjacencies, both in our increases in headcount as well as from our increases in acquisition dollars. So, that's really where the focus of our dollars will go and we continue to also grow the quarter nicely, but that's primarily organic.

Terence Whalen - Citigroup

Okay, thanks.

Operator

Your next question comes from the line of Harlan Sur with Morgan Stanley.

Harlan Sur - Morgan Stanley

Hi, good afternoon. Great job on the quarterly execution. Mike, it seems like we are in the bottom in-process here in the semiconductor industry. Just wondering maybe you can talk about some other demand trends you are seeing in the different end markets, consumer, communications, computing and trends towards migrating towards the advanced technology in each of those segments?

Mike Fister

Yeah, not much just changed. The elements to consumer are really, really hard, exciting. Those are all mixed signal trends. Some of them stay at 180 or 130. There is a lot more aggressive move to try to get to 65 by some people and kind of skip in over 90 as we've talked about before.

In any case, those are extremely complex chips and the kind of tripping over not only mixed signal but verification, a lot of MAC core, bit cores on a die, so there are software core design issues. And that's one of the things that make some fun.

The computing electronics is up and down. I wanted to say the communication especially around wireless that are very exciting, seen some announcements of some of our wireless companies especially building an ultra-wideband product or something that have been testimonies to the technology. Those are kind of mixture of 90 and 65 probably.

On big digital, the biggest of the big are moving aggressively the 45 nanometers and have stepped up to 65 nanometer design or doing all the most complex chips on the digital side and they tend to be extremely power conscious kind of the previous conversation. So, it doesn't always have to be advanced in the movement that funds the need for evolution of the tools.

In general, I think we are in unlocking capability for our customers to either move up that abstraction software verification or whatever, or try to attack productivity you are trying in the market. And that's been wonderfully consistent or release my three years and I think it's going to persist for the next period of time too. So, we are participating in across all those things and tend to make our business little kind of cyclic. So, we don't have to worry about if ones are little bit slower and one isn't or any particular customer.

Harlan Sur - Morgan Stanley

Okay, great. And then queuing off some of the DFM focus question, I mean it actually does seem like from my perspective that the Cadence team is very focused on DFM. I think more recently you brought on board a pretty senior executive in the space with a great track record. I know you’ve made some small acquisitions, the most recent being Invarium. Is the message here that you are just trying to accelerate the progress and penetration into this emerging market segment or I mean how would you characterize the DFM strategy as it stands today?

Mike Fister

It’s a revolution to something that has been relatively static in the industry for almost since the mid 90s, at least from my participation as a chip developer. And our team especially Jim had to get a lot of the rest of the pieces in the play, including they get the Catina technology integrated nicely in which is just a wonderful job of and that was a foundation with the PVS to kind of componentize the platform both up the stack or correct by construction and then sign off.

In the modeling technology approach, that’s an evolution of physical rules, its not about just how close the wires are now you got a model of the things around three dynamics, lithography, metallization as well the progress for [servicing] has got to do with and chemical etch.

Are the way that we change that whole industry and I can appreciate some level of abstractness in that because we are very focused with some big companies at different elements of it? And we embedded the, correct my constructed things up into the design stack.

Yeah, we are passionate about it, Jim has continued to evolve the team, I think its very exciting to see what’s going on there. And I and he are both intimate with the customers all around the world and I like our position. No we are not trying to just replace some other incumbent because that will happen as a byproduct of the revolution. We are trying to change the way that our customers' can really work with the ecosystem Ask the foundries, the IP guys and achieve better results and that's the kind of a change that we're facilitating.

Harlan Sur - Morgan Stanley

Okay. Great, thank you and again, congratulations on a nice execution.

Mike Fister

Okay. Thanks Harlan.

Operator

Your next question comes from the line of Tim Fox with Deutsche Bank.

Tim Fox - Deutsche Bank.

Thank you. Good afternoon. Just following on the earlier question about the activity, the advance nodes up. Can you characterize in your view Mike, where we are. And the mainstream customers move to 65, we've heard a number of competitive benchmarks that are going on. Some customers are struggling mightily. Just wondering, how active you see that benchmarking activity now and where you would think we are in that cycle?

Mike Fister

Yeah, I was given a talk at one of the CD and Mizo a week or two ago. We are at eight active process nodes now as opposed to four, which would have been historical to participate in.

So it's not all about a rush to 65 or 45, although, that's an important element of demonstration of new technologies attacking this DFM things. God helped us in building a big verifiable system, and for the big digital guys have been at 65 and now some of them moving aggressively to 45, that's kind of another year in transition.

And the now, mixed-signal people are trying to go either to 90 or skip over 90 and the 65, we are very far along that transition, but there is a lot of legacy that will move over the next few years.

So, I think as a proving ground I am excited about what we've been able to do with some of those lead vehicles at 65 around complexity, power and manufacture ability or let's call predictability in general. Sometimes that's first time right, sometimes its [parasitic] speed and power for sure. And those guys, those leading edge customers are good kind of roto-routers for the process and there is a lot to show that the topness of 90 actually learned a lot as we got the 65 and the ramp rates can be faster. The thing, I think Tim it's difficult to project and where some of the struggle is, is that 45 because the learning curves don't totally apply to 45, in fact they may not apply very well. Now mostly around manufacturability fancy stuff like lithography, like I characterizes lithography a metallization. And so that's the biggest dynamic. There is one other dynamic it's just a practical one. Some of our customers -- because I am already back to the first question, are trying to decide how to make massive improvements in their cost bases and they are considering mega consolidations.

We've been very proud of the few that we've been able to be public testimonials on and that requires big changes in their mindset and the engineering teams and so that's another source of complication to this whole thing. Now they are trying to get their design teams to figure out how to move or they may have tens if not a hundreds of designs in the middle between the old and the new way. And so, its not just about process technology but in any case they value when you get results that's why these things around power and complexity and time in the market are resonating I think and its takes the complete technology portfolio to do that, whether you are doing a pure digital or mixed signal device and everyone is struggling with that right now.

Tim Fox - Deutsche Bank

Okay. And secondly we've heard from one of your competitors that their new emulation product is doing fairly well at least in the early stages of its delivery, just wondering have you seen anything out of the competition any change in the dynamics to the Palladium family?

Mike Fister

Well, I tell you, we continue to have great success with not only enterprise level but anything that's advanced certification and you could tell in the prepared remarks about some of the co-verification or co-design for software in silicon, I think we only stretch to service that. It's not of just a Palladium thing, for us its sound like stream and the complexity, I am saying the compliment of that entire line is very intriguing. The only place we have seen is upgrade potentials in the competitive install base. I now tell you that we have lost anything to any of our competitors and our Palladium space.

Tim Fox - Deutsche Bank

Okay. And lastly just one quick for Bill. Did you say bookings from time base for 75%?

Bill Porter

I did Tim.

Tim Fox - Deutsche Bank

Okay. And then 18% revenue customer was that more weighted to and upfront just given the size of that revenue?

Bill Porter

Yes that would be, essentially any customer that has that level of revenue in a quarter would be a term contract just to be specific.

Tim Fox - Deutsche Bank

Well termed, okay. Thank you very good quarter.

Bill Porter

Thank you.

Operator

Your next question comes from the line of Matt Petkun with D.A. Davidson.

Matt Petkun - D.A. Davidson

Hi good afternoon. Then just real quickly, I know you guys haven't given the exact number in the last couple of quarters, but roughly what percentage of the revenue in the quarter came from backlog.

Bill Porter

Matt, the percentages for the year continues to be two thirds.

Matt Petkun - D.A. Davidson

Okay. And then there is a lot of talk obviously about DFM and I think its pretty clear to all of us that the private closest revenue opportunity in terms of adjacencies is probably going to be in DFM. But, Mike I was wondering if you could give us some more insight as to what might be going on in your mind in terms of system level design. Obviously, you talked about getting into higher levels of abstraction, your verification product lines, but are there other elements that you are looking at in terms of offering system level design technology perhaps even things outside of traditional EDA offerings?

Mike Fister

Yeah, the first thing I would say is, I don’t know if I would say that the nearest revenue opportunity is DFM and I actually think that as we revolutionize that, that’s got a relatively slow and predictive fulfillment cycle, because you want to be calculative about the customers you are dealing. That’s why there is some discussion.

The fast growing part of the business is in verification of the stack as I call it in there, in that element in of design and that’s because there is large numbers of engineers that are being specialized to go and do that verification and we can start to touch the software side and the system side. We do that through the emulation, simulation and in the VPA the process architecture that we did when we merged with Verasity and that’s the simplest part of the tools.

We are already out there with tools that are called ISX, that appeals to the soft dynamic, software environment, we are doing now, out there with the tool already active called Builder, which allows engineers, either verification and design engineers to make tradeoffs in the construction, how many cores should I have, how much memory should I have, those kind of tradeoffs and we are up there with the incubated technologies that we discussed on analyst day in CTS and then one that we didn’t name that are way up the systems stack.

If you studied Hitachi announcements you will find that they were a testimony for using that CTS technology. So the thing that makes it magical from an all silicon designer is that you can test the idea predictably, through all that kind of fancy tool, mumbo-jumbo, as it will be implemented in the IC.

I've shown that as, in stair-steps that lead all the way down into the implementation. That's the thing that makes our technology strong and why that part of the business is growing great. That's the thing that’s isolated the pieces of system design environment that some of the historical analyst have held out as the golden nirvana. And I think it's a holistic view once again. Probably a lot of people discount that as [marching] high and capable of that. I'm a technology guy. And I think that’s really going to revolutionize the systems designs penetration and it just an unlimited ability to grow up that stack as it's ten or hundreds times the size in total available market of the core EDA designs space expanse.

So, I really think that that's a lot of where the future is and especially in the immediate one, we've enjoyed great success over the last two and a half or two years and I think we've only touched the surface of it.

Matt Petkun - D.A. Davidson

Okay. Thanks. Then just my final question. Mike, if you comment a little bit on the pricing environment both in digital designs as also verification, as the caller early noted the total spend on the semiconductor side continues to consolidate, but it really doesn't seem like in the EDA market to spend a reduction and funding for both new design implementation software as new verification. Obviously, with [Manor] coming in and deciding to finally play in the implementation space, I just wondered what your view on pricing is both in the current quarter and as you look through the remainder of this year.

Mike Fister

Yeah, I don't know. I mean in the digital stuff, it's hardly commoditized in the low end of it. It's got nothing to do with Mentor making an investment or not to be best and I am going to see how that turns out over time. It's the incumbents that are Magma, Synopsys and Cadence. We enjoy a major market position in the back-end stuff. And when we segmented the product line, it stratified that usage by functions, so that we get more value for the more complex functions when you are doing a complex chip or not.

Bill has reported that we've seen some nice trends there and we will continue to report on those. The thing that really makes the value go is that holistic thing like power and that's why that's the mega change, because it drags digital into verification where there is not as much. I mean we are very, I think differentiated in our verification offering. And the pricing is not as aggressive.

Now in a piece of it like Palladium versus somebody else, you build an imitator or competitor Palladium. Maybe there is some pricing competition. But increasingly, we are not just selling it Palladium against that. We sell Palladium with our Incisive product line as our kit itself, as a holistic entity. And they drag each other because they are inner optimized between he pieces.

And so in many cases kind of holistic bindings for preference that demonstrates the interoperability to a business thing, power, time the market, productivity, that's what customers pay for.

The last point I would make is on verification is very interesting and it happens on pieces of the other product line. You can let the computer automation and spun multiple licenses per engineers, so it's not just to proceed. In the simulation, we've shown our customers how they buy 100 licenses and let 100 of those things go at once. One engineer can analyzes those 100 things, so they can get the thing done faster in terms of calendar days. We do that a little bit with our Encounter back-end, because we can spun it across 20 different servers and decrease the amount of its runtime that it takes to do that. And so there is a isolated pieces and verification Encounter placing around and even manufacturer ability where that's going to be material. And that's the third reason why customers spend more money.

Once you get in there and you show them a value always appealing to those business processes, they'll pay more money because that allows our engineers to be more productive.

Bill Porter

Okay, Matt. This is Bill. I'd just like to add as we give our customers more choice for segmentation that in itself is helping us competitively. And then as we continue to differentiate the technology as Mike described, particularly with our GXL or our high-end capabilities, then customers have choice and then they need that functionality which many times they do. They are more willing to pay for it.

And we are also seeing that start to resonate and we are hearing others are starting to follow in the industry following our lead with segmentation and I think that will overall be a good environment for pricing. Customers have choice and then you win with technology. And I think we have the holistic technology that will help us win.

Matt Petkun - D.A. Davidson

Okay. Thanks Bill. Thanks Mike.

Operator

(Operator Instructions) Your next question comes from the line of Sterling Auty with J.P. Morgan.

Saket - JP Morgan

Hi. It's 1:35 file 26 [Saket] for Sterling here. Hey, Bill, two questions for you. First, deferred revenue was down a little over $20 million sequentially. Any thoughts on what cause that?

Bill Porter

Yeah. On deferred revenue, Saket that is just the timing of when we can get customers to part with their cash. So, I would not look into anything. As you know if we can get customers to pay cash ahead on a subscription, it ends up in deferred revenue. If they pay as they go, then it doesn't. So, that's just the matter of timing of billing and the recognition of revenue. I would not read too much into that.

Saket - JP Morgan

Okay. And then secondly just on I guess the adoption of the new Virtuoso platform I think Mike said that it was on plan. Can you give us an idea of where you are relative to the 50% by mid '08?

Mike Fister

You are too early. I think we're making good progress against what we laid out at analyst day. Both in terms of how we're working with customers and its going to take some time to get them to move through an upgrade cycle. But we're getting good feedback, they like the road map and they making decisions to go with that product line and its not always apparent when you look at the table, because the table is influenced more by revenue able transactions. And as we look at the total book of business for custom it is tracking right into the range that I described at analyst day which was between 10% and 20%.

So I just wanted you to know that we do feel that we're making good progress of that product line. It takes a lot of effort so customers are putting that effort in but we see good success and so we're comfortable that we're on the right track with Virtuoso and it is a competitive differentiation for us.

Saket - JP Morgan

Well actually just one follow up and that since you brought up the analyst day presentation. Digital has just been performing so well and at analyst day I think your expectations for that over the year would be zero to 10% growth. Its just been doing so well in the first half do you expect a slowdown in the second half maybe I guess on power that zero to 10% or can you give --?

Mike Fister

No I don't expect a slowdown. I think that's the power of a portfolio. You get strength out of the different components not always being able to predict exactly what's going to outperform. But I would be surprised if we were within the range. I would expect to be above the range that I described at analyst day.

Saket - JP Morgan

Okay. Thank you.

Operator

Your next question comes from the line of Raj Seth with Cowen & Company.

Raj Seth - Cowen & Company

Hi thanks. Bill shifting gears a little bit, just a quick question. Is there a material difference in the contribution at the operating line segment-to-segment, given higher R&D intensity or support requirements and I've got a follow-up?

Bill Porter

No Raj I think through out our largest business segments, custom, digital, verification contributions are relatively consistent amongst all of those. Certainly we are investing a little bit more in DFM, so we are not going to have that same level of contribution. And the more mature product areas, you get a little bit better contribution for example from Silicon-package board, because it doesn’t change as fast. So that’s how I would describe the contribution levels.

Raj Seth - Cowen & Company

So I guess you answered the second part which is the R&D intensity or where you are spending R&D dollars is roughly proportional to the revenue we see outside of DFM, which is obviously small and has some outside short term investments, but is relatively proportional to the revenues we see among the major segments today?

Bill Porter

Yes, I think it's correct we have a little bit more effort in R&D in DFM because it does influence some of the other technologies as we described it has the effect of helping both custom and digital. So we look at that holistically, because they will drive business and also for verification. So if we do get that drive drag on affect from the DFM capabilities across all of the product areas.

Raj Seth - Cowen & Company

Okay. Thanks.

Operator

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

Rich Valera - Needham & Company

Thanks. Bill just a clarification on your response to previous question on Virtuoso, you said it was tracking towards the 10% to 20% mentioned at analyst day. Did you mean on a booking space, is it tracking there?

Bill Porter

Yeah, Rich and I just said it's on our business level, right, so that its not always apparent, just from the revenue table.

Rich Valera - Needham & Company

Sure. Should that 10% to 20% business level through the first half translate into higher revenue for Virtuoso in the second half or is it still just pretty dependent on deal renewal and deal activity going to revenue?

Bill Porter

Well, clearly overtime it will show up but it doesn't always come that quickly, a lot of it does depend on the mix of the upfront business. We'll impact those tables, so as usually you have to kind of do the weighted average over a longer period of time but the business itself will show up its just the matter of time. I can't say its all going to pop in the second half.

Rich Valera - Needham & Company

Right. And with DSOs, they were over a hundred again this quarter and I am not sure if this was an increase or not, but I think you said you want to see mid to high 80s by the end of the year. Is that sort of the same target or has that moved up, in general, how do you feel your progress with DSOs has been?

Bill Porter

We were a hundred in two days this year versus a hundred in Q2 of last year, so we were up a couple of days. What I had estimated last quarter was to be in the mid 80s by the end of the end and based on where we are so far. I would say mid to high 80s, so slight upward revision to the DSO estimate. And I think what we are seeing is, the environment is a little mixed. Now, we see some of the customers deciding to hold another cash a little bit more than others and so I think that's just having a slight upward pressure on DSOs, but as I mentioned I think we can work away through that in terms of and getting to our operating cash flow target for the year and we are focused on doing that.

Rich Valera - Needham & Company

And sort of follow-up to some of the questions on stock buyback, but I guess more general, obviously there is been a lot of talk about sort of private equity and I think that sort of speak to what sort of the ideal capital structure for Cadence, I think you are more aggressive certainly than some of your big competitors as far as capital structure, but still periodically have pretty significant capacity for additional debt, can you just talk about how do you think about that and do you think you are pretty close to an optimal capital structure or you know would you consider making any significant changes depending on the conditions or whatever else?

Bill Porter

Rich I think we will use our cash to grow the business and I think again that's the place I would focus. I think we also realize that we have additional capacity to add leverage and we have led others in doing that and I think we'll continue to look at that to provide the best value to our shareholders overtime and its really to grow the business to use our balance sheet in both what we've got in terms of cash and also what we have in borrowing capacity if that so it takes to really grow the business which is where we think the most value that can be created.

Rich Valera - Needham & Company

Great, thank you.

Bill Porter

You're welcome.

Operator

Your next question comes form the line of Erach Desai with America's Growth Capital.

Erach Desai - America's Growth Capital

Good afternoon. Mike, if I may ask, you have some commentary on the call and then I think in response to Tim's question, you had some very good color in terms of how many active technology notes there are right now, perhaps that's part of the answer, but I'm just wondering how Cadence, you guys are internally quantifying sort of production designs starts, if that’s the way to measure it or whatever by the various notes. Because some of the data and analysis that I am looking at that comes from a proprietary source seems to suggest that mainstream productions is still relatively at 90-nanometer and a 135-nanometer, in terms of design start production. So, I am just curious what your thoughts are on with all this talk about 65 and 45 etcetera.

Mike Fister

Yeah, now I don’t disagree with you. I think there is a lot of predominant volume into quarter-micron too and so we are looking at it across all the different process nodes. We are looking for the lead vehicles are the roto-routers or process lining curve, whatever it want to be, whether its 65 or 45 for mixed signal or high-performance digital and quantizing that as a surrogate to drive volume or design wins in the future.

Those are good for us, learning vehicles for the special functional things that we have for a complex chip or a big mix signal chip and the volume certainly in the 90 and there is a lot of active designs in 65 in 45 and we are looking at designs starts when we analyze this every quarter. We use that with outside sources and collaborate with the customers every time when Kevin or I go out and talk to them. So you get the triangulator across many different things.

Erach Desai - America's Growth Capital

You got some great data directly from your customer so.

Mike Fister

Of course and one of the biggest values that we have and I can only speak of it is. I think our competitive differentiator is we are highly analytic about it as opposed to talking about it drinking beer or something and so it is a valuable interchange to be able to do that, especially as collaboration of where our customers are spending money. Because somebody is making a decision about our 65 nanometer design is going to spend a lot more money. If they do it there then they do it at 90. And so they got to see a productivity increase or something to be able to justify that cause and we sometimes are the unlocker of being able to do that. And I think that there is growing sentiment that says that the metrics to be able to measure those productivity in such, has not been as methodical as it could be.

So, what's really fascinating is to watch those kind of analytic supply, so that people are making good trade-offs as opposed to just running to the most advanced process node they can find. And a lot of the customers will then value and staying at 90 longer or operating at 130 were skipping the process node entirely. And I think it's great sophistication for the industry and will ultimately add a lot of value to what we do, because that's what we help them do.

Erach Desai - America's Growth Capital

No. That's a very useful answer and speaks to I guess to some level, a ROI analysis at an enterprise level for your end-customers, especially those larger customers, rather than a point to decision per se.

Mike Fister

You got it my friend and that's why we look at it holistically. And that's why we're talking about it at the enterprise-level. That's why we appeal to a business level dynamic and in the IT industry we called it total cost of ownership, and that's what the drove the IT change or revolution and that's what will drive this revolution and it values somebody who can do that by experience and by total technology package. And so, yeah, I know it's, I think it's a good evolution.

Erach Desai - America's Growth Capital

Hey, question for Bill. Bill perhaps Jay asked it more diplomatically, so I'll try to be more direct. It is a fact that over the last three or four quarters, you've been getting let say 18% to 35% of revenues upfront in terms of any given quarter. By my calculation it looks like you sold about 110 million in receivables in the second quarter. And if I look back to '98-'99 timeframe I know that's aging at or whatever, but history sometimes is a lesson. I think there was a similar kind of numbers perhaps the percentage of upfront business was a little more than the 18% to 35% range. So, I guess what I am wondering is why won't history repeat itself or why is it different this time that one large deal will not potentially cause a hiccup which is exactly why you went to the subscription model for that not to happen?

Bill Porter

Well, Erach, let me help out a little with clarifying some of the information for sale of receivables in the second quarter, and if look at our cash flow it's about $35 million, maybe you looked at a wrong number not a 100. In terms of our model, I think we've been very consistent that we have about 25% of our bookings. It translates into about a third of our revenue happens from our pipeline every quarter.

And so, do we have the risk that if we miss the right mix of business or we don't get contract, could that cause a blip in results? Absolutely, it could, have we been successful with this book of business over the past almost four years we have. And so I think that's just the nature of our business and our model. If something is and you know as we have been very upfront, a lot of the business happened in the last two weeks of the quarter. And so that's just the way it works.

We are able to be consistent because we have good technology across our portfolio and we have a ability within the field to work a lot of business that funnels down, but it doesn't eliminate the risk. So, I think we are comfortable with business model, but it's not going to be 95% because that's just not the model that we are on. But we've had good success in generating revenues, increasing our margins and continuing to generate cash from that model.

Erach Desai - America's Growth Capital

Okay. I'll definitely grant you that. You have been able to execute two that sort of hybrid model, however long you refer to, I probably don’t have the data. But it just seems like and this is only on the competitive basis, it's not right or wrong that Synopsys as your largest competitor is clearly running a lot more conservatively in terms of taking large deals upfront and therefore revenue recognition upfront.

Mike Fister

Yeah. And again as you look at the ability for them to grow their business, it will be the strength of their technology over time. And I think we will see really where we end competitively and I think that's the thing to pay attention to. The models are different. We have recognized that, but I think we have got good success and we will continue to have success based on the strength.

Erach Desai - America's Growth Capital

Thank you.

Operator

There are no further questions at this time.

Mike Fister

Well, Bill and I were excited to tell you about the quarter and delivering on the operating metrics and the strategy to grow the core business and expanding the adjacencies. Thanks for participating and then all the good questions, and we'll look forward see you at CDNLive! Silicon Valley in September.

Operator

This concludes our conference call for today. Thank you for participating on the Cadence's second quarter 2007 earnings call. You may all disconnect.

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Source: Cadence Design Systems Q2 2007 Earnings Call Transcript
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