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Synopsys Inc. (NASDAQ:SNPS)

F4Q07 Earnings Call

December 6, 2007 5:00 pm ET

Executives

Lisa Ewbank - IR

Aart De Geus - Chairman of the Board, Chief Executive Officer

Brian Beattie, Chief Financial Officer

Analysts

Analyst for Harlan Sur - Morgan Stanley

Raj Seth - Cowen & Co.

Terence Whalen - Citi Investment Research

Jay Vleeschhouwer - Merrill Lynch

Matt Petkun – DA Davidson

Rich Valera - Needham

Sterling Auty - JP Morgan

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Synopsys Inc. earnings conference call for the fourth quarter and fiscal year 2007. (Operator Instructions) At this time, I would like to turn the conference over to Lisa Ewbank, Vice President of Investor Relations. Please go ahead.

Lisa Ewbank

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 recent quarterly report on Form 10-Q; and in our earnings release for the fourth quarter and full year issued earlier today.

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 fourth quarter and full year earnings release and financial supplement. All of these items are currently available on our website at www.Synopsys.com.

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

Aart De Geus

Good afternoon. I'm happy to report a strong Q4, a strong fiscal '07, and a strong outlook for 2008. Three realities account for our excellent results and confidence in our outlook:

First, exceptional financial execution and visibility.

Second, impressive technology strength and a substantial pipeline of new products and capabilities for 2008.

Third, the favorable customer landscape for Synopsys, with increased commitments to our comprehensive solutions.

Let me begin with our financial results. In Q4 and fiscal 2007 we achieved the highest level of business in Synopsys history. We either met or exceeded all of our goals in terms of strong revenue and earnings growth; a substantial increase in ops margin; and excellent cash flow.

Specifically, we delivered non-GAAP earnings per share of $0.40 for the quarter and $1.37 for the year, substantially above the target communicated at the beginning of FY07.

With Q4 revenues of $315 million, we grew our business 11% for the year to more than $1.2 billion, also above our target. We delivered that revenue while adhering to our uniquely predictable business model with over 90% time-based licenses.

Through disciplined expense control and a focus on efficiency, we improved ops margin over last year from 14% to 20%; again, ahead of our targets. We grew our backlog to $2.5 billion, cementing our confidence in the outlook for '08 with over 80% of revenue in hand for the coming year; over 90% for the coming quarter; and already substantial visibility into 2009 and 2010.

Based on our results, our outstanding backlog and our promising technology pipeline, we expect strong results for 2008 as well. In '08 we expect to grow revenue 7.5% to 8.5% while rigorously adhering to our ratable business model. We plan to expand operating margin an additional 300 basis points to 23%, and we expect very solid earnings growth.

Let's take a look at the context in which we offer this guidance. In spite of the turmoil in the financial markets, our customer's environments remained relatively steady. The consumer segment continues to drive growth in unit volume and the quest for more functionality is far from over.

Differentiation through design is increasingly mission critical, boding well for EDA and for Synopsys in particular. Our best users are rapidly adopting 65 and 45 nanometer silicon nodes, with 65 nanometer becoming much more broadly used and 45 nanometer tape-outs accelerating. At the same time, mainstream users wring more capabilities out of mature and cost effective 90, 130, and even 180 nanometer nodes.

From a design perspective, three drivers clearly stand out. The rates for more functions on chips; low power end yield and the most encompassing technical challenges, and productivity and predictability of schedules as the top execution concerns. With our comprehensive technology foundation, Synopsis is uniquely positioned to meet these needs.

One especially notable growth element for us this year was the substantial increase in our territory business. These are start-ups to mid-sized companies served by a local geographic team. As you recall, about a year ago we instituted a strategy to better address this user segment by:

(a) providing a combination of easy to adopt solutions including tools, IP, and services;

(b) introducing new products targeted at their specific needs; and

(c) increasing our marketing and sales focus to better understand and penetrate the segment.

The results so far are extremely encouraging. With further tuning, we are poised to accelerate our progress with these customers in 2008.

From a business perspective, every product group came in significantly over plan for both the quarter and the full year. In core EDA, which grew 9% for the year, we had many successes. In physical implementation, IC Compiler continues to serve as the mainstay for the most advanced designs in the world.

Our overall transition is right on track. The number of tape-outs is growing massively and IC Compiler is helping to solve some of the most difficult technology challenges in the world. In fact, the first ever 45 nanometer consumer chip in volume production was designed using IC Compiler.

Our synthesis and sign-off tools extended their technology leads, especially with our unique topographical capabilities resulting in solid numbers for the year. In verification, both digital and analog mixed-signal it very well. Digital verification delivered outstanding results, substantially outpacing market growth for the year. In Q3, we executed the ArchPro acquisition, adding a new dimension of low power verification to our simulation offering.

On the AMS side, our new XA technology combined the accuracy of SPICE with the speed of FastSPICE. This went into limited availability in September and is already enjoying solid acceptance by customers. In Q4, we expanded our analog mixed signal verification position by acquiring Sandwork Design, a leader in AMS analysis and debugging products.

Moving on to our design for manufacturing adjacency, we delivered very good results as well. In Q4, we had several high profile competitive wins including a large global semiconductor company who adopted our optical proximity correction over its incumbent solution for 45 nanometer production.

Complementing our individual product successes, we are rapidly integrating the design for manufacturing flow as well. Following on the heels of our first integration, PrimeYield, in Q4 we completed yet another key piece: the linking of Odyssey, our yield management solution, with Design [for test].

We had a very strong year in IP and systems as well. We greatly tuned our IP developments and technology coding processes, providing a very responsive and cost-efficient offering for our customers, while maintaining the high-quality IP they have come to expect. We demonstrated our design process discipline through our 30-day integration of the DDR assets of MOSAID acquired last quarter. In fact, we've already had our first orders for the DDR cores.

Looking forward to 2008, we have a substantial pipeline of new products and capabilities with first deliveries on track for this December. Overall, we expect significant new technology advances throughout our portfolio, focused primarily on speed and productivity.

With run support of parallel processing throughout our digital flow, from synthesis to physical design through sign-off. Parallel processing enables significant speed improvements by taking advantage of the multiple processors now available in compute servers.

In physical design, we are shipping completely integrated floor-planning capability, two to three times faster performance and brand new unmatched DFM capabilities for 65 nanometer and below. We will take sign off to the next level, with 2x performance improvements and subtle but significant manufacturing checks. We plan rapid advances in verification with expanded, low-power capability and a new solution targeted for the broader market.

In our analog/mixed-signal flow, we will introduce a broad set of parallel processing capabilities as well. But even more importantly, we will introduce our brand new, custom design solution. This long awaited set of capabilities will substantially complete our company product offering and increase our total addressable market.

In DFM, we also plan to introduce a new tape-out flow. This flow intends to significantly speed up turnaround time for fabs by integrating all three lines of DFM -- lithography, TCAD and yield management. We'll also launch the integration of our mask synthesis and mask data press solutions, allowing customers to do both in the time it now takes to do OBC alone. Finally in IP, we will further expand our product line with new, in-house developed products for USB 3.0, wireless USB, DDR, PCI Express 2.0, and SATA.

In conjunction with our support technology pipeline, let me talk about an even more compelling aspect of our corporate strength. Pushed by technical and economic challenges, customers are increasingly partnering with us to increase their design differentiation and decrease their costs and schedule risks. Years ago, we anticipated that customer productivity would be greatly affected not only by tool quality but also by the needs for much more integrated solutions from concept to volume production.

So we focused on assembling a complete design system, including the links to IP and manufacturing. While every customer has unique needs and its own transformational timeline, the power of increased collaboration has become obvious. This year we made excellent progress with some of the leading semiconductor companies in the world. Last quarter, we communicated that we had moved several important long-term relationships to the next level of collaboration, including Intel, who selected Synopsys as its primary EDA supplier.

Last month, we announced that Renesas, another the world's top ten semiconductor companies, chose Synopsys as its leading EDA supplier. With Renesas, technology collaboration on design and manufacturing efficiency is supported by increased use of our products and increased run rate.

As mentioned earlier, we also saw particularly positive movement in the territories. A growing number of the smaller companies are using Synopsys as the anchor to their design methodology with very good results. We believe that the segmentation initiatives towards more mainstream, easy to use products are paying off and we will continue our focus on broadening our market opportunity.

To conclude, we had an outstanding 2007. We are looking at 2008 and beyond with confidence based on three perspectives: a strong ability to execute financially, supported by a unique business model with excellent backlog; a comprehensive technology platform with a strong product pipeline; and an expanding set of collaborative and committed customer relationships.

With that, I will turn the call over to Brian Beattie, our CFO.

Brian Beattie

Thank you, Aart and good afternoon, everyone. In my comments today, I will summarize our financial results for the quarter and fiscal year and provide guidance for 2008. As a reminder, I will 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 the financial supplement posted on our website. In my discussions, all of my comparisons will be year over year unless I specify otherwise.

Synopsys delivered excellent fourth quarter and full fiscal year results, executing well on many fronts. In fact, our strong performance and momentum throughout the year enabled us to meet or exceed all of our original 2007 targets.

As Aart mentioned, Q4 revenues increased 11% to $315.2 million and annual revenues also grew 11% to $1.212 billion. Business was strong across all product lines and geographies, reflecting the highest orders year in Synopsys history, with total backlog growing to an industry-leading $2.5 billion. This of course includes the benefit of a large Q3 customer agreement. However, even excluding this transaction, business was very robust. One customer accounted for slightly more than 10% of Q4 and fiscal year revenue.

Turning to expenses, Q4 non-GAAP costs and expenses declined sequentially to $246.2 million as the variable compensation impact of an excellent Q4 and full year was offset by overall expense control. For the full year, we achieved our total annual expense target of a very modest 3% increase, inclusive of our extra week of spending in Q1.

GAAP expenses were $277.4 million, which included $1.1 million of in-process R&D; $12.7 million of amortization of intangible assets; and $15.3 million of share-based compensation. For the year, GAAP expenses also increased just 3%.

I'm very pleased with the progress we've made on controlling expenses. We've outsourced and offshored certain processes, shifted our employee base by approximately one-third in lower-cost geographies, and are focused on streamlining our business processes. Of course, we are not done.

Even as we invest in technology development, including the advances we'll introduce in 2008, we plan to keep expense growth to about half of revenue growth to reach our margin expansion targets. In 2008, we'll focus on several expense control initiatives including:

  • Reengineering across our lead to collect process to maximize efficiency.
  • Continued focus on hiring in lower-cost geographies.
  • A reduction in CapEx spending by about 10% as we centralized IT resource management.

As the result of both revenue growth and expense control, Q4 non-GAAP operating margin increased to 22% for fiscal 2007 and we exceeded our margin commitment by achieving 20% for the full year. We expect non-GAAP operating margin to increase approximately 300 basis points in 2008 as we continue to move towards our next target of mid to high 20s.

Turning now to earnings, GAAP earnings per share were $0.27 for the quarter and $0.87 for the year, both up substantially from a year ago. Non-GAAP earnings per share were $0.40 for Q4 and $1.37 for the year, both representing increases of approximately 80% over the same periods of last year.

Our non-GAAP tax rate was 21.4% for the quarter. Better than our guidance range, due primarily to geographical business mix and higher than expected tax credits. For the year, we reduced our tax rate to 24% from 32% last year through the optimization of our international operations and last year's reenactment of the R&D tax credit.

Our revenue visibility remains strong. Upfront revenue was 6%, well within our target range of less than 10%. Additionally, the amount of backlog that turns into revenue over the next year is already greater than 80% of our 2008 revenue target.

The average length of our renewable customer license commitments for the quarter was approximately three years, consistent with historical trends. For FY07, it was approximately three-and-a-half years, primarily due to one large, long-term contract. This metric will continue to fluctuate depending on the mix of contract signed, but we believe it should remain in the three-year range.

We continue to have the most predictable revenue model in our industry and we believe in all of software. It allows us to focus on the long-term strength of the business and on growing and deepening our customer relationships and we believe this is beneficial to our customers and our shareholders alike.

Now turning to our key cash and balance sheet items. Cash and short-term investments increased $190 million sequentially to $984 million due to strong operating cash flow of $173 million. For the year, operating cash flow doubled to $433 million, driven by very solid collections and two payments made by one very large customer.

Capital expenditures were $8 million in the quarter and $45 million for the year, down 8% from last year.

Now as you know from our previous disclosures, we have been involved in a material tax dispute with the IRS for the years 2000 and 2001 associated with the establishment of our Irish subsidiary. Today we are happy to report that we have reached a tentative settlement with the appeals division that would resolve this dispute. The settlement is subject to further review and approval within the government, which we will expect to take several more months, but as of today, we believe that settlement is likely. We reiterate that if the settlement becomes final, we are adequately reserved for this item.

Now while this discussion was ongoing, we repurchased approximately 0.5 million shares of our stock in the quarter for 11 million. For the full fiscal year, we spent $152 million repurchasing approximately 5.7 million shares, buying back approximately 60% more shares than we granted during the year. We considered Q4 buyback activity an anomaly and expect to return to our more aggressive pattern of buybacks, subject of course to our ongoing review of uses of cash. We have $430 million remaining on our current authorization.

In Q4, net accounts receivable totaled $124 million and DSOs declined 25 days sequentially to an industry-leading 36 days, reflecting the high quality of our accounts receivable portfolio and the timing of invoices. Deferred revenue at the end of the quarter was $643 million.

At the end of the year, we had approximately 5,200 employees, a slight sequential increase due to our recent acquisitions. Now let me address our first quarter and fiscal 2008 guidance and then provide some additional comments on our expected quarterly profile throughout the year.

For the first quarter of FY08, our targets are:

  • Revenue between $308 million and $316 million.
  • Total GAAP costs and expenses between $262 million and $278 million, which includes approximately $17 million of share-based compensation expense.
  • Total non-GAAP costs and expenses between $236 million and $246 million.
  • Other income and expense between $3 million and $6 million.
  • A non-GAAP tax rate between 27% and 28%.
  • Outstanding shares between 146 million and 151 million.
  • GAAP earnings of $0.20 to $0.28 per share and non-GAAP earnings of $0.37 to $0.39 per share.
  • We expect greater than 90% of the quarter's revenue to come from backlog.

For fiscal 2008:

  • We expect revenue between $1.3 billion and $1.315 billion, a growth rate of approximately 7.5% to 8.5%. We plan to limit total non-GAAP expense growth to about half of revenue growth.
  • A non-GAAP tax rate of between 27% and 28%, which does not assume renewal of the R&D tax credit.
  • Outstanding shares between 146 million and 151 million.
  • GAAP earnings per share of between $0.94 and $1.11, which includes the impact of approximately $73 million in share-based compensation expense.
  • Non-GAAP earnings per share of $1.54 to $1.60.
  • Cash flow from operations of greater than $325 million.
  • We are targeting a 23% non-GAAP operating margin for the full year.

In addition, we are repeating our commitments to achieve our next non-GAAP operating margin in the mid to high 20s over the next several years. We plan to get there by making the appropriate level of investment back to the business to drive sustainable, long-term growth while at the same time controlling expenses.

Finally, let me provide some comments on our 2008 expense profile to help you as you model your quarterly estimates. While revenue was quite predictable, the timing of expenses is more variable. As a result, we expect Q1 expenses to be lower than the rest of the year, reflecting anticipated timing of deals.

For the balance of the year, we expect the expense profile to be more typical with Q2 and Q3 moderately below a traditional higher Q4.

In summary, we are very pleased with our exceptional fourth quarter and fiscal 2007 results. We leave 2007 in excellent financial condition. Our balance sheet has never been stronger. Our commitment to revenue growth and margin improvement is unwavering and we look forward to another year of solid business execution in 2008.

With that, I'll turn it over to the operator for questions.

Question-and-Answer Session

Operator

Your first question comes from Harlan Sur - Morgan Stanley.

Analyst for Harlan Sur - Morgan Stanley

In regard to the demand environment, I think the last couple of weeks or so there has been some concern about customer sentiment in terms of their spend on EDA tools. Could you give a little bit more color on that, if you’re seeing any kind of slowdown? Thank you.

Aart De Geus

Sure. We are not seeing any slowdown. Obviously with all the noise in the financial market, there are a lot of questions of what are the impacts of that on our market? First I would observe that there has been very little impact on the technology market, maybe with the exception of some software in the financial circles.

But having recently talked to about 20 CEOs in a room about what they were seeing, not a single one of the technologies saw any real slowdown and everybody else is reading the newspapers as well. I don’t want to say that we won’t be affected by it, but only as far as what Synopsys can see we, I think, are doing very well.

Operator

Your next question comes from Raj Seth - Cowen & Co.

Raj Seth - Cowen & Co.

Brian, can you talk a little bit about what your strategy is with regard to buybacks? I know, I probably harped on this too much in the past, but you have now got $1 billion on the balance sheet and you are guiding for $300 million more in cash from operations. How do you think about buybacks? I acknowledge the comment you made about Q4, but how should we think about the pace of buybacks going forward at these kinds of price levels?

Brian Beattie

We always look at our cash balances and looking at the appropriate level of where we invest, whether that is internal growth, M&A or stock buybacks. We’ve generated a very good amount of buyback activity this year with $152 million and we bought back 5.7 million shares and did pretty well for the full year, but we were a little slower in the fourth quarter. Obviously while we’re negotiating that very significant IRS settlement we felt we shouldn’t be in the market; as a result of that we indicated we would be back to our more aggressive pattern now that we’ve made this announcement relative to the IRS settlement.

We see it as an important part, but again, we will always balance between the appropriate uses of that cash and do the appropriate levels going forward.

Raj Seth - Cowen & Co.

Brian, with this level of cash sort of $1 billion again going to $1.3 billion, how much do you need to run this business? There is not a lot out there that is sizeable for you to buy. What are you waiting for, is the question?

Brian Beattie

Well, we do continue to look and clearly in this financial environment having close to $1 billion in cash is very, very strong and allows us a lot of dry gun powder to put our strategy into effect without having to depend on the external credit markets. I really believe that we are at the strongest financial position we’ve been on our balance sheet.

All that being said, we have been very aggressive and in many years buying back twice as many shares as we grant and we continue to look at that as a pretty good use of cash, but you always have to balance that with external opportunities that we really focus on.

Raj Seth - Cowen & Co.

Aart, you mentioned that you have a lot of technology coming in ’08 and you touched on a custom flow. Can you talk a little bit more about the strategy there? Do you go heads-up against Virtuoso or how should we think about what you have coming?

Aart De Geus

Obviously the custom implementation side has always been -- or for a long time been the singular hole in our product offering. Being able to fill that is really a fantastic step forward because it completes the instruments needed for broader strategy.

Having said that, obviously there is at least one very, very strong player on the market and frontal attacks are never wise. I would like to highlight the fact that on the analog mixed signal side, on the custom side from a verification point of view, Synopsys actually is very, very strong. So from that perspective, we can clearly roll out the new product in conjunction with the position that we already have. I think it will be going quite well for us.

Raj Seth - Cowen & Co.

Is this something we should expect in the first half?

Aart De Geus

We are a little reticent to give more detail here, given that typically we announce these type of products mainly aimed at our customers. So you will certainly hear more about it in the first half.

Operator

Your next question comes from Terence Whalen - Citi Investment Research.

Terence Whalen - Citi Investment Research

My first question relates to some of the larger account consolidations that you have had recently with Intel in the third quarter, Renesas in the fourth. I think you mentioned one other. It appears based on your expense guidance that we are not expecting another one in the first quarter but we could have others in fiscal ‘08.

Can you rewind a couple of quarters and explain why these consolidations have begun to occur? What are the factors that are really driving the wins? It seems like the acceleration in your business in regard to account consolidations has occurred while it has dropped off in some of your competitors.

I was wondering if you could make observations and comment on that?

Aart De Geus

My first observation is account consolidation is something that happens gradually, over time, but is invariably driven by two things: technology needs and economic needs; invariably, the two play well together.

On the technology side, we have said for a while that complexity is growing much more rapidly than Moore’s Law, because when you do a chip design it’s not only having many more transistors, if the interaction between power and timing and signal integrity and yield all play together making it much more difficult for people to solve things. Therefore, an increasingly integrated solution has a much, much better chance of getting good chips in a predictable time flow.

On the economic side, you have clearly seen that there has been a massive change in the semiconductor industry in terms of their investments as playing for the next technology node development has become very expensive, and therefore either you see consortia or you see people deciding to team up with foundries. Economics are starting to play a big role in looking at how people move forward.

That brings me to the third point which is I think our strength. We have seen this coming for a number of years, we have prepared for it by having a complete design flow that is state of the art that takes into account all of these solutions; is well connected to the IP flow; it is well connected to the DFM realities and when we are talking about collaboration, it is actually bringing it about with customers, helping them in the transition and helping them essentially improve their ROI both very quickly in the short term, but also substantially in long term. That is what will drive the selection of preferred vendors.

Terence Whalen - Citi Investment Research

If I could touch on the recapitalization issue that was spoken about previous to my question, you have $1 billion cash. You are generating over $300 million. Also, you are now in the third or fourth year of this steady three-year model. So clearly, you have tested the model change out, have made observations, are more mature into this. You’re growing at a consistent rate.

What’s your thought not only on returning the cash with buyback, but also on a dividend potentially, given that you can generate a 4% yield with less than 50% of your free cash flow each year? Thanks.

Brian Beattie

Terence, as I was saying in the previous response, we will look at all of the alternatives, recognizing how we can leverage our cost of capital to a higher return going forward. To this point, our buyback and our return to shareholders has been very aggressive, basically about twice as many shares we grant each year to improve the EPS and have a very solid contribution to both EPS and obviously to the price of the stock.

In addition, we are generating a significant amount of cash and continue to focus on that as we go forward with good collections from our customers, a very solid DSO metric on those receivables and obviously the quality of the product is working well and customers are paying on time; I think reflective of very good relationships that way.

Then we do look at where we can use that cash. I believe at this point relative to dividends, most technology companies that are continuing to grow and pushing the levels we are looking at are not really focused on just returning to the shareholders but leveraging that capital into higher returns than our cost to capital into our markets, into the adjacencies of our IP, DSM businesses and other areas that we can continue to drive synergies in operations revenues and our products that will ultimately return a far greater amount to our shareholders than simply a dividend.

Operator

Your next question comes from Jay Vleeschhouwer - Merrill Lynch.

Jay Vleeschhouwer - Merrill Lynch

Aart, I would like to ask about some of the assumptions behind the ‘08 outlook, starting first with your geographic perspective. You had a good year-over-year comparison in Asia Pacific outside of Japan; that’s been the fastest growing market regionally for EDA for many, many years. The question is, would you expect to be able to maintain a disproportionate growth in Asia Pac?

In addition, you referred to some of the structural changes that have occurred in the semiconductor market. How do you see that specifically within Europe and Japan, which have already been both concentrated regions anyway in terms of a relatively small number of large customers?

Aart De Geus

That’s a lot of questions, Jay, because what you’re really looking at is the question of how does the overall global semiconductor industry develop over time? I share the perspective that Asia Pac has grown rapidly and will continue to grow rapidly. At the same time, when I look at the worldwide revenue distribution by region for the last three years, I do see change but the change is relatively minor. The reason for that is because utilization is going up rapidly in Asia Pac, but there are a number of global companies where the buying patterns may still be centralized at their headquarters, which typically for the large companies tend to be the U.S. The revenue itself is an interesting but not quite sufficient indicator of what’s happening in practice in the field.

Secondly, you asked specifically about regions such as Europe and others. We do see that there are changes there as well. As you know FC, NXP and Infineon all three essentially have gone towards the path that I would say is fab light, not fabless. What we are also seeing is an increased number of start ups in Europe and specifically in Israel. And so these things sort of come a little bit in waves, and I think we both more sensitized and much better equipped to deal with them with having now a much broader product portfolio.

Overall, I think it is sort of a pathway towards a more complete solution, where the solution includes the words “be prepared to serve globally”.

Jay Vleeschhouwer - Merrill Lynch

In terms of some other metrics that you are thinking about for ‘08, do you expect to be able to continue to drive higher run rates with many, if not most, of your customers? Do you think your run rate expansion track record in ‘08 can be what you’ve seen in the last year or more, particularly since you’ve been trying to measure and compensate on run rates more than you have in the past?

Aart De Geus

That is definitely the plan. It has to be the plan because notwithstanding the fact that we do see new start-ups, the reality is that the vast majority of the revenue always will come from companies that are well-established. Therefore, we need to increase our footprint going forward.

You are also alluding to the fact that our compensation has become more induced by looking at run rate growth and that actually has been quite effective. One needs to be careful to not go overboard there, but at the same time I think we have seen very good progress in being able to articulate more value.

Lastly, because the solution will be complete as we deliver the custom capabilities, we can now really leverage our position into both the adjacencies and specifically the new business in IP has been very, very strong and I think will increase substantially in the coming year again.

Jay Vleeschhouwer - Merrill Lynch

Just a couple more. On your installed base, other than IC Compiler, for which products, if any over the last year or so have you seen the most significant increases in the base in terms of the number of licenses? If there is some way you can measure that as a capacity indicator; or conversely, have there been any products where the installed base of usage might have been in decline, notwithstanding the general trend in run rates overall?

Aart De Geus

The set of tools where we have seen an increased base is actually quite substantial. Clearly, the leads are in the verification side, VCF; we have also had growth in the things that touch the lithography, and that is directly linked to just the amount of work that has to be done there.

Interestingly, Design Compiler has done very well, the topographical capabilities are really helping substantially in increasing the predictability of design. You mentioned IC Compiler has now surpassed Astro and you may recall that a number of years ago we predicted that we would be on a good ramp, and we are on a good ramp.

Now these products tend to pull with them others, but I think I mentioned some of the key anchor points.

Jay Vleeschhouwer - Merrill Lynch

Brian, you or Aart referred to the strength in your territorials business. Does that necessarily correlate to marginal increases in your upfront business? It looked like your upfront business was quite strong in Q4 at around $20 million in sales. Does that correlate to the strength in territorials and would that continue into ’08.

Brian Beattie

No, it really doesn’t relate to the specific regions. The model is consistently applied throughout all of the product lines and all of the geographies and 6% is our upfront levels relative to the revenue, and it is very consistent and well within our target range of being less than 10%. So seeing as we’ve already got more than 90% of 2008 already completed for our first quarter and more than 80% of the year already booked, it really is reflective of a very, very strong ratable business model.

Jay Vleeschhouwer - Merrill Lynch

Thank you.

Operator

Your next question comes from Matt Petkun – DA Davidson.

Matt Petkun – DA Davidson

Aart, I might have missed this because I snuck out of the office for a second, but could you give the commentary about tape-outs? I think on the last call you said you would no longer be discussing 65 nanometer, it is so mainstream now, so I was wondering if you gave that data?

Aart De Geus

Actually, I did not. Let me give it you now. We sort of coerced the team to count one more time. So for 65 nanometer, we have a total active design number of 551, with a tape-out count of 307. The tape-out count is substantially up from where it was just three months ago.

For 45 nanometer designs, we have a total active design of 109 and a tape-out count of 26, also substantially up. This will be the last time that we report 65; passing 500 is just too much work to really audit all of this work.

Matt Petkun – DA Davidson

Aart, given that metric, I am wondering what you’re thinking just in terms of 65-nanometer design activity next year? More specifically, what I’m looking at is new fab construction. Obviously it’s impossible to completely correlate what’s going on from a capacity perspective in the industry relative to the design part of the industry. Still, if you look at the foundries, a small portion of their revenues today come from 65 nanometers. Do you think that your opportunity at 65 now is obviously you have a lot of designs there, but is there still room for growth in IC Compiler for 65 nanometers next year or is next year really about 45 nanometer design activity?

Aart De Geus

No, I think there is substantial opportunity for growth of 65. As a matter of fact, I think that much of design is going to now migrate rapidly to 65 as the mainstream, including for some smaller companies and including for many companies that are sort of jumping over the 90-nanometer point. Those folks actually do need some handholding, which as you can imagine, we are happy to provide.

Having said that, the most advanced designs are all migrating to 45 given that there is a natural delay between design and manufacturing capacity needed. I can say though that having talked recently to some of the top foundries, they are starting to layer in now more capacity for 65 and I think certainly in the second half of ‘08 we will see that happening.

Matt Petkun – DA Davidson

Aart, if you could comment a little bit more specifically on what’s going on in the design for manufacturing realm, and not just in the caps and the design rule checking part of the business for you, but more specifically what you are seeing in terms of process aware design, what you have been investing in with TCAD and with your HPL acquisition.

Are those going to be assets that you start to really see monetization in ‘08 or is that really something that needs to be longer term in your mind?

Aart De Geus

My first observation is those are assets that we are actually making very good money with right now. That doesn’t mean that all of the DFM problems are killer problems because our design tools are very capable of proactively avoiding them.

I would say that overall it is becoming now much more urgent and much more important to have strong technology between 65 and 45, and that we are now rapidly going to see that the tolerances, the variability, the issues around sizes on these designs compared to the actual size of the design is so large that the DFM connection will become a rapidly strong differentiator for our offering.

The very fact that I emphasized a little bit the efforts that we have put in integrating and aligning all of these capabilities makes it a good indicator of where our future will be, which is to provide a complete solution. As a matter of fact, we see the statistical needs already ramping up.

Matt Petkun – DA Davidson

Is a standard subscription model the right revenue model for a world where your tools may be delivering a lot of value to a few number of chips at 32 nanometers and beyond?

Aart De Geus

That’s a very good question. Let me parse it out into two dimensions. One is the whole dimension of revenue accounting, steady business model, financial predictability and so on. We are absolutely strong believers that the business model that we are on, that it took us a number of years to get to, is a very good business model because it is the very model that right now allows us to look into ‘08 and as a matter of fact ‘09 and ’10 with a high degree of confidence and thus make very proactive judgments as to where we want to invest, how we want to run our business.

Having said that, the very fact that we are entering the opportunities space of providing much more complete solutions that we have a much more complete product portfolio, I think gives us an opportunity to now work with our customers and look at touching their fab budgets, touching their IT budgets and rethinking how we should grow our business. But the fact that growth is on our minds should not be a surprise.

Matt Petkun – DA Davidson

But, you would hope to tap those fab budgets with license revenue or maybe a different model?

Aart De Geus

This is precisely where our creativity and thinking has to go into right now. Given that we are looking at many of these opportunities, let me hold back a little bit as to what we want to do specifically; but having said that, we are clearly looking at ‘08 as a great opportunity year for us to think through how do we evolve the engagement model with the customer to take advantage of the fact that they really need us and we need them to work together. That is an opportunity I think to look at how we want to grow our business going forward.

Operator

Your next question comes from Rich Valera - Needham.

Rich Valera - Needham

Brian, I was wondering if you could give us any sense of the size of your settlements in the IRS issue? I think the original claim against you guys was somewhere in the $400 million range. I wonder if you could tell us what you currently have reserved on you balance sheet against this and any more color in terms of what you actually expect the settlement amount to be?

Brian Beattie

We are not really in a position at this point to disclose the ultimate settlement because we are not there yet. The normal process is that once you reach this tentative settlement with the IRS Appeals Division that is then in turn put to a normal review of the Joint Committee on Taxation of the U.S. Congress. So, that’s the one that we are saying it may take several more months to have it finally resolved, but we have reiterated that the accrual that we put in place, the provision for that liability is fully satisfactory and therefore when we finally receive that signed document in a couple of months we’ll be able to make any adjustments that are required.

So at this point, I am confident it’s going to get approved. The original amount, just to clarify the number of it, is an assessment, a $477 million assessment against the company and again reiterating that it is now in our range of the accrual we already made for the company and that will flow through when we get the final signature.

Rich Valera - Needham

Can you tell us what that accrual is?

Brian Beattie

Not really. We don’t give out the specifics of each of the accruals like that and really prefer at this point until it’s signed to release that when we get the final signature, because it could move around perhaps and we just don’t want to send the wrong expectations here. But we are fully accrued at the appropriate level and we will keep you posted as we get the final settlement signed.

Rich Valera - Needham

Would you expect that number to be in your K?

Brian Beattie

No, until it is signed the rules are officially from an accounting perspective that until you have the final signed document, you have an ultimate agreement signed, you are not in a position to release any of those accruals and to disclose even the tentative settlement because it’s not finally, finally signed yet. It just allows us to protect our position going in subject to this final Congressional U.S. Tax Sub Committee to approve that.

Rich Valera - Needham

Aart, just in the SPICE and FastSPICE area you mentioned you have a product, I think you called it XA, that is relatively new and was seeing good traction. Is this a multithreaded product and essentially in response to Magma’s FineSim Pro or is there something else coming out on your end that is a multithreaded response to that?

Aart De Geus

No, no. We have had multithreaded capabilities in quite a number of our tools; this is one of them that takes advantage of that. Actually, it’s a capability that has been in development for quite a while, it was introduced – I forget exactly which month, I think maybe September officially or so. We have quite a number of users already. Speeding up things in that domain is a never-ending quest but we’ve made fantastic progress and the customer reception is outstanding.

Rich Valera - Needham

Can you give any sense of if you have had any sort of competitive situations since that tool has been out there? There are some claims on their end of some pretty substantial performance deltas relative to existing tools which presumably were yours. I am just wondering if you have any sense of how much that tool has improved relative to the old tool?

Aart De Geus

Well in all of these domains there are constant competitive battles and you have to really defend your turf or attack on the basis of your strength. As a company we are probably on the conservative side in making bold predictions, but fundamentally we’ve done very well and actually have won a number of accounts. We feel very good about our technology, but it is a competitive environment and there are multiple players there.

Rich Valera - Needham

Aart, you have observed over the last several years that the long-term growth rate of the semiconductor industry has been trending down first towards low double-digits and it seemed like it is trending towards single-digit now. Where do you see the long-term growth rate of semiconductor revenue? In that context, where do you see the long-term growth rate of EDA going forward?

Aart De Geus

If I may just put it slightly differently, I have not been a predictor of the trends going down. I have been arguing that we had a secular change right after 2001 and that before that the semiconductor market was essentially living a little bit beyond its means, and so was most of high-tech, by the way. If we look at the actual curve, you see that in ‘01 there was a massive correction on ‘00, and after that of course the market came somewhat back.

Today I would think that the semiconductor market is growing if you want to be broad, between 6% and 9% and of course from year to year there will be fluctuations and you can see that the fluctuations are a little bit less large than they used to be in the ‘90s and ‘80s. I think that’s fundamentally because there is much more capacity available, therefore fluctuations around individual products don’t trigger much supply demand on balance.

But going forward, I think the market will continue to grow at about that rate and one of the encouraging signs of course is that no matter what happens to the global economy there is no question that electronics and specifically consumer electronics is going to keep growing massively in terms of demand, because they are so many people that are joining the mainstream of buyers. That will continue, in my opinion, for quite a number of years.

Operator

We do have five minutes remaining in the conference. Your next question comes from Sterling Auty - JP Morgan.

Sterling Auty - JP Morgan

As you look at the margins in 2008, I am curious how much of that is being helped by the fact that 2007 was such a big bookings year, do you actually end up getting a little bit of a boost from some of the variable sales expenses? Where else are you going to get the additional leverage from in 2008 for the margin target?

Aart De Geus

Well, there is no question that you always have to slightly weld a double-edged sword, which is if you do really, really well in bookings you have to pay commissions and you have to pay bonuses to everybody, which comes out of the expense line. That is never quite an easy dance as we try to predict this. Having said that, I will take higher bookings any day versus not having to pay the expenses; that’s obviously clear.

Going forward, you have heard us now talk about operating margin improvement for at least two or three years. I do believe that within the company we have a much more systematic discipline from an attitude point of view and processes from a management perspective to keep doing that.

Our intent for ‘08 is to grow 300 basis points and that is really our top constraint. Our top objective is obviously the top line revenue growth and then the longer-term objective is really to make sure that we can sustain growth in ‘09 and ‘10.

Much of our own focus and compensation is to put in place or to have in place an orders process that looks at a multi-year set of arrangements and I think we have become quite proficient at that.

Sterling Auty - JP Morgan

Given several of the very large contracts that you closed this past fiscal year, how should we think about the backlog as it migrates through to 2008? In other words, can you still grow backlog year on year next year, or is it just to tough of a comparison?

Aart De Geus

I think it is a tricky comparison no matter what because it’s always a function of a few very, very large deals that when once you get them obviously backlog goes up and then for the next typically average three years, they roll off gradually.

Secondly, the timing of those or indeed the length of the deals if it is beyond three years would impact that.

Having said that, I think almost more important from your perspective should be our confidence in coming into a given year with a strong coverage because that is really what’s giving us the ability to predict the short and medium term well, thus reducing substantially the financial risk.

Secondly, it allows us to tune carefully how we grow the company and take maximum advantage that we have. So obviously growing backlog, whichever it is, be it the three months, the 12 months or the overall backlog is all good. The short-term backlog is really what determines the financial security of the company.

Sterling Auty - JP Morgan

Last question would be on cash collection. On some of those large deals that you did this past fiscal year, how much of that has already been collected or what were the collection terms? Are they annual over the life of the contract? I am just trying to get a sense as to how that will contribute to cash flow in this fiscal year?

Brian Beattie

We factored in obviously to the forecast for ‘08 cash the payments; receipts are always just about the timing, does it fall into ‘07 or does it move into 2008? With the performance and focus we had on DSOs coming in at 36 days was great. We almost doubled our cash to $433 million in ‘07 and then our estimates for 2008 take into account that there were two payments from a pretty significant customer that did come in, were both invoiced and collected in 2007. So that obviously doesn’t follow and replicate itself again in 2008. it is all factored into our guidance on cash.

Sterling Auty - JP Morgan

I would assume that is factored into the guidance, so the two payments came in early; what’s left? Are all the big collections on the big contracts already done, or is there more left?

Brian Beattie

There is clearly more left. That’s what we factored into our cash forecast for 2008, to be over $325 million of operating cash flow for next year, all of those ongoing payments, including annual payments from these customers continue to come in 2008.

Aart De Geus

With that, if you don’t mind, let me close off the call. We have passed our one hour allotment. We really appreciate your time, and of course your support over this past year. ‘07 in many, many ways was a very, very strong year but clearly the most important aspect of the strength of ‘07 is the confidence it gives us for ‘08.

I hope that we delivered well against your expectations and are looking forward to a strong ‘08. Thank you very much.

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Source: Synopsys F4Q07 (Qtr End 10/31/07) Earnings Call Transcript
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