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Cadence Design Systems (NASDAQ:CDNS)

Q4 2007 Earnings Call

January 30, 2008 5:00 pm ET

Executives

Jennifer Jordan – IR

Michael Fister – President, CEO

William Porter – Executive VP, CFO

Analysts

Jay Vleeschhouwer - Merrill Lynch

Harlan Sur - Morgan Stanley

Rich Valera - Needham & Co.

Sterling Auty - JP Morgan

Analyst for Mahesh Sanganeria - RBC Capital Markets

Raj Seth - Cowen & Co.

Tim Fox - Deutsche Bank

Terence Whalen - Citigroup

Operator

Good afternoon. I would like to welcome everyone to the Cadence Design Systems fourth quarter and fiscal year 2007 earnings conference call. (Operator Instructions) I would now like to turn the call over to Jennifer Jordan, Corporate Vice President of Investor Relations for Cadence Design Systems. You may begin your conference.

Jennifer Jordan

Welcome to our earnings conference call for the fourth quarter and fiscal year end 2007. The webcast of this call can be accessed through our website at 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 September 29, 2007. In addition to financial results prepared in accordance with generally accepted accounting principals 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 discussion. I’ll now turn the call to Mike Fister.

Michael Fister

Thanks Jennifer. Overall I am pleased with our accomplishments and results for Q4 in 2007. Q4 bookings exceeded plan and we grew backlog to $2 billion. We reached a 30% non-GAAP operating margin level for the year and continued to build enterprise level relationships with key customers. At the same time it’s not secret that the economy is under pressure. A fourth quarter survey of CEOs put their confidence at the lowest level in seven years. When speaking with semiconductor and electronics customers their tenor is increasingly conservative reflecting concerns about the tightening semiconductor ASPs and the need to run their businesses more efficiently. Therefore we too are going to be conservative in how we forecast and run our business in 2008.

Throughout 2007 we continued our strategy to concentrate on key customer focuses at the enterprise level such as improving productivity, reducing turnaround time and [inaudible] methodology especially up the stack. This approach allows us to demonstrate that our solutions and services have measurable impact. Functional verification was the best performing product area in the fourth quarter led by our advanced verification solutions and incisive enterprise. Employing system level verification and validation has a clear impact on customer’s time to market. Cadence continues to outperform in this market sub segment. The fourth quarter was our strongest ever for hardware assisted verification. We shipped over a billion gates of systems world wide. The businesses included new engagements, renewals and upgrades to our most advanced solutions. In fact, we have yet to have a competitive loss in this arena. A leading European company which is renowned for its selectivity just chose palladium three as is its emulation platform after an extensive evaluation of the current competitive alternatives.

Another of our advance verification customers, Nvidia, was named Technology Company of the Year in the January 2008 issue of Forbes Magazine. The article highlights their decision to adopt emulation at a defining moment in their competitive history in order to speed time the market. There’s a picture of their palladium center in the article. Quoting Brian Kelleher, the senior vice president of engineering at Nvidia, “We continue to invest in Cadence’s most advanced emulation solutions in order to meet the demands of getting new graphics chip to market every six to nine months.” As promised with Mentor Graphics, we publically released open verification methodology. OVM has generated extremely high levels of interest. In fact there were nearly 1500 downloads in just the first two weeks. Already it’s won the Electronic Design Magazine 2007 Technology of the Year Award in the EDA category and is a finalist for the International Engineering Contortions’ Design Vision Award.

Our latest release of incisive enterprise now fully supports OVM providing best in class verification capabilities for system Veralog, E, System C or any combination of these languages. Customers have clearly picked up on this differentiation and we have good momentum here. In the systems area we announced the technology collaboration and sponsorship with BMW Motorsports. [inaudible] on race cars are sophisticated systems that require control and coordination of hundreds of parameters and also very short development windows. Cadence is partnering with BMW Motorsports to develop new design flows and methodologies for their automotive systems.

We experienced strong growth in digital design in 2007 driven by consolidations in competitive that were founded on our low power leadership. Customers are saving time to market while dramatically improving the power consumption of their designs using the Cadence low power solution. With more than 200 projects underway and over 50 tape outs to date. With Arm, we introduced new implementation reference methodologies for two Arm processors which leveraged the Cadence low power solution to enable advance low power design techniques. These methodologies allow designers to exploit Arm’s intelligent energy management technology and realize up to 60% reductions in energy consumption.

STARC released its PRIDE reference flow during the fourth quarter. PRIDE uses the Cadence low power solution to deliver this fully automated flow for architectural exploration, design, verification and implementation of low power SoCs at 65nm and 45nm. It also takes advantage of our unique design for manufacture ability technologies to reduce overall design time and increase production yields for high volume products. STARC confirmed a 3X improvement in design time using the Cadence low power solution for architectural exploration to floor plan while the CPF base flow enabled up to a 40% power reduction in the pilot designs.

Our design for manufacture ability approach delivers an end to end solution especially at advanced nodes. And in the fourth quarter TSMC qualified our litho physical analyzer for its customer’s 45nm designs. This significant step for us because it signals that this foundry partner is recognizing the leadership of this important DFM solution for advanced nodes. And IBM has adopted Cadence DFM solutions for both processor and [ASIC] optimization. The IBM processor group uses Cadence chip optimizer for post route design optimization, critical area reduction via insertion, litho fill and yield rules compliance.

Our analog mix signal capability is a key area of differentiation. The Virtuoso solutions provide breadth capability in automation for analog, full custom, digital chip finishing, mixed signal RF and memory design that are unmatched in the industry. This year we focused on the transitioning a number of major accounts to new Virtuoso platform and as with any migration this process takes time and we’re making very good progress. Toshiba chose the Virtuoso ultra simm for its design at 65nm and below because the solution includes a reliability analysis flow that enabled Toshiba to meet their stringent reliability metrics, estimates the costs of tests and debug and meet their market window. This is just one example of the strength of Virtuoso’s multi mode simulation technology.

Our enterprise focus leveraging the breadth and depth of our great technology, proven methodologies and our world class services and support team is predicated on measurable results and that’s what customers require to meet their demands and survive or thrive in a changing and challenging environment. Now I’ll let Bill speak to the financials.

William Porter

Thanks Mike. The results for the company’s key operating metrics for Q4 were total revenue up 6% year over year, non-GAAP operating margin of 38%, improving 500 basis points from Q4 of 2006, and operating cash flow of $194 million. For the year 2007 total revenue was up 9%, non-GAAP operating margin improved 300 basis points to 30%, operating cash flow was $402 million and book-to-bill exceeded one for the year and backlog grew from $1.9 billion to $2 billion. GAAP earnings per share for Q4 were $0.41 compared to $0.16 in Q4 of 2006. For the full year 2007 GAAP earnings per share were $1.01 compared to $0.46 earned for 2006. GAAP earnings per share for Q4 and the full year included an income tax benefit of $28 million or $0.10 per share from the settlement of a tax dispute with the IRS for the years 1997 through 1999 related to our transfer pricing arrangements.

Non-GAAP earnings per share for Q4 were $0.46 compared to $0.38 in Q4 of 2006 up 21%. For 2007 non-GAAP earnings per share increased 25% to $1.35 from $1.08 for 2006. Total revenue for the fourth quarter was $458 million compared $431 million in Q$ of 2006, up 6%. Product revenue was $328 million, maintenance revenue was $100 million and services revenue was $30 million. Revenue for the year totaled $1.62 billion up 9% from $1.48 billion in 2006. Revenue mix by geography in Q4 was 50% for North America, 17% for Europe, 22% for Japan and 11% for Asia. In the quarter approximately 70% of our product business was represented by ratable licenses compared to approximately 50% in Q3 and our forecast of 50% for Q4.

The ratable mix has become more variable from quarter to quarter and less meaningful to us as a metric. Our key metrics are revenue, operating margin and cash flow generation. As a result we’re not going to be forecasting or reporting this going forward.

Estimated contract life on a dollar weighted average basis approached four years due to average contract lengths increasing for EDA card customers to approximately 3.6 years. In Q4 total cost and expenses on non-GAAP basis were $286 million compared $290 million in Q4 of 2006. The non-GAAP operating margin in Q4 was 38% and 30% for the full year 2007. Year end headcount was approximately 5300. Total DSOs for Q4 were 111 days a decrease of one day from Q3. DSOs were higher than our mid 90s estimate because we were unable to sell a portion of our accounts receivable due to reluctance by banks to increase their exposure to the semiconductor industry. The quality of receivables remained high with less than 1% of receivables at 90 days past due.

Operating cash flow for Q4 was $194 million compared to $205 million in the fourth quarter of 2006. For the year we generation $402 million in operating cash flow compared to our forecast of $450 million. Cash flow was below our forecast because of our lower than anticipated accounts receivable sales in the fourth quarter. Capital expenditures for 2007 were $82 million including $21 million for work on our new engineering building. Cadence repurchased 1.5 million shares of stock in Q4 at a cost of $27 million. Approximately $128 million remains under our current stock repurchase authorization. Cash and cash equivalents were $1.06 billion at year end.

Now I’ll turn to our outlook for Q1 and the year 2008. As a result of our discussions with customers in Q4 and our assessment of an increasingly aggressive pricing environment that we have not seen during the past few years, we believe it is prudent to plan our 2008 business conservatively. For Q1 we expect revenue to be in the range of $280 million to $290 million. GAAP EPS should be in the range of $0.06 to $0.04 net loss and non-GAAP EPS in the range of $0.03 to $0.05 of net income. For the year 2008 we expect revenue to be in the range of $1.49 billion to $1.54 billion. We expect backlog to grow to $2.1 billion at the end of 2008. For 2008 we are targeting a 27% operating margin. GAAP EPS should be in the range of $0.69 to $0.77 and non-GAAP EPS in the range of $1.11 to $1.19. For the seasonal pattern in 2008 we expect to generate 18% to 19% of annual revenue in Q1, 19% to 22% in Q2, 26% to 29% in Q3 and 321% to 34% in Q4. Also note that Q4 will contain an extra week due to the timing of our 2008 fiscal year end which will increase Q4 operating expense by approximately $17 million. Other income and expense for 2008 should be in the range of $31 million to $35 million. For 2008 we expect to generate operating cash flow of at least $350 million. We expect DSOs to be approximately 125 days at the close of 2008. Capital expenditures for 2008 should be in the range of $70 million with an additional $37 million for work to complete our new engineering building.

The current environment is more uncertain and the value discussions are longer and harder than in the past several years. However our strategy is intact, our technology has never been stronger and we’re dedicated to preserve the value of the solutions we are providing to customers.

Question-and-Answer Session

Operator

Your first question comes from Jay Vleeschhouwer - Merrill Lynch

Jay Vleeschhouwer - Merrill Lynch

Mike, Bill, help us understand the different components of the outlook here. So you have a down revenue expectation for the year. You’ve just grown backlog and had positive book-to-bill. You’re apparently expecting to grow backlog again in 2008. But the environment is substantially more difficult than you’ve seen in awhile and so there’s several questions. One is this anything akin to 2001, 2002 when the bottom fell out of R&D spending or are you still anticipating some more gradual deceleration of R&D and has there been any fundamental change in your competitiveness or the timing of your renewals in ’08 because I think most investors will find the outlook substantially disappointing versus ’07 and perhaps conclude that there’s just a basic change in your competitiveness.

William Porter

Sure Jay, many parts to the question. Let me see if I can take them one at a time. For the R&D spend, as we look at the different forecasts that we monitor we have seen them coming down. The best estimate that we have now is around 4% for R&D spending growth for 2008 from the approximate 7% that we saw in 2007. So I think we will probably see them come down but that’s something we will wait to see. From a competitiveness perspective we don’t see any change, in fact we think we continue to do very well head to head in all of our major technologies based just on the strength of those platforms and the ability for those to work together much better than any of our competitors. This is not about competitiveness. This is really about our ability to get better value from the 40% of the business approximately that we do in turns every quarter. As we’ve discussed historically in 2007 we generally would see about two thirds of our business coming from backlog. In 2008 that’s probably around 60%. So there’s 40% of the business that we will generally book and turn in a quarter and it’s that part of the business where in our judgment, the value discussions we had in Q4 were more complex, they took longer and as we see more concern with our customers and their businesses and we see harder pricing discussion, we think it just bodes well for us to take a little bit more time to close that business because we will preserve that value. We think we will get the business but we think it’s just better in this environment to take a little bit more time and not put undo pressure to close it just to meet an expectation.

Jay Vleeschhouwer - Merrill Lynch

After the last call, there was a fair amount of skepticism among investors or some that EDA cards were nearly a stop gap, a rear guard action if you will, to stave off a challenge in the business whether it was bookings calendar or something else. Are you still as convinced as you were that EDA cards were in fact the right thing to offer as a licensing mechanism and a way to deliver technology and we haven’t heard you say anything at all about expense reductions to mitigate the decline in the revenue outlook?

Michael Fister

I think EDA cards are brilliant. I get a kick out of it was a stop gap measure; we took a billion dollar’s worth of bookings, that wasn’t an accident, that was over a prolonged period of time. The value of those things is exactly the opposite. What it allows is an objective conversation with a customer about the use of technology where they’re probably trying to prolong the discussion with their engineers and given them less technology then they need. The fact that we used the customers in the predominant number of situations use the technology faster, that it has continued to grow, it is reinforcement that it’s a very thoughtful way to go have that kind of a conversation with a customer. It continued this quarter again aggressively and it’s an advantage we have that garners more value because people use the technology when they need it. And so the way that Bill characterized it is extremely accurate. I spend quite a lot of time out there with the customers. You said it yourself, on the tails of a great booking year it’s not the bookings. What we want to do is we’re going to go work the next levels of business for value. That’s a continuous process and EDA cards are one of the essential ways that we do that.

William Porter

Just to provide a little bit more information Jay for the Q4 business in the fourth quarter the cards represented about 40% of our business level. And so that continues to increase. We have also continued to see that about 44% of our customers are consuming the technologies faster then they would under a straight line rate. So again we’re seeing the customers liking what the ability to have more flexibility and the predominant number of them are still using it faster. We also saw that a number of customers, particularly the smaller one, did increase their contract lives a bit for the cards and that was one of the things I mentioned. And I think it also provides us some competitive differentiators because the customers are a little bit more uncertain about their environment so they want the ability for another quarter or two to use the technology if they think they need to, but I think what we’ll see and we have been seeing, is they in fact use it faster.

Jay Vleeschhouwer - Merrill Lynch

All right and expenses?

William Porter

I do think that as you look through and do your modeling that our expenses for 2008 will be down from 2007 and so that is going to continue to be a focus for us. We as part of our normal operating cycle did some expense reductions in the fourth quarter where we made some investments and then we also made some disinvestments and I think that’s part of our normal cycle that we’ll continue to look at that in 2008. So you should expect 2008 expense levels to be lower than 2007.

Jay Vleeschhouwer - Merrill Lynch

All right thank you.

Operator

Your next question comes from Harlan Sur - Morgan Stanley

Harlan Sur - Morgan Stanley

Again, maybe if you could just help us out here I mean as you mentioned Mike, things appear to be tracking very well through December, you mentioned it was a strong bookings quarter and then thinking about it near term it really appears that most of the weakness at least near term is with your view on the March quarter and if we just take a look at the model it seems like the company is just recognizing revenues off of backlog in Q1, is that a fair statement that you’re not really anticipating any upfront business in the quarter?

William Porter

No Harlan I don’t know that that’s quite correct. I think as you look again for the year we would expect about 60% coming out of backlog, about 40% of the business will be in turns. It’s not quite that high in the first quarter. We do a little bit less in turns just because it’s seasonally a lower bookings quarter for us. But I think nonetheless we still expect that the business will do for turns we are going to have to have longer and more complex discussions with customers. So we’re giving ourselves the ability to have those conversations. But there’s still a fair amount of turns business and I think you could see from the way we’re looking at the business we want more time to work that particularly in the first half of the year.

Harlan Sur - Morgan Stanley

Okay and I know you’ve talked a lot about pricing pressure and wanting better economics but again as we look at the near term environment and as we look at your pipeline are you seeing any signs that customers are wanting to push out or cancel or are we just talking about them wanting more favorable economics.

William Porter

We’re not seeing anything in terms of what I would say cancellations, and I think we still have a good book of business or I would say a good pipeline but I think the conversations on what customers are expecting in terms of price and value are going up significantly and I think that’s where we just need to be more patient.

Michael Fister

Customers are in a tough box Harlan; I think you probably see it in your own check. They’re trying to deal with the complexity of a device that’s probably maybe in order of magnitude more complex than it was. They’re hiring software and verification experts at two or three times the rate that they’re hiring the digital people so they’ve got a cost bubble they have to deal with and many times they have a bubble in egocentricity as they expand to emerging geographies and they have to deal with the bubble of their existing workforce. I think the beautiful thing is automation is a way out of that because it unlocks people to try to think at different levels. But they’re holding on to their cost pretty preciously and sure anybody can go and give this stuff away to them, we’re not going to do that, we spent years going and driving value for what we do and I tell you I’m committed that we’re going to keep doing that because once you give it away it doesn’t come back and the technology strength is the reason that we can do that, end to end service in the solutions orientation and so the cyclicality of the business next year isn’t that much different. It’s just that we’ve got a very uncertain environment for customers and we obviously see a wide range from the biggest companies in the world to the smaller ones in the world across all different elements of the world and I’m telling you there’s a skittishness, a worry out there, that’s, is a real concern for them.

William Porter

We’ll spend a little bit more time at Analyst Day looking at our pricing but our experience in 2007 is we’ve seen a pretty stable pricing environment as we’ve examined the data for segmentation and in fact we’ll show that for the 10% of the business for example in digital that is in the GXL category we’re able to see that we’re able to improve pricing based on the value that we’re getting for some of this newer technology. And that’s really what we’re trying to protect here because if in this environment we are not going to be patient, we have the risk of giving up some of the gains that we’ve made with the segmentation and the technology really over the past couple of years. So that’s why we think it’s important to work a little harder and demonstrate the value and be patient to get the same level in return.

Harlan Sur - Morgan Stanley

And so you brought up a good point, which is the whole strategy of segmentation as a means to counteract pricing pressures and pricing competitiveness out there in the industry, so I’m surprised that we’re not seeing the segmentation really sort of kick in here for the business model and help the business as it relates to the tough times that we’re going through here in 2008.

Michael Fister

Oh it does and it does it in places where we’re often [aligned] and the manufacturer [inaudible] where we imbed those tenants into the high end technology, that’s why we get that price uplift in those categories. I don’t remember the exact phenomena, we’ll have it at Analyst Day but the Virtuoso new entrance, the people are trying that out, most of them do it at the XL or the GXL level, I mean by a long, long margin. That’s at differentiated features. But I think what we have to be realizing is while there’s a lot of advanced node design, that’s a small fraction of what people’s total design continuum is. So we’re out there with the advanced features and all those, those will waterfall down nicely and have been doing, it’s one of the reasons we see the uplift but you’ve got to see that pervasive waterfall across all the constituent designs that a company does, big or small. And so I think we’re you know greatly positioned, we tried to talk about it in the prepared remarks and time will prove if that really is the case as the market segment share shifts from the bookings that we got last year already have demonstrated and it would just be crazy if we went and hurried that to ruin the pricing that we’ve been able to generate. Remember we came up with that segmentation as a pro action to be able to go and drive these kinds of changes years ago and those are well laid, thoughtful strategies. So I think they’re going to continue to pay off.

Harlan Sur - Morgan Stanley

Okay great, thank you.

Operator

Your next question comes from Rich Valera - Needham & Co.

Rich Valera - Needham & Co.

Bill do you know what the duration of the backlog was in ’07 versus ’06, in other words did it go up in ’07 versus ’06 and could we, do we know what the backlog is on sort of a duration weighted basis?

William Porter

Rich I don’t think the duration has changed in any significant degree. I think the only thing again as we mentioned in Q3 and Q4 we’ve seen the contract lengths kind of move slightly about three and a half to get to the four level, but in general we’re still seeing that same average contract length and so again from what we see coming out of backlog where its generally been about two thirds this year it’s going to be about 60% so that’s incorporating slightly the contract length and slightly a little bit of the mix that we saw with the EDA cards. But that’s not a demonstrative difference year over year.

Rich Valera - Needham & Co.

Okay, and with respect to the license mix, I think you mentioned in the prepared remarks that it’s become more volatile, can you just explain that, I mean historically these mixes have been pretty steady for most EDA players over large periods of time unless there was sort of a conscious shift in one direction or the other, what is it that’s making your mix become suddenly so volatile if you can elaborate on that, thanks.

William Porter

Well I think our recent experience for example in Q3 where we saw the mix move to more of the EDA cards which has been happening over time and then in Q4 we actually saw a higher number of traditional subscription contracts more than we had forecast and so I think it’s just one of those things where customers are making their decisions based on what their needs are at the time. It’s not, we’re not trying to drive our business to a particular mix, its gonna really be based on what the customers are coming to. I think the trend towards cards will continue. I don’t think that will change. But we will see customers change their minds based on their business needs and I think my only point is it’s not the major driver for us. The major driver for us is going to be revenue, improving our margins and getting cash. The mix of business is just something that will fall out based on how we serve the customers.

Rich Valera - Needham & Co.

Great and with the accounts receivable, found that surprising that the banks actually wouldn’t buy them. One did you shop them around or it is sort of the one bank you always deal with just kind of got a little skittish and two if that’s the case, would you consider shopping them around and aren’t these your usually your highest quality receivables and it just seems kind of unusual that they would not be willing to take receivables from customers presumably of the likes of Intel, other very well established companies, if you could just elaborate on that, thanks.

William Porter

Sure Rich, I think I’d say before what we’ve seen particularly in the last six months and particularly in the fourth quarter and we do have a number of banks, we don’t have a bank, we have programs with a handful of very high quality banks. What we traditionally would see was it would be a matter of what particular rates we would get quoted and what we would choose or not choose to take the, to sell the business based on the economics, this time it was a little interesting, we were getting actually pretty interesting rate quotes but the banks I think my guess is their credit process, and this was in more than one case, said that they had enough of a certain level of exposure and it could be for particular customers but I think it was probably a combination of both semiconductor and customers and they chose, they were not going to purchase even though the quotes we were getting were pretty reasonable. And this happened pretty close to the end of the quarter so I think they were going through different levels of approvals than we had visibility to in the past and I think that’s just tightened up.

Rich Valera - Needham & Co.

Great and your current headcount is it similar to the 5,300 you reported for the end of the year?

William Porter

It is about the same level but we would expect that that will come down by the end of Q1. There was some cost reduction activities that we did and you can see in our reconciliation in the fourth quarter and you’ll see that headcount number come down by about 200.

Rich Valera - Needham & Co.

Okay that’s helpful, thanks very much.

Operator

Your next question comes from Sterling Auty - JP Morgan

Sterling Auty - JP Morgan

Question is if we go back when the pricing pressure really hit, we saw a bigger move to subscription by yourselves, Synopsys basically the whole market, so if the pricing and the value discussions are getting tougher why not move more to subscription then even the 60% 40% mix that you’re talking about for 2008?

William Porter

Yes Sterling, I don’t know that that actually provides you with any difference than what we’re doing right now. I mean I think what we’re doing is more visible but I think the ability to compete is going to be based on the technology and having patience. I think as you compare over the long term it’s the amount of business that you’re able to win and I fully admit that our model is a much more transparent model than one that is 100% ratable. And so I think it’s kind of one of those you’re damned if you do damned if you don’t. We’re pretty visible you can see and we’re saying we’re being patient and you can see that in our model. I think others may not have that same level of visibility but I think we are winning competitively and that’s really what we’re about.

Michael Fister

And the bookings progress that we did all throughout last year without knowing how the market segment share shift is going positively in our direction, to me that’s one of the transparencies of the EDA card in that we sub segment stuff that we give access to new technology to and stuff that we don’t and you can see bookings push out. If there was going to be such a thing with transparency in ours, it may be less visible in other potential models and any respect it’s the way the customers want to buy it now.

Someone’s hanging on to a cost that they have for development costs or EDA spend or whatever it is that they want to do and they choose to lock it in with a term for a fixed amount of time with some variability on usage model that the EDA card affords them that luxury of doing, and they don’t want to pay for access to new technology, that’s all fine with us because we don’t want to give away access to new technology.

I think that’s the risk that people run with large, large and long term subscriptions. So I don’t know that you can extrapolate, I wasn’t really around in 2001, extrapolate back any kind of a particular business model as the salvation to it. It’s always what customers want to do, to be able to buy and mix and the access to new technology is a value conservation mechanism that I have a lot of passion for.

Sterling Auty - JP Morgan

Based on what you see and based on your guidance how much of what we’re seeing here in the numbers do you think is a Cadence-specific issue versus a broader issue for EDA?

Michael Fister

Well I don’t know, I think it’s the industry. We’re the leader in the industry, big is the law of large numbers for us. So you know, I guess if someone does a fraction of that maybe they don’t see it as acutely. We are certainly by the projection, we are making, not inconsistent with some of the semiconductor equipment manufacturers and a few of those other, let’s call it supply interest that come into the major semiconductor industry.

I think the good part about a solutions enterprise-wide approach is that it unlocks the productivity in either time or manpower -- let’s call it a cost equation or predictability equation that really allows those customers to attack some of those problems. Maybe we’re on the edge of conservative but we have always said that that’s what we were going to be. It’s just prudent to do that because when you plan expense bases correctly and timing and you try to predict that with good accuracy and that’s what we are doing.

I don’t know what everyone else is going to do, but that’s what we are going to do and I think it is not inconsistent with some of the other big bellwethers that supply back into the semiconductor industry at large.

William Porter

What I would add is I think you are seeing us do something in terms of leadership on pricing and in how we are packaging our product and as we compare in different customers where we are doing leading edge designs and then getting value for it that makes sense; but we are also seeing some of those accounts where we have others that are more willing to give the technology away for we don’t think the right value and we’re choosing not to participate in that, even though it is going to take us a little bit longer to prove our value equation.

Sterling Auty - JP Morgan

Bill, over the years there has been volatility in the amount of receivables that you have sold. You talked about the issue in the quarter but as we think about 2008 sale of receivables and overall level of cash flow, can you give us just a general indication of what your thoughts are in terms of levels?

William Porter

Sure Sterling. As you saw my cash flow forecast for 2008 is down and that reflects primarily the ability to sell some of those receivables. So the level that I’m looking at for 2008 is probably similar to 2006 which is in the neighborhood of about $40 million below, $40 million to $50 million below what we saw this year. So we’re taking that experience into account and that’s why it’s reflected in a lower cash from operations number primarily in 2008.

Operator

Your next question comes from Mahesh Sanganeria - RBC Capital Markets.

Analyst for Mahesh Sanganeria - RBC Capital Markets

I have a couple of questions. A curious phrase was used couple of times, I wanted to pick up on that. The phrase is “giving it away”. Are you saying that’s what you guys have been doing in the recent past? That’s what some of your competitors are doing? Is it possible that this extremely conservative guidance which you are giving for ‘08 one should view ‘08 more as a reset year wherein you can take the pressure of yourselves during negotiations and get fair pricing from your customers so that you can reemerge stronger in ‘09?

Michael Fister

Giving it away is not just a euphemism for some of the pricing especially in the highly commoditized segment, back-end digital plays and around highly commoditized pricing, very aggressive. You can go do your own checks about just how crazy that can be. What we do in selling the segmentation range is compartmentalize competitive offerings that are not as feature rich and choose to be as aggressive in the pricing as we want to or not. By selling the mix of the segmentation, we actually blend it and it blends to holding our own or up, as Bill intimated before.

That’s a conscious strategic approach to that kind of a phenomenon in the world. The customer conversation can be since they have a continuum of designs, I really only need the really good stuff for some of the designs and I can use yesteryear’s technology for other pieces of it. It always bodes well for advanced node migration for people that are feature rich and that’s why you often see questions or they have questions about that dynamic.

There are still some people doing a lot of technology development at 0.18 or 0.13 micron who are being able to use tools to just do back end placement around. So it’s a real phenomenon that is blended by that technology, the element of commoditization and the usage of it. There is nothing about 2008 that’s a reset year for us; what we are trying to convey with some insight that insight is with the breadth of the technology because it spans all those three conditions I just talked about is that the customers themselves are going through a heck of a migration in 2008. Complexity is way up. ASPs are way down. The volume is hard to make up for it. They are spending more money to develop the stuff and they are trying to figure out a way out of that box.

I think we are part of the solution but that alone isn’t going to solve, if they have got people in the wrong spot or where they have the wrong talents or where their ASPs are terrible. And so pragmatically what we are going to do, what we have done is forecast with as much visibility as we could for us and for you guys now to see what the potential impact to that is while conserving the hard fought value for what we have done with differentiated technology across that whole continuum and unfortunately it’s a complicated world out there but that’s the world that we live in.

Analyst for Mahesh Sanganeria - RBC Capital Markets

On your average contract lifespan, you folks typically had a three-year lifespan; for Q3 and not for Q4 you folks are reporting a close to four-year lifespan. If I were to assume that what you received in Q3 and Q4 of ‘07 was roughly flat with what you had in ’06, would it be a fair takeaway that if the number of years increased from three years to four years that the spend per year has actually shrunk?

Mike Fister

I don’t think that math works for me. The transparency of the model where we reported average contract life, back to your earlier question, gives some insight into what the bookings duration is, as was the term used. The fact we remain relatively constant is a testimony for us holding out that value and let’s say garnering the value of new technology. It allows us or engages us when someone wants to engage for new technology, we have a different discussion with them. That’s a beautiful thing because they pay more money in the end for it. They value that technology more in the end.

The good news of a consolidation -- whether it’s with a big company or smaller ones -- when they bind together as partners is that the conversation naturally becomes more of one of let’s make a longer relationship because I am entrusting my confidence in you, Mr. Cadence. So it’s natural for those to go out a little big longer even in that case and when you parley that on to the fact that they are trying to spend their money over a period of time more slowly and the card enables them to do that, that does contract wise would tend to push out.

The beautiful thing -- and that’s why we report it to you -- is that people use the cards more quickly. That’s a key indicator that says some of this is their own creation. Now hoping they can squeeze the engineers to use the licenses longer and we make a bet with them and then in fact the engineers use the stuff faster. Even better if they pay us a little bit more money for the ability to use it faster.

So I hope that will become understood, a well informed strategy to once again have an objective conversation about value whether its new technology or the time use of a license of technology that currently exists. I think the opportunity that we have to engage people as we continue to innovate in new technologies with different business discussions and sell them more is a wonderful thing. That’s the conservation of value ultimately for our new technology access.

William Porter

I would just add that Q3, as we mentioned, at the time particularly one large customer took the average over in Q4, as Mike clarified and I think we are seeing the impact of the cards. I think what we will see over time is that there is going to be your contractual length and I think we are also going to see another metric that’s going to evolve which is what their practical usage will be. My bet and I think what we are seeing is that usage is going to be less than four years and it will probably be three or lower but that’s going to take time to demonstrate.

So that’s the thing that we expect will happen is that customers will use it faster but in these times where they are more uncertain if they say hey, we want an extra quarter or two in the event that we need it before it expires, we absolutely don’t see any issue with that because I believe we will see it being used up in that three-year horizon at least from we’ve seen in the past.

Analyst for Mahesh Sanganeria - RBC Capital Markets

I heard you say that you are going to suspend giving the ratable percentage information for future quarters to come. Would you guys be willing to give some other metric for orders? So that we can go to the models, would you want to start giving out the actual order flow or may be an idea as to the quarterly book-to-bill ratios?

William Porter

I think what I am saying is how much business do we expect to come out of backlog, which is about 60%, that’s I think gives you the indication of what we have to turn for the year. That’s what we are planning on talking to on an annual basis because I think the quarter-to-quarter variations are not that important. We include that as we give our forecast. It is really, as you look at 2008 we expect about 40% of our business to come from our pipeline and that’s the piece of the business that we were watching for price. That’s what I think you try to do in your models with coming up with this different ratable versus percentages.

Mike Fister

I think you have to be very careful with bookings on a quarterly basis. Too much frequency in that puts a target on your chest when you go talk to customers, especially the purchasing agent who says, you need my business this time. We’ve proven in the last years and we will continue to prove it because we are in this for the long term that having a little bit of obscurity or ability to use that to work business has generated a lot of value for us.

I think we will stick with the simple metrics now. We’ll consider it because we are going to get together at the analyst day and see if there is some other insight that we could do, but for now we are being as transparent as possible on how we plan the business and giving you insight into it.

Analyst for Mahesh Sanganeria - RBC Capital Markets

Would you want to comment on your plans for buybacks going forward?

William Porter

In terms of use of our cash, it really hasn’t changed. We are still looking to see how we can grow the business with our cash and also to do buybacks. But it is still in that priority. So, we will always consider it, we have active discussions with our board about the topic but again the priority -- particularly with valuations the way they are and we can see the ability to add to our portfolio particularly as we expand into the adjacencies. We want to take advantage of that and we also will look at the value that can be driven from stock buyback.

Operator

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

Raj Seth - Cowen & Co.

Bill, I wonder if you can talk a little bit about expenses. I haven’t plugged the numbers in yet but just order of magnitude, your guidance I think you mentioned ‘08 expenses would be down relative to ‘07. Can you give me an idea of about how much they are down and given the very tough outlook that you have described, why have you decided not to cut expenses more aggressively? Thanks.

William Porter

Sure Raj. Again, I think we’re looking at driving value and that takes some time. In terms of the expense levels, as you work it through the models you can see that we are going to continue to be more efficient in the business. It will result in expenses being down most likely a couple of percent. That’s how you’ll get there when you work the margin versus the revenue range. We do that very carefully so that we can make sure that we’re not over the longer term going to impact our ability to deliver the best technology and continue to have the best field force to be able to work with customers.

So we’re selective, we’re always looking for efficiencies and we just do it carefully. We don’t try to do it with a knee-jerk reaction just because we think that the environment is getting harder that we are going to do something that is going to hurt the business longer term. We have always focused on expense. We are going to continue to do that from an efficiency and effectiveness perspective.

Raj Seth - Cowen & Co.

I mean obviously there was a ton of uncertainty on this whole semi complex. Is there something that you might look for that would cause you to get more aggressive with regard to cost reductions or is there anything you are looking for or how do we think about the calculus that goes into making that decision?

Mike Fister

I don’t think there is any event that we are looking for. This is something that we do as part of our DNA and we are always making some judgments. We are trying to be nimble because that’s what it requires to be successful in the business. But we want to make sure we are looking out to see what the impact is on any -- both investments and disinvestments -- that we make and so we do it very carefully.

Mike Fister

I mean that calculated methodology got us to 30% operating margin which is a pretty amazing number; unparalleled in our peer group for sure. it puts us nicely in a down revenue year at 27%. That’s still pretty amazing at that level and we do that by continuously aggressively performance managing out the people that could do better, by looking at investments and investing geocentrically and the team has done a nice job doing that and I think we can parlay those efforts that we have used in the last years and apply them to this year just like we are going through and they will be just as effective.

William Porter

Raj, just a couple of other things when you start to peel it back. Again, we are probably having 1 percentage point of impact as I mentioned on the detail relating to our 53-week year this year. That’s $17 million that’s a percent of margin. So if it wasn’t that one of these things happens every five to six years that would be another point in margin for us.

I think the other thing that’s a little bit of a headwind again that we’re expecting in 2008 is currency. Now we still see probably another point of margin impact because we’re seeing the strong, the weak dollar impacting our cost base, particularly outside of the US. That is probably another point worth of margin.

So we just have to be careful. I think those things you know were different in a little different currency environment and with a different fiscal year we’d be at 29; just to be careful with where we are. So we’re looking at those, we want to make sure that we’re managing this to have technologies deliver to customers and as well as getting the value for it. So we’re balancing those.

Raj Seth - Cowen & Co.

Bill, just a quick one, the backlog you talked about -- $2 billion or whatever the number was -- just so I am clear, entering calendar ‘08 how much of that gets recognized in the next four quarters?

William Porter

For the year Raj, we expect about 60% of that business to come into revenue. We do a little bit of that business from bookings in the year so we don’t just do it as of the beginning of the year; that’s the metric that I’m referring to which is the 60%.

Operator

Your next question comes from Tim Fox - Deutsche Bank.

Tim Fox - Deutsche Bank

You mentioned bookings were greater than 1 for the year and fourth quarter were ahead of plan. R&D spending looks like its going to be up about 4% this year and yet you are suggesting that in your guidance, you’ll sort of hold maintenance and services flattish, down 9% or 10% this year, it seems that you are a big skeptic here that you’re either losing significant share heading into ‘08 or anticipating really losing some share or that in some meaningful way you’ve really sucked the pipeline dry on the renewal front.

Can you just help reconcile what was a pretty decent year, a decent quarter, a decent outlook for R&D spending with such a deceleration in your license business and help the skeptics understand that?

William Porter

Tim, when we look at our experience in Q4 we had a very good bookings quarter, but we also saw that customers were getting much more aggressive in their pricing requirements, what their ask was. So as we project it, we don’t think that difference is going to get any easier, particularly in the first half of ‘08 and really through ‘08. That’s really the driver for us.

We have and we can see our pipeline, but we can also see that if we try to close that pipeline what I would say is the same rate we would have in different economic times, we would give up more value than we’re comfortable with.

In terms of the share component, I think we will continue to demonstrate as we’ve announced consolidations and competitive wins across all the major technologies that we are not losing share and this is really a matter of just being patient with customers versus any share. I don’t think you’re going to see any significant share shifts from any of our competitors and I’d be patient to see if that happens, but I don’t expect it.

Mike Fister

Even in the places where we lead in market segment share position in the analog and verification -- we created the verification category as far as I’m concerned, the biggest quarter ever in hardware verification. These are stronger than we projected. That’s a byproduct of consolidations on the low power technology where we are once again a clear leader in that. Market segment share shifts were inevitable.

The question the cynics should ask themselves is our bookings and our progress is transparent. Is everyone else as indicative of that same kind of transparency or not? I don’t know. I only know what ours is. But I’d tell you the market is of a relatively constrained size so when we’re growing like that I think there is an equally opposite question to pose to the cynics.

It isn’t that we are projecting that relative position it goes upside down in ‘08. As a matter of fact, it’s the contrary. We are going to continue to reinforce that because it’s a value equation more than it is a pure volume equation.

Leading edge technologies are all in our favor for high performance digital, for mixed signal characteristics, everything has got mixed signal on it, for system and package where IC packaging is a co-design; for verification to verification where software is at the adjacency and even for the perpetual cynic, DFM at advanced geometries is a correct by construction technique in our approach. That’s one of the reasons that the digital stuff is embedded and Virtuoso is embedded as high-end characteristics in a high-end segmentation model. You cannot do 65-nanometer and 45-nanometer design without modeling those characteristics into the design.

We’ll see what happens; we are in it for the long term, it’s not just that we hit the ball nicely out of the park in ‘07. ‘08 will be what it is. The semiconductor industry or hopefully the customers will see their way clearly to find their way out of their cost box. We are going to be a part of the solution and we’ll see what happens as time moves on.

Tim Fox - Deutsche Bank

If I may on the EDA cards just a couple of questions, I think you mentioned Bill that 40% of the business was from the EDA cards. I am just a little surprise that the upfront mix was back to 30% given that EDA cards were, at least last quarter, were primarily term based. Can you just talk a little bit about what were the mix of EDA cards? Were they mostly term versus subscription and why was it that you are at about a 30% upfront level given that high level of card adoption?

William Porter

Tim, the trends that we have talked about with cards has not changed. It continues to increase and the amount of the term versus the subscription cards is still running at around a four to one so that hasn’t changed.

What we did see in Q4 is we saw some customers that wanted more traditional subscriptions and that is what took the mix higher than we were forecasting. I think the overall trend for the cards is going to continue, customers like it. If they choose to be price sensitive they buy the cards and than when they are ready to buy some new technology they will buy a new card. If they want the flexibility, which some do, they will get the subscription card but that’s still not the predominant purchasing choice.

I think that will continue. Some customers, again, like traditional models and we saw some of that happen in Q4 more than we had estimated and I think customers are still trying to figure out what’s best for their business?

Mike Fister

It’s lumpy. Anybody who says that the world is all subscription or all term doesn’t understand how people buy. Even geocentrically some customers prefer to buy traditional subscription; that is a fact of life and it’s hard to predict. That’s why, why keep trying to predict it and be wrong? The good thing is that we are selling across all those continuums and we have got a great mechanism to do it with a card for value.

Jennifer, it seems we have time for one last question.

Operator

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

Terence Whalen - Citi Investment Research

The first one builds on your operating cash flow targets for ‘08. I think you set a number of roughly $350 million. Really quickly, what amount of factoring receivables is built into that $350 million estimate?

William Porter

Sure Terence. As I indicated, it’s going to be about the same level we saw in 2006. So it’s about $40 million to $50 million below what we did this year. You can see this year we did about 215.

Terence Whalen - Citi Investment Research

$8 million in legal costs and G&A. What was that exactly and what are legal costs expected to be going forward?

William Porter

Terence, periodically we will have to make some reserves. This is one of those times. I think all I would say is why don’t you just watch our regulatory filings. When we can describe it, we will. At this point, I am really not at liberty to say what it was about.

Terence Whalen - Citi Investment Research

Lastly, my question comes back to the topic of duration. I think people are a little confused because you talk about a very visible model yet the average contract duration we were told to be about three years, I think up to three-and-a-half over the past three years, now it’ crossing over the four. In May of ‘04 when new management came in, were there any executive decisions made to adopt a longer contract duration? Because it appears to us looking before new management came, the company was underperforming with sales decline 20% year on year, but then remarkably when that occurred, when new management came in we saw sales growth very consistently at 10% year on year.

So it seems consistent with how things have played out and the order gap we are seeing in ‘08 that may be an executive decision of adopting higher contract duration was used to boost sales, which now puts us in a place of a dearth of contracts. Can you comment on whether average duration over that time actually went closer to three-and-a-half years versus three years? Thanks.

William Porter

Well, Terence, I have been here throughout all those periods and I can tell you there has been no decision to change contract lengths. For those who I have talked to -- and I have talked to many of you -- I think what we have always seen is generally larger customers have a tendency to try to go slightly longer to get more visibility and a little bit more price protection and we have seen smaller customers have a tendency to generally go shorter and that has given us an average duration of around three. So it has not been over that level.

What we have seen I think recently and in particular with the cards that is starting to drive that average duration higher because the smaller customers -- and that’s what we saw in Q4 -- on average have gone to about 3.6 years versus what historically has been three or under. Again, I think what we are seeing there is they want the flexibility to use the cards longer and we don’t think they will but they have that contract flexibility. So that’s really the change here, the larger versus smaller customers; I think the larger customer behavior has not changed and it’s going to continue to be that way.

I think the smaller is changing because we’re giving them some additional flexibility with the card mechanism. I don’t think it’s anything other than that simple explanation.

Mike Fister

The last time I came at the arithmetic, we were steadily growing the backlog over those times but the contract life continuously reported. That’s more backlog, my friend, not less. The confidence that customers have that drives even a small company to extend the duration is a technology commitment to us. That’s in light of all the big consolidations that we’ve done across the board. So the transparency of ours is trying to be reporting those trends so that you can associate them for whatever you want to do with it. I think the technology prowess and the consolidation record that we have is a testimony to the technology value and durability.

This concludes the conference call today. Thanks for your participation as always and we look forward to seeing many of you at analyst day in a month or so. Operator, you can disconnect the call now.

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Source: Cadence Design Systems Q4 2007 Earnings Call Transcript
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