Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Cadence Design Systems Inc. (NASDAQ:CDNS)

Q2 2008 Earnings Call

July 23 2008 5:00 pm ET

Executives

Jennifer Jordan - VP of IR

Mike Fister, President and CEO

Kevin Palatnik - SVP and CFO

Analysts

Rich Valera- Needham & Company

Mahesh Sanganeria - RBC Capital Markets

Jay Vleeschhouwer - Merrill Lynch

Eric Kobahashi-Salome

Terence Whalen - Citigroup

Doug Rudisch - Brookside Capital

Matt Petkun - D. A. Davidson & Co

Operator

Good afternoon. My name is Teresa, and I will be your conference operator today. At this time, I would like to welcome everyone to the 2008 Q2 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you. Ms. Jordan, you may begin your conference.

Jennifer Jordan

Thank you, Teresa, and welcome to our earnings conference call for the second quarter of 2008. The webcast of this call can be accessed through our website, www.cadence.com and will be archived for one week. With me today are Michael Fister, President and CEO; and Kevin Palatnik, Senior 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 March 29, 2007 and our 10-Q for the period ended March 29, 2008.

The information set forth under the headings cautionary statement regarding forward-looking statements and important information in the earnings press release issued today. In addition to financial results prepared in accordance with Generally Accepted Accounting Principles or GAAP, we will also present certain non-GAAP financial measures today.

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

And with that, I'll turn the call over to Mike Fister.

Mike Fister

Thanks, Jennifer. Good afternoon to everyone has joined us on today's call. I'll begin today's call with some high level comments on the quarter, our business as a whole, and also provide a brief update on our proposal to acquire Mentor Graphics. Then I will turn the call over to Kevin, who will go into more detail in the numbers in our outlook.

Revenue for Q2 was $329 million, and non-GAAP earnings per share were $0.14.

Key business highlights for the quarter include testimonials from several major customers, as well as the announcement of new technology for the systems software space.

Matsushita is deploying Virtuoso 6.1 for both its advance and legacy process nodes. Renesas publicly endorsed our solution for integrated statistical timing and optimization, and are recently followed up with an announcement that they have adopted SoC encounter for their largest and most complex advanced chips.

Broadcom recently increased its capacity using the latest play in three technology, and told us that the palladium n-circuit emulation and Ethernet speed bridge adapters have been key to the system validation efforts for market-leading Ethernet switch products.

This quarter we announced a C-to-Silicon Compiler, which helps customers reduce iterations between system specification and design implementation, and improved designer productivity for IP creation and reuse.

Hitachi and Renesas both provided input into the technology, and are now using it successfully. Although we achieved our Q2 numbers, and had a number of successes with our customers and new technology releases, it was challenging. The impact is slowing and the price conscious economic environment exceeds what we originally anticipated.

Customers are demanding even more flexibility in when, what, and how they purchase software and hardware. Many of our customers are facing uncertainty, or outright slowdowns, in their businesses. Others are choosing to amortize current technology investments, staying with the same process nodes and methodologies longer.

This means new design methodologies using our advanced products are slower to migrate from high-end to gain broad proliferation in the main stream. This invariably puts greater risk into our ability to do incremental business in the second half. And yet other customers are demanding greater flexibility in terms and access due to market conditions in order to close business.

As a result, we made the difficult but necessary decision to lower our outlook, and transition to an approximately 90% rateable license mix. We believe this transition will enable to us keep our focus on the value of our technology, and this decision is the right one for our business over the long-term and for building sustaining strong customer relationships in the future.

Cadence's fundamentals are intact. We have strong customer relationships around the world, and continue to maintain our share of customer spend. We continue to make investments in research and development, and have a robust pipeline of technology. Product rollouts are on track, we'll introduce some of these CDNLive! in September.

We have a talented team committed to the long-term success of our business. Now I would like to take a moment to update you regarding our proposal to acquire Mentor Graphics. As you know, on June 17th, we publicly disclosed our all cash proposal to acquire all the outstanding shares of Mentor Graphics for $16 per share.

We continue to believe that our proposal is extremely compelling for the Mentor Graphics shareholders. Our proposal provides them with the unique opportunity to realize with certainty a significant cash premium value for their investment in Mentor Graphics.

It remains our preference to work cooperatively with Mentor Graphics to complete the acquisition. Although we have not had discussions with Mentor Graphics concerning our acquisition proposal, we continue to communicate to them and their advisors, both privately and publicly, and we want to meet with them immediately to begin substantive discussions regarding our proposal.

That said, we remain committed to the transaction, and are moving this process forward on several fronts. We have commenced the regulatory process and filed the require HSR notices with the US regulatory authorities. We remain confident that proposed transaction will receive all necessary governmental approvals.

Additionally, as of July 11th, Cadence has acquired, through open market transactions, approximately 4.3 million shares of Mentor Graphics. This represents approximately 4.7% of the Mentor's outstanding common stock. We're confident that our HSR filing and ownership stake in Mentor Graphics demonstrate our commitment to this transaction.

We're also in the process of working with our financial advisors to structure the permanent financing for the transaction on the most attractive terms available to us. And let me reiterate that our proposal is not subject to any financing conditions. We continue to believe strongly in this acquisition, and we will do what makes sense for us and our shareholders in making this combination a reality.

I will now turn the call over to Kevin.

Kevin Palatnik

Thanks, Mike. Results for our key operating metrics for Q2 were total revenue of $329 million, non-GAAP operating margin of 15%, and operating cash flow of $77 million. GAAP earnings per share for Q2 was $0.02, compared to $0.20 for Q2 of 2007. Non-GAAP earnings per share for Q2 was $0.14, compared to $0.30 for Q2 of 2007.

Total revenue for the second quarter was $329 million, compared to $391 million for Q2 of 2007, a decrease of 16%. Product revenue was $195 million, maintenance revenue was $100 million, and services revenue was $34 million.

Revenue mix by geography in Q2 was 49% for the Americas, 21% for Europe, 18% for Japan, and 12% for Asia.

Total cost and expenses on a non-GAAP basis for Q2 were $280 million, flat when compared to Q2 of 2007. Non-GAAP operating margin for Q2 was 15%, and quarter-end headcount was approximately 5,100.

Total DSOs for Q2 decreased to 139 days from 176 days in Q1, and quality receivables remains high, with less than 1% of receivables 90 days past due.

Operating cash flow for Q2 was $77 million, compared to $101 million for the second quarter of 2007. Capital expenditures for Q2 were $36 million. Cadence did not repurchase any common stock in Q2, and approximately $412 million remains under our current stock repurchase authorization. Cash and cash equivalents were $837 million at quarter-end.

Now, I will turn to our outlook for Q3 and the year. The outlook reflects the shift to a 90% ratable mix, and lower business levels for the remainder of the year. For Q3, we expect revenue to be in the range of $235 million to $245 million. GAAP EPS should be in the range of a loss of $0.25 to $0.27, and non-GAAP EPS in the range of a loss of $0.09 to $0.11.

For the year 2008, we expect revenue to be in the range of $1.12 billion to $1.14 billion. We expect year-end backlog to be approximately $2 billion with order levels at approximately $1.1 billion.

For 2008, we expect weighted average contract life to be in the range of three to four years. We expect to be breakeven for the non-GAAP operating margin on an annual basis for 2008. GAAP EPS should be in the range of a loss of $0.50 to $0.54, and non-GAAP EPS in the range of a positive $0.01 to $0.05.

Other income for 2008 should be in the range of $12 million to $16 million. For 2008, we expect to generate operating cash flow of approximately $175 million, down from our prior estimate of $300 million, due primarily to lower business levels and to a lesser extent fewer receivable sales. 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. I know it is hard to analyze this software company when it goes through this kind of transition because of the impact the ratable mix has on revenue and operating margin.

Although it is too early to provide specifics on 2009 guidance, I do want to provide some insight for operating cash flow. Our preliminary look at operating cash flow for 2009 suggests that it will be approximately $250 million, with less than 10% coming from receivable sales.

Looking forward, our strategy is to continue to leverage EDA cards. Customers, large and small, continue to embrace our EDA cards as a preferable sale and delivery mechanism for our software. We expect to change to a high ratable mix to contain an increased proportion of platinum cards, as well some as ratable gold cards.

One final point, I believe the reduction in our outlook, and the move to a higher ratable mix is the right change for the business, as we look to the environment and our customer base. Going forward, we'll have more flexibility to provide the right solution to customers when they need it and value it appropriately.

Operator, we'll now take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Rich Valera.

Rich Valera- Needham & Company

Hi. Good afternoon. I guess I will start off with just on the Mentor acquisition. When you proposed that deal, you talk about a leverage ratio of 2.5 X based on trailing cash flow of the combined companies. Obviously with your new forward projections, your cash flow in '08 and probably '09 are going to be significantly less than they were in '07, which gives you a very different leverage ratio.

I guess the question is, do you still feel like you can support additional $1.1 billion of debt, and at what kind of terms could you support that debt to make the offer?

Kevin Palatnik

Hi, Rich, this is Kevin. With the model shift the appropriate metric going forward is operating cash flow, and the strong cash flow from the combined operation will allow the business to deleverage fairly quickly. The $250 million that I gave for guidance for 2009 is on a standalone basis, and basically if we went to the markets for $1.1 billion in debt, we would be able to pay that back in approximately four years even before any adjustments or synergies based on the combo.

Rich Valera- Needham & Company

In terms of a rate, I think you talked about a rate of LIBOR plus, 150 points to 200 points. Do you still think that is a doable rate?

Kevin Palatnik

Rich, we're still working with our financial advisors to structure that financing in the most favorable terms for us, so probably won't get into specifics on LIBOR.

Rich Valera- Needham & Company

Okay. As far as the model transition that seems to make sense for the long-term, I guess the real question is on bookings. Last year you guys had a modestly positive book-to-bill which would have suggested bookings were around $1.6 billion level, and if I heard you correctly, you're talking about $1.1 billion of bookings this year, so that's obviously something that's not affected by a model transition and is really a function of the strength of your current business.

Can you just talk about clearly a quarter ago, presumably you were expecting to do something on the order of $1.5 billion or so of bookings. So, did the environment deteriorate that quickly that your bookings outlook could have gone from $1.5 billion down to $1.1 billion in one quarter, or any color around that would be helpful?

Mike Fister

Well, certainly the environment has deteriorated. I have been around the world almost everywhere in the last month, and even if you look at the spade of announcements from a variety of sources, not necessarily concentrated in the semiconductor industry, environment has gotten worse. I am struggling to find anybody who thinks that the second half is going to be strong, let alone hold up to where it was, and that's continuing to reach out into, not just the first half of '09, but the second half of '09.

Certainly we're choosing to be conservative about our forecast. The mix change gives us the opportunity to have longer conversations with customers about value and it is consistent with the comments that I made about the three types of customers. Those are in outright stress of one type or another financially, those are deciding that their waterfall rights are just a little bit slower for proliferation, and those that are willing to do stuff, but probably at terms that we're not that interested in doing. Because, we're holding our line on what we think to proceed in real value of our technology is.

And I don't know if that's in contrast with everybody else, but I know that's what we're going to do, so that's what led us to draw the conclusion that we did.

Rich Valera- Needham & Company

That's helpful. Thank you.

Mike Fister

Sure.

Operator

Our next question comes from Mahesh Sanganeria.

Mahesh Sanganeria - RBC Capital Markets

Thank you. Mike, again, just to follow-up on that, you were expecting earlier in the year a big ramp in the revenue in Q3 and Q4, and I just want to get some more color on what were your assumptions that became different, because I think we have been in this environment for awhile, but what degraded?

And again, I will say the same thing that, yes, things are bad, but I can't get from any semiconductor companies or any in the companies that things are gotten so much worse… what you're forecasting. Can you help us understand that a little bit more?

Mike Fister

I don't know if it's worse or better relative from the semiconductor conferencing. I can tell that you we are relative time discretion spend for them, especially for waterfall in new technology, and that's a conversion of bookings and bookings converted to revenue.

I think that we could continue to go along and force some of the characteristics that we projected, but it is not going to be at the same value terms that we're really interested in doing, and I've always believed and I continue to believe that it's not in anybody's best interests, certainly ours, but even our customers to jam them with technology, extend the licenses forever, or extend contracts to infinity, to be able to drive any kind of reasonable bookings or revenue dynamic.

And certainly, with the transparency of the model we had, we were making decisions about bookings-to-revenue conversion, and this makes it a lot simpler that we don't have to force that as much if we don't want to. So that's the combination of things that drives this.

The customers, I think it is a Seminole that the customers are staying on old process nodes longer. Some may never move to 45-nanometers, and that's relatively recent and continuing to change, and even the ones that are doing it are sticking with older technologies that are not either more efficient, productive, or give the same kind of results, and just taking more risk in what they're doing.

And that's the second change in the industry that has been nontraditional, some of them continue to evolve, some of them just continue to escalate at more rapid pace, but the pricing in the environment for the semiconductor manufacturers is only deteriorated and to some of them very drastically, the worst on the memory side, and the some of our customers have seen radical drops in either their inventory condition, their ability to drive pricing for their product or even to deliver it, and that those things have an impact on what we do.

Mahesh Sanganeria - RBC Capital Markets

Can you give us a little bit more color on what was the thought process in changing, going back to the 90% ratable model? You just recently went from 70% plus to 50% kind of, and now you're going back to 90. Can you walk us through some of your thought process in that?

Kevin Palatnik

Mahesh, this is Kevin. As Mike said, the environment as we exited Q2, the early Q3 proved much more challenging than we anticipated even though we successfully completed the quarter.

With that as a back drop, it was our conclusion that moving to a more ratable mix will enable us to keep our focus on the value of our technology. We've talked about maintaining that value throughout the first half, and we believe that this further solidifies that.

Mike Fister

Certainly you can see based on the book of business that we have and what we convert, some companies that want to do more upfront and some that want to do more subscriptively, and it's largely a function of access to new technology and their own buying predisposition.

I think we're in excellent shape to do that with the EDA card. It's an objective mechanism to talk about it. We're separated the access to new technology between gold and platinum, and that's a very nice farmable pool, so we already had that to as a way to exercise a ratability element for value.

And rather than try to predict the absolute ratability dynamic even a quarter ago, we started to object obscure that. It's primarily ratable right now. That gives us maximum flexibility, something that some of the other customers are used to from competitive dynamic and that's what we'll do.

Mahesh Sanganeria - RBC Capital Markets

And so, maybe you can help in a slightly different way, comparing the bookings from last year to this year. Can you give us an idea of how did the timing of renewal of your four top customers, was it heavily loaded last year and much lower this year, and how does that linearity work? So that's something we can use truly reconcile this discrepancy in your orders?

Mike Fister

I am not going to give you a lot of detail. I will tell you that in the last years we've had some very nice bookings from customers. You can imagine their consolidations are attractive to us, as well as to our customers, because they operate more efficiently. What you have to do since we're not going to give a lot of detail on the bookings and the construction of the backlog is value of the backlog and the average contract length, and that gives us the pool that we go and farm.

It has been relatively consistent, Kevin gave you some metrics on where it's going to be, and I think that's a very nice pool to be able to go and at any time there is value in that and working these arrangements and the technology absorption with our customers longer, it gives us a better way to farm that pool.

Mahesh Sanganeria - RBC Capital Markets

Okay. Thank you.

Operator

Our next question comes from Jay Vleeschhouwer.

Jay Vleeschhouwer - Merrill Lynch

Thanks, good afternoon. Mike, at your analyst meeting a few months ago management said the following, which was quote just doing consolidation in itself doesn't capture the value, and you went on to say that you have to be recognized as the causality of that value, end quote.

So, I guess a couple of questions, which is why is it still proving to be so difficult, and granted, you have the environment for the company to be granted the recognition of what you believe to be the value of the software, and if you just look at your forecast for bookings this year, I assume $1.1 billion is total, so within the product only portion of that, we're looking at something like a 30% to 40% decline of bookings versus '07. That's a pretty significant disconnect, particularly versus even conservative estimates for R&D spending growth this year.

So, I guess the question becomes how much is really the environment, versus just a GAAP or some discontinuity in terms of your current competitiveness and ability to get recognized for the value.

Mike Fister

I think it's time versus value. That's the equation. We have never lost a consolidation or decision has been made to consolidate to one person. I am pretty proud of that. I think that speaks reams for the technology. You still have a migration period from whatever their incumbent position is.

One of our customers we have 160 some odd programs we helped them migrate over a year-and-a-half away from an incumbent digital position where they had to migrate those things, and they were still valuing the technology investment they made with that competitor over that timeframe of migration, so it isn't an instantaneous switch when you do that. It takes some time to do that and that's the business base that we build on when we do that.

And so when you win one of those consolidations, the confidence of the customer to consolidate, it builds an excellent platform to build on top of, and you have got that time equation to be able to work through their technology pool, and so it is all pre-loading a business, and it also gives us a platform to expand on and up into the system space, that's why we mentioned the C-to-Silicon technology, down into the manufacturability spaces with the technologies that we have in lithography and mask that are just now really debuting themselves even though we've been piloting for more than a year, and so you get some time delay when you do that.

In some respects, the momentum that we're talking about now is predictive about other consolidations that are in the pipeline and there are some, and they're back to Mahesh's question. Those are fruitful for us to go do. They're less about how fast the technology will proliferate into the mainstream. That is certainly going much, much slower. As I say it’s almost bifurcated into separating a smaller use of advanced technology only on the most complicated things, and trying to hang on as long as you can in the incumbent position, and in some respects it is good old-fashioned EDA 101 from 10 years back, I don't know much more than that, where people will go and try to play let's make a deal and we've been working on trying to show patience and value in that equation. That's trying to be considerate with our customers, and I know that that's our modus operandi.

And so, we'll see how it turns out, but that time equation is huge, especially when you know that business is back ended in the quarter and in a year, and we said going into the year that a little bit of the hockey stick that people categorize of the second half. If it pushed in and out of this year would be big for us, because Q4 is our biggest cyclical quarter of the year and we're worried about that, and we're trying to be proactive in projecting that, and at the maximum case that amounts in a fair amount of conservatism, so that's how you get to the numbers we got to.

Jay Vleeschhouwer - Merrill Lynch

Couple questions about the model change, are you suggesting that had the environment and not deteriorated further from what you suggested earlier in the year that you would not have changed the model or you would have done it anyway?

And secondly, what are the long-term advantages of any of anticipating longer durations? I mean, if you have an average of three to four years within the bookings that implies there are some deals that are going to be four to five years if not longer, so what are the long-term advantages or disadvantages of having some portion of the deals go out that long?

Mike Fister

Yeah. We're not in the middle of a model change. We obviously were confident that we can continue to sell through with our existing strategies and had a good pipeline to do that. The deterioration driving consideration of such a thing is a considered discussion with our customers, and I say it is real-time. We're going to do our best to try to hold the contract length, because I think that that's coherent with the nominal development cycle of products those tend to be two or three years. People are making those decisions intelligently. It is coherent with the length of technology projection that we do with the roadmaps. It is coherent with the development cycle for most of our product developments that we do. So we understand the pipeline of what we do.

And I think it is the best for value, and I can see other trends that are trending out well beyond that where they don't have sophisticated mechanisms like EDA card that allow objective conversation, or whatever other reason they may be trying to drive technology and incumbency over a longer period and we're not going to do that. We're going to try to hold it. Now with some customers, it is a fact, some of our biggest customers are near the four-year kind of engagements, and when they have confidence in us and the roadmap and they make big commitments, it is hard to say, yeah, why not. I mean sure, we were doing it together, but that's why we're projecting average contract life every quarter. Kevin is reporting on it now, just like Bill had reported on it, and we're going to continue to do that. We use it as an active management mechanism to monitor what we're doing, not only the customer's utility of it, but the way we're driving those discussions with customers.

Kevin Palatnik

And Jay, I would add, from a mix change or model change, it really boils down to environment. We're very happy with the numbers we publish for Q2, but in those last few weeks the discussions with customers were very, very challenging, and as they took another look at their businesses in the second half, we had those conversations. We had on our plate both selling, I'd say, incremental technology, as well as renewals in the second half, and when discussing the potentials for that with our customers, it was pretty obvious that they wanted either more flexibility, or I'd say more challenging discussions around terms, so boiling it all down to an environmental change, that's really what caused us to move the model.

Jay Vleeschhouwer - Merrill Lynch

All right. Thank you.

Operator

(Operator Instructions) Our next question comes from [Eric Kobahashi-Salome]

Eric Kobahashi-Salome

Hi, thanks for taking my call. I think the points that I wanted to ask have been touched on already. One thing, I spent a long time talking with your team about the EDA cards and the way the EDA card rollout was explained to me was that customers who are actually using the technology faster and that you had greater visibility into technology used by your customers. And so, I guess I am just feeling a bit amazed that, in terms of disconnect, by the rest of your guidance as well, in light of what seemed to me kind of incredible strategy.

Mike Fister

All true, but do remember EDA cards do have a term life to those as well. Those are kind of three-year engagements, so some statistics for you, I think 43% of the customers in the current statistics use them faster than expected, and 70% use them equally or faster than expected.

That's great. Over that three-year period, and if you go back and track through our Analyst Day, you will see that we showed how that stacks over time, and amounts to not only using the technology value of the card up sooner, but probably building on in a bigger way.

But you still got to get near the end of the term to be able to do that, so if the card length was three years, and they use it up in two and three quarters years, or two-and-a-half years, you still got to get to the two-and-a-half years.

Second fact, we started doing the things about two years ago, and so the end of '08 is when we start to see some of the first renewals of those things and really stagger into the beginning of '09, if you look at the momentum of them as we reported it, and so we've got good objective data looking at the utilization, and we're just beginning and really coming into the end of year, looking at the re-up rate those things, both in timing and value.

I think we have a lot of confidence that they are going to get used faster and hopefully be of equal value, and we have some confidence that in many cases they're going to get subscribed for more value the second time, which is coherent with what we said at Analyst Day.

So we need to get through another six months or so, maybe nine, to really see to get two quarters worth of stuff to make a trend, but what I am confident in is that the conversations we have with customers are more objective and factual based on information of utilization than conjecture and subjectivity, which has been the history, and that's the thing that's most interesting about the EDA cards.

I've just came from all around the world. I can tell you big customers and small all around love these things because of the objectivity of it, and they buy the stuff at the rate they want to use it, and if they short call a shortfall, they don't mind paying a little more to be able to do that. And so that's the goodness of that mechanism and is not that you misunderstood, you just got to give a little bit more time to play out, but I am still very optimistic about it. Kevin.

Kevin Palatnik

Yeah. Eric, one more point. So, in terms of Mike's point about our customers embracing the cards, we do approximately half our business on the cards, and when we talk about consumption, that's on cards already sold, so in terms of the second half outlook, those will be cards to be sold.

And in terms of the re-up rate that Mike also talked about, we did the cards in volume starting in 2006. So based on the three-year card, we'll see some statistics at the second half of this year, end of this year, early next, so we'll understand what that re-up will be, but again specific to consumption, it's all about cards that have already been sold.

Eric Kobahashi-Salome

Okay. Thanks for those comments. I was also wondering kind of how much of the weakness would you characterize as a customer-specific weakness, are there particular customers of yours that that just simply aren't just ordering, or would you say it's more broad based?

Mike Fister

It's pretty broad based. I mean, there is not a lot of euphoria out there across the broad base of customers. When Kevin or I'm with customers, the first question is not will you buy more tomorrow. It is how is the outlook for the sec half, how does it look going into '09, what's the pricing look like, et cetera, and that's not just with customers. That's with partners.

I mean go look at fabless equipment manufacturers or equipment manufacturers look at the foundry infrastructure, and that's why you see the thing on inventory. So it's across a broad base. Certainly, there are customers’ engagements, that one of the earlier questions referred to, that are natural renewals and the tradition of the customers is to engage nine months to a year ahead of when those contract lives come up.

So we have a pipeline of those things, and we have as good a pipeline, if not better, than anybody else as far as I am concerned. And those cases, while these conversations may start, they're taking longer to complete, people are waiting longer to try to make those decisions, and even in some light of the information around our proposal for Mentor that's another little bit of a twist to it, because they're fascinated with the opportunity for a more efficient holistic solution across a broader base.

And so, the economic situation is the predominant piece of it. They are going to hold onto their cash longer, trying to stretch it across margin or something else and use the time discretion to be able to hold those conversations longer and to a smaller extent or another extent the water falling of superior technology into wide base is really has been a tradition.

I think it will still be the tradition, but they're holding on longer to old methods and taking more risk in delivery or efficiency and just telling the engineering teams to work harder. And that's why it affects the broad base. And you saw that Kevin gave you some of the geographic splits. We continue to do well across all parts of the world, so we're a little counter-cyclic that way.

But Asia is evolving, pausing a little bit; Japan is concentrated in a few customers. We still have big base of concentration in some of the biggest customers around the world. So that's a good first surrogate to go study if you want to look at their bravado or confidence and figure out how that waterfalls into their supplier base, they're one of their suppliers.

Eric Kobahashi-Salome

Great. Thanks very much for your comments.

Mike Fister

Sure.

Operator

Our next question comes from Terence Whalen.

Terence Whalen - Citigroup

Thanks for taking my question. I have a couple questions. The first one or two are administrative, regarding how you intend to report going forward. I think you alluded earlier to giving time range three to four years of average contract duration. Would you actually consider giving that to the tenth point like 3.4 or 3.5, like your competitors did? Then I have a couple follow-ups.

Mike Fister

Terence, no. we would stay with three to four years for our guidance. We wouldn't take it to the next decimal.

Terence Whalen - Citigroup

Okay.

Mike Fister

Yeah. That's preciseness that what we don't believe in.

Terence Whalen - Citigroup

Okay. And then the second question is in regard to making the model change, are you going to be giving the percentage of bookings that were ratable or up front on a go-forward basis, so we can track the transition toward that 9010 model change?

Mike Fister

Yeah. Once again from a ratability standpoint, we're only going to report backlog once a year, so we're not going to get into the bookings ratability on a quarterly basis. We know that we manage it on an annual basis. It is lumpy within the quarters, and we don't want to confuse anyone with the quarterly numbers.

Terence Whalen - Citigroup

Okay. And then, I guess one other quick administrative question on CapEx. I think you said $70 million for '08. Do you have a CapEx number for '09, so we compare that to your 250 operating cash?

Kevin Palatnik

Yeah. I don't think it will vary much from that 70, but we haven't got into '09 in detail yet other than cash and, yeah, plus or minus 70 million is probably a reasonable range.

Terence Whalen - Citigroup

Okay. And then, I am just having a little trouble understanding the decline in orders this year. How can customers delay renewing contracts that would be expiring this year? In other words, if I look back three years, in '05, there were a number of 10% plus customers and larger deals. Do I have to assume those were four-year deals, because otherwise they would be coming up for renewal and a customer would have to renew those deals, or else they wouldn't have use of tools? Is that correct?

Mike Fister

If someone has a renewal that expires this year, then they'll have to do something about that. If someone had renewals that were on the cusp of a year, then they have flexibility to be in this year or outside this year, depending on what their natural cycle are if they wait to the last minute or they engage six months or a year ahead of time.

Certainly, not all of our business is on renewals, and I will tell you in my time that we worked very hard to make it countercyclical. So these weren't feast or famine things around one big business arrangement that was cyclic every three years, and that's some of the things the cards do, it allows us to layer some of the business, but we still do have some big companies who prefer to buy that way or some big geographic region that prefer to buy that way, and that's influenced in the timing that we both execute business and that we project the business.

If you were looking for the biggest rationale for cyclic shift, we said it going into the year, saying it again now, it matters to us if it's in this second half and if it's just a little out of the second half and into the first and with the staggering business of the backend, that could be significant and is and people are choosing to wait longer and longer and longer to be able to exercise their option and make their decision and even in the consolidation discussion.

I think our pipeline of customer and customer engagements is strong. Technology is excellent. We're getting super feedback. We've maintained our share of the customer spend as that's modulating, mostly modulating more conservatively or down, and I think it bodes nicely for us, especially if we amortize this thing over a longer period.

Terence Whalen - Citigroup

Okay. And then, last one and I will re-queue. Mike, your commentary is appreciated and you do paint a positive picture of the company's health, but from a share price point of view and from a financial perspective, from an analyst perspective looking inward, it honestly looks like the organization has really deteriorated over the past several years, and is facing an uncertain transition period with the model and a large risky acquisition.

So I guess my question is, what are some of the business catalysts going forward and how will those flow through to financials? And then lastly, Mike, I know some investors will be asking tomorrow, what the management plan going forward is post acquisition. Can you give us several reasons why you're the right person to continue to lead Cadence into the acquisition and after? And I ask that with all due respect. Thank you.

Mike Fister

I suppose you can have whatever opinion you want to have. The technology is strong, and it has been over the time, and that's a bias that you can impugn on us, and customers have voted with their own confidence on that, whether it be the consolidating ones or the ones that you can't read about that have fueled the business growth over the last four years and will continue to fuel it going forward.

The confidence that we have in the combined, continued consolidation of the marketplace is both historically rooted in other industries and certainly concentrated in ours, and I am a technology guy. I will give you my rationale. Take it for what it's worth.

Most of the customers engage in heterogeneous solution set. I mean they use technology from all different kinds of people, and when they do that they have to figure out how to glue it together. When they do that, they spend money to do that, experts, extra money, and inefficiency in terms of building interface layers. A holistic solution supply from Cadence makes that more efficient, makes it more predictable, you get better results like lower power when you use the low power flow.

When you do that on a broader base, including increasingly more and more some of the complementary component that are largely implicit in what Mentor Graphics has, we just make that whole system more efficient for them, and that's a beautiful thing as far as they're concerned and you can go pulse them and ask them what they think. I think you just don't have to believe me. The business model, as far as I am concerned, has always been one of discipline, at least in my participation of it. That's to try to show the value we have if we do and some respects we would be rewarded with value. I say that very carefully, and the relationship that is we have not with just the customers but with the partners are as strong or stronger than anybody else's in the industry as far as I am concerned.

So those are the things that I think are interesting about it. I don't know that it is a risky acquisition. You use those words. Those are your words, not mine. I think it is extremely complimentary technologies of technologies who'd love to do this, because they love to see their solutions realize and the broader base gives them a better way to do that. The cultural integration of those things is something that we become very good at in 10 years of acquisitions Cadence has integrated something like 36 companies, and the ones that have been done in recent history have been the most successful acquisitions in terms of retaining technical talent and demonstrating business results of any parallel in the industry. We study that, and we continue to grow the organization to be able to show muscle and be able to do that efficiently and coherently with the integrating people as well as the people exist in the company.

So that's the way that we do it. We try hard to hit every projection that we do, and we try leaders lead and we try to be upfront with why we think the environment continues to evolve and be predictive about it, and that's our MO, and that's the way we're going to continue to do it.

Kevin Palatnik

And Terence, beyond the technology combination or the strength in the combination for technology, of course, there is a financial aspect to this as well, and I am going to focus on cash flow. As I mentioned earlier in my prepared remarks, we'll generate $250 million of cash flow in 2009. That's stand alone as the business comes together, and given the synergies that we've talked about on the June 16th call, where net it is $50 million worth of income benefit.

I think when we put the combination together, and it's our hope that we'll sit down with Mentor in a negotiated transaction, we'll do some due diligence, and maybe we can unlock even more synergies we'll see, but as software companies come together, very strong cash flow generation, so huge positive.

Terence Whalen - Citigroup

And I am sorry to chime in again, but the last facet of my question was with regard to management. Mike, what are you going to do over the next four or six, eight quarters to really rebuild confidence of the investor base in management, and to really get the business reaccelerating again? Thank you.

Mike Fister

We generated hundreds of millions of dollars of positive cash in the last year, and as Kevin said, we'll measure the business on cash. The conservation of the technology to work inside and outside the company is landmark good. It is an industry dynamic. The industry dynamic in the semiconductor has changed a lot.

Take it from somebody who’s been in it a long, long time, and we aim to be a leading player, if not the leading player in this for a long time. We structure the business to win in the long-term. I think we have the best team of the peer group in the industry and we're rewarded with that confidence by many customers.

That's good enough for me, and I hope as we demonstrate the financial says that Kevin talked about that it will also be encouraging for people who want to invest with us in the company.

Terence Whalen - Citigroup

I appreciate and best of luck, guys.

Mike Fister

Thank you. Next question, please?

Operator

Our next question comes from Doug Rudisch.

Doug Rudisch - Brookside Capital

Hey, guys, two parts to the questions. One is does the tougher environment make you rethink about how you manage the expense side of your business? I think you have some platforms where you earn very good returns and then others diverge in sort of R&D efforts and other such things where the economics are less clear.

Are you guys going to rethink how you're spending money and where you're spending it? That's question one, and I have a follow-up.

Mike Fister

Yeah, Doug, expense management has always been a key focus of the management team, demonstrated by the improved operating margins over last few years. Obviously with the change in model that tends to change things a bit. But in terms of expenses management going forward, we'll continue to maintain that key focus, the specifics at which at this point I am not going to get into but clearly it is a key focus for this operating team.

Kevin Palatnik

Doug, on the peer strategy side, there are things that increasingly more Cash Cow-oriented, and those are either slow growers or places where the technology if we make a to ton of investment, if the customers aren't going to value that, we're going to slow it down.

And the products that these men and women make with our stuff are amazing, what's in a cell phone, what they're carrying around in terms of complexity and stuff. All of that mixed signal content is enabled with our technology bar none, and so I am as interested in the pacing of the investments outside of traditional EDA as anything because the core of EDA is the thing that's kind of stagnating or getting slower growth.

Its first surrogate was kind of semi R&D spending, and it's decelerating, so we've been trying to track our net bigger investments up into adjacencies in the manufacturability of the system space, the C-to-Silicon technology is debuted into the broader industry, just had rave reviews on it, and I think that's a great first surrogate for what we're doing. Jim Miller talked about Sydney technologies at large in its analyst day, and we're going to continue to vector spending into the place that is grow and expand to total universe for EDA as opposed to just concentration in the core of what it is, especially as that it's hard to find a customer who wants to pay the same amount for what he had let alone doesn't want to pay less. And we're very cognizant and studied on that. We have very tight management processes to measure those things.

Doug Rudisch - Brookside Capital

Although sometimes accepting that business' slow growth is the key to optimizing the earnings power of the business. If I move to my second question, I think this industry has demonstrated some strange cyclicality and stranger cyclicality in bookings than one would expect, both you guys now, synopsis a couple years ago, and it is clear that, sometimes for unusual reasons, bookings can tend to go above what might be a normalized level, and then post doing that, they'll go below what is normalized level.

The question is, if you look back at your bookings over the last couple of years, they're running in the $1.8 billion to $2.1 billion range, I think. Now you're guiding to $1.1 billion. Clearly the $1.1 billion is below a normalized level. On the other hand by implication that some of the previous years bookings probably got ahead of themselves. The question is, what do you guys think is a normalized level of bookings? How do you quantify it? And what is the normalized level of cash flow that should come off those numbers in a steady-state?

Mike Fister

Yeah. It is a good question, and your numbers are high, backing into them from the backlog. They are $1.5 billion, $1.6 billion, and it has got a lot to do with market segment share shift in the end, and we clearly took by our analysis market segment share over the last years and are holding somewhat of a position this year as we say, and that's a tough thing to do because, you're trying to make guesses whether the total universe is really growing or not, especially around the core which I agree with you, you got to be objective about slow growth and where you stagger your investments, and that's why we try to be pragmatic about it.

I don't think that they were crazy out of bound before and they're biased a little bit by big things, either consolidations or if someone does things where they artificially extend the thing into big time, , you can artificially make a booking huge if you take it over five years or longer as opposed to try to hold in a three or four-year life and that's why we're reporting that and trying to use it as a management metric, so I think what I'd like to do is see how it plays because the customer psychology for buying and the amount of money they're going to spend has got a large amount to do to influence at least the core. Turns out in a strange way, their health or their relative optimism has a lot to do with expanding the core because these guys are struggling with increasing their R&D spend in software resource developers and verification experts. At the same time, they don't really fire all the design guys, and so they compound their problem by trying to spend that money. I believe automation is the way out of that.

On your cyclicality comment, I agree. One of my frustrations has been that we couldn't totally break whatever the cyclicality of the natural business was, which was probably somewhere in the three to four-year lifecycle of average contract life.

Yet, that doesn't mean we're not going to keep doing that, because I think inherently it is not healthy. It drives behaviors and buying or even in some respect selling processes when that happens, and our hope is that as we take these objective measures like the EDA card, we have disciplined management practices to try to objectively decide what's going good and what isn't, be outspoken about it, and give the thing more time that we'll continue to do that.

I think the consolidations bode well for people being first movers to try to change those practices.

Doug Rudisch - Brookside Capital

Thanks for the thoughtful answer. I didn't mean to interrupt. But if I just ask it a different way. You just walked through a complicated set of vectors, but isn't it simpler? There is some cyclicality, if you just assume the industry was very slow growth for the last couple of years and will be very slow growth going forward. It is just a waterfall chart, you know how many five-year deals you cut, and you know how many three-year deals you cut.

And you can stack out what a normalized revenue, or bookings level should be, and don't you need to do that for planning purposes and to manage the expense side of your business?

It seems like it should be actually just stack the mat. You know the customers, know the deal, and you guys should be able to form a pretty good estimate of what normal booking and revenue and cash flow should be. And don't you need to do it to budget expenses?

Mike Fister

We certainly have done that, and that set the foundation of what Kevin was talking about. The thing we've been able to do, which I think has helped us in some of the last years of growth that we may or may not get credit for, is we built that broader base. We did that through an indirect touch on purpose. We did that with the broad GO accounts and Bill was reporting some of that growth dynamic.

Those are companies that aren't necessarily in anybody's top 100, but represent large volumes of business and business potential. Lots of China is that way. These are companies $100 million and less that are going to spend a lot of money doing stuff. And the fabless industries are rife with that.

Also the amount, the quantization of market segment share shifting, consolidation is the first protagonist to that. It's difficult to call in time, but we use leading technology engagements as a first barometer of that and like I say, I am optimistic about the results we've been able to generate over the last years and look forward.

As that's where the waterfall down in the proliferation of that is in another secular change. Used to be that, part of the cyclicality of this industry was biased in the cyclicality of the semiconductor developers. I'm one of them where every two years the process changed, every two years you looked at a tool set difference or four. And when you found the best stuff that was an excuse to change.

People aren't necessarily doing that wholesale any more. They're doing it incrementally. And they are separating it into the high-end and the low-end. That's why we segmented the product four years ago. We'll see what happens. We have a very complex model that we built to forecast the business. I suppose that the critical will say your model must not be very good, because you're struggling to forecast it now.

My view is that the industry is going through catachrestic change right now, not just ours but the semiconductor industry and that's certainly impacting some of our historical and modeling characteristics, and we're fluid with it. We're going to be out there leading, trying to anticipate them, integrate them and learn from them.

Thanks for the question, though. Thanks for the observations. I think we have time for one more question.

Operator

Our next question comes from Matt Petkun.

Matt Petkun - D. A. Davidson & Co

Hi. First, Mike, just on this Mentor transaction, with your shares likely down significantly tomorrow, and as you discussed the questions on the FTC, HSR side which ultimately you suggested the deal would get done, but given all that uncertainty, I as a Mentor shareholder would probably want to see a pretty significant breakup fee attached to that $16 bid, and so far you guys haven't really articulated what you're willing to do to that front. Can you provide any color there and then I have one follow-up.

Mike Fister

Well, like I say, Matt, I think the transaction makes a lot of sense for the shareholders certainly in a time where they may not have any. We don't have a financing; we're not subject to any financing conditions so that isn't a problem. As I said, Kevin and I both said we're out there working on our finances now on the permanent financing. We're dying to discuss that with the Mentor management team and implicitly the Board and the shareholders. When we do that, that will be a component of it, I am sure, and we're certainly well advised and thoughtful about that, so I don't lose a lot of sleep over that to tell you the truth.

Matt Petkun - D. A. Davidson & Co

Okay. And then the other thing you were talking about earlier was the EDA cards. It sounds like you're still going to be offering both the gold and the platinum EDA cards and in the past you had articulated that customers preferred the gold term cards versus the platinum cards. How are you going to be incentivising customers to say move towards subscription-based rather than term-based deals on these EDA cards?

Kevin Palatnik

Matt, with regards to gold card versus platinum cards, yes, we're going to still offer both. Those are we believe differentiating factor for Cadence. Our competitors don't have those. Gold cards offer fixed price book and the platinum card offers technology access overtime. As we look at the environment, as we talked with our customers, they're looking for more flexibility. Flexibility when it comes to accessing future technology, especially in light of what we announced with Mentor, our pursuit of Mentor, if you will. They're looking for more flexibility and access, and that's why we believe that there will be going forward a higher proportion of platinum cards.

Matt Petkun - D. A. Davidson & Co

Okay. And then Finally, do you expect your average deal size to increase a year ago roughly Bill Porter was talking about the fact that you guys were moving towards smaller average deal sizes and this may move you towards larger deal sizes on average.

Kevin Palatnik

Yeah, Matt, in Q3 when I would say the EDA cards really took off in significant volume, that did move the dial a little bit in terms of average contract length, and coming into the year we said with EDA cards being roughly half of our business, we would average out between three and four years, and we're not changing that guidance.

Matt Petkun - D. A. Davidson & Co

I am not talking about duration as much as much as let's talk about the number of seats per deal or products per deal.

Mike Fister

In a perfect world and equilibrium, there will be more smaller ones. What people tend to do is they tend to buy them by project. So you can imagine that it is not a static environment in the customer and they do project A and then about a quarter later they do project B, and those things hang on for awhile and that's how they make access decision about current technology or new technology, and in a nice way the model that we talked about here makes it easier to have that discussion because we had that discussion concurrently.

Some of the accounting before, we had to separate those discussions in time. That was cumbersome to the customers, they don't really like to think that way. They're thinking about multiple projects overtime, and the good thing about it and take this for what it is, with the momentum of the gold cards that was most pragmatic because they were locked in a project you kind of know what you need on project A, but when you get to project B you wanted a new one. All those things are no access to new technology; it's a farmable base for us. That's part of that pipeline that Doug Rudisch the previous questioner was asking about, that's part of what makes it complex and part of what makes it intriguing for us.

And so that's why Kevin says with some confidence that we continued to see an increase in those platinum technology cards, and it is not going to be a digital switch it happens. As time comes along, we’e got to predict a rate for it, and the technology is valuable to us and to the customers, because it has productivity efficiency or quality of results built into it, those three things I said very carefully. Those are all valuable aspects of the technology aspect and the objectivity of the cards.

Matt Petkun - D. A. Davidson & Co

Okay. Thank you for taking my question.

Mike Fister

Sure. Thanks for the question. Okay, operator, with that we conclude. I thank everybody for their attendance and we'll look forward to seeing you next time.

Operator

This concludes today's conference call. You may now disconnect.

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

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

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

Source: Cadence Design Systems Inc. Q2 2008 Earnings Call Transcript
This Transcript
All Transcripts