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Cadence Design Systems (NASDAQ:CDNS)

Q1 2006 Earnings Conference Call

April 26th 2006, 5:00 P.M.

Executives:

Jennifer Jordan, Vice President, Investor Relations

Michael Fister, President and Chief Executive Officer

William Porter, EVP and Chief Financial Officer

Analysts:

Tim Fox, Deutsche Bank Securities

Raj Seth, Cowen & Company, LLC

Harlan Sur, Morgan Stanley

Woojin Ho, Merrill Lynch

Richard Valera, Needham & Company, LLC

Stuart Muter, RBC Capital Markets

Rohit Pandey, HSBC Securities

Operator

Good afternoon, my name is Angela and I will be your conference facilitator today. At this time I would like to welcome everyone to the Cadence Design Systems First Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. Operator Instructions At this time, I would like to introduce Ms. Jennifer Jordan, Corporate Vice President of Investor Relations for Cadence Design Systems. Thank you. Ms. Jordan, you may begin.

Jennifer Jordan, VP, Investor Relations

Thank you operator. And welcome to our earnings conference call for the first quarter of 2006. The webcast of this call can be accessed through our website: www.cadence.com, and will be archived for one week. With me today is 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 October 31st, 2005.

In addition to financial results prepared in accordance with Generally Accepted Accounting Principles, or GAAP, we will also present certain non-GAAP financial measures today. Cadence management believes that in addition to using GAAP results in evaluating our business, it can also be useful to measure results using certain non-GAAP financial measures. Please refer to our earnings press release for a discussion of non-GAAP measures and both our earnings press release and our website for reconciliations of GAAP and non-GAAP financial measures used in today's discussion.

Now, I'll turn the call over to Mike Fister.

Michael Fister, President and Chief Executive Officer

Thank you, Jennifer. Good afternoon and thank you for joining us to discuss our performance in the first quarter of 2006. We had a terrific quarter. We reported first quarter revenue of $328 million. On a GAAP basis, we earned $0.07 per share for the period. Non-GAAP EPS was $0.21 per share. Functional verification, especially our hardware verification was super strong. We had our enterprise verification -- with our enterprise verification capability, it is a clear differentiator.

Custom IC had a great quarter. Demand for mixed signal design, for example, designs with big analog and a little digital content drove increased adoption of our Virtuoso analog platform and, in turn, pulled through sales of our Encounter digital platform. We saw competitive wins in digital and verification this quarter. The segmentation of both those product lines helped contribute to the success. And we saw strength across all geographies with strong movement continuing in Japan.

Let me give you some insight into the quarter. Consumer electronics, wireless, networking continued to drive the electronics industry and the semiconductor market. Those products are highly complex and put tremendous demands on our customers' design and verification teams, calling on them to rapidly develop expertise in the analog mixed signal and systems validation. Here we excel with our Incisive Enterprise and hardware verification solutions, customized key leadership, and innovative kit strategy.

We saw the strength reflected in our Q1 performance. Functional verification was again robust, anchored by our differentiated enterprise verification software solutions and excellent results on the hardware front. I'm especially pleased with the progress we made with our systems customers in Japan and Europe. Toshiba Semiconductor Company adopted our Incisive Enterprise solution, Palladium, as the advanced verification methodology for their system, LFI. This complements our verification preeminence within the well-known Cell Broadband Engine ecosystem.

We also scored emulation and capacity upgrades at major networking and multimedia companies, including ACI. The graphics market is constantly evolving, and customers demand new chips every 12 months. Both the complexity of these chips and their development costs are increasing. At S3 Graphics, our vertical solutions knowledge, combined with the Incisive Palladium strength helped them reduce risk and achieve first silicon, first software success on a recent project. And we had numerous competitive wins with customers choosing the Incisive verification platform based on our capability of our total solution. A major supplier of high-performance networking and security infrastructure chose Incisive's design team over competitive offers for just this reason.

IEEE's decision to standardize "e" was a major milestone. And we recently announced that we've extended our Incisive platform with Enterprise Scenario Builder. This technology improves designer productivity by empowering them to play a significant role in advanced verification without having to undergo lanky specialized training.

Our Virtuoso custom IC business was extremely robust in Q1, particularly in Japan, where we had great success with system-level customers, including some well-known consumer electronics names. Renesas adopted new Virtuoso optimization technology to shorten design turnaround time and accelerate IP reuse. Zarlink, a medical technology solutions provider, also chose Virtuoso to reduce the time designers spend on routine tasks and increase the time they had for validation on low-power design.

Consumer wireless and networking systems require analog content on their chips and increasingly require digital content on the same chip. This is causing two things to happen. First, we've seen an increase in the uptake of our Virtuoso platform within our existing custom IC bay. The second, we've seen a number of these customers adopt our digital Encounter solution. It's becoming easier for them to choose us for their digital design business because our segmented product line allows them to purchase exactly what they need to get the job done.

For example, IKONOS, a longtime user of our Virtuoso analog platform, we use Encounter XL as the backbone of its new digital implementation flow, with Encounter L for block generation. In China, we worked with SMIC to jointly develop an analog mixed signal reference flow using our Virtuoso platform and our DFM technology. And OmniVision adopted our low-power flow and added additional licenses for Virtuoso, Incisive, and Encounter to accommodate growth in their U.S. and Shanghai locations.

Texas Instruments recently endorsed RTL Compiler in a release of its Pyramid ASIC design kit version 5.0. TI's support of RTL Compiler gives their customers more flexibility, better turnaround time, and helps them achieve a higher-quality of silicon. After using Encounter digital platform on several design tape outs in Europe, the United States, and India, STMicroelectronics will support RTL Compiler for its ASIC customers at 90 and 65-nanometers. RTL Compiler showed ST significant benefits in reducing chip area, a key differentiator in the competitive domain of consumer electronics design.

And you may have seen earlier this quarter that Hitachi, using RTL Compiler, improved its time to quality on 130-nanometer design by reducing synthesis turnaround time by up to 70%. They also found that RTL Compiler had the added benefit of reducing chip area by an average of 25%.

And it's not news that power is a major product issue for customers moving to large-scale silicon integration at 90-nanometers and especially looking forward to 65 and 45-nanometers, but there is amounting evidence that just scaling the smaller silicon geometries will not have the same power benefits as it has in the past. So, a different approach is needed.

The EDA industry is responding in what I would call a relatively narrow way, adding low-power features to the traditional digital implementation flow. Other than the good first step, there's only so much you can do in layout. What's needed is a broader and more holistic approach that starts earlier and goes beyond the boundaries of what the EDA companies have traditionally considered implementation. To address this challenge, our next-generation digital initiative: Torino, includes a collaboration which we will now call Power Forward. We're showing elements of Torino and Power Forward at CDN Live in September.

Today's market drivers are causing pull across all our technology platforms and strategic initiatives from verification to kit. For example, although it's still early days for kit, the AMS Kit is getting good response with sales regionally spanning in U.S., Europe, EMEA, and Japan. Saifun, a leading provider of non-volatile memory headquartered in Israel, beat its design time list by using the AMS Kit to develop an optimized design methodology for both reuse and migration of critical AMS block.

With this type of feedback, we are encouraged that our kit strategy is on track. We're making good progress on the RF SiP and ARM Verification Kit development, and we're on target for delivery of the PCI Express Kit as well as the Wireless Kit later this year.

We continue to see customers consolidating into our Allegro System package-board platform. This quarter, a leading supplier of technology for oil and gas industry consolidated PCB design to Cadence for a superior technology and global reach. And this morning, we announced that we completed the segmentation of the Allegro platform into Allegro L, XL, and GXL -- with levels of technology that match design complexity. Allegro L for the mainstream PCB challenges; while XL for more complex, high-end challenges and distributed team-based design; and GXL for leading-edge challenge, like advanced package co-design.

Interest in our System-in-Package or SiP development is also growing. We added partners in both Europe and Japan, and SiP as you may know, a cost-effective alternative producing a new SoC. It can shorten time to market, reducing product footprint and rapidly integrate disparate technology. However, those who have done SiPs know that it has also demanded extensive internal CAD and design resources.

It's really exciting to see strong partners showing us to bring a commercial SiP solution to market. STMicroelectronics signed an R&D collaboration to jointly develop and deploy a System-in-Package designed platform for both RF and digital applications. Our approach in design for manufacturability has been to work closely with partners, especially since DFM is a truly multi-variable challenge.

This quarter we worked with IBM and Chartered to enable a low power, yield-aware 90 nanometer reference flow for their common-process platform. We're also developing reference flows with them for 65 nanometers and beyond. The IBM, Chartered, Samsung common platform announced our chemical-mechanical polishing, sometimes known as CMP modeling technology, for 65 nanometers in a recent announcement. And we've broadened our collaboration with PDF Solutions. Currently, we encounter GXL leverages PDF's cell yield model to improve product yields for mutual customers. Moving forward, we will partner to deliver industry-leading capability spanning design for test, digital, and custom design.

With the launch of our Virtuoso RET Suite and Chip Optimizer, which we've already had successful tapeout, and the excellent response we've had to our PVS, Physical Verification Solution, I'm feeling pretty confident that Cadence is addressing the top contributors to manufacturing costs and variability.

So, once again, our success demonstrates that the breadth and depth of our technology continues to resonate with customers. We're making good progress on our strategic initiatives. We have strong competitive momentum, and a team that is dedicated to operational execution. And I'm going to let Bill tell you some more details.

William Porter, EVP and Chief Financial Officer

Thanks, Mike. I'm pleased to report that our first quarter of 2006 was highlighted by consistent execution and strong financial results. Total revenue was up 12% year-over-year. Non-GAAP operating margin improved 2 percentage points, to 20%, compared to Q1 of 2005. And we had another good cash flow quarter, where we reported operating cash flow of $41 million.

Our results demonstrate continued momentum. Strength in our verification business was driven by customers increasing their verification efforts on complex chips in part driven by the need to meet shorter design cycles that are common in consumer electronics. Our custom IC business benefited from the need for more mixed-signal design capability in areas such as wireless communications and networking.

GAAP earnings per share for Q1 were $0.07, compared to breakeven in the same quarter last year. Non-GAAP earnings per share were $0.21 for the quarter, compared to $0.15 in Q1 of 2005, a 40% increase. Total revenue for the first quarter was $328 million, compared to $293 million in Q1 of 2005, up 12%. Product revenue was $208 million. Maintenance revenue was $88 million. And services revenue was $32 million.

Revenue mix by geography in Q1 was 51% for North America, 21% for Japan, 19% for Europe, and 9% for Asia. Our Japanese business was strong in 2005, and that strength continued into the first quarter of 2006, both with semiconductor companies and system companies, where we are increasing our penetration. In Japan, where the economy continues to improve, we're winning with both our technology and strong execution from our team.

In the quarter approximately 74% of our product business was represented by licenses, for which revenue will be recognized overtime. Approximately, two-thirds of our product revenue was generated from backlog. Contract life, calculated on a dollar-weighted-average basis, remained at approximately three years.

Q1 total costs and expenses, on a non-GAAP basis, were $262 million, up from $257 million in Q4. The increase was due to higher costs of product from increased hardware sales. Our non-GAAP operating margin in Q1 was 20%, up from 18% in Q1 of 2005. We continue to look for a non-GAAP operating margin of approximately 28% for 2006.

Headcount at the end of Q1 was approximately 5,000. The quality of receivables remained high in Q1, with our receivables 90 days past due at 1%, within our historical range of 1% to 3%. Total DSOs were 97 days, compared to 92 days in Q4. We expect DSOs to settle into the mid to high 80s by the end of 2006.

We started 2006 with a good cash flow quarter. The Q1 operating cash flow was $41 million, compared to $67 million in the first quarter of 2005. Q1 operating cash flow was reduced by the $25 million tax payment for our repatriation, as well as a $6 million reclassification required by FAS 123(NYSE:R). For 2006, we expect to generate operating cash flow of at least $425 million.

Capital expenditures were $15 million, keeping us on track to spend approximately $75 million for the year. Cadence repurchased 4 million shares of its common stock in Q1 at a cost of $69 million. Cash and cash equivalents grew to $873 million at the end of Q1, from $861 million in Q4. FAS 123(R) expense was $29 million for Q1. For 2006, we continue to estimate FAS 123(R) expense of approximately $100 million. Our non-GAAP measures exclude FAS 123(R) expense.

Now I'll turn to our outlook for Q2 in the year 2006. For Q2, we expect revenue to be in the range of $340 million to $350 million. GAAP EPS should be in the range of $0.09 to $0.11, and non-GAAP EPS in the range of $0.21 to $0.23. For the year 2006, we expect revenue to be in the range of $1.41 to $1.46 billion. GAAP EPS should be in the range of $0.47 to $0.55, and non-GAAP EPS in the range of $0.97 to $1.05.

With respect to the seasonal pattern for the remainder of the year, we expect to generate 24% to 25% of annual revenue in Q3, and 28% to 30% in Q4. Other income and expense for 2006 should be at the high end of the $38 million to $42 million range.

I believe we're off to a good start in 2006 against the objectives I summarized for you at our Analyst Day, which will demonstrate growth, execute consistently, and achieve our operating targets. Operator, we'll now take questions.

Question-and-Answer Session

Operator Instructions Your first question comes from Tim Fox at Deutsche Bank.

Q - Tim Fox

Hi, good afternoon. Congratulations on a strong quarter. First question, I know it can be seasonal, but the digital IC percentage of revenues seemed to drop off from the end of last year and from the percentage for the whole year. Was there anything in particular there driving that weakness in digital IC?

A - William Porter

Tim, this is Bill. It's not uncommon to see some fluctuation in results by product groups, particularly on a quarterly basis. And so what we usually do is, we look at a four-quarter rolling average just for trends. So, we don't see anything in the trend or as we look at the business that indicates that we're not going to continue to experience strong digital growth.

Q - Tim Fox

Okay. And you mentioned that Japan was strong exiting '05, and then in the first quarter, it seems like it was continuing that strength. Could you talk a little bit about the share, if you are gaining any in particular? Obviously, one of your larger competitors has some big deals up for grabs this year. And if you could just comment on how you're progressing and possibly taking some of that share back that you lost, that 130-nanometer node?

A - Michael Fister

Well, I think the trend that we've seen in Japan, led by the technology, first off, that's across the board. We're seeing functional verification continuing to do very well in Japan. And as we mentioned, both with semiconductor and systems companies. So I think that's continuing to lead our strength. And I think we should be able to continue that throughout 2006. Our digital platform continues to do well there, so I think you will see us continue the momentum you've seen last year, as we pick up business in Japan. And we're still going to be doing well with our custom business because the drivers that we referred to in the script are going to be the same things that particularly around wireless and consumer, that are driving our customers in Japan. So, all in all, we think we have opportunity there, and we're looking forward to a good year based on the strength of the technology and the strength of the team.

Q - Tim Fox

Okay great. And lastly, R&D looks like it picked up pretty significantly in the quarter. Could you just address that increase and whether you continue to see that across the rest of this year?

A - Michael Fister

Yeah, I don't think there's anything that's really driving an increase. There's going to be again, some fluctuations. Usually, we see a little bit of pickup in payroll-related expenses, for payroll taxes, and so that's kind of the pickup that we see. That will kind of fade off a little bit throughout the year. So, nothing really that's going to drive our R&D up. We're continuing to manage investments carefully. We are investing, but, on the other hand, we're watching our costs as well. So I think the total costs and expenses should remain pretty flat throughout the year, if not trend down slightly.

Q - Tim Fox

Thanks. That's helpful.

Operator

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

Q - Raj Seth

Hi, thanks very much. Mike or Bill, I'm curious if you think your growth, the growth you're experiencing now in bookings, do you feel like that's materially ahead of the market? Clearly, there are some areas where you're, you’ve suggested you're gaining share. And if it is, how much do you think you're outgrowing the market at this point?

A - Michael Fister

Raj, this is Mike. I'm not sure that I can quote you a number, but definitely in the adjacency, in particular in verification, that's faster than market as far as I'm concerned. We're plowing new ground there. And we're not only doing it with technology, we just want our technology to go with customers. It's very rewarding to see that because that's what we anticipated. And I think, in the drag effects, with the digital and custom analog business, that's really going to pay off some dividends as we continue to do that, because what we'll actually be doing is showing customers how they can prove the goodness of a design approach before they have to implement it. That's the big idea, and it will be fun to see that translate into the other adjacency in manufacturability, as we really see PVS and some of those technologies pick up some momentum.

Q - Raj Seth

What is, Mike, your current view of, if it's hard to pin down how much you're outgrowing the market, what's your general view on market growth? And, most importantly, do you see the space, the EDA space, picking up in the last couple of quarters as a market? Or remaining about as it has been?

A - Michael Fister

Well, I think we see it picking up a little bit. I spent a lot of time out there with customers. Kevin is obviously spending all of his time out doing that. And there's a lot of optimism in some of the customer bases in the hot in the hot segments in consumer and wireless, and people are forecasting good results. If you just look at some of the customer results I mean, there have been some excellent releases by some of the customers. And I think that kind of bodes confidence. And I think the third point I would say is we're totally focused on showing our value by helping our customers be successful. I know that sounds look a cliche to some, but it's gospel to us. And I think that we're benefiting by showing that success to customers. It increases our business with them, and it bodes well to increase our business in the future.

Q - Raj Seth

Okay. Let me try one more time. If you had to think about growth in this space over the next couple years, is this a, still a high-single-digit growth space? Do you think it can grow over double digits? Anyway to kind of pin it down at all on what you think the market grows here?

A - Michael Fister

Well, Bill and I, we tried to lay it out in the Analyst Day. We said that the base industry is growing at high-single digits, and we have our gun sights set on being into the low-double digits. We can do that by the adjacent growth. And I think the verification progress bodes nicely for us. We thought we'd get some out of the manufacturability stuff, we're still trying to understand that ourselves. And we thought that the segmentation in kit could add another couple of points on that base too. And we haven't changed our mind on that. I think that, if anything, I'm encouraged by every sign that we see, both with customers and technology and momentum. So, I hope that's a little bit more pinned down for you.

Q - Raj Seth

Yeah. Thank you. That's helpful.

A - Michael Fister

Sure.

Operator

Your next question comes from Harlan Sur of Morgan Stanley.

Q - Harlan Sur

Hi, good afternoon, and, again, congratulations on another well-executed quarter. Question for you, Mike, we're hearing that 65 nanometer process technology is at both the IDMs and the foundries are ramping up much quicker and with better defect densities versus prior generations. So, I guess, are you seeing any indications that there will be a faster migration from 90 to 65? Or, even some companies moving from 130 straight to 65? And, if so, what are the implications for Cadence if this were to happen?

A - Michael Fister

Well, we're certainly engaged with a lot of companies at 65, and I think that on the digital side, in particular, you may even see, Harlan, people who are kind of cutting back on the performance goals of 65, just to make sure that it ramps well. And we're going to help them with every aspect of that. I haven't seen anybody skip from like say 90 to go to 65 except in the cases where they maybe had a lot of analog content. And there, where the structures are so difficult to migrate, they may choose to do it every other process generation so that, there's a lot of strength at 130 for mixed signal designs.

Q - Harlan Sur

Yeah.

A - Michael Fister

I think the next big design focus is going to be more at 65. The other thing I would add on is that there's an awful lot of activity in what are sometimes called the half nodes, 80 nanometers and those are relatively simple migrations from 90. Some of the big fabulous guys are pursuing that technology. And so, I think there's activity kind of all over the place, and the good news for us is that we're engaged across the board.

Q - Harlan Sur

Good to hear. You also mentioned the strength in Japan from both semi and systems companies. If we take a look at things at a global level, what are some of the trends that you're seeing at the systems companies? Is demand skewed more towards Incisive because they're more systems and software focused? Or are these systems levels companies really starting to build-out or build-up their chip design capabilities?

A - Michael Fister

Good question, Harlan. That's one of the reasons that we're so bent for election on the verification. It's a way to engage the mind of those system designers who aren't worried about every nuance of semiconductor design. I'm not trying to denigrate anybody's who's spent their life doing that. Heck, I spent a lot of my life doing it, but the whole purpose is to try to kind of abstract up above that noise, and the verification and simulation are the first places where they do it. And I think that's, we're just on the precipice of that. We're just kind of scratching the tip of the iceberg. And in the end, with the kit, the idea we have is to make some of that mundane a lot more easy to absorb for a system designer, and we're just starting to scratch the surface of that now. The analog mixed signal kit, as you could hear from my comments had a couple of nice wins, and I've gone and visited a bunch of those companies, and it works just like we thought. They use it, abstract up above the noise, don't re-invent the wheel, concentrate on innovation. I think it bodes well for systems-oriented companies to do the same.

Q - Harlan Sur

Okay. Great. And then final question. Is Cadence still on track for the release of Virtuoso 6.1 here in Q2?

A - Michael Fister

We have got the whole team going and blowing on that. Yeah, we're going to get out there. We continue the customer early access programs and got nothing but really good, positive signs. And we're going to continue unless something happens. The early adopter release will be this quarter.

Q - Harlan Sur

Okay. Great. Thank you and nice job on the quarter, again.

A - Michael Fister

Thank you.

Operator

Your next question comes from Jay Vleeschhouwer of Merrill Lynch.

Q - Woojin Ho

Hi, good afternoon. This is Woojin Ho (phonetic) for Jay Vleeschhouwer. Mike or Bill, is Cadence getting paid incrementally for the new technologies? And if so, how can we really know that it is the case?

A - William Porter

Woojin, one of the things that I think I've mentioned is that part of our process is to sell incrementally to our customers. And we've talked about in the past, moving away from trying to do these larger, cyclical type arrangements. And because we're really focusing on selling incrementally, it's really when they need it, we make sure that the fit is right and then, of course, we get value for it. So I think that is what we're seeing. And then as we look at strength across our geographies at what we call the geolevel, we're seeing very good mix of business at that level throughout all our geographies, that some of the technology is picking up with, not only our big customers, but a lot of our small customers, and it's picking up just on a more frequent basis.

Q - Woojin Ho

Okay, great.

A - William Porter

So you'll see that in the numbers as verification, for example, we're doing well both on the software and the hardware side. We're continuing to see mixed signal, for some of the innovations that Jim and the team are doing there, taking hold with the customers, particularly as we're getting feedback on the early release program, as Mike talked about for Virtuoso. So those are adding value, that's why we're seeing the technologies picking up as we do.

Q - Woojin Ho

Okay, great. In terms of the average contract duration, Bill, you mentioned that the duration was approximately standard around three years. Can you comment on the interest in or the propensity for longer deals, for example, four to five years?

A - William Porter

Really aren't seeing much interest in that Woojin. It's just that customers are very confident with our roadmaps, and so they're willing to work with us, technology and platform at a time. So we're not seeing the need to have to do big, long contracts.

Q - Woojin Ho

Okay. And lastly, you've made some comments around the Japanese market. Can you comment about the North American share? It's been trending in the mid to, mid 40s to the low 50s for quite some time now. Have we peaked in terms of the U.S. share in terms of total revenue?

A - William Porter

I don't know if we've peaked, but I think one of the macro-trends that we've seen our customers follow is, they are continuing to do more of their designs internationally. And I think that's a trend we've seen not only in North America but in Europe. Just take a trip to Bangalore to see that. And so I think that's what you're seeing kind of reflected in a lot of the numbers overtime. There's a lot of multinationals that they are spreading out their designs internationally. And I think that's just the trend that we've seen. And we're adopting with our teams to make sure we can support those customers, both from an R&D and from a support perspective, and it just shows up in the topline numbers.

A - Michael Fister

I think a very interesting, or maybe more interesting thing to look at is the spread of business to wider geographic customers. We refocused a lot of the company's sales efforts on growing the base because we thought that was an attractive thing to do, and it was going to play nicely in the adjacencies, and we continue to succeed in doing that. And those are kind -- those are the next-generation of NVIDIAs or somebody like that, whoever you associate as successful. And we've got to be looking for those in the United States and around the world, wherever they're going to be. There's definitely some more of those coming in the United States, very exciting companies, as there are in some of the other parts of the world.

Q - Woojin Ho

Great. Thank you, gentlemen. That's all I have.

Operator

Your next question is from Rich Valera of Needham & Company.

Q - Richard Valera

Thank you, good afternoon gentlemen. Mike, the emulation market had a lot of years where it really didn't live up to its promise. And last year, it seems like you had some real nice success there and that momentum's carrying into this year. Do you think there's maybe an inflection point being reached in that market? Or is it just that you guys have just sort of nailed the products there and have the right breadth and mix of products and that's what driving your success?

A - Michael Fister

Rich, a good question. I for sure our product mix and technology is at a good peak. And the team spends years trying to get those things right and does that in collaboration with customers. And I think it's even more than that. I think it's that when we link that with the simulation and the so-called VPA, that process architecture, we show customers how they can use those kind of technologies in innovative ways. Show them how they can not only create the logical correctness, something a logic designer might do, like in my old days, but also how software developers use exactly the same platform to run the software, whether it be a driver or full applications while the chip is being developed. So they parallelize the effort, at the time-to-market reduction. And I think we just scratched the surface of being able to do that. We're just going to keep marching up that abstraction curve and making it easy for people to do that more and more. And it's a good growth opportunity for us for sure. I don't know about the industry, because that linkage of all those capabilities is something that I think we do extraordinarily well. But I think that's why you see that, and it is an inflection point.

Q - Richard Valera

Separate topic. On your PVS, I think you mentioned in the comments that that was going well. Any more specific update on PVS in terms of numbers of customers that have been engaged or sort of when we might expect to see some sort of meaningful revenue from that product?

A - Michael Fister

Yeah, I don't have anything specific here. I personally have gone and visited a bunch of them between Jim and I. I'm going to do it again here in another two, three weeks. There's a very targeted list that we have, and the results I know this is going to sound like a throwaway, have been very, very encouraging. I expect that the next two quarters we're going to start to see testimoniable stuff to show you by customer name. And you won't be surprised where some of those customers are coming from. The technology has lived up to every element of its performance. It's fun to see, and I think it makes for a kind of fantastic platform to build on top of. So, we're thoughtful about the development and outlet of it, and we're going to prove, let it prove it by its actions as opposed to trying to hype it, its just that was something we were perceived to be behind on. And so far so good as far as I'm concerned.

Q - Richard Valera

Fair enough. And one final one. Bill, any 10% revenue or bookings customers?

A - William Porter

No 10% revenue customers, Rich. And as you probably recall, I just don't comment on bookings customers.

Q - Richard Valera

Okay, that's all for me. Thanks, guys.

A - William Porter

Sure.

Operator

Your next question comes from Stuart Muter of RBC Capital Markets.

Q - Stuart Muter

Yes, thanks for taking my question. A question for Mike. The functional verification revenues as a percentage have grown nicely over the last few quarters. Do you think that trend will continue? And where do you think that would be roughly by year-end as a percentage?

A - William Porter

Stuart, this is Bill. I guess, I will try to predict an actual percentage by year-end, but I think the double-digit growth that we outlined at Analyst Day, as you can tell from the success we had putting these products together and how that is working in the market is doing very well, if not as good, maybe a little better than we were hoping and expecting. So I think you'll see that trend continue. A lot of it as a percentage of business systems depend on the strength of the other technologies, which I think also are going to do pretty well. So all in all, I think you'll see it grow, I think solidly, probably the leading technology this year I would suspect. But I think all can do pretty well.

A - Michael Fister

Yeah, I'd add in. I think it's a little bit confusing, if you just look at that as an absolute compared to everything else because the most beautiful thing of this is not only that it's an adjacent and a new category, that's a growth segment for EDA in total, or us in particular, but that it drags across those other technologies. So, as we can go and be powerful or let's say productive in terms of time or engineering efficiency for our customers, it allows them to go and use more digital or build fancier devices and it drags the technologies. And so I don't know how the percentages really grow that they grow out of whack. I would absolutely concur with Bill. Do you see what I'm saying?

Q - Stuart Muter

Yeah, that's helpful. Thank you.

Operator

Operator Instructions Your next question is from Rohit Pandey of HSBC Securities.

Q - Rohit Pandey

Thank you, a few questions for Bill. For the first quarter, you reported about $8 million above the midpoint of your guidance, and yet you're guiding the whole year up by only about $10 million. And, similarly, on the EPS, you already reported about $0.01 above the midpoint of the guidance, yet the whole-year numbers go up just by $0.01. So, why is that?

A - William Porter

Well, Rohit, I think, at least the way I looked at the numbers, in Q1, we probably did 6 million or so higher than consensus. If you look at our midpoint for Q2 we're probably up another 4 million or 5 million.

Q - Rohit Pandey

Right.

A - William Porter

So when you add that to the midpoint of where we were before, I think that's where you come out with the midpoint for the year. So I think we saw good strength in Q1. That gets added into the year. We see a little bit better in Q2, that gets added in. And so, I think that's how the topline works. And in terms of leverage, one of the strengths that you saw for us in Q1 was hardware. And therefore, the cost and expenses were up commensurate with cost of sales, so we didn't see the exact same leverage in the business, but we did see good leverage, which is why we saw a little bit of the earnings moving up, because we overachieved in Q1, and I think that penny also gets added to the total year. So, I think we'd rather show how we do better and then that will reflect in the over achievement as opposed to maybe taking a different trajectory right now. We like to kind of prove what we're seeing as we go.

Q - Rohit Pandey

Yes, but does it mean that you should have, just based on the midpoint of your numbers, that you just have 2 million more upside for the remaining three quarters of the year? I mean, I'm trying to reconcile the first half the first quarter numbers, second half guidance with the full-year numbers.

A - William Porter

Yes, I think it's just simple as simple as we did better in Q1, a little better in Q2, and that's just reflective of the year. And, again, you're seeing us being conservative. We like to just say we're going to do something and then do a little better.

Q - Rohit Pandey

Right. Okay. And, again, on the guidance is all the backlog which amortizes in the next three quarters, is it already included in the annual guidance, or do you have room there?

A - William Porter

Again, I think we continue to expect the consistent view as we look at our backlog when we entered the year, about two-thirds will come into our revenue from backlog and a third every quarter is what we have to generate and turn in a quarter, and as I look for the year, I think that's going to be consistent for us.

Q - Rohit Pandey

Right, but as you look at your books today, is everything which is materializing in the next quarter, is it already included in the guidance? So, the upside would come from the new bookings, is that the way I'm understanding it?

A - William Porter

Yes, I can't get to be that precise, Rohit. It's generally we have a good view as we enter a quarter, and that view is about two-thirds of the business. And so the rest of the business is what we turn, some of that turns into revenue, some of it turns into backlog. It just depends on the mix.

Q - Rohit Pandey

Okay. Then I have a few more. What's the change in the accounting principle if you could remind me that?

A - William Porter

Sure. You'll see the, for FAS 123R, which is what most companies will be adopting in Q1. There is a cumulative adjustment for all companies that adopt that. And what essentially it means is that you start to take into account forfeitures for options or stock that you did it in the past, so you'll see, usually, a one cumulative line item in many P&Ls to take into consideration of forfeitures that you could in the past. It's a very small number for us in our GAAP number. But that's what it's about.

Q - Rohit Pandey

Okay. And there is a stock expense in the cost of goods sold line. So, is that related to the hardware sales? Or what kind of employee profile is getting those options?

A - William Porter

Well, I think as you look at how our FAS 123R cost is spread, it's spread throughout our product areas, so there are people who work in that area. And so that will also be included in the cost of product.

Q - Rohit Pandey

Got it. So it's the manufacturing guys who are perhaps working on the hardware or people supporting the telephone support for the customers?

A - William Porter

Absolutely. We have people who worked in developing the hardware as well as supporting the customers, that go all up in the cost of sales.

Q - Rohit Pandey

Got it. So it's there. Okay. And on the stock expense, the total you said would be 100 million for the year, 30 million in the first quarter. So it should go down as the year progresses?

A - William Porter

I think that's correct. I think we're all learning about it. It's what that I would have described it as a very over engineered accounting standard.

Q - Rohit Pandey

Right.

A - William Porter

But I think it has tendency to front-end expense what you see in a year, and it should trend slightly down.

Q - Rohit Pandey

Okay. And what's your assumption for the stock price embedded in that $100 million expense?

A - William Porter

I think as you look throughout the year, I mean, you guys are probably the ones who best pick what stock prices will be but we've assumed that there probably is going to be a reasonable pickup in our stock price and that's embedded in what our option expense is.

Q - Rohit Pandey

Okay. That's embedded. Okay. But would we see get to see that number in the 10-Q, is that reported?

A - William Porter

No, I don't think you see those kinds of assumptions.

Q - Rohit Pandey

Okay.

A - William Porter

The assumptions you will see is volatility, the risk rate, those types of things.

Q - Rohit Pandey

Okay.

A - William Porter

You won't see our estimate on stock price.

Q - Rohit Pandey

Okay, got it. That's all I have. Thank you.

A - William Porter

You're welcome.

Operator

Ladies and gentlemen, that was the final question. This concludes the Cadence Design Systems First Quarter 2006 Earnings Conference Call. You may now disconnect.

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