Synopsys Q3 2006 Earnings Conference Call Transcript (SNPS)

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Synopsys, Inc. (NASDAQ:SNPS)

Q3 2006 Earnings Conference Call

August 16, 2006 5:00 pm ET

Executives

Lisa Ewbank - VP, IR

Aart de Geus - Chairman, CEO

Brian Beattie - CFO

Analysts

Harlan Sur - Morgan Stanley

Rich Valera - Needham & Company

Stuart Muter - RBC Capital Markets

Raj Seth - Cowen & Co.

Dennis Wassung - Canaccord Adams

Jay Vleeschhouwer - Merrill Lynch

Rohit Pandey - HSBC Securities

Vishal Saluja - Seligman

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Synopsys earnings conference call for the third quarter of fiscal year 2006. (Operator Instructions) At this time, I would like to turn the conference over to Lisa Ewbank, Vice President of Investor Relations. Please go ahead.

Lisa Ewbank

Thank you, Mary and good afternoon, everyone. With us today are Aart de Geus, Chairman and CEO of Synopsys; and Brian Beattie, Chief Financial Officer.

During the course of this conference call, Synopsys may make forecasts, targets, and other forward-looking statements regarding the Company and it's financial results. While these statements represent our best current judgment about future results and performance, the Company's actual results and performance are subject to significant risks and uncertainties that could cause actual results to differ materially from those that may be projected.

In addition to any risks that we highlight during this call, important factors that may affect our future results are described in our quarterly report on Form 10-Q for the second quarter, and in our third quarter fiscal year 2006 earnings release. In addition, all financial information to be discussed on this conference call as well as the reconciliation of the non-GAAP financial measures disclosed to their most directly comparable GAAP financial measures can be found in our third quarter earnings release and financial supplement. Our third quarter earnings release, financial supplement and our quarterly report on Form 10-Q are all currently available on our website at Synopsys.com. With that, I would like to turn the conference over to Aart de Geus.

Aart de Geus

Good afternoon and thank you for joining us. Q3 was an excellent quarter for Synopsys as we again executed well on all fronts. Our financial results show strong revenue and earnings growth and solid cash flow. Our momentum is also visible in the customer adoption of our technology and our introduction of multiple innovative new products.

To summarize the financial results, revenue for the quarter was $277 million. That's a 10% increase year-over-year on an expense base that remained flat during the same period. Operating margin was 14.9%, more than double the 7% in Q3 '05. As a result, non-GAAP earnings were $0.21 per share, almost twice last year's $0.11.

We have solidified our outlook for 2007 and are on track to deliver on our commitments to a 20% plus operating margin during the year. With our growing confidence in FY '07 we're increasingly focused on plans and programs to deliver further revenue and earnings growth in 2008.

Let me now give you my perspective on the overall environment. While we've heard questions about the state of the semiconductor industry going into the second half of the year, we haven't seen our customers’ behavior change. If anything they are sharpening their focus on differentiating their products with technology, cost, time to market. That bodes well for Synopsys as we deliver solutions dedicated to precisely these goals.

With that let me give you some of the quarter's highlights. Business in Q3 was very robust across all our product lines, especially in DFM and verification and it was the seventh straight quarter that we substantially beat our internals order targets. DFM was very strong with expanding business, new products, and new powerful links between design and manufacturing.

Galaxy, our core implementation platform also delivered solid results and we rolled out brand new capabilities to deal with manufacturing variability. Discovery, our verification platform, had outstanding results in both analog and digital. Finally, in IPN systems we showed good growth and announced our expansion into embedded software.

Let's now zoom into each area, starting with DFM. At the recent Design Information Conference there was a lot of buzz around design manufacturing, much of it centered around Synopsys’ new product announcements. Customers are striving to improve yield at every step in the process given it's direct impact on their overall cost of goods.

In DFM, our strategy is twofold. One, understand and develop a powerful position in all key technologies that link to manufacturing such as lithography, TCAD, View Management, process, and test chips. The other critical piece of our DFM strategy is to close the loop among all these products, bringing manufacturing data up into the design process and tuning design for better manufacturability.

To this end, just today, we closed the acquisition of SIGMA-C, a German company with leading products in lithography simulation. These products will enable a tighter integration between design and manufacturing, benefiting customers with fewer chip respins increased product yield.

In Q3 we introduced an important new product. Prime Yield. Prime Yield systematically integrates the real data from the fab into our design environment. It detects manufacturing issues that will negatively affect yield and enables customers to find and fix those issues early in the process, saving both time and money. Customer industry reaction to our DFM agenda has been extremely positive.

For Toshiba, Prime Yield provided a dramatic seamless way to detect lithography problems and deliver correction guidance right into the IC Compiler environment. Toshiba will be deploying Prime Yield into their standard layout flow. Prime Yield was ahead of that with packed demos and a flood of inquiries. Today no other vendor has the breadth of technologies or the integration that Synopsys provides in DFM. Given this market opportunity, we will continue to innovate and invest in this area.

With respect to Galaxy, our implementation platform, we continued our strong business and customer success. There are three major components to Galaxy: synthesis, physical design, and sign off.

In synthesis, Design Compiler Ultra is doing well. Our newest topographical features significantly improve the predictability of the design flow. In physical design, IC Compiler is giving customers excellent results. Tape out counts are mounting at companies like Necrona, Sun Plus, a top Japanese IDM and a large broadband firm. Designers are reporting 40% to 50% faster time to results and 8% to 10% better quality of results.

Six customers discussed their IC Compiler tape out successes and plans for the future at a standing room only customer panel. TI, Toshiba, Necrona, Conexion, SD, and Stark highlighted their success in designing for applications ranging from wireless terminals to home networks to high-definition TV.

In Q3, we also delivered the newest advances in physical design with improved low power and design for yield techniques. Our field has completed the migration to IC Compiler support. It's the fastest ramping product transition we've ever implemented. We continue to expect that roughly 80% of our customers will have upgraded to IC Compiler over the three-year period since it's introduction.

In sign-off we delivered brand new capabilities to deal with variability and manufacturing. These so-called variation-aware analysis and extraction tools have already been endorsed by ST and TSMC along with Stark in Japan.

In summary, the Galaxy platform has produced a number of technical firsts that designers need to address ever-shrinking process geometry. This quarter we tracked 243 active 65 nanometer designs of which 80 have taped out to date; a solid majority done with Synopsys.

Let's look now at Discovery, our verification platform. Business in the quarter flourished in both analog and digital. In fact, we booked our largest verification deal ever, a large growing customer selected Synopsys to meet it's expanding need for license growth to tackle increasing verification complexity. The measurable speed advantage of our technology and the productivity benefits of System Verilog are clearly resonating with customers. We're seeing competitive displacements, some migration from internal tools and strong endorsements from companies like Vitas, Altatech and S3.

For example, a U.S. secure networking company switched from a combination of Verilog tools to a full Synopsys System Verilog flow resulting in an important competitive displacement. At DAC, six industry leaders highlighted verification with System Verilog. Transmeta reported 10X faster performance and Transilica reported 5X to 8X reduction in code size. Verification is a growing, major pinpoint for our customers. Synopsys is well-positioned for growth in this area as we continue to provide highly differentiated technology.

Moving up the design flow to systems and IP solutions, I'm pleased to report that our digital and analog IP course again came in notably above plan. Customers are leveraging our high quality off-the-shelf connectivity IP to accelerate their time to market. On the digital side, we shipped our first release of the new wireless USB product. Wireless USB is the hot new standard as customers demand easy wireless connections for the electronic environment. There are more than a billion wired USB devices today and we expect 70% of them to migrate to wireless over the next five years.

In analog mixed signal, high demand continues for our multi-standard IP. During the quarter we ported Nano 5, our new low power analog USB product to two platforms, TSMC and the IBM chartered Samsung platforms, and we sold our first copy.

In system level solutions we closed the acquisition of Virtuo, a creator of virtual platforms for embedded software development. Virtual platforms enable engineers to develop and validate embedded software up to a year before silicon is available, rather than wait until the end of the process. This saves time and money and reduces risk. This new market segment looks very promising as software content and devices grows rapidly. For Synopsys, it's an opportunity to raise the level of our customers engagement and address a whole new universe of software engineers. You'll hear more about ESL strategy in the months to come.

Now let me address some of the things we're doing to solidify our Q4 and 2007 outlook, align the Company for growth, and streamline operations. Focusing on the go-to-market side of the Company first, we have promoted Joe Logan to lead our worldwide sales organization. A seasoned sales executive, he has done a tell after job during miss five years at Synopsys most recently heading the North America East region. Joe has a very solid team and we expect the transition to be quite smooth.

From a customer support perspective, we are merging our worldwide applications support and our services business to create a single point of contact for our customers and to reflect the increased complexity and value of helping our customer succeed. The group will report to Deidre Hanford who over the years has led Synopsys to the highest customer satisfaction ratings in the industry.

In addition, as part of our ongoing cost control efforts, we have taken several actions to streamline our infrastructure. We announced this week that a number of functions such as procurement and some IT functions are being outsourced. In addition, recognizing the global distribution of our customers, we are co-locating more of our own resources to a low-cost geography.

In summary, Synopsys is firing on all cylinders from our financial results and execution to our product and customer momentum. 2006 is turning out to be a very strong year. We have solidified our 2007 revenue and earnings outlook and we are on track to deliver a 20% plus operating margin during the year. In addition, we're increasing our focus on further revenue and earnings growth in 2008 and beyond.

With that I'll turn the call over to Brian who will provide more details on the financials.

Brian Beattie

Thank you, Aart. As a reminder I'll be discussing certain GAAP and non-GAAP measures of our financial performance. We have provided a full reconciliation in the press release and financial supplement posted on our website. I'm very pleased with our performance last quarter. We again executed well and our financial and business results were strong. Revenue was up 10% year-over-year. We exceeded our orders plan for the seventh quarter in a row.

Non-GAAP operating margin increased by 2 percentage points compared to last quarter and it more than doubled year-over-year. Our non-GAAP earnings per share beat our internal targets and also nearly doubled year-over-year.

Total revenue for the quarter was $277.2 million, the seventh straight sequential increase. Of this, 95% came from beginning of quarter backlog. From a product perspective, 78% of revenue came from our core Galaxy design and Discovery verification solutions; 18% came from IP and manufacturing; and 4% came from professional services and other revenues.

Business remains strong worldwide with particular Q3 strength in North America. Revenue mix remains relatively stable. North America was 53%, Europe was 17%, Japan was 16% and Asia Pacific came in at 14% of revenue. One customer accounted for more than 10% of revenue in the third quarter.

GAAP earnings for the quarter were $0.05 per share with costs and expenses totaling $264 million. GAAP results include $13.4 million of amortization of intangible assets and $15.6 million of stock-based compensation expenses in compliance with FAS 123 R.

We continue to focus on operational discipline which helped drive non-GAAP earnings per share of $0.21. Q3 non-GAAP costs and expenses were $236 million, a decrease of 1% sequentially. Non-GAAP operating margin of 14.9% was the highest in two years and we're well on track towards achieving our target of 20% plus during 2007.

The non-GAAP tax rate was 32%, slightly higher than our target due primarily to a higher than expected mix of U.S. net income.

We continue to execute well on contract mix. 94% of product orders in the quarter were booked as time based licenses with 6% as up front. The average length of our renewable customer license commitments remains healthy at 2.9 years.

Turning now to cash. Operating cash flow was $59 million in Q3. Capital expenditures were $11 million. Cash and short-term investments decreased $23 million to $511 million reflecting a repurchase of 3.7 million shares of our stock for $71 million. In the first three quarters of the year, we spent $170 million repurchasing approximately 8.4 million shares. We have approximately $267 million left in our authorization and we'll continue to evaluate the best uses of our cash each quarter including company operations, investments and stock repurchases.

Primarily as a result of the repurchase program, diluted share count decreased 2 million shares in the quarter. Q3 net accounts receivables totaled 111 million and DSO's were 36 days, well within our normal range. Deferred revenue at the end of the quarter was $474 million, a moderate sequential decrease, as expected. Headcount totaled 5,131 at the end of Q3 reflecting some additions in lower-cost geographies and the acquisition of Vertio. We expect to leverage our lower-cost geographies to keep spending in check in 2007.

Now as Aart mentioned we just announced the acquisition of SIGMA-C, a lithography modeling company providing yet another critical link in the design to manufacturing process. It was an all cash deal valued at $20.5 million and we expect it to be slightly dilutive for the first six months and then roughly neutral in fiscal 2007.

Now on to guidance. As a result of our strong performance in Q3, we are raising our annual revenue and EPS targets. For fiscal 2006, our targets are revenue between $1.086 billion and $1.094 billion, an increase of 9.5% to 10.3% over last year. A non-GAAP tax rate of 31%; outstanding shares between 142 million and 147 million; GAAP earnings per share between $0.11 and $0.15 which includes the impact of approximately $64 million in stock-based compensation expense.

Non-GAAP earnings per share between $0.73 and $0.75, an increase of more than 80% over last year. We continue to expect cash flow from operations to be greater than $175 million. Over the next four quarters we expect approximately $940 million of our beginning of quarter backlog to turn to revenue.

For Q4, our targets are revenue between $274 million and $282 million; total GAAP costs and expenses between $265 million and $281 million, which includes approximately $16 million of stock compensation expense; total non-GAAP costs and expenses between $239 million and $249 million, an increase sequentially due to a variety of factors including costs associated with streamlining our business operations, higher variable compensation due to our stronger than expected business and the impact of SIGMA-C and the Vertio acquisitions.

Other income and expense between zero and $4 million; a non-GAAP tax rate of 30%; outstanding shares between 140 million and 144 million; GAAP earnings of $0.01 to $0.05 per share; and non-GAAP earnings of $0.17 to $0.19 per share. We expect more than 90% of the quarter's revenue to come from backlog. We will provide 2007 guidance in our next earnings call, following the Q4 results.

In summary I'm pleased with our excellent execution again this quarter and look forward to the rest of the year. With that I'll turn it over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Harlan Sur - Morgan Stanley.

Harlan Sur - Morgan Stanley

Hi. Good afternoon. Aart, first question for you, post the launch of Prime Yield at DAV, you've obviously been working with a lot of your major customers on this for some time and you can plug seamlessly into IC Compiler.

My question is, can Prime Yield also be integrated into some of your competitors physical implementation tools like the Encounter platform? I think this would probably significantly expand your addressable market opportunity.

Aart de Geus

Well, Harlan, this is all technology that is built very much on the principle of openness, and so the intent is to be able to support multiple tools. Clearly, IC Compiler is way ahead on many of the other physical implementation tools and it works today; meaning that -- you can use the term “seamlessly” -- find issues and fix them in IC Compiler. So the benefit is just very large with our own solution, but we fundamentally want to support as much as possible openness, where it is practical and makes common sense.

Harlan Sur - Morgan Stanley

I would think that you're currently booking orders for Prime Yield right now?

Aart de Geus

Yes, we are.

Harlan Sur - Morgan Stanley

Great. Then maybe you can help me also understand the SIGMA-C acquisition and what that brings to Synopsys? I know the team already has a set of litho modeling capabilities in your product portfolio so what's the differentiator that SIGMA-C brings to the table here?

Aart de Geus

The way to think about SIGMA-C Is TCAD for lithography. With all of these things, you always trade off between accuracy and speed, but at the end of the day, you must have sort of the golden measure which is the highest accuracy in order to determine if the trade-offs that you make, make any sense. SIGMA-C is the very high accuracy, high precision, three-dimensional capability to do that.

So in that context, it will be used first and foremost wherever hot spots are found to analyze them very rapidly, and then used to avoid those in the first place in the design. So it's actually a very deep cornerstone technology.

Harlan Sur - Morgan Stanley

Okay, great. Thanks and then a question for Brian. Operating expense, total expenses at the mid-point of the range are going up by about $10 million sequentially and you gave us I think three reasons for that: streamlining of the business ops, impact on the SIGMA-C and Vertio acquisition and a few other things. Can you kind of prioritize what the biggest piece of that movement is from these three areas?

Brian Beattie

Yes, sure will. Basically what you're seeing a number of costs which are viewed as one-time such as for example the biggest contributor to the growth in the quarter alone would be associated with higher variable compensation. Again, the Company is doing much better than we had planned from the orders and from the revenue perspective and again expense management has been tight. So primarily, that's where the costs are going up.

The other elements related to the acquisitions of Vertio and SIGMA-C, again we'll start in the fourth quarter so that's the next part of the increase. Finally we did have some costs associated with streamlining the operations this quarter that will also be expected to be booked in the fourth quarter so that's kind of the priority of the way the three big elements come together.

Harlan Sur - Morgan Stanley

So the variable compensation is sort of a one-time Q4 type of issue? The streamlining of the business operations, is that also, can we think about that as one-time in nature as well?

Brian Beattie

Yes, I would. Those are the costs associated with some of the reductions that we put in place in terms of getting ready for 20% plus operating commitments we made for 2007.

Harlan Sur - Morgan Stanley

Okay. So can you maybe then just give us a sense in terms of Q1 what the normalized operating expense run rate could look like?

Brian Beattie

Well, I'd like to, but I think you have to stay tuned for our next call at the end of the fourth quarter. We'll be reviewing in more detail both revenue and expenses. Again, we're just very focused on both growing the business and also focused on the cost management as we go forward. I think if you looked at the year-to-date numbers you'll see revenues up about 10% and our spending is up by 2%, so again, that's allowed us to almost double the operating margins in 2006.

Harlan Sur - Morgan Stanley

Right, okay, one last question if I may. So any 10% customers in the quarter from a bookings perspective?

Brian Beattie

Yes. We don't disclose the bookings level detail, but we did have one customer that was greater than 10% of the revenues.

Harlan Sur - Morgan Stanley

Okay, great. Thank you.

Brian Beattie

You're welcome.

Operator

We will move on to the line of Rich Valera - Needham & Co.

Rich Valera - Needham & Co.

Thank you. Could you give us the headcount associated with SIGMA-C? And any revenue figures if you're willing to share that with us?

Brian Beattie

Yes. We haven't gone through that level of detail. at least for providing that. We give the information out on what we paid for the Company which I said is just over $20 million, so from an expense perspective, that will take effect as of today going forward. We haven't given out the exact headcount. We can follow-up with more detail the next time around.

Rich Valera - Needham & Co.

Sure and is there any earn out above that or is that just a fixed $21 million?

Brian Beattie

That's a fixed amount of the cost that the shareholders at SIGMA-C will see.

Rich Valera - Needham & Co.

Okay. That's helpful. Aart, just on the ESL front, you made the Vertio acquisition which puts you a little further into that space. There's still lots of interest in that area and buzz around hardware/software co-design and various types of verification and synthesis. How do you see that space and how do you see Synopsys' continued push into that space beyond Vertio?

Aart de Geus

Sure. The problem with that space is it has been filled with hype for a number of years which by many companies and many analysts has made a very strange impression of what in practice has been accomplished. We are entering it or we're moving forward in it in an eminently practical fashion, meaning the virtual capabilities are proven today on some key platforms, I think they have already talked about the utilization of TI and freescale for example.

Moreover, we think that it is a direct adjacency to our strong IP position, and so we will continue on that path, not promising to boil the ocean or anything like that, but really to say here are some practical tools that have major impact when used well on accelerating the development and the quality of the software while the hardware is in development. And so it's a very practical pathway.

Rich Valera - Needham & Co.

Okay that's helpful. Thank you.

Brian Beattie

Just to follow-up on your question, we looked at the details at SIGMA-C and there are about 50 employees.

Rich Valera - Needham & Co.

Great. Are they mostly in Germany?

Brian Beattie

Yes, they are.

Rich Valera - Needham & Co.

Just a little bit of follow-up on the expense side, Brian. Is there any color you can give us on the primary driver of the margin expansion next year going from mid-teens probably at your peak this year, as your peak quarter up to that 20%. Could you give us any sense of how much revenue versus expenses, how that mix is going to play out? Do you have a view of that yet or do we have to wait until the next call?

Brian Beattie

Other than saying it's coming from both areas, both in keeping the cost in tow as well as driving for growth on the top line, it's both going to come through. We'll give you a fair amount of detail, again, as I was just highlighting it, so far this year it's been 10% top line and 2% spending growth contributing to that, and we'll continue to improve for the '07 numbers to give us that 20% plus.

Rich Valera - Needham & Co.

Okay, thank you.

Operator

Our next question comes from the line of Stuart Muter - RBC Capital Markets. Please go ahead.

Stuart Muter - RBC Capital Markets

Yes, thank you for taking my question. I guess first a big picture question on DFM and Prime Yield. How far away do you think we are from most designers using a tool like Prime Yield where they're generating a design, and they are more or less real-time seeing impact of the design on yield and it's linked to factory data?

Aart de Geus

Well, we are both very close and very far away. Close in the sense that the Prime Yield product today uses real data and that pathway is being closed and we have in the pipeline a number of additional capabilities that will be rolled out in the subsequent quarters. So every new version will really enrich it substantially.

Far away in the sense that the focus on yield really starts to take on a much higher urgency with 65 nanometer and then very high urgency with 45 nanometer. Now, the good news is we're seeing the 65 nanometer design has picked up well for us -- actually very, very well -- and the interest therefore is pretty high for these type of tools.

The other thing that is very positive in this context is this was specifically designed to work particularly well in the whole ecosystem with IC Compiler and Prime Time which has been sought out for the next generation of how do you design and manufacture, essentially in the same train of thought. And so from that perspective, I'm not surprised at the very high interest and enquiries that we have. As a matter of fact earlier there was a question are you selling it today? I should have answered that we have sold it already.

Stuart Muter - RBC Capital Markets

That's helpful. Do you have a sense of what it takes in terms of cost for 65 nanometer design relative to 90 and is it substantially harder than the 130 to 90 shift?

Aart de Geus

This is a question that often leads to confusion because invariably people say oh, it's much higher but what they really mean is typically the very first generation of technology. The semiconductor industry has been amazingly good at overcoming what initially is very difficult to do and then in a matter of 12 to 24 months bring down the cost substantially.

Now, I encompass EDA in the semiconductor industry here because a lot of what made that possible is the sharpening up and the maturing of the tools and so as much as 65 brings harder problems in terms of power optimization, in terms of yield and so on, simultaneously we're making just tremendous progress in managing these type of issues.

I think that after a period of 12 to 24 months, it becomes increasingly similar to 90 nanometer, which in turn has already increasingly become similar to 130.

Stuart Muter - RBC Capital Markets

Fair enough. That's helpful. Thank you.

Operator

Our next question is from the line of Raj Seth - Cowen & Co.

Raj Seth - Cowen & Co.

Yes, thank you. Aart, just a follow-up on the 130-90-65 question. Do you have a sense yet, how much does a fully loaded seat at 65 cost relative to, whatever capability folks need on average at 90? Is there a material step up in the average price per seat, if you think of it that way?

Aart de Geus

I think, Raj you've asked this question for ten years and for ten years I've never been able to give you a very good answer, partially because this notion of seat has never quite settled in for advanced technologies. For the less advanced technologies over time, things mature and sort of become fairly standard. For the advanced technologies, you sort of throw everything you have at it because it's part of your differentiation.

Clearly, if you move to 65, you can not dream of doing design there without having a fairly strong investment in low power solutions, for example. You will have a set of discussions and interactions on yield that will increase as we move to small geometry.

So the product set that is used for these advanced geometries is definitely broader than the product set that used to be used for let's say 180. Do we view it as a seat? I don't think we do and neither do our customers but I think the gist of your question is still, are they going to spend more with us and I think the answer is definitely yes.

Raj Seth - Cowen & Co.

Okay. On IC Compiler, a quick question. How are people using that today? Are people in fact using that as an RTL, the GDS 2 flow or are people still using pieces of this flow in conjunction perhaps with tools from others? Has the industry really moved in the way that some of the suppliers have talked about from RTL to GDS 2, beyond the lower complexity guys that probably do do that? Or are people still mixing and matching and how are they using IC Compiler, at least what you've seen so far?

Aart de Geus

We absolutely still see both, meaning that there are a number of customers that are now doing more and more complete very advanced design with specifically a Synopsys solution, and they are absolutely seeing some key benefits not only in the quality of results, but also in the overall time and risk it takes.

At the same time when I described the Galaxy, the implementation platform, you may have noticed that we really look at it as three portions. The synthesis, the physical design, and the sign-off, and one of the key reasons for that is so that we can use these technologies, that our customers can use them with competitors tools if so desired so we want to make sure that we have good access to that market.

Having said that though, if you specifically take the connection between synthesis and physical design, the topographical capabilities absolutely give you some key benefits in improving the predictability of the flow and therefore knowing earlier what kind of results you're going to get. So those are the type of things that have us say, hey, a complete flow from Synopsys really is a better option if you want to go there.

Raj Seth - Cowen & Co.

Last quarter on IC Compiler you said you were just beginning to seed this product in competitive, in non-Synopsys incumbent accounts. Anything that you can report in the way of displacements of competitive technologies with IC Compiler at this point?

Aart de Geus

Yes. I alluded to the fact that our fields team has really dramatically shifted it's emphasis, and so from a support point of view, there's an enormous amount of effort that is going into not just benchmarking, it's actually really a supporting of the early tape outs with IC Compiler. Yes, we have seen actual people migrate to Synopsys from others. It’s going to be interesting to see what happens the next few quarters because now the ratio is roughly 4:1 of our support efforts between IC Compiler and PC Astro.

Raj Seth - Cowen & Co.

Okay. Thanks.

Operator

Our next question comes from the line of Dennis Wassung - Canaccord Adams.

Dennis Wassung - Canaccord Adams

Thanks. First question is following on Raj's line of questions on the IC Compiler side. You talked about your goal is still maintaining a 80% conversion plan over three years. We've had the product out for a little while now. I'm just curious how can you quantify your status today? How far along do you think you are? You may not want to give a number here, but do you have a significant number of customers using IC Compiler across-the-board here in full production designs or are they still using it on initial designs at this point?

Aart de Geus

So we are one year into this and to your last comment/question, we are absolutely massively in production, and the very reason why our support is maximally taxed is that many of the people that use IC Compiler are using it simultaneously on some of the most advanced designs, and so in that sense, every technical problem in the book is being thrown at our service and support team. Thank God they are doing a good job there because we are seeing number of tape outs now grow rapidly, and we have quite a few coming out in the next couple of quarters. So from that perspective, yes. This is real production work on chips that go into very high volume, high sophistication products.

Dennis Wassung - Canaccord Adams

Can you give us any kind of thought on conversions at this point in the process?

Aart de Geus

No. We don't want to do that, but we have looked carefully at the statements that we've made early on and I think we feel exactly on track versus the 80% three years.

Dennis Wassung - Canaccord Adams

Okay, great. A couple of questions on the DFM side of the equation. When you look at the revenue that you put up in the DFM area it was a little bit down sequentially here. Talked about having a strong quarter and I think it was about 10% versus 12% of revenue last quarter. How do you see this revenue fly wheel moving from this DFM area? Do you expect that to grow here as a percentage of revenue? Obviously it's one of the faster growing pieces today. What are your thoughts there?

Aart de Geus

Our thoughts are exactly that it will grow. It is one of the faster pieces. The only comment I would make is we ourselves use the terminology the revenue wheel, but it's a wheel that's not quite round; meaning that every so often they are anomalies from one quarter to another versus I think one of the previous quarters we had a fairly high piece of upfront revenue attached to some specific business.

Conceptually your point is exactly right. This is part of the business that's growing very well that we will continue to run fast with and leaving alone the quarter by quarter anomalies, if you were to look at that rolling average, we would probably see that it's growing just fine.

Dennis Wassung - Canaccord Adams

Okay sort of related, the Prime Yield products you said that you've sold the product. Have you taken any revenue yet and what do you see in terms of a revenue impact in FY '07? Do you expect a material piece of revenue from that product in fiscal '07?

Aart de Geus

Realize that most our revenue is now ratable and so, if we sold a ton of business today, tomorrow our revenue is only a small portion of that, and so Prime Yield falls into that category. Actually to be honest I'm not quite sure if we sold last quarter or the beginning of this quarter. I remember the deals, but I don't remember the specific dates.

Dennis Wassung - Canaccord Adams

All right and last quick one for me. Your top line revenue guidance for the fiscal year, the high end of it went up about $4 million I think over last quarter and I'm just curious what kind of impact you're seeing from the SIGMA-C and Vertio acquisitions going into that number? Or do you lose the vast majority of that revenue on the purchase accounting involved in the deals?

Aart de Geus

Yes, typically in the first couple of quarters, one sees almost nothing of these small type deals. They will have impact positively next year, but for this quarter that's not the reason -- I think our business is just strong and that's why we're able to raise our guidance for the year.

Dennis Wassung - Canaccord Adams

Thank you.

Operator

Our next question comes from the line of Jay Vleeschhouwer - Merrill Lynch.

Jay Vleeschhouwer - Merrill Lynch

Thanks, good afternoon. Aart, I'd like to follow-up as well on one of Raj's earlier questions where you in reply questioned the notion of a seat. The question is as a practical matter, you of course have an installed base, you have active licenses for all of your products. Could you comment on for which products you are in fact seeing the most growth in terms of the active number of licenses? Or by the same token, reduction of licenses? Just try to help us understand a little bit better in terms of the net activity in terms of your installed base and active users?

Aart de Geus

Sure. With the caveat that we typically don't disclose very fine granularity, there's no question that the highest growth in number of seats is in verification which is also no surprise because as you know, we've been saying for awhile that the verification problem is growing much more rapidly than Moore's Law and moreover, people are putting together very substantial systems that they are very worried about that the functionality is not right.

So in that context, the verification has got to be the one that is using most hardware resources to run with our software.

Jay Vleeschhouwer - Merrill Lynch

What about any areas where in fact you're static or declining in terms of active users or licenses?

Aart de Geus

There's nothing big that comes to mind. There may be some products that are converting to the next generation, but I can't point to anything right now.

Jay Vleeschhouwer - Merrill Lynch

You pointed out earlier of course that in your subscriptions model it takes awhile for bookings to convert to revenues and yet, we see that the Galaxy revenues have been flat now sequentially for three quarters. You've talked on earlier calls about run rates generally increasing, including the run rate or bookings for IC Compiler. So the question is, at what point does the Galaxy revenue number begin to move higher than flat sequentially?

Aart de Geus

Well, I think you are going to see that growing gradually now as the IC Compiler impact becomes more visible. Again, let me remind you, these fly wheels are not round by any means, and it is very much a function of how the different deals were accounted for three or more years ago. It is really in the last two years that they are becoming more and more rounded because more of our business is on a very ratable basis, actually about 95%, so that's as good as it's going to get.

So that's my main comment. You will gradually see it and some of the other areas percentage wise of course have grown very well. Partially by virtue of some acquisitions, partially by virtue of their being very high growth areas.

Jay Vleeschhouwer - Merrill Lynch

When you look back over the last two or three years or so, Aart, at the various acquisitions you've done numerical and silicon co-design, what was left of Monterey, ISE, Nasden, how would you assess how well all of those have been integrated into your overall platform strategy? After all, it took you awhile to finally get the Avanti product to where you wanted it to be in Galaxy. Are there any similar issues at all with some of the smaller transactions you've done?

Aart de Geus

Well, those are very different in scale. Avanti was the largest merger in our industry and one of the largest mergers in software, period. In addition was a complete shift to a next generation system and so you're actually right. That took awhile and was actually pretty hard to do. Partially because we had done a good job on that, the integration of some of these other pieces was easier because they could be embedded directly into an overall set of platforms that were very well thought out.

Having said that if you take some of the more recent ones, they're doing very well and specifically if you look at the whole area of DFM, I think we have really been able to build stellar set of technologies and already after not a very long time, you're seeing now the benefits of connecting those in a fashion that hopefully extrapolates well the vision that design and manufacturing are connected in both directions, both design down to manufacturing and manufacturing data back up into design. So I'm actually very pleased about these integrations. Nothing is simple, but I think we're doing a really good job at it.

Jay Vleeschhouwer - Merrill Lynch

Just a couple last ones. In years past or some of your analyst meetings, you've talked about the distribution of your deals by size or range of order. In other words, deals under 20, deals over 20, deals over 50 and so forth. As your product mix is changing here, more DFM and other, beyond physical design and the like, how do you think that might change your distribution of deal size or order size going forward?

Aart de Geus

That's a very good question. I don't have a very hard answer for you. I can tell you that at the top level for the very large deals, which is of course where one spends most attention, it's probably not changed all that much in nature. There's some very big ones and medium ones, et cetera.

You are correct though that because of DFM, as one example we're selling into a customer base that before we were not selling into, which of course for us are new budget opportunities. So specifically DFM has a number of customers that in the past were not part of the corporate column. Some of those are very small. Some of those are growing rapidly because there too, the needs are going up. Now, if you take for example, the whole lithography area, clearly as people are moving to a 65 or smaller geometry, the needs there grow quite rapidly.

I think these companies or these customers will come gradually into the corporate distribution, but you're raising a good point that I should follow-up and look a little bit harder at how the distribution has changed.

Jay Vleeschhouwer - Merrill Lynch

Finally could you go into a little bit more depth on how you're doing by geography, particularly in Japan? I think it's well known that three years ago you did very well in Japan so presumably, a lot of that business is coming up again right around now;, some of it's already occurred, some of it is probably still in the works. How are you doing over there?

Aart de Geus

Overall, actually very well. The notion of three-year deals is actually a bit of a misnomer because as much as our business is on a three-year basis, the business increasingly is sort of rolling business. If I overly simplify it, ideally you'd like to do a three-year deal every year so that you have sort of a rolling backlog that you can in the process factor in the new products that you have, customer interaction and that is mostly what we're doing.

You are correct that three years ago, Japan was very strong at that point in time. Right now we're much more concerned on continually increasing the run rate. It is also very clear that Japan specifically in the last year-and-a-half to two years has been on a come back after literally almost a decade of hiatus.

So the investments in Japan are strong and they're strong increasingly in all of our areas of business.

Jay Vleeschhouwer - Merrill Lynch

Thanks, Aart.

Aart de Geus

You're welcome.

Operator

Our next question is from the line of Rohit Pandey - HSBC Securities.

Rohit Pandey - HSBC Securities

Brian or Aart, every quarter you come in and tell us about how you're controlling expenses and every quarter the headcount goes up. So please help me understand where does headcount fit in your picture for lower expenses?

Brian Beattie

Okay, why don't I handle that one. As we're looking at the headcount, of course as I mentioned this quarter, we had the additions of an acquisition that we completed and also that any of the additional headcount we grew in was in low cost countries.

Now, in addition to that -- that was in the third quarter -- in addition, we have announced as well that we are reducing a number of our infrastructure costs this week. We are outsourcing areas of IT and procurement and we're going to continue to look at taking advantage of lower-cost operations where we already have pretty significant engineering resources to look at what we can do in keeping our costs down for the year.

So again, I build that in an overall structure of while we may add heads, we're really focused on the dollars that are going into that and tying that into our whole operating margin focus.

So again, we're calling the 7% operating margin range that we're producing today which is in the range of about 13% and then that 20% plus next year, that's really significant reductions and improvements in our operating margins. But also looking at how the Company goes global. I mean, if customers are located on a global basis then so are we. So we're going to continue to look for that and look for where we can grow and invest in the future.

Rohit Pandey - HSBC Securities

Has the headcount peaked?

Aart de Geus

I'll take that. I hope not. The whole point is to grow the Company and we will grow the Company by trying to do as much business as we can while being very diligent on cost management.

There should be one message that should be very clear. In the last two years we have taken a very systematic approach to cost management and we continue that discipline now going forward. At the same time, we are now looking at how can we grow the Company as fast as possible while continuing to expand the ops margin. So the ops margin is really right now our best metric of success in terms of expense control, and if we can grow the Company and increase the ops margin at the same time -- which we think we can do -- that is what will increase the value of the Company most.

Don't misread that for not paying attention to expenses. We're spending dramatically more attention to that than two years ago and I think we're doing a much better job at it.

Rohit Pandey - HSBC Securities

You spoke about the streamlining expenses. Are you able to quantify the contribution it would have towards your more than 20% operating margin growth for next year?

Aart de Geus

We have streamlined throughout the year quite substantially. Where streamlining means a couple of things. One is to make sure that a job that one can do without actually leave over time the Company, be it through attrition, through other mechanisms, through outsourcing, et cetera; but also by putting people on to things that are the investment areas going forward.

Secondly, don't underestimate what we've been able to do in terms of globalization, because that is one of the very mechanism in which one can have growth while simultaneously improve the profitability of the Company.

So the two go hand in hand, and for the last, I guess it's almost two years now, we have been very systematic in moving towards the commitment we have made for '07. I think we're well on track for that. We do see that it can get better beyond that, and we are certainly planning for continued increase of the ops margin after the 20%.

Rohit Pandey - HSBC Securities

So operating goal for next year already included streamlining?

Aart de Geus

I'm sorry?

Rohit Pandey - HSBC Securities

Your operating margin goal for next year already had some degree of streamlining efforts built in the target?

Brian Beattie

In order to achieve those, yes, most definitely we had to focus on a number of streamlining actions, yes.

Rohit Pandey - HSBC Securities

Talking about the revenue model, given that more than 90% of the revenue is backlog, should there be any strong seasonality in your revenues? Is it possible that the Q1 revenues are higher than Q4 revenues?

Aart de Geus

I mentioned earlier that we started out with a fly wheel that's not completely round. It's a fly wheel that now with every year becomes more rounded because the new business is layered up at the tune of 95% ratable and only 5% up front. So if you were to extrapolate that to infinity you'd have a maximum variation of 5% and I think we managed even better than that.

Rohit Pandey - HSBC Securities

On the technology side do you think you need emulation products at some point in time or that's not needed per your strategy?

Aart de Geus

It's a question that comes up periodically. There are a number of emulation vendors today, some of which we are working with. It is definitely not on the high feedback side from our customers, especially in light of increasingly good software alternatives being available for many problems, and so this is one of those areas where I would say never say never, but it's not on my top worry list.

Operator

Thank you. And there are approximately five minutes remaining in the conference. Our next question is from Vishal Saluja - Seligman.

Vishal Saluja - Seligman

Thanks for taking my question. Aart, I have a question on the competitive environment and specifically whether you are seeing more favorable pricing trends as a result of the move to the heavy subscription model.

Is it finally beginning to pay dividends with you not having to scramble at the end of the quarter? Then I have a follow-up as well.

Aart de Geus

There's no question that our own behavior at the end of the quarter is not only more disciplined but also more relaxed because one is not in sort of this double bind of having to close business and meet expectations that could be difficult at the end of the quarter. So from that perspective we think that we are doing better business with our customers if we did not have such a mechanism.

Overall, it is a very competitive market, but it is also clear that we have been able to increase our product differentiation steadily in the last, I would say six to eight quarters, and I see that that is starting to pay dividends.

Vishal Saluja - Seligman

I see. Just referring to one of your comments earlier in your prepared remarks about being ahead of internal plan for the last seven quarters, can you just give us a little bit more color on whether that's a result of a conservative plan or a better macro environment or better success on certain new products?

So if you can just give us a little bit more specificity around that because clearly it prepares you for a better '07; we’re just trying to understand how you got there.

Aart de Geus

Sure. It's too bad in the list you didn't put better management, but in all fairness the reality is it's always difficult to actually put the plans in place that are sort of just right because on one hand, you want to put a plan in place that is reachable because you make many commitments and compensation is targeted against it. On the other hand you want to put a plan that's a bit of a stretch because you want to push yourself and your team. If you make too much of a stretch you have negatives.

So I'll be the first to say planning is an art more than a science; although, because of the ratable business model, I think we're in much, much better shape for planning than we've ever been in our history, and that is the very reason why already today we have a pretty solid focus on what we need to do for '08. I think that is a different planning horizon that we've had in the past.

Regarding why we think that we're doing well. It is absolutely the product and the technology strength. I reported that in all four areas, we feel that we have strong differentiation, the Galaxy platform is doing very well. The Discovery platform, as mentioned, certainly this quarter was way above expectations, DFM is an area that we bet on about two years ago and I think these investments are paying off. IPN systems I think will be following DFM over time and certainly holds a lot of promise, but for us is doing very well specifically on the IP side. So, it really is product technology. It's the same old recipe. In technology you win with technology.

Vishal Saluja - Seligman

Okay. Thanks a lot.

Aart de Geus

You're welcome.

Operator

And with that I'll turn the call back over to you.

Aart de Geus

Well, we appreciate you sharing your time with us today. As usual, Brian and myself will be available after the call. Thanks for joining us.

Operator

Ladies and gentlemen, this conference will be available for replay after 5:30 pm Pacific Time today through midnight, August 30. You may access the replay service by dialing 1-800-475-6701 and entering access code 838366. International participants dial 320-365-3844. This does conclude our conference for today. Thank you for using AT&T Executive Teleconference. You may now disconnect.

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