Cadence Design Systems Q3 2022 Earnings Call Transcript

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Provided by Quartr
October 24, 2022

There are 12 speakers on the call.

Operator

Good afternoon. My name is Abby, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Third Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.

Operator

On your telephone keypad. Thank you. I will now turn the call over to Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead.

Speaker 1

Thank you, operator. I'd like to welcome everyone to our Q3 of fiscal year 2022 Earnings Conference Call. I'm joined today by Anurag Devan, President and Chief Executive Officer and John Wall, Senior Vice President and Chief Financial Officer. The webcast of this call and a copy of today's prepared remarks will be available on our website cadence.com. Today's discussion will contain forward looking statements, including our outlook on future business and operating results.

Speaker 1

Due to risks and uncertainties, actual results may differ materially from those projected or implied in today's discussion. For information on factors that could cause actual results to differ. Please refer to our SEC filings, including our most recent Forms 10 ks and 10 Q and today's earnings release. All forward looking statements during this call are based on estimates and information available to us as of today, and we disclaim any obligation to update them. In addition, we'll present certain non GAAP measures, which should not be considered in isolation from or as a substitute for GAAP results.

Speaker 1

Reconciliation of GAAP to non GAAP measures are included in today's earnings release. Today's earnings release for the Q3 of fiscal 2022, related financial tables and CFO commentary are also available on our website. For the Q and A session today, we would ask that you observe a limit of 1 question and one follow-up. You may re queue if you would like to ask additional questions and time permits. Now, I'll turn the call over to Anurag.

Speaker 2

Thank you, Richard. Good afternoon, everyone, and thank you for joining us today. I'm pleased to report that Cadence delivered excellent results for Q3, driven by our technology leadership, strong execution, diversified customer base and resilient business model. We beat our Q3 guidance on all key metrics and are raising our financial outlook for the year yet again to 19% year over year revenue growth and 40% operating margin. John will provide more details on our Q3 results and updated outlook for the year.

Speaker 2

Notwithstanding the prevailing macroeconomic uncertainties, hyperscale computing and AIML driving robust design activity over the long term remains intact. These secular trends are accelerating the digital transformation across several end markets. While the growing hyperconvergence across multiple domains, mechanical and electrical, Hardware and Software and Systems and Semi is driving the strong need for continued innovation in compute, connectivity and storage. Customers are investing heavily to differentiate their next generation platform with system companies increasingly developing purpose built silicon and semiconductor companies benefiting from expanding silicon content. Our comprehensive offerings comprised of leading End to end EDA solutions, IP, hardware and expanding systems portfolio uniquely positioned us to support our customers, while providing us with ample growth opportunities.

Speaker 2

In an environment of increasing design complexity, tighter time to market requirements and growing shortage of talent. Sophisticated AI ML solutions can greatly help to democratize chip and system development, while dramatically increasing productivity and quality of results. Customers deploying our game changing AI driven Cadence Cerebras and Optimality solutions are realizing amazing results. And in Q3, we augmented our portfolio with the transformative Verisium AI verification platform and the JEDI data platform. Verification continues to be the critical part in system time to market, consuming the vast majority of resources, with debug being the largest component.

Speaker 2

Verisium provides a generational shift in verification, Moving from a legacy single run, single engine approach to algorithms that leverage big data and AI to optimize multiple runs across multiple engines, leading to a 10x boost in debug productivity. Several customers, including Samsung and ST Microelectronics, have observed impressive results with Verisium for automatically triaging and root causing bugs. JEDI is our revolutionary AI driven Big Data Analytics Platform that is foundational to unifying our AI innovations across Cadence Cerebras, Optimality and Vericium. JEDI operates on vast amount of data, including all types of design, verification, analysis and methodology information to facilitate smaller design optimization to facilitate smarter design optimization and enhance productivity. In Q3, we significantly expanded our footprint with market shaping customers as they increasingly embrace our optimized platform offerings.

Speaker 2

We deepened our partnership with BAE Systems across our core EDA and systems portfolio, including proliferation of our digital full flow and analog products and a broad expansion of our PCB and Multi Physics System Analysis Solutions. Additionally, in Q3, we strengthened our collaboration with Teradyne, Which included a broad proliferation of our core EDA software across digital, analog and verification, as well as a significant expansion of our PCB and System Analysis business. Demand for our core EDA software remains strong and broad based. Our digital business had another strong quarter With 22% year over year growth, driven by key competitive wins and continued proliferation and market shaping customers. 13 new customers adopted our digital full flow in Q3.

Speaker 2

It's been just over a year since we launched Cadence Cerebras and it's fast becoming a linchpin technology for customers. As they derive incredible productivity and PPA results on a wide variety of their most advanced SoC designs. Several leading customers have major multi design, multi project production deployments underway and are reporting up to 30% improvement in quality of results and 30x productivity improvements. Additionally, we see accelerated growth in our front end and sign off offerings, in part due to the Cadence Cerebras pull through effect. We launched the Certus closure solution, which dramatically accelerates Complete Design Closure by using an innovative hierarchical architecture and a fully automated environment for concurrent full chip optimization and sign off.

Speaker 2

Using Certus, Serenas' observed 6x faster chip level sign off closure versus current methodology. And MaxLinear experience overnight full chip sign of closure, while realizing up to 5% of untapped power savings. Our custom IC business continues to define the analog market for this bold vision, market leading technology and comprehensive portfolio. In Q3, it grew 12% year over year, driven by best in class Virtuoso platform and by strong growth in our Spectre simulation solutions. Now moving on to functional verification.

Speaker 2

In Q3, our business grew 31% year over year, led by hardware and Xcelium. Our Palladium Z2 and Protium 2 hardware platforms providing industry leading system verification and software bring up capabilities, added 3 new customers and had 20 repeat orders, including from high end mobile, AI and hyperscale customers. Our IT business led by Star IP offerings at the most advanced nodes continue to benefit from ongoing IP outsourcing trend and from customers increasingly embracing IP reuse for risk reduction and faster time to market. During Q3, we signed our largest IP contract ever with a marquee U. S.

Speaker 2

Semiconductor company and had a major expansion at a leading U. S. 5 gs company. Tensilica extended its leadership in the true wireless stereo market, while proliferating its functional safety and Infotainment Solutions with Automotive Companies. We also had multiple design IT wins across our leading PCIe, BDR and die to die portfolio.

Speaker 2

Our system design and analysis business is a key tenant of our growth strategy to leverage our computational software expertise and expand our TAM by growing in near adjacencies. This business continued its strong momentum, delivering 29% year over year growth as we increased our footprint in several verticals, including aerospace and defense and Hi Tech Electronics. Our broad systems portfolio providing tightly integrated platform solutions across the design simulation and analysis is resonating strongly with customers as they increasingly choose a broader set of our solutions across these domains. In Q3, we broadened our collaboration with Emerson, A global industrial technology and software leader, as they significantly expanded their use of our system solutions. Notably our PCB, AWR and system analysis technologies.

Speaker 2

Fidelity CFD software that was announced earlier this year is ramping nicely and facilitating customers in verticals such as aerospace, marine and turbomachinery to do design optimization, leading to efficiency improvement and meaningful reduction in emissions and energy consumption and the addition of future facilities Digital Twin based Thermal and Power Optimization technology will further help data center customers to reduce their carbon footprint. Lastly, we completed the acquisition of Open Eye Scientific, a leader in the computational molecular design space. We are very excited to bring our system level simulation and AIML expertise to the life sciences market to help improve the speed and accuracy of biosimulations, thereby enhancing the efficiency and success rate of drug discovery process. Integration of both our future facilities and OpenEye acquisitions is progressing well. In closing, Q3 was an outstanding quarter as we advanced our intelligent system design strategy and continue to closely collaborate with our customers on their next generation designs.

Speaker 2

We are managing our business with an intense focus on innovation and operational excellence to drive both revenue growth and Margin Expansion and are very well positioned to capitalize on the massive opportunities ahead of us. Now I will turn it over to John to provide more details on the Q3 results and our updated 2022 outlook.

Speaker 3

Thanks, Anarud, and good afternoon, everyone. I'm pleased to report that we completed the acquisitions of Open Eye Scientific in future facilities in the Q3 of 2022. Cadence exceeded all key financial and operational metrics for the quarter. Here are some of the financial highlights from the Q3. Total revenue was $903,000,000 GAAP operating margin was 29% and non GAAP operating margin was 39%.

Speaker 3

GAAP EPS was $0.68 and non GAAP EPS was $1.06 Operating cash flow was $317,000,000 We used $150,000,000 of cash to repurchase Cadence shares. And at the end of the quarter, our cash balance totaled $1,000,000,000 while the principal value of our debt outstanding was $800,000,000 Before I provide our updated outlook for the remainder of fiscal 2022, I'd like to take a moment to share certain key assumptions embedded in our outlook. We expect the impact of the recent changes to U. S. Trade restrictions on our business to be limited and manageable.

Speaker 3

The impact is included in our outlook. Our outlook also assumes that the export limitations that exist today remains substantially similar for the rest of the year. Embedding these assumptions into our outlook for fiscal 2022, We now expect revenue in the range of $3,536,000,000 to $3,552,000,000 GAAP operating margin in the range of 29.7% to 30.7%. Non GAAP operating margin in the range of 39.7% to 40.7 percent GAAP EPS in the range of $2.71 to 2 $0.75 non GAAP EPS in the range of $4.20 to $4.24 operating cash flow of approximately $1,200,000,000 to $1,260,000,000 and we expect to use approximately $1,050,000,000 of our free cash flow to repurchase Cadence shares in 2022. Approximately 35% GAAP EPS in the range of $0.50 to $0.54 non GAAP EPS in the range of $0.89 to $0.93 and we expect to use approximately $300,000,000 of cash to repurchase Cadence shares in Q4.

Speaker 3

Our CFO commentary, which is available on our website includes our outlook for additional items as well as further analysis and GAAP to I'd like to thank our Cadence team for their exceptional execution and financial discipline. At the midpoint of our outlook, we expect our annual non GAAP operating margin to exceed 40% for the first time, which is especially pleasing. As always, I'd like to thank our customers, partners and our employees for their continued support. And with that operator, we'll now take questions.

Operator

Your first question comes from Jason Celino from KeyBanc Capital Markets.

Speaker 4

Great. Thanks for taking my question. Can you guys hear me?

Speaker 5

Yes, Jason. Go on.

Speaker 4

Okay. Perfect. Perfect. Perfect. Sorry to be straight to the point here, but China is on everybody's mind.

Speaker 4

It was 50% growth in the quarter. To some extent, it was an easy comp, but it was the largest revenue that you've seen In period. So I guess, where did you see the strength and then how would you describe the linearity of that strength? Was it all throughout the quarter or was this Run uploaded or back uploaded, curious and then I'll have a follow-up.

Speaker 3

That's a great question, Jason, and thanks for the opportunity to clarify. In Q2, you saw 13% of our revenue in Q2 came from China and that jumped to 17% in Q3. Most of the increase, the vast majority of that increase was a result of hardware sales in the quarter, hardware revenue that was recognized from deliveries into China during So that uptick in China revenue is all from upfront revenue sources.

Speaker 4

Okay, perfect. And then I did notice that backlog was kind of sequentially down a smidge in the quarter. How much of that was due to the inclusion of some of these new restrictions? Thanks.

Speaker 3

Yes, another great question, Jason. Last I think it was 2.75 in terms of our current RPO and that's down to 2.7 now. That's partly as a result of that hardware delivery into China. It also includes the this quarter we've included the impact of the new U. S.

Speaker 3

Export Regulations. On backlog, in total, I think it went from 5.6 to 5.5. The current the RPO piece that was slightly down more and we had An increase in IP. We signed our largest IP contract ever and that's in the non cancelable commitment portion of our backlog.

Speaker 4

Okay, great. I'll get back in queue. Thanks, John.

Speaker 3

Thanks, Jason.

Operator

Your next question comes from the line of Charles Shi from Needham and Company.

Speaker 6

Hi. Good afternoon, Anyu and Jiang, I really just want to go back to the China question, maybe not immediate Q4 Woah, fiscal 2022, but I'll try to look a little bit ahead. Among your like kind of like mid teens of the total revenue coming from China. I know you sell to China to various kind of customers. You've got multinationals, you've got the large semiconductor companies, domestic, you've got AI startups, Chinese system companies.

Speaker 6

But Across this wide spectrum of the different kind of customers in China, what kind of customer the sales The customer could be the most impacted by the actual control and well, can you kind of quantify to us

Speaker 5

How much of the percentage

Speaker 7

of your revenue is going to

Speaker 6

be impacted because of the latest round of export controls? And I have a follow-up to that.

Speaker 3

Hi, Charles. This is John. Yes. The good point there, we did call out that the impact is limited. We believe the impact is limited and manageable.

Speaker 3

That's not just for Q4, but for the foreseeable future going forward.

Speaker 6

Any thoughts on any specific type of customers that you may see the greater impact in the China in your China market.

Speaker 2

Yes. Hi, Charles. This is Anirudh. So overall, China is diversified customer base And we have a lot of design activity in China. Good thing about Cadence is we participate in all kinds of designs, right, whether analog or digital or memory and different market segments.

Speaker 2

So overall, I feel that that will be intact. I think there is some effect on local like China foundry in the latest regulations, As you probably know, but overall our business is very diversified, not just in China, but other geos. So And therefore, we feel the impact is limited and manageable. And like what John said, not just for the remaining of the year, But also going forward.

Speaker 4

Thank you.

Operator

Your next question comes from the line of Gary Mobley from Wells Fargo.

Speaker 8

Hey, guys. Thanks for taking my question. I wanted to talk about perhaps the indirect impact from the China export restrictions and as well the general semiconductor market backdrop and the challenges this may present for companies like Cadence. So you have some of your large customers who can ship product to China Because of various export restrictions, one of which can't ship $400,000,000 worth of product because of these export restrictions. So to what extent long term might the R and D budgets of those types of companies be impacted and related to that the chip design activity as they can no longer sell to various and large end markets like China.

Speaker 8

And then related to the overall market backdrop, Are you seeing any change in customer behavior with respect to the time it takes to get sign off on any large license deals?

Speaker 2

Hi, Gary. They're good points, especially the indirect effect and also overall macroeconomic uncertainties. And we are carefully Monitoring the situation on both of these fronts. As you know, we are more on the design side Ben, on the volume of shipments. So on the macroeconomic trends, of course, there's a lot of news in the press and we are carefully monitoring it.

Speaker 2

But right now, we see robust design activity. And as you know, we participate in all the market verticals. So even if some verticals may be weaker On their shipment side, they will still do design, but then some verticals are still good on the shipment side as well. So With this combination of us being on the design side and then us being very diversified across multiple verticals, Right now, we still see very robust design activity, and that's reflected in the results that we are reporting today, right, and our outlook for rest of the year. Now on the indirect effect on China, that's to be observed also.

Speaker 2

But again, we are pretty diversified. And then, Yes, there's always some effect on some of our customers, but again, we are pretty diversified and then so we But we will carefully monitor that going forward.

Speaker 8

All right. Thanks for the color, Anuruk. So I wanted to switch topics to your JEDI based AI machine learning tools, including 3 risks and some of the others you recently announced. I know you're in the early days of price discovery and introducing those products to market. What has been the feedback as it relates to price discovery and related to that how deeply you may be seeing penetration in some of your early days customers there.

Speaker 2

Yes. Hi, Guy. That's a great point and we are super excited. The EDA has always been like We have done a lot of great productivity improvements for our customers, but it has always been like a single run environment, right? You run our tool one time And then the multiple runs have been managed by the customers.

Speaker 2

Typically, when you do the design, you're not running our tools one time, you're running it multiple times. So with this data analytics and AI, we can really offer solutions in this multi run environment. And so AI is a key part of that, But in a multiyear environment, you also have to manage the data, because AI tools run on top of all the data that is generated. And we are very proud of this new JEDI platform. It's a new data analytics platform to capture all kinds of data in the design process.

Speaker 2

And that unifies our solutions across this space. And then we have 3 like big apps on top of JEDI, on top of this data analytics. So one, you already know like Cadence Cerebras, which was launched last year. Optimality, which is on the system space using some of the similar technologies as Cerebras, but applied to system simulation. And now Verisium in verification, which by the way, verification, as you know, is one of the most time consuming parts of the design flow and also the one that generates the most data.

Speaker 2

Logic simulation, Hardware Verification generates the most amount of data in EDA. So that's why it was critical to have JEDI To unify all these things, but also get ready for more data like in verification. And the adoption has been actually Surprisingly good. And all the big customers are engaged. You see in Vericium, we have endorsement from several big customers.

Speaker 2

We talked about Cerebras last time. So at this point, all the major customers really do want to deploy this solution. And like I mentioned in the script, not just for 1 or 2 designs, we are seeing broader and broader adoption and we are very happy with the progress so far.

Speaker 8

Thanks again.

Operator

Your next question comes Steve Lieschauer from Griffin Securities.

Speaker 3

Thank you. Good evening. On route for you first, When you look back the last 1 or 2 years, how would you rank the contribution to your bookings growth and or share gain in what we define as core EDA from the various products that go under your us and nomenclature. I assume Innovus has been part of that given its size, but when you look at some of the various other sign off and other tools that you've introduced under nomenclature. Again, how would you rank the new momentum or incremental contribution from those and perhaps even look out ahead over the next 1 or 2 years in that respect.

Speaker 3

Secondly, for you, John, what has been your experience today in terms of the predictability of your IP business. This is not a China specific question, but feel free to talk about China. Specifically in terms of the increasingly material upfront component that we've seen for IP rev rec as well as for your services engagements related to IT. Thank you.

Speaker 2

Yes. Hi, Jay. That's a good question. And actually, I'm very pleased with our strength of portfolio in core EDA. And as you know, we have been doing increasingly well over the last couple of years.

Speaker 2

And I can say that Cadence core EDA portfolio is strongest it has ever been. And we want to apply our expertise in computational software to new areas like system analysis and system design and analysis, but it's super critical to maintain the leadership in the core, Because core always comes first. And then we take those expertise and apply to new areas like systems. So we are always focused on the core first. And core parts are, let's say, 3 big areas, right, in core EDA, digital, analog and verification at a high level.

Speaker 2

And I feel that we have a very strong portfolio now. In terms of contributions of growth, in analog, we were always strong. I think there were some areas to improve in Spectre simulation, which have been fixed over the last 2 years. So I think analog is more steady and you can see even this quarter, it grew a healthy 12%. But a lot of the growth has come from digital and not just Innovus, which is placed in the route, but also now with Synthesis and Signoff and Cerebras.

Speaker 2

So I would say, digital It's growing very well also in terms of strengthening the position in the market. And then I'm especially pleased with verification. Now verification, there is systemic growth drivers that is helping hardware, But I think that some of it is strength of our portfolio and some of it is hardware becomes more critical to the design portfolio. But in verification, I'm actually also pleased with Verisium, our logic simulator. I think that's doing really well This year and over the last couple of years.

Speaker 2

And that completes our overall verification platform, because we are now strong in hardware with Palladium and Protium. And then Jasper, we have always been the leading solution in formal verification. And with the strength of Axcelium, that completes our verification platform. So I would say that growth in core EDA is driven by digital, Number 1, verification, close second and then maintaining and strengthening our position in analog.

Speaker 3

In relation to your IP question and particularly the predictability of IP revenue, our focus remains on profitable growth through differentiated Star IP that's highly reusable and easier to scale. And I'll be very pleased with the discipline from the management team that run that business for us and their ability to target more profitable and sustainable revenue growth. That's what we ask, but we always ask them To run IP like it's our family business, sign us up to business that you want to do if this was your family business, not just a public company. And of course, with IP in amongst that profitable, sustainable, regular recurring revenue, there's also some upfront components to IP that can have more variability. Naturally, we're cautious on that going forward, but We'll have to look at the macro and economic environment and on the impact of that for next year, but we see a lot of upfront revenue this year in our numbers.

Speaker 3

I think upfront revenue for 2022 is on track to be almost 50% growth year over year. That sets up some pretty tough comps for next year. So we'll look at that carefully. Now most of that's coming on the hardware side. But when I look at all of the business, all the businesses across Cadence, They're all on track to go by low teens or more growth this year.

Speaker 3

And like I Very, very pleased with the Predictability VIP business, particularly because they focused on profitable and sustainable revenue growth for us. Thank you, both.

Speaker 5

Thanks.

Operator

Your next question comes from Vivek Arya from Bank of America Securities.

Speaker 9

Thanks for taking my question. I wanted to ask the China question in a different way. How much of your 17% of sales to China were to customers that were involved in or would eventually be involved in sub-fourteen nanometer logic design or leading edge Lando DRAM. I guess it's just not intuitive that leading edge design is not possible without your tools. China just got restricted from doing leading edge, Yes, you are not seeing the restriction in any way.

Speaker 9

It's just not intuitive to me at all.

Speaker 3

Hi, Vivek. I mean, we've taken the necessary steps to be in full compliance with the new export regulations. And our guidance includes the full impact. We haven't broken out how much of our China revenue is sub-fourteen nanometer. But we do believe the impact to the company is limited and manageable.

Speaker 9

But is that a near term view, John, in that is it because you are more involved in analog? Is it because you are in 2 or 3 year contracts? Or is it because You think that there is other revenue sources outside of China that can help you kind of offset that deficit?

Speaker 3

We also feel it's limited and manageable going forward. Again, I mean, we're applying these rules, These new U. S. Export restrictions, we've applied them, so we've included the impact in our guide. We believe it's limited.

Speaker 3

And I'd say, like I say, manageable from an R and D perspective and we have to look at some resources and maybe redeploy some of those resources.

Speaker 9

Okay. And for my follow-up, I'm curious what happens if semiconductor sales go down 10% or 15% next year? What happens The budget for EDA. Like even if you don't decline, is it possible that the growth rate slows down from the mid teens? Or I guess, ask in a different day, under what scenario would Cadence's growth rate slow down next year?

Speaker 2

Yes. Hi, this is Anirudh. First of all, I think you know already, I just want to remind you that We believe our business is more resilient. But of course, we are not immune to macroeconomic situation, right? So it will depend on at a high level, it will depend There is a recession, how severe the recession is, right?

Speaker 2

Is it the mild recession or is it like a very, very severe recession? So if it's a very, very severe recession then, of course, nobody is immune to it. But in general, from our kind of business, I think there are 3 factors that makes it more resilient. So, one, as you know, we are essential part of the design process. So we are not tied directly to volume or shipment modes to design activity and then design activities there both in the semi companies and of course the system companies and we are also expanding our portfolio into systems.

Speaker 2

So I think first part is we are more essential and tied to R and D. 2nd part, as you know, we are very ratable. Most of our revenue is ratable. And 3rd part is we are very diversified in vertical geographies and verticals. So that gives us more resiliency than other companies in this environment.

Speaker 2

But of course, like I said, we are not Immune to it, especially if there's a very severe kind of correction. And so we are carefully monitoring that. And I think when we talk to you next time in January, we'll have more information on the macro situation and can provide more color for next year.

Speaker 3

Yes. And the macro will really impact upfront more. I mean, we have very resilient, robust stream of recurring revenue. I think that's what Jay was getting at in his earlier question about the predictability of the IP business. I feel very confident in the IP business, because we've been focused on profitable and sustainable revenue growth there.

Speaker 3

But we've had a really strong hardware revenue year this year. And I don't know myself, if there is a severe downturn in macroeconomic conditions, IT budgets are one of the first things that you look at in terms of do you need to purchase hardware and capital equipment and things like that. And that could impact us on the upfront side.

Speaker 10

Thank you.

Operator

Your next Question comes from Harlan Sur with JPMorgan.

Speaker 10

Hi, good afternoon. Thanks for taking my question. Yes, maybe as follow-up to the last question. So your functional verification portfolio, which includes hardware emulation and prototyping, right, that's up 25% for the 1st 9 months of this year, of very strong growth. But if I think about a weaker semi industry next year and think about where the risk could be, you talked about some of the upfront portion of your revenues and I think about hardware, emulation and prototyping platforms.

Speaker 10

But then on the flip side, we continue to hear that design verification and early software development continue to be very significant bottlenecks in these next generation Digital SoC Chip Design, so actually very critical to your customers' overall design process. Do you guys agree with this? And given your pipeline visibility backlog. Do you see your hardware emulation and prototyping pipeline at least as you're looking at it now remaining relatively strong into next year?

Speaker 3

So from a backlog perspective, we probably have 6 months of hardware revenue in backlog, But any kind of increased issues on the macroeconomic front will probably slow down hardware purchasing going forward. We'll need another few months to assess what the climate is like there. But hardware is really a pipeline business. You get about 3 or 6 months kind of visibility into what that pipeline looks like. So again, I think on the hardware side, it's been a phenomenal year.

Speaker 3

The functional verification group has had a tremendous year this year. We'll be lapping some tough comps next year, but we need a few more months to assess before we can guide anything to next year.

Speaker 2

But in general, your thesis is correct. I mean hardware almost become indispensable to the design of Chips and Electronic Systems. So without these emulation and prototype platforms, it's almost impossible to design that. And as the chips get bigger, As you go to near nodes, the chips in terms of they get bigger in terms of number of gates, right? So the next node always has more gates than the previous node, even if the chip size is same as you know.

Speaker 2

So as the chip number of gates gets larger, it requires more and more verification and emulation. So Overall, I think there is a systematic kind of support of how much emulation and verification needs to be done. So it just depends on how that overall baseline growth required gets affected by any large macroeconomic shift. But in general, these hardware platforms are almost indispensable now as you do design and almost all our big customers are relying on them. Yes.

Speaker 2

And from a business perspective, I

Speaker 3

mean, we're building out our cloud infrastructure to be able to provide that hardware in the cloud. So that changes Spend for emulation capacity from being capital spends to expense spending. Now from a revenue standpoint though, emulation capacity that's used in the cloud, we would have to recognize that revenue ratably, but we do have a business solution if there is cutbacks on CapEx spending.

Speaker 10

Thank you. I appreciate that. And maybe just a longer term question, because we're hearing more and more about this. But On the move to 800 gig and higher optical speeds in the data center, this is driving a pretty strong focus on more integrated silicon photonics based solutions either optical module based or co package electro optical, Intel, Marvell, Broadcom, NVIDIA, Cisco, all of some of your big customers for all working on FIFO solutions. I know you guys have a pretty strong portfolio here.

Speaker 10

You've got virtual also photonics. I think you've got some of your advanced packaging and module design solutions, thermal and power modeling solutions as well. And you guys also have pretty strong partnerships with some of the manufacturing guys. How do you guys see this market opportunity unfolding for the team over the next few years?

Speaker 2

Yes, that's a great point. I mean Photonics is big and then you also touched on package level integration. So I mean these things again play to the We are in a good position there based on the strength of Cadence. A lot of these things are done in Virtuoso platform, which is the flagship platform and then also Allegro, which is again flagship platform for advanced packaging. And then over the last For years, we have built all these analysis tools like Clarity and Celsius for electromagnetics and thermal, which are critical for photonics and 3 d ICs.

Speaker 2

So we have a pretty broad solution And that's the other exciting part is there are multiple vectors of growth that are possible with Cadence and this is definitely a very exciting area as you know. So we are working with all the because of our position in Virtuoso and Allegro and the new analysis tools, We're working in this very important market.

Speaker 10

Yes, great. Thank you.

Operator

Your next question comes from Gal Munda with Wolfe Research.

Speaker 7

Hi. Thank you for taking my questions. Maybe the first one, John, for you. When I think about the guys heading into Q4, Especially around the OpEx, what's implied to get to that level of profitability. Is there anything accelerated, anything that we need to kind of factor in there in terms of the hiring on cost side?

Speaker 7

Or do you think I think incremental margin is implied as kind of low 30s to get you to that number. Is it more conservative? How would you kind of assess that part of the guide?

Speaker 3

Yes, sure. Good question Gal. But on the plus incremental hiring that we did during Q3 and intend to do again in Q4. But you get the full bio wave effect of any hiring in Q3, the full quarter of that expense in Q4. Also on the bookings front, that we've had seen substantial increase in bookings compared to our forecast this year that sales have been very, very good.

Speaker 3

And So there will be increased commission costs embedded into that Q4 guide as well.

Speaker 2

Okay. That's helpful. As a

Speaker 7

follow-up, guys, if you're not obviously, hardware has done really well this year. But if you think about that When you introduced the Q4 divide for the year and then this is the 3rd race in a row, what Look back 9 months, what is the thing that surprised you most? Was it the hardware itself, how strong it's been this year? Or has there been anything else that's allowed you to keep raising the guide on the top line throughout the year?

Speaker 3

I've been very, very pleased with the performance of all the businesses. Like you say, every single one of our businesses is performing exceptionally well. The lowest performing business is showing teen growth year over year, absolutely tremendous. Now what I wasn't expecting with upfront revenue to grow by almost 50% over 2021. I don't think any of us would ever predicted that.

Speaker 3

But you're seeing a lot of that upfront revenue coming through from hardware. It's the popularity of our emulation systems. It's just been off the charts and long may it continue, but it's it was very hard to determine how long that will continue for. We do have substantial backlog already and a long lead time and we're making those systems as fast as we possibly can. I think if you have a look at the inventory, We've less than $10,000,000 of finished goods there.

Speaker 3

The vast majority of that is already out on demonstration with customers. But, so there's a triage situation that goes on every system that comes off the production line. There's a plan for getting that out to a customer as quickly as possible.

Speaker 10

That's very helpful. Thank you so much.

Operator

Your next question comes from Johnny Hunte from Deutsche Bank Securities.

Speaker 5

Hi, everyone. Yes, thank you for taking my questions and congratulations on delivering another great quarter. Now Given the strong performance that you've had in system design analysis and JedI and Cerebras, Could you perhaps give some color on how your customers are reacting to budgetary decisions regarding spend in this category given the current economic climate? Are you seeing customers sticking similar to that of EBITDA consumption? Or is this bucket of software spend more volatile to ethanol downwinds?

Speaker 5

And I'd imagine companies particularly for this bucket are more defensive, James speaking. I'll ask a follow-up after. Thank you.

Speaker 2

Yes. Hi, this is Anirudh. So, I mean, good question. We are Like I mentioned, we are pleased with the adoption of this AI based solution, because I think it can provide more automation And what EDA tools have done in the past. And to some extent, they are also deflationary.

Speaker 2

You have opportunity, I think, for the entire industry to move more of the work from people to automation, from people to tools. And this is possible because with JEDI and then Cerebras' optimality in Vericium, a lot of the lower level tasks, which were very mundane, Can be automated and the designer can focus on more value add higher tasks. That's the theme of our Kind of AI based solution is remove the mundane work, make the designer focus on higher value work, help in terms of You need the same resources, can you do more work? And that team is very popular and I've met all these CEOs over the last 3 to 6 months and that's even popular in a tough environment because there's need for more automation and it's even more so this is actually very timely, the launch of AI based solutions, launch of Cerebras, because the productivity of the organization goes up and also productivity of the Talent, because a lot of companies, one big issue is they have large teams, which are deployed across multiple Countries or locations. And the question always is, are you getting enough value from all the locations?

Speaker 2

And something like Cerebras or AI based solution naturally uplifts the talent of your whole organization, because these algorithms are the same whether they in one part of the word or the other. So I think the AI based solution, this is very timely and appropriate in this kind of tough environment. And I think we have a very good platform with JEDI and then we have 3 major solutions on top of it. And we will do more. I mean, you'll see more from us next year in this area.

Speaker 2

So we are very pleased with the progress, and I think it's very timely to the situation we are in, the macro situation.

Speaker 5

Right. Thanks. Just could you shed some color on whether there have been any changes to the backlog growth, pipeline conversion, lengthening of sales cycles given all of what's happening in software. Are your expectations unchanged to that report in Q2 where it's cheaper half of the backlog is expected to flow in revenues over the next 12 months. Maybe any commentary here on sort of economic impacts for next year would be Fantastic.

Speaker 5

I'm just trying to understand if there's any material changes to your backlog to pipeline conversion in how you're looking at it compared to 3 months ago. Yes, I just wanted to follow-up, that would be great. Thanks.

Speaker 3

Fair point, Janney. That's when I look at the current RPO, I'm Despite the fact that it's slightly down from Q2 to Q3, but slightly down including the impact of the latest U. S. Exports restrictions, but also including the fact that we shipped more hardware into China in Q3. I feel very, very confident in the current RPO and the RPO and very, very pleased with the growth that we've seen there.

Speaker 3

That's typically, I know you've just started covering us, but typically what we tend to see is about 55% of what we have in backlog turns up in revenue in the next 12 months. But and generally Q4 is a good kind of add on quarter for us for growing that current RPO. So I feel very pleased in terms of where we are. Annual value is about $2,700,000,000 now off of a backlog total backlog of 5.5. The annual value 2.7 percent, 5.5 percent represents time, but 2.7 percent is the annual value there.

Speaker 3

And I would anticipate that that should grow through to the end of the year and set us up well for next year for our recurring revenue. The Upwork revenue is a lot more difficult to predict because it tends to be more lumpy.

Speaker 5

Right. That's very fair. Yes, it's interesting to see how much revenue actually generated this year. Yes, fair enough. Thanks a lot.

Speaker 5

I'll jump back in the queue.

Speaker 11

Thanks.

Operator

Your next question comes from Joe Vruwink from Baird and Company.

Speaker 4

Great. Hi, everyone. I wanted to go back to the IT topic and specifically ask about the Record Award. If I look at your non cancelable access arrangements, it looks like that value went from $171,000,000 to $434,000,000 Is that primarily reflecting this award? And then Is there anything unusual or is this a normal term length?

Speaker 4

So kind of reading between the lines, this big step up in kind of what's visible in backlog. We should see that kind of hitting revenue next year.

Speaker 3

Yes, Joe, that record contract in IP is included in our non cancelable commitments in our number in our backlog. We're delighted with the performance of the IP team and how well they're doing. What's interesting, what I always find is kind of not intuitive when you look at Cadence's results is that sometimes in the biggest bookings quarters, You may not have a great increase in your current RPO for that particular business. I find When you have big renewals coming around, we tend to play defense on the renewal and then leave room for add on opportunities later. But So often you can have a big bookings quarter may not generate a huge amount of growth in current RPO.

Speaker 3

And then in contrast, you might have lower bookings quarters where there's a lot of add on opportunities get booked in those quarters and that can increase your current ORQO and drive growth for the company. In this particular case, it's a record contract. So you're trying to pay more defense on something like that. So you haven't seen a huge uptick and current RPO for IP this quarter, but I think that will come later.

Speaker 4

Okay. Okay. That is helpful. And then, I appreciate you're not guiding to next year, but there has been some conversation just around how good upfront deliveries have been this year and obviously that creates a tough comp. I wanted to take the other component and then just focus on recurring revenue.

Speaker 4

And John, I think in the past, you kind of framed recurring revenue on a 3 year CAGR basis. Last quarter, The number was I think 12% to 13%. And then you mentioned how you thought that rate of growth was sustainable going forward. Just a quarter later, some things have changed, but given the visibility you have in hand today, any difference that You would comment on kind of 12, 13 or some other rates on a kind of 3 year CAGR basis as it just pertains to recurring revenue?

Speaker 3

Great question, Joe. I think I would characterize my opinion on our recurring revenue. I'm more confident now post the now that we know what the U. S. Export restrictions are, I think I'm more confident in our recurring revenue going forward now than I was this time last quarter.

Speaker 3

I think the challenge from a macroeconomic standpoint is how the what the macro climate does to our upfront business for next year. I mean that's the toughest one to predict. That's why we need an extra few months just to figure out what that means for next year.

Speaker 4

Okay. Great. Thank you very much.

Operator

Your next question comes from Blair Abernathy from Rosenblatt Securities.

Speaker 11

Hi, nice quarter guys and thanks for sliding me in the questions here. Just I wanted to talk a little bit about The cadence on cloud and in particular, the Palladium cloud. Can you just walk us through sort of how you're looking at this cloud based emulation, how as a customer coming to you, having to make a decision between on prem hardware solution for Palladium Cloud. Just walk us through that a little bit and maybe How are you thinking about or how are you approaching pricing?

Speaker 2

Yes. Hi, Blaise. This is Anirud. Thanks for asking this question. That's a very important point.

Speaker 2

So in general, we really like these cloud offerings, especially for hardware, because even if you think about in the regular cloud, right, with the CPU Cloud by the big cloud vendors. What they're doing is they're amortizing hardware across multiple customers And moving from a more from a CapEx to OpEx model. So the cloud model has been successful in hardware first, right? And then you build all kinds of Software Solutions on top. So this is the same hope for our Palladium business.

Speaker 2

We would want more and more customers to go to our cloud offerings, Because that also makes the hardware business more and more ratable. And also gives a lot of flexibility to our customers, because One of the issues with, you know, Pareteum and Proteum being even more popular than they are now Is that sometimes the smaller companies are not able to deploy as much as some of the big companies, Because there is an upfront cost to get like a full Palladium rack. Whereas if you have them on the cloud, it gives access to a lot of Small companies also to use hardware emulation as they're doing more and more complicated designs. And then the second reason, of course, it makes it More and More Radable. So we prefer we encourage all our customers to move to the cloud.

Speaker 2

And we have built infrastructure in data centers together with some big data center partners to have this capacity in the cloud. So now it depends on customer choice, right? Now if the customer wants to buy more for in house use, then of course we support that. But I think I feel customers are becoming more and more in terms of whether they want to deploy on prem or on the cloud, I mean the hardware that they buy from us. And like what John was saying earlier, in this kind of tough environment, if they want to reduce CapEx and use more OpEx, then Palladium Cloud gives that opportunity.

Speaker 2

Okay. So I mean, this is something we have been building for several years and we'll see how it goes. But in general, we want to encourage all our customers to move to the hardware cloud. On the on cloud, which is on the software piece, I think like we talked about in the last earnings call, That's also great for startups and also for system companies that don't have big IT department, I mean IT departments and Data Centers. So we really feel that on cloud, that's why we started first with system products from Cadence is suitable for because systems companies, there could be like 50000, 70000 customers in that space.

Speaker 2

And then some of them are big, of course, and have their own data centers, but a lot of them are not as big and they prefer this kind of Cloud and it also helps us go to the long tail in a much more smarter way. We want to innovate not just on the product side, but go to market side. So especially innovating on the system side, the long tail on cloud is great. And Palladium and Protium Cloud are even good for the EDA big customers because it gives more ratability and flexibility and choice on how they buy hardware. So overall, I think these are 2 very strategic areas for us and we want to encourage Our customers to use more and more of these cloud offerings.

Speaker 11

That's great. Thanks for the color on it, Rich.

Speaker 2

Thank you.

Operator

Our final question comes from Ruben Roy from Stifel Nicolaus.

Speaker 8

Hi. Thanks. I I think you have answered just about every question there was. But I wanted to maybe drill into the new customers on the digital design flow. Can you maybe talk a little bit about What type of customers you're seeing is that competitive displacements of traditional semiconductor companies or non traditional combination of both?

Speaker 8

And then I guess attached to that, Are you seeing a higher attach rate in either semiconductor companies or systems companies for hardware these days as As you sign up these new deals on digital design. Thanks.

Speaker 2

Hi, Ruben. Great points. So in general, in terms of the digital business, I think it's both, new customers and existing customers and taking share. In general, I think what's great about Cerebras, one is like I mentioned earlier, it does more automation of mundane tasks. It's almost like having automatic driving versus manual driving, right?

Speaker 2

You don't have to control all the knobs and all the TDS works, the tool does it for you, but it also unifies the platform. We've been talking about unified synthesis placement and sign off from, I don't know 2014 or 2015. But I think Cerebras naturally unifies the whole platform too, because it can work across the whole Synthesis, Place and Route and Signoff. So like I mentioned in my comment, there is a pull through of Synthesis and Signoff along with place and route through Cerebras and we are seeing that. So we are pleased with the progress we are making in synthesis and sign off along with Place and Route implementation.

Speaker 2

And then it does help In terms of full flow, so this drives like full flow wins, right, not just place and route. So I think in 2022, We have more than 40 new full four wins. So that's helping our digital business. And you see this quarter, we had of good growth in digital just like we had last quarter. Now on the hardware side, I mean that attach rate Is there in the large kind of semi companies, but also there's a lot of hardware being used as system companies designed semiconductors.

Speaker 2

Because by nature, as you know, system companies have more software, right? That's why they are a system company. So when you have software, you naturally need these hardware platform for software bring up. So I think we are very pleased to see the growth of hardware, not just in the traditional large semi, but also in in the large system companies. And then we try to do these new offerings like I talked about cloud to help to lower barrier to entry for smaller companies, whether they are system or semi for hardware.

Speaker 2

So overall, I think we are pleased with the progress of both digital and hardware, and we Carefully monitor it going forward, please.

Speaker 8

Thanks for all that detail and I'll leave it there for now. Thanks.

Operator

Conference call. I will now turn it back to Anurud Devgn for closing remarks.

Speaker 2

Thank you, everyone, for joining us this afternoon. We are excited about our business momentum and the tremendous market opportunities ahead of us. We are proud of the innovative and inclusive culture we have built at Cadence and we are grateful for the recognitions we have received over the years, including most recently being named as one of the world's best workplaces for 7th time by Fortune and Great Place to Work. We're also honored to be included in the Investors Business Daily's 100 Best ESG Companies for 2022, the 4th year in a row that we have achieved this recognition. On behalf of our employees and our Board of Directors, we thank our customers, partners and investors for your continued trust and confidence in Cadence.

Speaker 2

We look forward to speaking with you again on our Q4 2022 Earnings Call. Thank you and have a great evening.

Operator

Thank you for participating in today's Cadence Third Quarter 2022 Earnings Conference Call. This concludes today's call. You may now disconnect.

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Earnings Conference Call
Cadence Design Systems Q3 2022
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