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Good afternoon.

My name is Derrick.

I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Cadence Design Systems third quarter 2004 financial results 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 period.

If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad.

If you would like to withdraw your question, press the pound key.

I would now like to turn the call over to Alan Lindstrom, Director of Investor Relations for Cadence Design Systems.

Please go ahead, sir.

Thank you, operator.

I'm Alan Lindstrom, Director of Investor Relations at Cadence.

Welcome to our third quarter 2004 earnings conference call.

The webcast of this call can be accessed through our website, www.Cadence.com and will be archived for one week.

With me today are Mike Fister, President and Chief Executive Officer, Ray Bingham, Executive Chairman and Bill Porter, Senior Vice President and Chief Financial Officer.

Please note that today's discussion will contain forward-looking statements and our actual results may differ materially from those expectations.

For information on the factors that could cause a difference in our results, please refer to our 10-K for the period ended January 3rd, 2004 and to our 10-Q for the period ended July 3rd, 2004.

In addition to financial results prepared in accordance with generally accepted accounting principals or GAAP, we will also present certain non-GAAP financial measures today.

Cadence management believes that in addition to using GAAP results in evaluating our business, it can also be useful to measure results using certain non-GAAP financial measures.

Non-GAAP net income or loss and the other non-GAAP financial measures used in today's discussion exclude amortization of intangible assets and deferred stock compensation, in-process research and development charges, integration and other acquisition-related expenses, restructuring charges and equity and losses from investments.

Non-GAAP net income loss is adjusted by the amount of additional taxes or tax benefits that Cadence would accrue if we used non-GAAP results instead of GAAP results to calculate the company's tax liability.

Please see our earnings press release for a reconciliation of GAAP to non-GAAP net income or loss and our website for a reconciliation of all non-GAAP measures used in today's discussion.

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

Thanks, Alan.

Good afternoon.

Cadence reported solid financial results today.

Simply put, we executed the plan in a challenging environment.

Total revenues for Q3 were $302 million, up 12% from Q3 '03.

GAAP earnings were 7 cents a share, a market improvement from Q3 of last year when we lost a nickel a share.

And on a non-GAAP basis, EPS was 19 cents, up 58% from one year ago.

Ray will add some color commentary on the business and industry environment and Bill will go into the details on the quarter's numbers in just a minute.

In an environment where many purchasing decisions are based on head to head product and technology evaluation, we continue to win competitive benchmarks and grow our design win.

Our consistent performance in execution in the third quarter and throughout a challenging year is a reflection of three things.

One, the deep partnerships that we have with your customers, two, our world class technology and our broad product mix, three, an outstanding global employee base that is passionate about customer support.

You'll remember that our top priority this year was to become the leader in digital space, and we are doing just that.

Product mix matters and we're leveraging the combination of our custom and digital product platforms as well as investing in new technologies to expand and to win new business.

Our technology and customer orientation delivered bottom line results for Cadence in Q3.

Of significance in these examples is our ability to provide a complete line of products and services, both analog and digital, needed to produce the chips for consumer, automotive and wireless markets, which are the strongest sectors in the semiconductor marketplace today.

Customers continue to embrace our approach of integrating technologies in the platforms.

Encounter, our digital IT design platform, is really gaining traction across market segments at nanometer technology nodes.

After only three months, the recent Encounter 4.1 release has been adopted by more than half of our existing digital customers.

Virtuoso, which is our market leading custom IC design platform, remains a clear leader for analog and mixed signal in the wireless [inaudible] markets.

In Q3, MEC Electronics agreed to adopt Encounter 4.1 and Virtuoso.

Among our existing customer base, we've seen expansion in a number of companies including SP, which is using both the Encounter digital and Virtuoso custom platforms.

We won new business at companies like Quay Technology.

They develop physical layered chips for Ethernet networking.

We addressed their need for signal integrity analysis, not just with the new product, but by collaborating to address the entire design methodology for nanometer challenges.

Quay and Cadence are also working together to integrate the Encounter Platform into the Quay design flow, including some of our newest synthesis and test products.

And AMI semiconductor shows Encounter over Synopsis because of the ease of integrating digital and analog through a combination of Virtuoso and Encounter.

So the conclusion I draw from what our customers are buying, is that they require and seek compelling value in the combination of Virtuoso and Encounter.

We see many customers adopting our new technologies in the Virtuoso platform.

We expanded our relationship with Atmel in Q3.

They adopted Virtuoso, Neocircuit and UltraSim Technologies.

That helped increase Atmel's productivity to keep pace with the time to market pressure of consumer products like digital TV's, multi media and wireless communication.

Hinic Semiconductor, leading supplier to the telecom industry, broadened its use of Virtuoso during the quarter as well.

Hinic is a longtime Cadence customer, and the increased Virtuoso adoption is a significant expansion of our business relationship.

What I hope you get from this is that we are focused and aligned with our customers’ business and technology challenges.

It's all about time to market, managing the complexity of chip designs and integrating for value to enable the ever-increasing functionality being engineered in semiconductors.

This innovation is in the name of the customer.

It's our strategy of deepening customer partnerships.

It's our knowledge of their products.

It's our world class technology and broad product mix, and it's about unwavering customer support.

So what it comes down to is this.

It's how we can help our customer achieve their goals, not just selling them plain old design tools.

Now let me turn it over to Ray for a look at business and industry environment.

Thanks, Mike.

Cadence's third quarter results demonstrate our strengths as a company.

Our technology and product mix, our people and their dedicated customer orientation, and our approach to business.

Cadence has been consistent and methodical in its outlook and its execution.

Our job has been to manage our business and to ensure that we successfully navigate a challenging environment.

We didn't share the excessive exuberance expressed earlier this year by some of our competitors and even some analysts.

We do not share now their excessive pessimism.

We know what our business is and what's required to do it well.

This quarter we have continued to deliver on new technology and on our financial goals.

We delivered as planned new releases in Encounter and Allegro.

On the industry commitments like the new open-access beta release, and on our financial goals, revenues, earnings, operating margins, and license mix.

We clearly gained traction this quarter in digital IC design, against both Synopsis and Magma, in our clear leadership in custom IC design, increasing our market share in formal verification, and finally, in our customer proliferation and emulation.

And it's important to note that these accomplishments were achieved against a backdrop of conflicting economic news.

Companies and consumers remain skittish on spending.

Consumer confidence, important -- [call interrupted]

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Mr. Lindstrom please go ahead.

Is this Derrick?

Yes, sir, you may go ahead.

Okay.

Ray, go ahead.

Our apologies for that mis-queue with the connection.

Let me pick it up here.

Against the strengths and accomplishments of the quarter, it is important to note that we accomplished this against the backdrop of conflicting economic news.

Companies and consumers remain skittish on spending.

Consumer confidence, important in a market driven by consumer products, has dropped for two months in a row over concerns about energy prices and employment.

As consumer products are currently the big driver for semiconductors, it's no surprise that we continue to see a degree of uncertainty in the chip industry.

As we look around the world, we see a sluggish recovery in the U.S., growing economic strength in Japan and Asia, and we're waiting for a rebound in Europe.

On the products side, we also see some market segment bright spots.

We see growth in consumer automotive and wireless, as Mike mentioned.

For example, companies benefiting from growth in the consumer markets like Apple with its iPod, PalmOne with its Treo Smartphone, and in the semiconductor industry, TI with its chips for handsets.

As we put it all together, this is the picture painted in many conversations with our customers.

Demand for chips is good, but the challenge is in managing inventory levels.

Customers are continuing to be cautious.

Since we are in a slow recovery, they continue to look for ways to restructure and lower their product development costs.

They turn to partners like Cadence to help them become more efficient in their design.

One way is by collaborating on industry standards like OpenAccess.

This helps new coalition members like AMD become more productive and help them reduce their costs.

A second way is by collaborating with other leaders in the design chain.

For example, our work with Intel on Allegro design kits for their 915 and 925X chipsets.

Allegro provides customers with seamless design-in for complex chipsets.

A third way customers gain efficiency is by reducing the number of vendors they use, turning to a partner like Cadence who can deliver leading technology end-to-end products and services.

In Q3, NEC honored Cadence with its "best partner" award.

What this says to me is that there will be continued demand for our technology.

Growth drivers in the industry are intact and Moore's Law continues to be valid.

Design start activity is presently flat this year, but the number of 90 nanometer design starts increased rapidly this year.

Next year, 90 nanometer design starts are expected to increase 52% and continue to grow nicely over the next three years.

We also see an increasing number of 65 nanometer design starts and work has even begun on 45 nanometer.

As Mike outlined, we're delivering world class technology.

Even some competitors have publicly acknowledged our strength in digital with First Encounter and Nanoroute.

By aligning with our customers and their markets, we can contribute to their bottom line.

That helps Cadence, enabling us to win increased share of their design budgets, through a business model fueled by innovation and customer orientation.

To sum it all up, the reasons for Cadence's consistent performance in an uncertain environment are the strength and capabilities of a global team, the right mix of products and services, investing in and delivering technology that is well integrated, taking a leadership role in the industry collaboration and finally, aligning with what our customers want.

It all builds a foundation for consistent performance in growth.

With that, I'll turn it over to Bill.

Thanks, Ray.

I'm pleased to report that in Q3, Cadence again delivered solid financial results within our target ranges in what continues to be an environment where customers spend cautiously.

At Cadence, we have laid the foundation of our financial model with a predictable base of revenue from backlog, target non-GAAP operating margin of 30%, and strong cash flow.

We continued to make good progress against these measures in Q3 and are on course with our financial model for the year.

GAAP earnings per share were 7 cents compared with a GAAP loss of 5 cents in Q3 last year.

Non-GAAP earnings per share of 19 cents were up 58% year-over-year and within our target range of 18 to 20 cents.

Total revenue for the third quarter of $302 million was up 12% year-over-year and within our target range of $300 to $310 million.

Product revenue was $183 million.

Maintenance revenue was $84 million, and services revenue was $35 million.

Revenue mix by geography in Q3 was 56% for North America, 20% for Europe, 15% for Japan, and 9% for Asia.

In the quarter, approximately 75% of our product business was represented by routable licenses - that is licenses where revenue will be recognized over time.

This is within our target range.

A key element of our financial model is predictability and consistency.

This marks the eighth consecutive quarter that our routable mix has fallen within our target range.

Revenue from backlog also came in as expected with about two-thirds of our product revenue from backlog in Q3.

Due to higher seasonal revenue in Q4, revenue from backlog should be about 60%.

For the entire year, we continue to expect approximately two-thirds of product revenue to be generated from backlog.

Average contract life was on target at three years.

We have now seen a dollar-weighted average contract life of three years for eight consecutive quarters.

I believe that the strength of our current technology and road map has given customers the confidence to maintain their commitment levels.

To date, we have not experienced the reduction in average contract life reported by some of our competitors.

In addition to growing our top line, another driver of increased profitability is managing costs.

During the third quarter, we continued to do a good job of managing our costs with total costs and expenses on a non-GAAP basis of $232 million, down slightly when compared to both Q1 and Q2.

Headcount was flat at 4,850.

The results of growing our revenue and holding the line on costs has allowed us to make good progress over the past two years in expanding our operating margin.

The operating margin for the third quarter on a non-GAAP basis was 23%, up from 17% for the third quarter of 2003.

I believe we're on track to achieve our goal of a 30% non-GAAP operating margin in Q4.

The quality of receivables in Q3 remained high with receivables 90 days past due at 2%, within our historical range of 1 to 3%.

Total DSO's remain flat compared to Q2 at 132 days.

Based on our experience in Q3, we are now expecting total DSO's for Q4 to be around 115 days, compared with our previous estimate of 100 days.

However, I expect DSO's to continue to decline into the mid-80s by the end of 2005 as our model matures.

I am pleased with the continued progress we have made growing our cash flow.

Operating cash flow for Q3 was $73 million.

Improving cash flow has been a focus area for us, and is directly related to the progress we have made, implementing our financial model.

We continue to expect operating cash flow to be at least $325 million for the year.

Capital expenditures were $13 million, putting us on track for Cap Ex of about 75 million for the year.

Cadence repurchased 2 million shares of stock at a cost of $24 million.

Our remaining repurchase authorization was $123 million at the end of the quarter.

Cash and cash equivalents grew to $424 million at the end of Q3, from $390 million in Q2.

Like our customers, we are looking to manage our cash carefully and build our cash balance.

Now I'd like to turn, to look at -- now I'd like to turn to our outlook for Q4 and the year 2004.

In the current environment, I am seeing customers taking more deliberate approach to their purchasing decisions.

As a result, we are moderating our bookings growth target range for 2004 to 5 to 8% from our prior expectation of 7 to 10%.

The result for Q4 is that we expect revenue to be in the range of 335 million to 345 million and for 2004, we expect revenue to be in the range of $1.19 billion to $1.2 billion.

Non-GAAP earnings per share should be in the range of 27 to 29 cents for Q4 and 70 to 72 cents for the year 2004.

However, as we've described in our earnings press release, reported EPS will be affected by a recent accounting task force consensus, EITF 0408, relating to our convertible debt.

This consensus, which is expected to be effective during the fourth quarter of 2004, will require Cadence to include in the calculation of its fully diluted earnings per share an additional 26.8 million shares of common stock.

Now, moving to our EPS guidance, which includes the impact of EITF 0408 for Q4, GAAP earnings per share should be in the range of 16 to18 cents.

Non-GAAP EPS should be in the range of 24 to 26 cents.

For the year of 2004, GAAP earnings per share should be in the range of 21 to 23 cents and non-GAAP EPS should be in the range of 63 to 65 cents.

As I look at our results for the first three quarters of 2004, I am pleased with our consistent financial performance.

I believe we are well positioned to continue to execute on our technology and business goals in the fourth quarter.

Operator, we'll now take questions.

Ladies and gentlemen, at this time, I would like to remind everyone if you would like to ask a question, please press star followed by the number one on your telephone keypad.

We'll pause for just a moment to compile the Q&A roster.

Your first question comes from Sterling Auty with JP Morgan.

Thanks.

Hi guys.

It looks like the product revenue was very strong in the quarter, yet services kind of tailed a little bit.

We had talked I think previously of services being a little bit of a leading indicator.

Is that still the case, and it that why you're kind of pulling back a little bit on the bookings growth guidance?

Sterling, this is Bill.

In terms of services, we actually continued to see good business momentum there.

I think what we saw in terms of the revenue was just the timing of when we completed some of our work, particularly it was a little bit slower in Europe than we had looked into when we started the quarter.

But overall business activity for services was good, and we're right on track with our services business.

In terms of just the total outlook, I think it's really the environment that caused us to just pause a second and take our guidance down slightly or our outlook down slightly for bookings.

It's been cautious for a while and just the longer this thing has lasted.

And as you look around the industry, I think it just made us step back and just take a little bit of a refection to tone things down.

It did not affect our revenue, just a slight tightening.

Okay, and then last question would be you know, everybody looking at your kind of expectations of large contract renewal cycle here, September and December, is there just-- you talked about kind of expansion of business with certain customers, but can you just give us either a quantitative or a qualitative sense as to how the renewals actually are going and what the outlook is here for December?

The renewal outlook continues to be good, Sterling.

Again, it's just gonna be tempered by what our customers are feeling like for their purchase activity.

So that's just a little bit of a moderation.

Business, uptake from new technology continues to be strong.

It really is just a matter of how much they want to commit at this point in time, but we expect continued proliferation of the technology and good renewal activity.

Okay.

Thank you.

Your next question comes from Raj Seth with SG Cowen and Company.

Hi, thank you.

First a clarification and then a question, if I might.

In your Q4 guidance, can you remind me again what the range of, what range in percentage terms subscriptions will be as a percentage of bookings, what's the normal range?

I think you said it was 75% this quarter.

Sure, Raj.

Targets have been 75 to 85%, and that would be the consistent range that we've operated in for the last eight quarters.

And then just a follow-up on the question that was asked a minute ago about big deal renewals.

As you think about, first, next year, and I'm sure you don't want to get too granular, but first, assuming that the environment stays the same, do you think of 2005 bookings in the same order of magnitude, 5-8%, first question?

And then a question about how much coverage there might be from big deal renewals.

Raj, at this point, we're going to wait and talk about the 2005 outlooks when we do our Q4 results.

That's what we have consistently indicated.

I think that's what we'll hold to, so we'll wait on 2005.

Okay, that's fair.

Then maybe to help modeling, is there any way that you can describe how much subscription backlog you carry into 2005, either from this point or assuming execution in Q4, just so we have a, maybe a better starting point or more accurate starting point for modeling purposes, in dollars?

Best I can give you at this point is that we will have used -- about two-thirds of our revenue this year will come from backlog, and I think that's a good indication of what our experience was, and as you can see in Q4, as we have seasonally picked up the business levels, the percentage is down a little bit, at 60%.

So I think those are the right parameters to think about and then we'll see what our position is as we exit the year and then we can give you some indicators when we, again--

If I might, quick question for Mike.

Mike, the other day Rick Hill, the CEO of Novellus, when commenting on the uptake of 90 nanometer production technology, suggested that that migration was slower than expected and the implication was that was gated by design issues.

I heard the comments earlier about 90 nanometer on the design side.

How do I sync those two comments?

Does what I heard from Rick in any way, does that make sense to you?

It could.

I would urge you to consider his comments as a front-end problem and a back-end problem.

My knowledge on the 90 nanometer drive production or manufacturer ability is more limited by back-end yield, establishing the yield characteristics to the customer satisfaction.

On the front-end, as Ray said, the design starts were up nicely for the year and projected to be very, a very big uptake in '05 and I think that bodes well that the front-end capabilities are working well and we're quite proud of the progress we've made with our Encounter platform to be a part of that.

And what would you guys say is the percentage of the base, the design base, that has the infrastructure today that's required to do 90 nanometer design?

Does that continue to be a real growth driver in the sense that people need to add technology in order to do that, or has a large part of the base already made that transition, given the design start percentages you reflected earlier?

Raj, Ray here.

Let me comment on that.

I think that most everyone has dabbled in 90 nanometer, but it's the proliferation that is still ahead of us and I think that that accounts for the large percentage growth in 90 nanometer design starts that I profiled in my macro comments.

Okay, thank you.

Your next question comes from Rich Valera with the Needham Company.

Thank you.

Maybe if I can try a little bit on the '05 question, maybe a different way.

This year, even with your 5 to 8% reduced bookings guidance, you'll still outgrow, certainly your largest competitor substantially on the bookings front and just trying to understand what are the components of that with respect to either renewal pipeline versus maybe competitive wins and maybe how '05 would look, maybe just in terms of renewal pipeline versus this year.

Thanks.

Rich, it's the new technology is really driving the uptake and that feeds into the renewals, so if we didn't have the strong technology, I don't think the renewals would be as robust.

So I think it's really that's the way you should think about the positioning, and as customers are adopting new technology, it is helping us incrementally go through and replace competitor products.

So I think that's how I would look at it so the-- those are two things that will feed right into continued renewals next year.

And I don't think I want to get into any more quantification until we really look at '05.

Hey, you know there might be one other point.

And I hope you can get it from my comment.

There is not an accidental linkage of analog and digital on our Virtuoso and Encounter platforms -- look like a fantastic win possibility for us because it's an indication of our breadth and product mix, why product mix matters.

So, there is an awful lot of design, especially in the consumer segment, that Ray and I both highlighted that use a mixture of analog and digital and as they adopt one piece of our platform, they tend to adopt two.

So I think product mix and complexity all bode well in our favor and we're certainly got great design win momentum as the customer testimonials, as Ray pointed out, and I don't see any reason why that's going to slow down.

Great.

Just following up on your comments on Virtuoso, there was a pretty notable increase in talk about Virtuoso on this call relative to previous calls, which had a fairly heavy digital focus.

Is there something changing in the market, or are you sort of highlighting Virtuoso as something that maybe in somewhat of a backward looking way would explain why you guys are outperforming Synopsis and Magma, at least in this last quarter?

Well, I think it's always been good.

Consumer, on the rise helps because most of those devices are mixed signal.

And, you know, heck, our Virtuoso platforms are a clear leader in the industry.

I think a lot of them are harkening on the digital stuff before was because it was topical.

People were wondering if we were relevant at all and we had to prove it and boast about it a little bit.

So you're gonna continue to see a mixture from us and what we'll try to do in these calls is try to give a blend of how we're doing across all the platforms.

Okay.

That's helpful.

Thank you.

Sure.

Your next question comes from Jay Vleeschhouwer with Merrill Lynch.

Thanks.

Good afternoon.

Question first for Mike.

You've been there now for about five months.

I'm wondering if you could perhaps comment on any changes you have planned to make, what stamp you're now beginning to put on the company in terms of continuing to bring in some new people and other sorts of changes you might make out in the field and so forth.

Secondly, for Bill, on the bookings front, kind of a several-part question, your reduction of the range by a couple of points, implies about a 20 to 30 million difference in product bookings for the year as a whole versus prior forecast.

Is that all coming out of Q4, or were you in some way light on Q3?

So, Jay, that's really our view for the second half, and the reason why we don't get into granularity on quarters is because we really look at it as a whole second half exercise.

So that's where we see the whole half coming in and it's really something that we try to look at -- as Kevin would say, we drink the wine when it's ready.

I think that's the real thing that we need to do, is take the business down when it's ready to do it, which is really to look at the half.

Jay, the -- I have gotten around to I think virtually all of our big customers, thousands of the employees.

It was an immersive process for me.

We had a plan coming in that Ray and I told you a bit about, bulking up the team.

I was one element to the bulk.

There is a few more bulkier pieces that come along that have gotten some speculation in the news.

About a month from now we'll be dying to tell you just all about that.

I know you're going to be impressed with that talent and it's an addition to the talented crew that we've already got on the team.

We are not being coy about it.

What it is is that that's also an immersive process for those people and we're letting them get out and feel and touch things just like I did, customers and employees and technology.

The stamp that I bring is just augmenting I think a lot of what we've got going here.

We've got some fantastic technology that we’re excited about, as you can tell from the call and the customer reaction to it.

The business models that we have been pursuing I think are paying some fruits just as were anticipated, and if there is anything that I would add, it's I'm going to say a passion for customer support at a whole 'nother level and the deepening relationships that Ray and team had already started.

That is probably evident as you walk around and talk to some of your own contacts in the industry who have seen any of us, and making sure that the whole 4,850 people in Cadence share and demonstrate that same kind of passion to succeed.

So I think for any changes we're making, some will report them as subtle.

People who are insightful will report them as leadership demonstrating, and what we are talking about today and what you'll continue to hear from us is that we'll continue to differentiate us as a leader as contrasted with some of our contemporary competitors.

You made a comment on the call about how much of the Encounter base is now on the latest release.

One thing I'd like to ask is to what extent are you in fact getting paid for or capturing value for all the new technology?

We have brought this point up before.

Synopsis got paid last year for the Astro upgrade.

They're hoping to get paid next year for Galileo, for example.

Can you say whether for current renewals or for the '05 renewals you can in fact bake in additional value, perhaps with less discounting, that would allow you to grow bookings and in fact, again, get paid for all the new technology that you have brought to market?

Well, I think we are, and that's the plan.

You know, and if we have our way, as we demonstrate leadership, you'll see even more productization of some of those components that will be differential value.

And maybe in the next call as we, you know, project what we can do in '05 we'll even be able to detail some of the product plans.

I think you'll be excited by them.

Two last follow-ups.

Bill, I see in your release that you've doubled the percentage of your business from DSM from 6% to 12% in the third quarter, from, as a percent in the first quarter.

What do you put in there?

How do you double the proportion of that business from DSM?

And then lastly, what are you seeing in terms of the propensity, if any, for customers to do early extensions?

Synopsis had a problem with that in the last quarter?

We heard of at least one instance where you had an issue with one, doing some early extensions as well.

Is that a factor as well in your bookings forecast?

Just let me first refer back to the comment on Encounter proliferation.

Adoption is something that customers are beginning to do, so as they proliferate, we have more opportunity than just 50% seems to imply.

So I just wanted to get some clarification with you there.

And then as we look forward in this concept of early renewals, I think it is really a misnomer.

It's really driven by where customers have in need access to our new technology.

Some have access and they don't get enough of the new technology.

Others don't have access and they need access to new technology.

And that's what brings the customers to the table, and so when that happens, sometimes they will just add some incremental technology or they will choose to, at that point, talk about all of the business.

So that's how the new technology proliferates.

We do have some access, but usually they need more, which is why it's been driving our business and we've got the right portfolio to adopt that.

Back to your other question on DSM, we continue to see adoption by a number of the technologies.

It's being driven by some of the integrity activities, particularly as we move into 90, things like Fire and Ice continue to proliferate well.

We just indicated the new test technology, that again, is in this area.

So really we have a number of offerings that we're continuing to move forward with, you know, this whole area that we would call design for manufacturing .

Operator?

Your next question comes from Harlan Sur with Morgan Stanley.

Good afternoon guys, and nice execution on the quarter.

First question for you, Bill, looks like on a pro forma basis your product gross margins were down about 400 basis points relative to the second quarter, despite the fact that you actually grew that in sales by about 10%.

Can you maybe provide some color as to why that is?

Sure.

We will see fluctuations in our product costs just based on the volume of business that we will see in emulation.

So strong revenue in emulation is going to be followed by an increasing costs.

I think that's what you're seeing, both impacting the margins.

That will be just a normal fluctuation.

As you know, the base business for us in delivering products is pretty stable.

So other than product cogs from emulation, that's just the normal course.

Can you give us a sense for what emulation did in the quarter on a sequential basis?

Actually we're not talking specifically about the revenue amounts.

It gets a reasonable margin, so I think you can probably enter an estimate of when you see the cost differential.

Okay.

Great.

And then second question regarding your cocos (ph), now that you're using the if-converted method, what's the approximate add-back from the fees related to the transaction?

Not quite sure I understand that.

The impact for shares is about a little under 10%, so 9.7%.

So that's what relates, is just those additional shares outstanding.

Maybe I just have to take your other question offline because I don't think I quite understand it.

Usually if you use the if-converted method, you need to add back-- you would normally add back the coupon rate and then you would also add back any transaction fees, but we can take that offline.

Then maybe my third question is for Mike.

If you look at the semiconductor design space, there are some pretty large OEM's that have large internal chip design teams, companies like Cisco, Juniper, Ericsson, Nokia and so on.

I'm just wondering, what are the EDA spending trends you're seeing within that segment of your customer base.

You know, good question.

They are not slowing down.

I mean they are cautious.

It's the same way as the rest of the industry.

What I think is it represents an opportunity as Cadence has demonstrated some of the past for us to go and help be a more significant part of their spend and allow that to be one of the focused targeted cost reductions that Ray was alluding to in his color commentary.

So we're, you know, kind of methodically going out and talking to every one of them to look for outsourcing opportunities, use our VCAD as a support augmentation to their business.

And they're coming back with very strong messages around consolidation and cost efficiency, you know, that I think make for some very interesting conversations.

One thing I would add also, Harlan, I think there is a place where we potentially differentiate ourselves from the competitors.

The breadth of our product offering, the size and financial stability of Cadence, the global positioning of employees, all make for great partnering opportunities, maybe almost, to you know, the differentiation of some of our competitors.

Okay.

Thank you.

Your next request question comes from Jennifer Jordan with Wells Fargo.

Yes, good afternoon, gentlemen.

A number of my questions have been answered, but not to beat the dead horse, but to ask again about the renewal cycles.

Bill, when you were mentioning that you anticipate that they will be kind of similar to what you have said all year, there has been some discussion and concern on the street that you could have been engaging in, in the past couple of years to keep yourselves going, the same type of process that Synopsis appeared to have been engaging in, where deals were pulled forward earlier rather than just coming up as customers were wanting more of new technology.

Could you address any idea of that type of risk?

Jennifer, I just reiterate, all of the business is really done when customers are ready, and they are ready when they are looking to adopt new technology.

That really has been the driver.

It's been the uptake.

We have new technology available and it's been that uptake that has really been driving the business really over the past couple of years, and I would expect we'll see that uptake continue next year as we probably have the best product offering that we have.

And the (indiscernible) is going to be the business environment.

There is cautiousness with the customer spending and that's where we're seeing them being a little bit more hesitant to either add it over time versus adding it in larger chunks.

And that's a piece that is really hard to gauge.

Okay.

And then, Mike, you just mentioned the idea about perhaps becoming the outsource source for your customer more and more.

How do you see the OpenAccess database play working with that in terms of your new products that should be coming in the next year, and also kind of where you are right now in terms of using that OpenAccess database as a driver?

It was a big, it was a big idea and I credit the company as having been very forward-looking that way.

You know, Ray and I have spoken often about the analogies in the IT industry and (indiscernible) of the open source and OpenAccess has exactly all the characteristics of open administration and source code access and all those kinds of elements.

I like the position that we're in with our own product kind of alignment with the technology.

Many of the pieces have been, in flight this year and they complete in late Q1 or early Q2 just like we said and they are focused on so-called version 2.2, which is just out in beta this quarter.

So that, I think, is one way to look at it and if we look around the industry of people adopting the standard, as Ray mentioned, we have expanded that number now at 32 members, and A and D was recent (ph) this quarter.

So you know, I think it was a very important essential strategy and we're helping the industry consolidate around it, as well as making sure our products are leadership on.

And when you look at the next fastest growing areas for EDA to pursue, where do you really see that opportunity coming, and is it in capturing these dollars that have been internal engineering spends?

Is it in design for manufacturability, is it in IT or some combination?

It's a combination and I think the adjacency (ph), I call it the adjacency that maybe a nerdy term.

Branching out in the verification where we can build on our emulation capability is a very important one and I'm dying to show you the continued product rollout that comes from that because that's been an incubation capability for the company for sometime.

The manufacturability as Jay was poking on and such is a big one and I hope the people on the call got to see our release yesterday on diagnostics that help with test and yield analysis.

Because that's a good progenitor for what we’ve got.

So those are two big areas, and those are relatively untapped, that's why we call them adjacencies, those are what we look at market expansion.

I think also the captive EDA spend, whether it's, you know, outsource augmentation, in some respects, you know, we actually replaced and, you know, captive teams.

There is another one where we may be even more advantaged than some of our competitors in the industry, but I think that's another element for expansion and, you know, there's still significant pockets of spending out there to go after.

So some combination of the three, I think is all fair.

Thank you.

Thanks.

Your next question comes from Rohit Pandey with CSFB.

Thank you.

Couple of questions.

You said the design activity remains flat, but you have seen improvements at 90 nanometers.

Do you think we should look at those improvements in light of what's the penetration of 130?

Because my understanding is that if you have already bought the EDA tools at 130, you don't need to buy the complete suite at 90 nanometers so you'd be buying smaller tools than 90 nanometers.

So how come an increase in 90 nanometer adoption would help EDA a lot if there is already a reasonable 130 penetration?

Yeah, there are a couple of pieces.

First of all, bear in mind we're working on a financial model with a time-based license and so if they have it today and the license is expiring, that it's a-- there's an opportunity to re-up to the more robust set of tools.

If they are using somebody else's tools or a combination of tools, or if the license terms and conditions that they are exposed to don't permit access to the tool sets that are important at 90 nanometer, then it's going to require new tooling.

And it's our belief that we are taking share.

We do have the best solution for 90 nanometer and it requires a different tool set.

And taking a step back on the overall state of the EDA industry, semiconductors had an upside, EDA did not participate in it, and difficulties in EDA -- in semiconductors, are being reflected in EDA, a little too early than what people would expect given that EDA is based on that (indiscernible).

What do you think is fundamentally not so good in the industry right now, and how do the industry leaders like yourselves need to fix (indiscernible).

Perhaps three issues, you think, that perhaps are not right in the industry right now, and how should the industry overall think about those things.

I think the -- I’m a big chip (ph) guy of five or six months ago.

I think that the industry has been too responsive to bickering about whether some tool is better than another one.

And didn’t look at fatality (ph) enough; they are trying to help the customer holistically with the problem.

Most of those problems, as we’ve outlined, have been associated with time to market, managing complexity or integration for value.

The current segment is by, depending on whether you build a consumer chip or it values a bit larger system or chip integration or just trying to manage complexity.

That is exactly what we’re going out and helping with.

Some of that is enabled by being capable, and to be considered as a partner as opposed to just a supplier or vendor.

And that is a perception change in some of the customers.

It’s certainly a leadership demonstration of the industry leader, whether it be isolated or the VDA industry try to take it as a whole.

The second thing is that the industry has been caught a little bit with the convergence of analog and digital onto single devices and trying to deal with that.

We're in a great position that way because we have both technologies, and as we were talking before, clear leadership position in the analog and emerging leadership in the digital and that, as you can see, leads to a fascinating combination, whereas you like one of them, you probably like both of them from us.

Demonstrating that capability and having people be confident of it, to broadly depend on it as opposed to their own homegrown solutions is something that we’re out to help to go do.

The third thing is that – because you wanted three -- is that the EDA industry has been full of marketing highs about manufacturability or verification or you test, and that we use terms that I think reinforce the old tools methodology, and so we're now proving ourselves capable to be a trustworthy partner on those adjacencies.

And in many respects, especially in the largest companies in the world [inaudible] huge amounts of people.

As Ray said, that’s a requirement to customers, to trim costs, drive efficiency up.

And that’s why we’re probing on the two adjacencies.

That’s why we’re trying to give you guys insight into the progress in them, and you haven't seen anything yet.

On the theme of increased collaboration with the customers, do you think your customers have an incentive to buy complete platform from either you or Synopsis because if they do that, they cannot play you against each other.

I think they do.

The incentive is that they don't have to do the integration themselves and that is a monster task, and not only the seamlessness of it is a problem, but in general, it just doesn't work as good.

The time to market is largely impacted sometimes by stitching together a bunch of different pieces.

I think the OpenAccess thing that Jennifer asked about is very good intuition.

That allows them to buy ours as the inoperable step, but also they add their own unique value and/or consider using some of the competitive tools.

I think it's one of the values – as some of our competitors have also embraced the initiative.

And so, it's not a strategy to back someone into a corner on a vendor dynamic.

The thing I want to add and I think Ray was trying to highlight for you is that those deep partnerships are as much of trying to identify somebody you can depend on because they're betting their business on it, and that's one reason why we do 'em, they do 'em.

Our breadth matters, our technology mix matters.

Maybe in deference to some of our competitors because all those things are fodder that allows them to make the big decision to go do that, and that's why we spend so much time concentrating on it.

Switching gears – given that your competitors missed their numbers this quarter, how was the pricing environment.

Was it tougher than the past quarter or was it the same?

As we've said really all year long, it's been a choppy environment.

If you look back at the earnings guidelines and the announcements of our customers, both systems and semiconductors, we've seen them deliver good quarters and cautious guidance.

We've seen them deliver bad quarters and pessimistic guidance and we've seen them deliver all of the above.

It's been a difficult environment and it has created a keynote from all customers from the market that they're gonna extract and look for value when they deal with their vendors and their partners, and so timeframes are a little longer, companies are building more layers of approval, cash is treated more dearly, but I wouldn't say that it's meaningfully harder today than it was a quarter ago or two quarters ago.

It's just carried on now for most of this year and we think it's appropriate to continue to strike a note of caution.

And then perhaps a question for Bill.

Looking at next year – if the bookings grow, let’s say, like the degree of this year – some (indiscernible) range, do you think that revenue can grow faster if the book-to-bill is more like closer to one?

Again, Rohit, I don't want to get into that degree of modeling until we get out to '05 so once we have a good look at Q4 and we finish, then we'll be able to tell you how things will roll out, particularly with backlog.

So for now, I'm gonna hold that question for the next call.

OK, thank you.

Your next question comes from Bill Frerichs with the DA Davidson and Company.

Good afternoon, a couple of questions.

First of all on DFM, does that include anything from the agreement you made with ASML?

I don't think it does yet, Bill.

That's still being worked into the product offering.

So it's the type of thing you mentioned such as the extraction and so on.

Yes.

And secondly – NEC adoption of Encounter;

Magma, of course, has made a big deal of its relationship with NEC, including a global adoption of it’s flow.

I take it there's a geographic bias towards perhaps them in the US and you in the rest of the world.

Is that what it really looks like?

I don't think you can default to something that simple.

We're aware of very, very strong use and strength for our technology - geography, but this is on a global basis - Japan, North America and Europe.

And I would also say that at least our understanding is that Magma has not confirmed the NEC deal that some people are talking about.

OK.

Since you’ve had NeoLinear (ph) under your wing for a while and you’re starting to talk about analog a lot, and actually mentioned NeoCell (ph) in the first part of the presentation, I was wondering if the sale forces has been effective in accelerating the penetration of Neolinear, in general, into your installed base.

What could you hope to say but of course?

I think that's part of the value of coming into the Cadence fold.

The people are well-matched on both sides of the integration; it's gone well and we're expecting good things from it.

Great, thanks very much.

You're welcome.

Your next question comes from Erach Desai with American Technology.

Good evening, I have a couple of questions.

A few logistic ones for you Bill.

Were there any 10% bookings in revenue customers in the quarter?

I don't believe so Erach.

OK, and then, was there any residue or revenue from the Rambus asset sale?

There was about $5 million left.

Was that in the third quarter?

Erach, the IT business that we're in, we didn't have any significant impact this quarter, but we always have some revenue from delivering our IT.

OK, did you -- I noticed the long-term contract receivables were up slightly, did you sell any receivables in the quarter?

Yes we did.

We sold 10 million on a non-recourse basis during Q3.

And just to clarify, we did have one 10% revenue customer.

We don't disclose bookings customers.

I understand, OK.

Would you be able to give some color in terms of whether that was a mixed deal, was that a subscription or a perpetual deal?

No, I don't want to give any color on our individual customer contract.

I think we'd just like to report the size as we are required to, but I think individual customer relations are better left unsaid.

OK, fair.

Just a broader question then, if you look at your 5 to 8% bookings guidance, and even at the 8% level, I look at product bookings -- would it be fair to say that product bookings in '04 (full year, I'm not talking about quarters), will be below the 2002 level?

I'm not sure we can go back to that level, Erach.

We know last year, bookings levels were about 1.3 billion, right?

You can tell that from our backlog growth so you know what the growth is for this year and I think that's probably the relevant piece to think about.

OK, thank you.

Your next question comes from Tim Fox with Deutsche Banc.

Hi, thank you.

Just one question, and following up on some of Mike’s comments about adjacencies.

One area you haven't really tapped into today is ESL and was wondering, beyond some of the partnerships you have with private companies out there, what's your view on the ESL market size, shape, growth going forward?

What are your plans in that area?

Tim, I'll take a shot at it.

You know, it's the holy grail.

You know, it's something that's gonna be fleshed out by partnership opportunities - some of them with the [inaudible], things like we do we with Coware (ph) today.

We're certainly dealing with some of the largest semiconductor manufacturers and probing those spaces.

We're going to do it with some selectivity with the big customers.

That is, they'll have different interests.

A guy who does system level extraction for a system on a chip (indiscernible) is much different than someone who attacks it on a large (indiscernible) semiconductor like a microprocessor.

I can sub-segment, and I like some of the foundation technologies that we have to go use it as a launching board, a springboard to move up into that space.

That said, it is a very, very complex field and if DFM or some of those kind of things are fraught with misunderstanding or overhype -- ESL is one that is way, way ripe for that.

What we're gonna do is work on the customer relationships, use those to develop and refine some of our technology, find the areas that are sweet spots, and then we'll be able to detail those for you.

OK, and then just on DFM if I may, do you have any thoughts about, with your Encounter tests and the yield diagnostics products, to enter into any kind of gain share or royalty types of agreements in the future to expand beyond the four walls of just licensing?

Yeah, it's all possible.

We are very open to business models that allow us to expand beyond the traditional tool.

These capabilities, especially when you penetrate these spaces where it involves a lot more collaboration because we're comparing notes about process dynamics and mathematical methods it would take to really exploit those.

Let me put it this way, we would not be embarrassed to say we think we can add value and if we can, we'll prove it to you.

And that's how confident we are.

What we'll do is we'll just probe it in a bunch of different ways and we'll do that selectively with some of the biggest companies in the world at their interest, and we talked about a few in the graphics space in the past and there'll be a lot more to come.

So we're going to be as methodical as you can imagine, an engineer like me and a bunch of my colleagues can be, in penetrating the spaces and trying to well represent how there are growth opportunities for the company.

Thank you very much.

Well I've got the 5 minute warning that says the 5 minute warning was 5 minutes ago so I wanted to say thanks a lot for everyone's attendance on this call.

And just before you go, I just wanted to say something -- we're proud of the strong results that we delivered in Q3, executing the plan in a challenging environment, and our performance is really a result of 3 things that we talked about: Ever deepening partnerships we have with our partners, our world-class technology and a comprehensive mix of products and services which is probably differentiated from a lot of our competitive -- and an outstanding global and employee base that's passionate, absolutely passionate about customer service and support.

Thanks for joining us, and we'll see you next time.

That does conclude this evening’s Cadence Design Systems third quarter 2004 financial results conference call.

You may now disconnect.