益華電腦 (CDNS) 2005 Q1 法說會逐字稿

Good afternoon, my name is Ramona and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Cadence Design Systems first quarter 2005 financial results conference call.

All lines have been placed on mute to prevent any background noise. [OPERATOR INSTRUCTIONS] Speaking on today's call will be Alan Lindstrom, Director of Investor Relations, Mike Fister, President and Chief Executive Officer, Ray Bingham, Executive Chairman, and Bill Porter, Senior Vice President and Chief Financial Officer.

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.

Welcome to our earnings call for the first quarter of 2005.

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 Ray Bingham, Executive Chairman, Mike Fister, President and CEO, and Bill Porter, Senior Vice President and Chief Financial Officer.

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

For information on the factors that could cause a difference in our results, please refer to our 10-K for the period ended January 1, 2005.

In addition to financial results prepared in accordance with Generally Accepted Accounting Principles, or GAAP, we will also present certain non-GAAP financial measures today.

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

Please refer to our earnings press release for a discussion of non-GAAP measures and to both our earnings press release and our website for a reconciliations of GAAP and non-GAAP financial measures used in today's discussion.

Now I'll turn the call over to Ray Bingham.

Thanks, Alan.

Good afternoon and thank you for joining us as we discuss our performance in the first quarter of 2005.

Cadence delivered very good results in the first quarter.

Revenue grew to 293 million, delivering 10% growth year-over-year.

For more than two years now, we've consistently met or exceeded guidance on revenue and earnings as well as our target ratable license mix.

Bill will fill you in on the financial results in a few minutes.

Stepping back for a moment, we projected 2005 to be a year of mid single-digit growth for Cadence.

Those in the industry began the year with higher projections that we thought were a bit too aggressive.

The warnings and lowered guidance over the past few weeks simply reinforced our original perspective.

Obviously, we are pleased with our achievement in what remains a challenging environment.

There are certainly mixed signals about where the tech economy is headed.

Capital spending and semiconductor equipment is down, but R&D spending at our semiconductor customers is up.

Currently it's 17.5% of revenue.

Product life-cycles continued to shrink, consumer end segment, like wireless phones and HDTV, are growing.

Many of the consumer product leaders like Intel, PI, Motorola, Ericsson, Nokia, are reporting stronger business trends.

There's a lot of activity going on in Japan, 90 nanometer production capacity for consumer products is ramping faster than in any other geography.

Inventories are shrinking, returning to more normal levels.

And some semiconductor industry experts, who began the year with flat projections for the industry, are now looking for steady, single-digit growth in the second half of the year.

When balanced against the quarterly reporting we've seen so far in the industry, a mix of ups and downs, and the mixed projections for the year, we can understand the atmosphere of uncertainty.

However, we feel that when you add it all up, the semiconductor and electronics industries are off to a better start than we might have anticipated and prime for some growth.

Our customers face powerful challenges as product development costs rise, R&D investment is at historically high levels, and design teams get larger and more global.

Amidst widespread uncertainty about the top-line, customers are going to continue to put pressure on their costs.

So it's not surprising we continue to see customers invest for returns and partner with vendors who can help them achieve technical and financial results.

We continue to see customers consolidate the number of vendors they use.

While cost is important, their primary objective is to increase the productivity of their organizations and get competitive products into the marketplace.

They achieve this by seeking to engage with a few strategic partners.

They're matching the need to innovate with the need to reduce costs and manage complexity of the new designs.

This is not a new trend.

We've been watching it develop for several years.

The same thing has happened in many tech-based industries.

Just look at the history of the IT industry, as one example.

Customers are choosing to work with Cadence because we have technology leadership positions in more product categories than any of our competitors.

The complexity of new chip designs and the integration of millions of gates, increased functionality and embedded software is increasing demand for verification solutions, in particular.

The recent completion of the Verisity acquisition adds to our already broad and deep verification capabilities and puts Cadence in a great position to help our customers meet their time to market demands.

By the way, customer feedback on the Verisity-Cadence business combination has been very positive.

We are also well-positioned to capitalize on the globalization of chip design.

Cadence's ongoing investments, particularly in Asia, strengthen our teams globally as we mirror our customers' activities.

Our first-quarter results also reflect -- reflect the success of our innovative business model.

Customers buy for different reasons.

We understand the importance of offering the right mix of products and license types, subscription, term and perpetual licenses, and offering innovative programs like virtual Cad, and our tools for equity program for the start-up community.

Despite sector concerns raised by competitors' recent business challenges, Cadence did well in what is seasonally the industry's weakest quarter.

In fact, we've been gaining share in all important design segments and grew revenue over the past year.

Product mix really does matter.

We achieved our results by providing our customers with a broad range of market-winning technologies, having superior customer relationships, and providing flexible business methods.

Now I'll turn the call over to Mike.

Thanks, Ray.

And good afternoon to everybody.

Innovation, expansion, execution.

As we laid these out at the last month at our analyst day, we're following through on a three-pronged strategy of growing our business.

Q1 execution led to great results.

We hit our targets in revenue, earnings and cash flow, through the strength of our technology in the core business, new business and pricing models, and expanding into adjacencies, such as verification.

You would(ph) also demonstrated the strengthen and diversity of our products coupled with our relentless focus on what makes our customers successful.

Our product breadth and depth is the best in the market and enables strong pull-through from one product platform to another.

The price of Palladium 2 continued the robust sales tracks begun when it went on the market in Q4 of last year.

Palladium is a family of processor-based simulators and Palladium 2 offers significant improvements in speed and capacity, especially when compared with other products in the marketplace.

Many of our customers have upgraded from Palladium 1 to Palladium 2.

It is our lead example of feature-based pricing.

That is establishing a family of products that offer customers peer capability matched by appropriately tiered pricing.

Been a number of customers who bought Palladium 2 to address their verification needs.

It's been deployed in telecom, networking, graphics, and military aerospace segments.

For example, in the cell communications and networking market, Agere has adopted Palladium 2 to address their verification needs.

As Ray said, a few weeks ago we closed our acquisition of Verisity.

We are all very excited about what Verisity adds to Cadence.

In addition to the innovative products like B manager, which is the unique technology and verification process automation, merging the Verisity team of experts with the Cadence team provides us an unparalleled level of expertise in product development and in the field.

With Verisity, we have the most complete verification capability in the industry.

We will expand our support for mobile languages including E and it's IEEE standardization activity, as well as provide a tier offering featuring the highest level of value and differentiation.

Bringing all the verification technologies together under one roof is exciting.

We are just getting started on this and we'll tell you more exact and you haven't seen anything yet.

This quarter we saw continued strength in our Encounter digital design platforms.

Encounter was our global physical synthesis technology, or GPS for short, is helping customers design bigger, faster and more complex chips in less time.

Since Encounter GPS was introduced last summer, it has completed over 150 tapeouts, a solid indication of success.

And, in ever increasing number of customers are using the full Encounter flow for physical design.

We continue to gain traction with our synthesis product, Encounter RTL Compiler.

RTL Compiler wins over 90% of the technical benchmarks and we've added more than 20 new customers in Q1.

We are actively engaged with customers at 65 nanometers from RTL to GDS 2.

During the quarter there were many notable customer engagements where they have turned our technology to help them solve the three main challenges of time to market, managing the complexity in chip design, and integration for value.

I could give you a long list and I'll name just a few customers such as Okie, Agere, Fujitsu, BLSI, Micro Linear, Lexar and Atnell(ph).

With lots of focus on verification and digital, Allegro, our silicon packaged board platform is often overlooked.

Allegro is yet another example of the depth of our product offerings.

It's important to our customers, customer, because the value of the chip cannot be realized until it's in the package and on a board.

In Q1 Allegro's advanced packaging capability was the key differentiator on winning business at companies like LG Electronics.

Low powers initiative's on everyone's mind in the electronics industry and it's because end users want long battery life on things such as cell phones or PDAs.

Cadence, through the silicon design change initiative, collaborated with industry leaders, Applied Material, ARM and TSOC to develop an automated design process that achieves low power savings for all types of 90 nanometer mainstream designs, not just leading-edge products.

The result of this collaboration has shown power savings of over 40%.

In Q1 we took the first steps towards our strategy of kits, introducing the flow needed to produce the chips for the wireless product by handsets.

In general, kits are aimed as a total solution, not just point tools, that leave the integration methodology in IPF to customers.

In the current environment, the reputation of our technologies, as well as our relationship with customers, are key elements in winning business.

Our results clearly speak to the commitment that global Cadence workforce has towards our customers.

And as I said earlier, we are following through on our three-pronged strategy of growing our core business through technology innovation, expanding into adjacencies such as verification and manufacturability and new business and pricing models.

I hope you'll be able to join us at our annual shareholders' meeting at 1 p.m.

Wednesday, May 11th, here at our corporate offices in San Jose.

Now, here is Bill with some details on the financials.

Thanks, Mike.

We were successful in Q1 because of strong execution in growing our core business.

We saw good traction from our functional verification and digital technologies.

We also saw good results in the remainder of our product areas, demonstrating the strength of our diversified portfolio.

The success we are seeing with Palladium 1 and Palladium 2 points to the value that can be created with tiered product offerings.

GAAP earnings per share in Q1 improved to breakeven compared to a $0.03 loss in the same quarter last year.

Non-GAAP earnings per share of $0.15 were up 67% year-over-year.

Total revenue for the first quarter of $293 million was up 10% year-over-year.

Product revenue was $174 million, maintenance revenue was $87 million, and services revenue was $32 million.

Revenue mix by geography in Q1 was 46% for North America, 16% for Europe, 30% for Japan, and 8% for Asia.

In Japan's traditionally strong Q4, we had one 10% revenue customer.

In the quarter, approximately 79% of our product business was represented by ratable licenses.

That is licenses where revenue will be recognized over time.

As we expected, approximately three-fourths of product revenue was generated from backlog.

For all of 2005, we expect to generate at least two-thirds of revenue from backlog.

And we expect to grow our backlog to the $1.8 billion level by the end of the year.

Contract life, calculated on a dollar weighted average basis, has remained consistent at about 3 years.

Q1 total costs and expenses, on a non-GAAP basis of $240 million, was flat compared to Q4.

Quarter end headcount was approximately 4700.

Challenging the organization to efficiently deliver products and services is an important priority for me.

We completed our streamlining action from last quarter and saw an opportunity to improve the way we deliver our design services.

This will result in a Q2 reduction in our work force in Scotland by about 60 positions.

The associated restructuring charge in Q2 will be about $5 million, generating annual savings of around $7 million.

Our non-GAAP operating margin in Q1 was 18%, up from 12% in Q1 of 2004.

We remain on track for an operating margin of approximately 24% for 2005.

Receivables quality remained high in Q1, with receivables 90 days past due at 2%, within our historical range of 1 to 3%.

Total DSOs were 120 days compared to 126 days in Q4.

We expect DSOs to decline to the mid to high 80s by the end of 2005.

Operating cash flow for Q1 grew 12% to $67 million.

We remain on track to generate over $400 million of operating cash flow for the year.

CapEx in Q1 was $20 million and we remain on plan to spend about 75 million this year.

Cash and short-term investments grew to $683 million at quarter end from $593 million in Q4.

Our net outlay for the Verisity acquisition in Q2 is about $280 million.

Now I'll turn to our outlook for Q2 and the year 2005.

For Q2 we expect revenues to be in the range of 300 to $310 million.

GAAP EPS should be in the range of $0.01 to $0.03 and non-GAAP EPS in the range of $0.14 to $0.16.

Because the Verisity acquisition was completed earlier in Q2 than we planned, we expect an additional $0.01 of dilution in Q2.

However, this does not change our outlook for the year.

For the year 2005, we continue to expect revenues to be in the range of 1.24 to $1.3 billion.

GAAP EPS should be in the range of $0.27 to $0.35 and non-GAAP EPS in the range of $0.73 to $0.81.

Please note that given the new effective date of FAS 123R, our GAAP earnings per share outlook for 2005 no longer includes an estimate for stock option expense.

Operator, we'll now take questions.

[OPERATOR INSTRUCTIONS] Our first question is from Jay Vleeschhouwer of Merrill Lynch.

Thanks, good afternoon.

You reiterated your revenue range outlook for the year but it wasn't clear if you were adhering to the mid single-digit bookings growth rate or not.

If you could just verify what you mean by the bookings outlook for the year.

Similar a bookings related question.

In your experience in Q1 or your expectations for 2005, what are you seeing with respect to the number of customers or transactions where you are maintaining or increasing your anticipated revenue run rate per customer as -- as validation of the -- of the statement that you're gaining share within the industry?

And then a couple follow-ups.

Thanks.

Jay, this is Bill.

In terms of the bookings outlook, no change.

As I said at the beginning of the year, we have now transitioned to pretty much an equilibrium model.

So that you should be able to see revenue and bookings pretty much track very closely together.

So, again, I think bookings will track roughly in line with revenues for the year.

Hey, Jay, Mike Fister here.

I -- from my look at the customers, we're getting not only what we thought but we're getting some extra business and it's evident in proliferation of the digital platform, as I mentioned in Encounter, and in the RTL Compiler.

And we're having a good quarter for validation.

Just like last quarter, that Palladium is doing extremely well, as are a number of our other products and verification.

And those signal share gain for us, I think, corroborates some of Ray's industry analysis that he commented on.

Okay.

You gave Palladium as an example of feature-based pricing, the you get what you pay for model you talked about at the analyst meeting last week.

But there were two other types of pricing models that you hoped to implement, the node-based and the kit pricing.

When do you think we'll begin to see more material evidence of either of those.

And then lastly, if you could comment a bit more specifically on your customized C or analog mixed signal business, are you maintaining that business and base, or are you in fact growing the analog mix signal business?

Thanks.

Starting backwards to forwards, we certainly are maintaining our -- a good position.

As you know we have a very -- enjoy a very nice market segment share position there, so to grow it is a difficult thing to do.

But our momentum with customers is very good, we had very good momentum in the quarter with customers on all -- all facets of that, especially the UltraSim product capability is moving nicely.

The -- the two other benefit-sharing models that we talked about, node-based pricing and kit pricing, come out commensurate with product announcements and they're scheduled for second half of the year, maybe you'll see something even at that.

Thank you.

Your next question is from Jennifer Jordan with Wells Fargo.

Yes, good job on the quarter, guys.

First, I was hoping that you could comment a little bit on, again, what you're seeing in the environment with customers.

We had Mentor say that they saw weakness across-the-board and if you saw any areas where the -- you felt that there was more weakness than normally expected?

Jennifer, it's Ray.

I think your view of what the market is doing today depends on where you sit.

We -- we have reported some good success here going into the year on top of a -- of a solid 2004.

And it -- I think it relates very well to the fact that -- that most semiconductor customers and most electronics customers are investing pretty actively, as I indicated in my opening comments, in developing new technologies and new products.

They're looking for value and they're looking for productivity.

And where we can offer them a broader well-integrated and open environment, we -- we think that we are positioned very, very well to serve in this kind of a market.

Now, you saw the -- the names, you're very close to the names that have announced and who had a good quarter.

I mentioned a few of them in my comments.

The -- the screen that I put on that is that they tend to be the leaders and, in particular, the leaders in -- in the consumer products areas that are doing -- are doing well.

So -- so interesting that -- that even in Ericsson, as it rolls out more 3 G infrastructure, is reporting stronger results.

The handset guys are reporting strong results in the wake of that.

And the chip guys that serve them, by and large, not consistent but by and large, who are the leaders, are serving as well.

Where we're seeing folks not do as well, they tend to be the nichier(ph) players or the followers that -- that are not making the investments or don't -- don't own the strong-market positions that the names that I mentioned have done.

Jennifer, I have one thing.

The reason I put the comment in about Allegro and Palladium was anticipating some of the shortcomings of the competitors.

In both those product categories, you know and I hope the rest of the listeners know, that those are direct competitors of Mentor.

And so the fact that we had significant business from them and those, I think, probably is an example of the market segment share gains against Mentor.

Jennifer, one final comment to build on on Mike's comment.

Even -- even those that are reporting weaker results are -- are investing in R&D.

And that tells me, and our experience supports this, that customers are looking for help with more complex chips, more complex systems and ever-tightening windows to deliver them into.

When you talked a moment ago about the -- the feature-based pricing, Mike, could you share some of the other products that we should be looking for that type of product strategy from?

Yes.

The thing that we're intrigued with is certainly elements of the verification space are going to -- are going to have feature-based pricing on them because they tier nicely.

And the -- I'm very intrigued with our digital platform.

What -- what we -- I think we've talked a little bit about it at the analyst day, was the ability to segment that product into kind of entry, maybe 500 megahertz to gigahertz chips, whatever better is, I don't want to be pejorative of somebody's interest, professional and then super-professional that are saying one gigahertz, 2 or 3 gigahertz chips.

So we can stratify by frequency, we can stratify by power, which is a -- got a nice frequency differentiator.

We could stratify by die area, which you know is one of the benefits of X technology.

So I think we've got lots of different ways to do that and those are both examples of the product line that the marketing team that Ajy and Jim are driving the developers to bifurcate the products, where as we said tier them for functional business.

Is there a timeline that we should start to look for some of these things to be released?

One in customer -- customer engagements now selectively on some of them.

And I suspect that the second half of the year is -- is timed to some of our big customer meetings that we're doing.

The so-called CDN live engagement that we have in the second half of the year is a good time to expect us to come out with product offerings, because we have a -- we have a customer forum that's made for that.

DAC, around the verification space we will -- we will feature some discussion and approach to the product lines at DAC because it's topical and -- and we're ready to do it.

Great.

Thanks.

You're welcome.

Your next question is from Sterling Auty of J.P. Morgan.

Thanks, guys.

A couple questions.

Ray commented on kind of the better start than expected in the semiconductor industry.

Are you actually starting to see that translate into better close rates or maybe a little bit improved visibility in the business?

Sterling, at a -- sort of at a clarification level.

I -- it's always -- it's always more positive to deal with customers that are doing better in their own businesses than not.

That -- that said, if you look at the -- the persistent and consistent levels of investment that all of them are making, those that are struggling and those that are doing relatively better, the comment about doing -- that -- that's the most-important comment that I would make about the tone of the market.

Customers are being hard on costs.

I made those comments in my opening remarks.

Managing costs aggressively is the only -- only thing that they can really, really, really be sure of.

But -- but at the same time, they have these investment imperatives that they -- that they know they have to make in order to drive to the next node or to the next product line and they are making them.

It's happening.

Okay.

If you look at the -- kind of the commentary around market share gains, we look at your digital performance.

What gives you the confidence that you can continue market share gains as Synopsis prepares to launch a new platform?

Well, Mike Fister here.

I like our chances because the capability of the products is not only a theory but proven.

That's why I tried to offer some -- there's a 150 tapeouts, 20 new customers.

There's always a long lag time even if they do have something that's new or better.

So the fact that we've been out there for years is quite good, quite encouraging to me.

The other thing that happens for us is that we get a drag-through effect and I think we talked about this a call or two ago, where we're strong with our analog product line, it has a natural drag effect and it brings it across to digital.

And vice versa.

Places where we're strong in the digital and people are entering mixed signal design, engaging mixed signal designs, they naturally use our technology because the completeness of the kit is very seamless.

It works better because we did all the pieces ourselves.

And so the breadth of our offering, I like our chances.

The third thing is that we're seeing active proliferation of the technology.

That is, once we put it in and we do kind of a case study on one of the tapeouts, it gets used in many, many more tapeouts.

We call that proliferation.

We're seeing active proliferation of Encounter now and that includes even a coupling of the synthesis capability.

So what per typically would have been a strong in Synopsys incumbency based on -- on synthesis, we're broaching that, too.

So, I think those are the things that give me confidence.

I'm obviously very deeply personally engaged with a lot of these customers and we use that as a barometer to make sure that we're kind of corroborate where we're going with where we've been.

Okay.

And then two quick ones for Bill, which are can you help me connect the dots between good gross margin result in the quarter and the commentary that Palladium 2 continues to do well given the hardware component of it.

And then can you tell us what was the deferred revenue that you ended up losing to acquisition accounting for Verisity?

Sure, Sterling.

On the margin for Palladium.

That is a very high-margin product, so it's not going to be something that's going to be as noticeable because we get very good margins with that in total.

We will have some additional product COGS, but it's getting fairly close to software margins because the product is doing very well and I think it's priced accordingly.

So you'll see some additional COGS.

But I think you'll also see good margins from that product.

In terms of the second question on Verisity deferred revenue.

That's still very much a work in process.

They are just actually getting their final books closed and we're starting the purchase accounting.

So I won't have an update on that for you today.

My assumptions haven't changed from what we talked about last time.

I'm still looking at it approximately at about a 75% write-off.

And if we can do better than that, great.

But that's still the base assumption.

Great.

Thank you, guys.

Our next question is from Garo Toomajanian with RBC Capital Markets.

Thanks, I wanted to go back to the sort of pricing questions for a second.

I'm curious as to whether or not you've been able to see improvements in the pricing environment overall.

That was another thing that you guys had stressed at the analyst day.

Well, it's Mike Fister, again.

A little bit.

You know, it's -- as Ray said, it's a tough environment and no secret that some of our competitors are engaged in some very aggressive price package trying to hold an incumbent position which may be waning technologically.

At least that's my opinion.

I think it's encouraging, Garo, is we've been able to continue to hold the discipline that says, if we have better stuff we don't have to give it away, we don't have to give it away early, we don't have to give it away for cheap.

And number two, the tiered pricing that we said we would get on something like a Palladium in the up sell is happening.

And that's fun to see.

And I'm encouraged by the initial engagements we've had with customers on some of the other tiered ideas that Jennifer was talking about, the future differentiated ideas and the benefit-sharing models that we talked about at the analyst day.

And while we can't give you examples of them now, I can tell you that customers came up to me after listening in to our call and said, I want to be a part of the benefit sharing that you're doing, obviously with some of my competitors.

And it's corroboration in our minds of things that we have believed and tested ourselves and the reaction to a complex environment and having to pick some partners and partner with them.

So, I guess that's what kind of comes off the top of my head to your question.

Okay.

On Japan, it looks like there was particular strength there, a lot more than seasonal strength with, I think, the highest percentage of revenue out of that region in about eight years.

Was that primarily due to the one 10% deal, or were there, I guess, a number of deals there that really helped overall in Japan?

Garo, this is Bill.

I think what you're seeing in Japan is really just a continuation of some pretty good momentum that we have seen there.

We've had, I think, a good success.

As Ray mentioned, there is definitely a pickup in investment as a lot of the Japanese companies focused on consumer are really ramping their 90 nanometer technologies.

So that environmental combined with, I think, having the right technologies right now, both digital and verification.

And, by the way, of having a very good team that is selling direct in Japan, as you know we've invested that team and they've been performing very well.

We've had good business across-the-board in addition to the one 10% customer that we've seen.

So we're looking for continued good things from Japan and I think we just had a particularly good quarter this quarter.

And one other thing I would add.

Ray has often talked to you about the value of relationships.

That part of the world we have some particularly strong relationships and you saw at least one of the customers at analyst day talking about that.

They have a long-term view, they have adopted the partnership attitude very aggressively and we have very successfully engaged with them.

They see the value and the breadth of the technology.

So we're definitely on -- hitting on some good cylinders in Japan last quarter and I hope it's going to continue.

One quick clarification, Bill.

Was that a 10% revenue and bookings customer?

Garo, we don't comment on bookings customers, as you probably recall.

So it's a 10% revenue customer.

Okay.

Thank you.

Sure.

Your next question is from Harlan Sur of Morgan Stanley.

Good afternoon, guys, and great execution on the quarter.

A couple of questions for you first, Bill.

Why were the G&A expenses up about 5 million sequentially?

Yes, good question, Harlan.

I've looked at that.

There's a number of things.

I'd say primarily there's compliance costs, a combination of -- of audit, SOXs, some legal, a little insurance.

So it's just a little bit more expensive to do business, unfortunately.

That's the primary reason why we see some up.

There's a little bit up sequentially because we have our Christmas shutdown from Q4, we don't have it in Q1.

But that's kind of smaller stuff.

It's really a little bit more kind of overhead of doing business, unfortunately.

Is there any one-time stuff in there which you maybe expect that part of it to trend down going forward, or is that something -- is that a level we should expect going forward?

Yes.

In total I think we're trying to -- manage the total costs but there isn't any big one-time cost in G&A.

So I think it's probably a level that we're going to have to manage with.

But I think we've done, as I mentioned, a reasonably good job of managing our total costs being flat from Q4 to Q1.

Yes.

And we looked and found some opportunities to reduce some additional costs in Q2 in services and we're going to continue to look.

That's an ongoing effort that the team and I are always looking at.

Okay.

Great.

And then the second question would be, I know last quarter you chose not to close some deals based on some of the unfavorable economics your customers are looking for.

And so, I guess I was wondering if the team was able to revisit some of these opportunities in the March quarter and then were you able to close some of these deals with more favorable terms?

Yes, Harlan.

We did continue to work some of the business from Q4 and close in Q1.

And there's some additional business that we're continuing to work.

We look at that pretty carefully and Kevin does to make sure that we are continuing to work that.

I think we're pretty confident that we haven't lost any of that business.

But we are still working it.

And as Mike mentioned, we're being thoughtful about price.

Where we think we have value, we're definitely going to continue to work it longer.

And I think we're also being practical where we think we need to do something to close, we'll do that.

So I think we're practical in how we want to close it as well.

Okay, great.

Thanks, Bill.

And then a couple questions for you, Mike.

The two largest microprocessor companies in the world, as you know, are aggressively moving to dual core implementations for both the desktop and the server arena.

And I'm wondering that with the significant amount of added complexity, if this should have a positive impact on chip tool spending.

And secondly, is Cadence benefiting from this?

Yes, Harlan, I'm quite familiar with that.

As you know, I was an author of it.

And I was giving a talk at one of the E-DAC things with some of our colleagues.

I pointed that out as a key trend in the industry.

It -- it values not only the complexity but the -- the drag effect of having large pieces of memory that go in between the two course to be able to make the efficient -- an efficient way to -- so they can talk between each other.

And I think that those are then technology avenues that automation will help drive to efficiency.

So the -- it's not just an increase in the base complexity or what you can put on the die, but any of those kind of things that we can -- can do to make the architecture of those things seamless and efficient.

And we are engaged with some of those manufacturers, as you know, on the digital platform already.

And I couldn't -- I couldn't tell you my testimonial to what depth that we are with any individual company right now.

Okay.

Thanks.

And then on my second question.

Obviously Palladium 2 shipments in the December quarter were very strong, I think you guys said you shipped something like 50 systems.

And you again talked about continuing strength here in the March quarter.

So I was wondering if you could tell us the number of systems that you shipped in March?

Harlan, I -- actually, I don't have that number.

I can try to track it down.

The level of business, just anecdotally, seemed pretty comparable.

We had a pretty heavy level of business and there's still some business coming down the line.

So it's -- it is a product that is in pretty good demand and even with the cost sensitivities, if somebody's cost sensitive then they have the opportunity to get into Palladium -- Palladium 1.

So it's kind of working on all fronts right there.

Okay, great.

Thank you.

And again great execution.

Thanks, Harlan.

Your next question is from Dennis Wassung of Adams Harkness.

Thank you.

A couple of quick questions.

In the opening remarks you talked about sort of R&D spending from the semiconductor industry roughly in the 17.5% of revenue range today.

I'm just curious what you're seeing in terms of -- or what your expectations are for that number changing here.

As some of the customers at your analyst day were talking about holding spending roughly flat and I'm just curious how you're expecting that number to trend going forward?

Dennis, that's -- that's a question you could better ask our customers.

But let me say this -- notwithstanding with the -- the mixture of results that are being reported, we're still seeing even those that are not reporting well, talking about as much as 10% increases in their R&D spending.

Now, I don't know whether those are at the lower end of that 17.5% average or the higher end of it, so I don't know what it does to the average.

But the -- the imperative against gate count, global teams, complexity, short-time time windows is -- is very, very clear and it's resulting in a reallocation of -- of their spending or an increase in their spending against the things you're going to get them to return.

Okay, fair enough.

And I guess sort of along those lines, when you look at things like 90 nanometer and 65 nanometer, how would you characterize, I guess, any changes in customer activities at those levels?

Obviously 90 seems to be ramping, is 65 picking up faster than you expect, or -- I mean, any commentary on those two areas?

Well, it's all relative, but the answer is yes.

It's moving fast.

The example that I gave was Japan, where they are -- they're issuing record orders for both manufacturing of equipment and -- and related design capability.

It's quite impressive what the Japanese are doing to get back into the logic game in a big way.

We're seeing in general the ramping of 90 and increased activity in 65.

Most of the 65 nanometer activity is around test chips and as people have -- customers have seen success or made progress on the test chips, now they're starting to do production design.

And so it seems like the anticipated target will be hit for 65 nanometer first production.

Okay.

That's helpful.

And last question.

At the analyst day you sort of alluded to some of the capabilities with KaTina, a manufacturing site coming up.

Any comments or updates you can give us there?

No.

Still a -- it's still a -- targeted customer engagements around a technology that I want to leave you in great suspense on, but, also, do it with the objective to show you that we're not standing still in the adjacency around manufacturability and the monetization of those in a unique was.

And it's -- it's not something I think we'll give you a quarterly update on because I would prefer to prove that out with the customers and then do products as opposed to science fair experiments and technology looking for problems to solve.

So should we expect to start getting more detail on this?

Is it sort of end of the year, or is this sort of a DAC event.

Not a DAC event.

Okay.

Thank you.

Yes.

Your next question is from Raj Seth of SG Cowen.

Hi, thank you.

A couple quick ones.

Mike, can you comment, there's been some chatter in the trade press about how much internal EDA development is done and obviously usage of tools.

Can you talk about whether or not you see a trend one way or the other?

Well, Raj, I think that, and it maybe sounds -- sounds kind of like I want it to be, but I think there's a trend that there's less money spent on internal EDA and it's a -- it's a by-product of two things.

Well, three things, actually.

One, the expertise to be able to do that exists and it's concentrated in companies like Cadence and even some of our competitors.

And so there's less of a expertise that's distributed around the industry.

Two, the opportunity costs for being able to or have to develop yourself is -- is a problem.

I mean, it's -- it's high and especially when there's lots of other software things that people could do.

So they could go and build drivers for the chips that they're building.

They could build applications for the chips that they're building.

And really the -- the application areas where people are doing may be more narrowly focused.

So, where certainly EDA has done a great job around core design, as we said digitally analog, chip sign-off, power signal analysis, etc.

The things that people are probably doing is concentrating on areas that are more closely held like manufacturability.

And that's why that's so intriguing and why KaTina's a customer focused engagement, I wasn't trying to be cute at the analyst day or to the last questioner.

It's something that you do in collaboration with customers that allows them to channel or offset the opportunity costs that they are plowing into that and have confidence to do with somebody else.

So I hope that gives you some insight or rationalization of why I think it's happening as opposed to the self-serving comment that says it must be going down and therefore we're going to pick it up.

Sure.

So when somebody like TI says that they may do a bit more, what I'm hearing from you is that that's likely in very narrow areas tied closely to their process.

I think that's a -- that's very intuitive of you to -- to understand and it is consistent with my belief.

That it would be focused around manufacturability, something that may be peculiar to their application.

In the early days of hot electron migration stuff, we used to do in our old alma mater special stuff that was a secret and after a while it becomes well known in the industry and then you can buy more off the shelf.

And so there are -- are things that people do in their own flows of work that are either historically rooted or rooted in the uniqueness of their products.

And I think that's where the application of most of those internal CAD resources are going these days.

Sure, thanks.

One more, if I might.

Can you talk now that Verisity is closed, a little bit -- a little bit about how organizationally you're going to fold that in?

And in the context of all the discussion about Palladium and emulation, what happens to Access here?

Yes.

Moshe's -- we're actually going to have Moshe Gavrielov up to, who as you know joined the executive team at the DAC, concentrate on this because it's an often-asked question and he's engaged with the team now.

At a high level what we're doing is we're bringing all the verification pieces together.

He's the leader of that band.

And we've had some of those discussions.

It amounts to -- we persist -- all the product lines that exist today and then drive them for more seamlessness, because we got an idea how to do that and it's music to the customers' ears, as Ray I think said in his comments.

They are very enthusiastic about what we're doing and -- and see a lot of leverage in it for their own application.

And we're going to take the things that were strong in common positions, you know, E -- drive the standardization up for harder.

I think we'll walk the talk, a multi-language support where some of our competitors are casting FUD, fear and uncertainly and doubt, around things that are kind of foilway(ph), potentially.

So we really have a lot of pieces there and the truth is there's a practical element to it.

Customers that had bought products from either of us, still -- once they have those products, be supportable and move forward and so we're out and it's why it's a better -- better done at the DAC.

We can show you some of the road maps that we intend to drive the product lines and I think it'll be quite engaging when you see it.

Good, thanks, look forward to that.

Thanks.

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

Thank you.

Bill, a question for you on operating margin targets for the year.

I think in your last call you mentioned that Verisity would cost you about 2 percentage points of margin for the full year in '05 and your target is 24.

I think you also said you were targeting 30% for the full year in '06.

And, I guess, just wanted to clarify that those were in fact what you said.

And secondly, the 30% in '06, seems like you will still have probably at least a half year of Verisity's limited deferred revenue contribution there, so essentially dilution from Verisity, still in the model in '06 and is that baked into your 30% target for '06?

Thanks.

Yes, Rich, just a little hard to hear your question, so let me just restate so that everyone can hear.

I did indicate that our target for 2005, target operating margin non-GAAP is 24% and that does include the Verisity dilution.

So that's correct.

And as we get into 2006, we actually will only have a quarter of dilution left because given that we closed Verisity right here at the beginning of Q2, we'll only have that little bit of a headwind to have to carry.

So for us to get that target, as I mentioned, we're going to have to grow our top-line primarily.

We'll manage costs carefully as we're doing now.

But I think it's a -- it's a target that we -- we've got our sights on and if we can execute along the lines that we talked about, I think we've got a pretty good opportunity there.

So we'll talk more about that, obviously, as we get at the end of the year and set our targets for '06.

But clearly we've got our eye on that as a goal and we're shooting for it.

I know you don't want to give '06 guidance now, but would you envision that entailing top-line growth roughly in line with this year or perhaps an acceleration, if you would be willing to comment that far.

I don't want to get into that level of specifics, Rich.

It's probably going to be at or above this year and that's probably as far as I'd go.

Fair enough.

Thanks, guys.

Your next question is from Tim Fox with Deutsche.

Hi.

Thank you.

Good afternoon.

First question.

At your analyst day there were a few customers that seemed receptive to the gain share model or whatever one may call it going forward.

I was wondering if you've had any -- any further discussions with other customers outside of your early partners on the X architecture and whether there's any sense of what percentage of your bookings of revenue this year may come from those alternative pricing models?

Tim, Mike Fister.

I -- I did comment before that I had customers come up and ask me if they could participate in the benefit-sharing schemes with us.

And those were not isolated to X technology.

As Bill and I said at the analyst day, we have a target list of customers that were engaged with the X and the benefit sharing is implicit in the business dynamics that we're going to do with them.

Those discussions have moved forward and we just don't have anything to announce right now.

Tim, I guess I would just add it's not going to be a meaningful percentage, given the size of our business currently, whether it be revenue or bookings this year.

So I think really we'll be talking about the momentum with customers in particular.

And the other thing I'd add is we are continuing to see progress just on the technology in particularly with X and we're just monitoring the next chip that's starting to make its way through fabrication.

So there is good progress being made on the technology, probably a little early to try to quantify the results.

Besides we think there's value here and we're going to pursue it.

Okay.

And then a couple specifically for Bill.

I know you mentioned that bookings for the full year would be about on par with revenue.

Can you talk at all about how bookings came in for the first quarter, whether specific or just -- on plan, ahead of plan?

Yes, Tim.

I'm not going to get -- as I've mentioned, I think the right metrics for the business on a quarterly basis are revenue earnings and cash flow.

And so I think those are the things that you'll hear me talk about.

At a very high level, we are going to grow our backlog in 2005.

And if I thought that direction was going to change, I'll let you know.

But really the quarterly metrics are going to be all around kind of revenue earnings and cash flow.

Okay.

Generally, I think the business is tracking very well according to our plan.

So we're pretty much tracking to plan and I think that's making us feel pretty well.

Okay.

And, lastly, around the -- the mix, I think you mentioned it was 79% right in the middle or so of your -- of your planned range.

Has there been any pressure at all?

We've heard some other vendors getting pressure to move to more -- more of a ratable mix and given your high percentage of business in Japan, being able to keep it in that range seems like that there may not be much pressure.

But are you feeling any of the edges to get more ratable in your offerings?

Not feeling any pressure, Tim.

I guess the way I'd just characterize it is we've been, as you know, looking at just flexibility with our customers and as we've talked about different business models to try to optimize the value.

And looking at license models is a similar thing to just looking at tiered pricing.

And the philosophy is pretty similar.

We offer license-type subscription term in perpetual each with a different value proposition.

So a customer will definitely pay a premium for the subscription for that flexibility and access to the new.

And those who really want ownership will go for a perpetual and you've got terms somewhere in the middle.

So it's really kind of a customer preference that we've been able to kind of work with and help manage as the primary driver.

And of course I think we all recognize in the environment it's just harder to do up-front because of all of the implications of payment terms and all of revenue recognition.

But that's just something we've been able to work our way through.

Generally, I think customer driven and we try to make sure we take advantage of the value of the different offerings.

Great.

Next quarter, thank you.

Sure.

Your final question is from Jennifer Jordan with Wells Fargo.

Yes, thank you.

My question was answered.

Okay.

Well, with that, maybe a few closing remarks.

Q1 was a very solid quarter for us and we executed well in the ongoing challenging environment that Ray did a nice job outlining.

Revenue grew 10% year-over-year to $293 million and the verification adjacency is really, I guess, kind of on fire.

It offers a great growth potential for us because we've got the technology and we just closed the Verisity acquisition, so we're only just getting started here.

Continue to gain segment share in digital as well as verification and increased our share in other key segments.

And overall, we're executing our three-pronged strategy of growing the core business through technology innovation, expanding any adjacencies such as verification manufacturability and new business and pricing models.

With that, thanks once again for joining us and I wish everybody a good afternoon.

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