益華電腦 (CDNS) 2006 Q2 法說會逐字稿

Good afternoon.

My name is Brooke, and I will be your conference operator today.

At this time, I would like to welcome everyone to the Cadence Design Systems second quarter earnings conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer session. [OPERATOR INSTRUCTIONS]

I would now like to turn the call over to Ms. Jennifer Jordan, Corporate Vice President of Investor Relations for Cadence Design Systems.

Thank you.

Ms. Jordan, you may begin your conference.

Thank you, Brooke.

And welcome to our earnings conference call for the second quarter of 2006.

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

With me today are Mike Fister, President and CEO, and Bill Porter, Executive Vice President and CFO.

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

For information on the factors that could cause a difference in our results, please refer to our 10-K for the period ended December 31, 2005, and our 10-Q for the period ended April 1, 2006.

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 reconciliation of GAAP and non-GAAP financial measures used in today's discussions.

With that, here is Mike Fister.

Thanks, Jennifer.

Q2 was another good quarter for Cadence.

Revenue grew 12% year-over-year led by sales of our verification and digital platforms.

Our business fundamentals and outlook for 2006 are unchanged.

Now, I know many of you have some concern about the environment, given the recent technology sell-off.

Let me give you some sense of how we triangulate on our business.

First, a look at the macro economy and the industry, where the data as you know has been mixed.

Forecast for semiconductor growth in 2006 span a wide range from 6 to 17%.

The forecast for semiconductor R&D spending for 2006 though remains in the high-single digits.

Design start forecasts are steady to slightly up, with the number of design starts from 90 and 65 nanometers continuing to grow.

The consumer market will make up 54% of the $246 billion in chips that will be sold worldwide this year, according to the Semiconductor Industry Association.

Second, we take a deep dive into our book of business customer by customer.

The customer by customer look is crucial, because while some tech sectors may not be doing as well as others, and competition everywhere is fierce, customers who hit their market window with the right product are having success.

And third, is geography.

In order to maximize our business opportunities and align our resources correctly with them, we need to know where our customers are invested.

And we need to understand what new business models and strategies will best suit different regions.

One of the most interesting trends continues to be the emergence of both multinational and local semi industry investments in China and India.

In our core business, our analog mixed signal expertise is a key differentiator with customers, and is fueling purchases of our other design platforms as well.

We released our next generation Virtuoso platform to early adoptive partners on schedule in June.

The initial feedback from these partners has just been excellent.

We also completed some full production release of the Cadence space-based router.

ST Microelectronics used the Cadence space-based router on it's latest 65-nanometer mixed analog RF digital design, taping out in Q3 2006.

IT has upgraded our analog mixed signal kit, and announced our RF SiP methodology and ARM functional verification kits at CDNLive! in Europe about three weeks ago.

Customers are adopting kits that target new vertical markets for design style.

And ETV Technology which is a U.K.-based company, specializing in RF design and manufacture, is an example of who chose our AMF kit and the Virtuoso platform, to ramp a new design team quickly, and save time in the design cycle in attacking the new vertical markets.

In Digital IC, we continue to develop innovative technology for managing the challenges of low power design.

We have partnered with ARM, to develop an automated digital flow for implementing their top line microprocessors, the Cortex-A8, to achieve the highest performance with the lowest power.

And 10 companies led by Cadence formed the Power Forward Initiative to work on the refinement and promotion of a new specification called a Common Power format, which captures essential design intent for power and links to design, implementation, and verification demands, to address obstacles to lower power designs.

UMC and TSMC announced support for the it's X technology at 65-nanometer, and a gear [out of XNSI] for TSMC's 90-nanometer process.

Consistent [Packaging] historically announced the industry's first commercial SiP implementation solution.

And to look at it's verification adjacency, we enhanced our Incisive Enterprise solutions to enable architectural modeling to pull system validation, combining system level hardware and software to our enterprise management.

The combination of our verification process automation with enterprise Specman and Simulator again drove the displacement of competitor simulation from a another of accounts in Q2.

Customers continue to see the value in our holistic approach to verification.

And this holistic approach has led to a similar impact in the hardware emulation, where we clearly lead the market.

Cadence is the only company delivering uniform emulation systems at the massive scale required to verify our leading customer's most complex designs.

And the system is capable of handling greater than 200 million gates, and in Q2 we delivered our second such system to a key customer.

In the design for manufacturer ability adjacency, we are making steady progress with TBS, where we completed 7 tape outs.

As well as with Virtuoso RET, a chip optimizer.

We continue to add forward-looking modeling technologies such as chemical, mechanical polishing, and critical area analysis as well.

Geographically, in North America and Europe each had a great quarter, while in Japan, momentum and execution were unabated.

Hitachi entered into an agreement which includes joint flow creation, validation and more comprehensive technical support.

And consistent with the pull we are seeing across our platforms, NEC extended it's relationship with Cadence to include verification technology including Specman, and added Virtuoso technology for their business in China.

We look forward to seeing you at CDNLive! in Silicone Valley on September 12, each and every one.

And now I will let Bill take you through the numbers.

Thanks, Mike.

In the second quarter, Cadence again demonstrated consistent execution and strong financial results.

Total revenue was up 12% year-over-year.

Non-GAAP operating margin improved 4 percentage points to 25%, compared to Q2 of 2005.

And we had another good cash flow quarter, where we reported operating cash flow of $115 million.

GAAP earnings per share for Q2 were $0.10 compared to breakeven in the same quarter last year.

Non-GAAP earnings per share were $0.23 for the quarter, compared to $0.17 in Q2 of 2005, a 35% increase.

Total revenue for the second quarter was $359 million, compared to $321 million in Q2 of 2005, up 12%.

Product revenue was $232 million, and maintenance revenue was $93 million, and services revenue was $33 million.

Revenue mix by geography in Q2 was 48% North America, and 24% Japan, 18% Europe, and 10% Asia, as we demonstrated balanced growth across all regions.

One customer accounted for 13% of our second quarter revenue.

And in the quarter, approximately 76% of our product business was represented by ratable licenses.

Approximately two-thirds of our product revenue was generated from backlog.

And our contract life calculated on a dollar weighted average basis remained at approximately 3 years.

Q2 total cost and expenses on a non-GAAP basis were $270 million, up from $262 million in Q1.

Our non-GAAP operating margin in Q2 was 25%.

Up from 21% in Q2 of 2005.

And we continue to look for a non-GAAP operating margin of around 28% for 2006.

Head count at the end of Q2 was about 5100.

The quality of receivables remained high in Q2 with receivables 90 days past due at 1%, within our historical range of 1 to 3%.

Total DSOs were 100 days compared to 97 days in Q1.

We still expect DSOs to settle in to the mid to high 80s by the end of 2006.

Q2 operating cash flow was $115 million.

For 2006, we expect to generate operating cash flow of at least $425 million.

Capital expenditures were $20 million for Q2, and $35 million for the first half.

Keeping us on-track to spend approximately $75 million for the year.

We repurchased 5 million shares of common stock in Q2, at a cost of $92 million.

Cash and cash equivalents was $826 million at the end of Q2, compared to $873 million in Q1.

Stock-based compensation was $26 million for Q2, and for 2006 we continue to estimate stock-based compensation expense of approximately $100 million.

And our non-GAAP measures exclude stock-based compensation expense.

Now, I will turn to our outlook for Q3, and the year 2006.

For Q3, we expect revenue to be in the range of 350 to $360 million.

GAAP EPS should be in the range of $0.12 to $0.14.

And non-GAAP EPS in the range of $0.24 to $0.26.

For the year 2006, we expect revenue to be in the range of $1.425 billion to $1.475 billion.

GAAP EPS should be in the range of $0.45 to $0.53, and non-GAAP EPS in the range of $0.98 to $1.06.

Other income and expense for 2006 should be in the 43 to $48 million range.

We're working closely with our customers, and watching the environment in which they operate carefully.

In spite of the uncertainty in the environment, I feel confident that we'll make progress against our objectives to demonstrate growth, execute consistently, and achieve our operating targets.

Operator, we'll now take questions.

[OPERATOR INSTRUCTIONS] We will pause for just a moment to compile the Q&A roster.

Your first question comes from Jay Vleeschhouwer with Merrill Lynch.

Good afternoon, this is [Wu-Jen Ho] for Jay.

Mike, can you comment on the design requirement demands from market, other than consumer and mobile?

For example, automobile and imaging?

They're very similar.

The mixed signal content is high especially in Automotive where you have a lot of electro mechanical devices.

They are also driven to value integration.

They may not be the first always on the most advanced process, because they try are trying to prove their reliability, and the reliability considerations are extremely aggressive, like literally zero defects per million, but what really is much more a value of the verification as it turns out, because what you are trying to do is architect in the goodness, and that's a very powerful approach, when you take it and you do it correctly.

So both of those segments are very, very interesting to us, and you may remember that we actually consider targeting kits into the automotive as a declared vertical next year.

Right.

And in terms of the kits, are there one or two of the kits that have, that you've introduced so far that you think might have especially stood out, out of the rest?

Well, it is a good question.

You know, what happens is some of the kits are methodology foundations, like the analog mixed signal one.

The ones that are probably particularly interesting, and you know, they require, this is a journey, not a destination, are the ones that are more vertically integrated.

So I'm very excited about the things that we're doing with the RF incorporation.

We released RF SiP.

Our packaging in general is a good vertical integration.

And the way you can look at those if you are not a techy like me, is look at ones that contain verification content, because that's the inclusion of planning through implementation, and I think that, you know, what we have on our road map, I'm very excited about.

Okay.

Now, Cadence has released pieces of that contain thus far, including Chip Optimizer.

How have these done so far, and what's the schedule for the remaining pieces?

We had been releasing it, and as you know our DFM strategy is very thoughtful, and structured around big customer engagements, because you're kind of comparing notes on what they know or what may be special to them, with how we can help them solve those problems.

The Chip Optimizer is an excellent example with IBM and ATI, and you're right, we did release the RET technology, we have got kind of a continuous stream of those coming out, and the PVS is an excellent foundation for being able to add and innovate technologies on top of it.

So they kind of come as they go, and I don't have anything to project for you.

That would be maybe giving so much insight in some of the special customer engagement.

But they are many and they're deep.

Fair enough.

And what products if any underperformed, or generally speaking to which mature segments are you most exposed to?

I don't know.

To tell you the truth it might sound kind of goofy, I don't think we underperformed anywhere.

Bill said it very nicely across geographies and across product lines it looked good.

The one the most mature are in the full custom analog mixed signal, and that's why I want to keep in front of us the Virtuoso platform.

And that's just marvelous to see what the teams have done with that, and the customer response.

And even something that would be considered relatively mundane like the Package board for printed circuit boards, you can see, we have taken that technology and innovated on top of it, and brought in to the semiconductor packaging.

So I think the technologies and the products that we have are excellent fundamentals, and there isn't any of it that isn't capable of evolving and growing.

Thanks again for taking my call.

Your next question comes from Harlan Sur with Morgan Stanley.

Hi, guys.

Good afternoon.

And congratulations on another well-executed quarter.

A question for Mike and Bill.

You've talked about moving out the bookings cyclicality as it relates to renewals, are large opportunities, and in speaking with some of your customers this quarter, you know, we got the sense that several of those customers that placed large orders in the second half of last year, are buying more this year.

So it seems like your strategy is working.

Maybe you can just give us your view on whether or not it is working out the way that you envisioned.

This is Bill.

I think when we talk about what our strategy was, and what we expected the results to be at Analyst Day, we were thinking that we should see continued strong growth in verification, we should also see that trend continue where we're continuing to come back and show strength in digital, particularly in the high end, and I think we see steady growth in the custom business, and I think we're seeing all three of those, so that tells us that at least from the results we're expecting, you know, that is going according to plan.

And as we've talked in the past, the team in the field really is trying to address the customers' needs when they need things.

And so the ability to continue to work with them, and to sell when they need it, as opposed to trying to sell too much in big chunks in advance, I think is getting good play with our customers, and so that's why, you know, we're willing to be patient, to get them what they need, in particularly those three areas.

And then we're also continuing to work in what I say are the more greenfield areas of, you know, the kits, and the segmentation, because those are still early days, but they're seeing some value there, it is just going to take a little time for those to really show themselves.

Okay.

Great.

Certainly seems like you guys are executing to that plan, based on what we're hearing from customers.

Mike, a question for you, based, again on our channel checks in the quarter, we think you did particularly well with some of your large wireless semiconductor companies, so my question there is, what trends are you seeing within this sector of the market?

And you know, where are these guys leaning heavily on Cadence for support?

Is it verification?

Is it digital?

Is it AMS, or is it all of the above?

That's a good question, Harlan, and it is is kind of all of the above.

Particularly in the digital.

You know, there are customers that are characterized as doing very, very complex things, and we have a constant strategy of demonstrating our digital technology, and having it waterfall down, that means it debuts in most of the complex configurations, and that's a perfect target, and I think that's a very astute observation, that's a good example of the pull-through or across, where digital and verification go kind of hand in glove.

And these are customers that are many a times have microprocessors in big blocks, as well as RF blocks, and they're trying to make intelligent tradeoffs about how they structure those, and balance a chip, which is a miniature system-on-a-chip, and those are the kind of customers that really value verification, and kind of moving up that abstraction, and it is a pleasure to get to work with them on it.

Thanks.

And the last question for you, Bill, in terms of the guidance, you're expecting higher earnings on roughly comparable revenues in Q3.

I'm just wondering where is the leverage coming from on the expense side?

Well, I think we're always looking for a little bit of leverage, Harlan.

And so I don't think it is one particular area.

I mean we're all kind of watching where we're investing a lot of our growth is outside of the U.S., particularly these days in head count, and so I think we're just going to continue to get that operational leverage of, as our customers move to lower cost areas, we're going to get that kind of leverage, but that's just the way the business has been playing itself out, and that's the way it has been planned, so it is not a particular area, it is just across the board.

Okay.

Great.

All right.

Thanks, guys.

And again, good job on the quarter.

Thanks, Harlan.

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

Hi, thank you.

Can you hear me?

Yes.

Sorry about that.

Mike, just to follow Harlan's line of questioning, you're obviously executing well.

You've been showing good, real good year-to-year growth, 12-ish percent.

Helped I guess a little bit in the beginning of the year by Verisity.

Do you think you're gaining meaningful share against your larger competitors?

Or do you think this reflects an overall market updraft relative to the last couple of years?

And if you're gaining share, where are the principal areas of share gain?

Well, we're definitely gaining share, and you know, it is a focus element that we do, we're gaining in digital, in the historic and in common areas around simulation and verification, and you know, I think we've even got a good opportunity up in the synthesis, as we have been trying to evidence that, as much as we could in terms of testimonial, and we have lost count on how many designs that we've done with RC, so those are elements, but I think the biggest indicator for me, Raj, is that it is an example of a holistic approach we've taken, and the completeness approach, and so that whole idea of moving up the scale and verification and linking it, or inter-optimizing it with some of those pieces is evidence increasingly to our customers.

Some of them, it is a little bit slower than others, because they have got more historic incumbency maybe.

And that's a practical problem, as Bill said, we're going to be patient about that.

And between that kind of migration and the new projects that those customers are tackling across the board, we almost always see opportunity to go and engage in a new project, and I think that amounts to a lot of kind of scale-out that we can have, as time moves along, and it is a multi-part strategy that felt good to us when we laid it out, and it has been feeling good to us in the last quarters, and I appreciate you noticed in the execution.

I will just add a little bit, that I think we are seeing market expansion in verification.

We are, you know, putting some technologies that people are using more of, so I don't think it is just share, and that's part of the expansion, also, at some point up into the systems area.

So emulation continues to do well, and people are finding new ways to use it.

So it just adds a little color there.

That market I think is growing probably faster than implementation, which in most cases I think is the share piece.

If I could follow up a little bit, you've mentioned both in early June at our conference, and today on this call, that you're seeing design starts slightly up, which is, I think, the first time in a number of years we've seen design starts pick up, sounds like around 90.

Is it your sense that there is an actual EDA investment cycle going on, and I guess the question is, will it end at some point?

Or is the run rate of business reflect, you think, something more like a new steady state for the industry, post the impact of the downturn, which lasted, you know, a couple of years at least in this sector.

Bill probably has a perspective.

Mine would be it's too early to tell.

And I think Raj, the numbers talked about in the industry, there is kind of a bifurcation around those customers who are rushing to the more advanced geometries, and some of those who are staying more fixed, and even up to 130-nanometer, particularly around the analog.

And certainly, we could take it either way.

The early evidence says if everyone follows the industry leaders, maybe that is a massive investment cycle, and if it continues to stay bifurcated, then you better be able to sell across the whole continuum, and that's why the holistic approach that we have, and kind of the whole segmentation or the conscious part of the strategy, because we can waterfall in from the top, and take advanced technologies and methodologies, and apply them in kind of what would have been a traditionally backward way, at 130-nanometers for power or die size, and I think it could, it should bode well for us in any case, and certainly, if there is a massive EDA investment cycle, then I think we may be leading it.

This is Bill.

I guess the color that I would add is that a lot of the design starts continue to be around consumer electronics and wireless, and I think that -- I don't know if it is trend, but clearly there is a lot of activity there, and so I think that piece of the business looks like it is going to be driven for a while, as everyone tries to connect and build out that infrastructure.

And as you know, that plays pretty well into our mix signal capability and our verification capability.

So that's in terms of the design starts, what we try to, as we peel the onion back, see how that leads to our business.

Thanks, Bill.

And I've got one last one, and then I will just listen for the answer.

You bought back near $100 million worth of stock.

You're generating a lot of cash now.

What is your buyback plan?

Are you going to try and take, keep taking shares down?

Are you going to step up the buyback?

How should I think about buybacks as we move forward?

I think as you know, we had the authorization back in Q1 for $500 million, and we have been taking that down really Q1, Q2, and we think currently at this price, that it is an opportunity to continue, because it is a pretty good value.

So operationally, we are going to keep going, generate the cash, and I think you should look to see us at these prices continue our program, because we think it is an opportunity for us to get some value and use that cash.

Thanks.

Your next question comes from Tim Fox with Deutsche Bank.

Thank you.

Good afternoon.

Bill, I guess just slicing this a little bit differently on talking about the successes around the top line, could you talk a little bit about your run rates, and some of the efforts you have made in breaking some of the larger contracts up?

Are you seeing renewals coming in at a meaningfully higher level than you expected?

You know, really what is driving that strength in booking?

Well, I think it starts with the technology, and we're able to deliver to the customers.

And as we mentioned, I think we are probably in the strongest position that we ever had with all of the different pieces of the technology.

And so customers now can add some verification that they may need, or they haven't used enough, so we see customers adding that capability.

While they're starting to evaluate some of our newer offerings, say in digital, and they would add that next, and so in many cases that I'm aware of, we have seen work, particularly with the larger customers, move into multiple sales engagements over a year, and over a couple of years, where we have active campaigns, working with them, and the patience and the ability to solve their problems when they need it.

So it is that strategy that Tim and the field are working on, and I think it is working well with customers, and again, it is the technology and the patience seem to be paying off.

And not trying to get into specifics around quarterly bookings, but should we still think about your overall bookings rate on an annual basis, to relatively closely match revenue growth?

Is that the right way to think about that?

I think it is pretty close.

As I mentioned at the beginning of the year, our objective really is to try to improve our run rate with our customers, so it is not just to build backlog.

So I would be satisfied even if our backlog was flat to last year, as long as we could see those additional pieces of business coming, you know, in the next year, 1.5 years, as opposed to just trying to, you know, build bookings in advance of revenue.

We're trying to keep them pretty well balanced.

Okay.

And you know, given the strength in the top line, and just looking at your cost structure, I guess we had modeled costs coming down a little bit, and just implied in your midpoint of guidance, you sort of, you beat by a penny, I'm just wondering, was there anything outside of say commissions, that drove the cost structure to be a little bit higher than your implied guidance from last quarter?

I think you will see a little bit of variability, Tim, as we do have some of the financing costs, when we sold some receivables.

That can have a tendency to move around a little bit.

And that drove a few million dollar increase from Q1.

But other than that, it is pretty steady as we go, in terms of just the operational spending.

And we do a lot of tradeoffs.

We invest, but on the other hand, we're always looking to where we can see some efficiency.

Great.

Thank you.

And then one last, actually, if I could, just you've been talking some time about segmentation in your kit strategy, and hoping at some point you could give us a little bit of extra color, or at least some metrics, around how those are increasing your business.

Are you at the point now where you're getting a better sense of how those are being taken up in the market, and whether a certain percentage of your business is being driven outside of your core strategic customers, by the segmentation strategy?

It is something we are looking at, Tim.

I would say still more anecdotal than it is in terms of data or trend driven.

But I think the anecdotes are that for the segmentation, as we would have expected we're seeing, somewhere I would say in the mid-teens, in terms of the GXL range, for example, for our digital line which is the one that we have now out for two quarters, and probably a little bit, maybe less than that, on the L side, and the predominant part of the business continues to be XL, which has been the workhorse for digital for us.

So that seems to be where we're going.

We will need some more trends to see how that really plays out across the rest of the product areas, and through digital, as we get better data.

On the kits, again, that's probably a little bit early as well.

In terms of the anecdotes, we are trying to track to see customers who are using the kit and then really what kind of pull-through we're getting.

Because that's where we will see the leverage.

But based on looking at the geography data, which is this is one of the more, one of the tools that our geo accounts will have, because this is towards the mid small accounts for the most part, we're seeing continued very good strength in the geos, and so I think this tool, even though it is early, will get some pickup there, and as we get pull through, I will share it with you anecdotally, and I will try to get some information together for CDNLIVE! in September, but the trend data will probably be, you know, more toward, as we looked at 2007.

That's helpful.

Congratulations.

Thank you.

You're welcome.

Your next question comes from Matt Petkun with D.A.

Davidson & Company.

Hi, good afternoon.

A couple of questions.

First, Bill, just looking at your guidance, you guys have put up through the most recent quarter 8 straight quarters with year-over-year revenue growth in the double digits.

The midpoint of your guidance for Q3 would imply 5% year-over-year growth.

If we're trying to use the second derivative to kind of gauge the overall strength of the cycle, if there is a cycle, what should we read into that guidance?

Matt, I don't think I would try to read too much into it in terms of the mathematics.

I think simply, you know, we had a good strong growth last year, compare is a little harder, and I think we just want to make sure that in going into the environment, that we're just a bit cautious from everything that we are seeing out there.

I don't think that we're expecting the business to slow down.

On the other hand, I don't think we want to get ahead of ourselves.

Okay.

And then the upside that you guys delivered to your previous guidance for Q2, is that maybe some of what is pulling from your expectations for Q3?

Maybe the few deals renewed ahead of expectations?

No, I don't think this is anything that would be moving in, and if anything, I think we're just again trying to be conservative, as we look at the business, and that would be the outlook we took at the beginning of the year, and I think particularly now, as the market is trying to digest the economy, and everything else, it is just good for us to be steady, and if the time is right with customers, and maybe we get a little bit of extra business done, and if not, we will be patient and get that extra value when it is ready.

Great.

And then Mike, just a question, you were talking about some of the new business models that may be emerging in EDA, and it is pretty clear, both from your offerings like PVS, and a lot of the back-end requirements in the industry, as well as people looking at things like statistical timing for 45-nanometers, how do you see the environment for the actual CPU, the hardware that is going to be running your software changing, and is there perhaps a new business model available for you, to capture some of the new kind of system requirements that will be required to actually do all of this work?

It is a good insightful question.

Our stuff is structured to run across many different processors.

That is, to take advantage of the scale-out that happens in some of the server configurations.

So we demonstrated a year ago at DAC, scaling of the router across 20 different CPU servers at a time, so it is basically scaled linearly.

And that itself is thoughtful on our part, because we're anticipating that the computing dynamic requirement and opportunity exist to be able to differentiate that way.

The illusion that you have around some of the emerging geographies, where you know, maybe they want to have access to the stuff without owning it, is more of a capacity on demand environment.

I'm very excited about trying that.

We don't necessarily have to do it ourselves.

We could very well do that with a big partner or two that is in the computing business.

But the whole motivation there is to do it so that our customers, it makes it easier on them, and if you consider an emerging environment where an engineer might be getting paid a fraction of what a U.S. engineer does, to arm them with up to $500,000 worth of tools is hard, so if they can pay kind of as you go, as opposed to absorb the whole mess to start off with, that is a pretty exciting value proposition, and we needed to have some scale of, or segmenting of our product line to really make that amenable.

Than that's why there is an order to it.

That's why we segment it, like the digital offering and such.

So I think we're setting ourselves to do that.

And the kit is an essential element of that strategy, and just watch it go over time and see how it evolves.

Thanks, Mike.

And final question.

What should we be reading or lack there of of your presence at DAC this year, should we read into it you are stepping away from the industry as a whole, and if so, is there a new direction you would be headed in?

I would hate for you to take that.

That we were all over the DAC, I was wandering around the show floor myself.

We're prominent there, and I particularly think, that that conference has continued to focus itself more as a technology conference, than a trade show extraordinaire, and you know, many of our customers think about, it and one of our big customers wants to have a conversation with me or Kevin, he gets it, he doesn't have to come to DAC to do that.

And we augmented that with the CDNLive! and the technology toward those events have been very, very well populated, extremely well responded to by the customers because we get a focused time with them, and a time of a day, or maybe a day and a half, they get everything, they see the executive base across the board, we bring big technologies, and so on, and so on.

So I think that as DAC goes, it continues to be a valuable technology gathering, we're prominent there, we're going to stay prominent there, and we are going to supplement our customer engagements with CDNLive! and Tech On Tour, and we will just see how the industry continues to evolve.

Okay.

Thanks a lot.

Sure.

Your next question comes from Sterling Auty with JP Morgan.

First, just two house-keeping.

Bill, in the other incomes, can you just give us some components, is it just higher interest rates that is driving other income?

Yes, Sterling, higher interest rates, predominantly, we also did get a couple million dollars from investment sales.

It just happened, you know, to us.

So it was a long-term investment that just got changed.

So other than that, it is really interest income driving the majority of the increase over time.

When you say long-term investment, a couple million dollars, I'm not clear.

Was there something that was sold or matured and flowed through?

Something that was sold in the long-term investment area for a couple million dollars.

That would be the only thing in the quarter that would not be interest income driven.

Okay.

And as you talk about the operating expenses, operating margin targets, you mentioned G&A and the fluctuation around financing, but can you comment a little more specifically on the R&D expenses and controls, and how you're managing that, and also a little bit on sales and marketing, in terms of what the plans might be to build out on the go to market strategy?

Well, sure.

And R&D, as Jim indicated last December, there is a number of programs that have been worked to continue to improve our operational efficiency.

Those have been ongoing.

And we're seeing benefits.

It is as simple as going through the operating engines.

That's not a simple task, but that's been ongoing for the first half of the year.

We're seeing those results in the second half.

Those additional resources are being deployed back into new development.

So we're getting very good leverage, from people who don't have to do things that maybe not the most efficient.

We're also seeing, you know, the continued migration in small pieces of customers to newer geographies, so you're seeing some of our R&D resources being added in those newer geographies, both through development to serve those customers, and that's with a lot of our head count growth has been, particularly in Asia and India.

And there are other operational things that we're continuing to do in R&D, but that's where we're getting leverage, and that's continual, and you will see some of that, that's why we can do more, and you're not going to see the R&D expense number grow as fast, or stay relatively flat.

But we are adding people.

We're just doing it in an efficient way.

I think the field is very much the same way.

We're seeing, you know, the field migrate towards the customers, they're also getting leverage from their programs in areas like support.

And being able to leverage some of the benefits in R&D.

So we don't have to hold our customers' hands as much, because the technology is stronger, and we're going to start to get some leverage from kits.

And still provide customers what they need when they need them.

And simple areas, such as services, you know, that business is very well utilized, and it is being very steady, and is developing the customer benefits without having to spend a lot of time in growing that.

So across the board, I think efficiencies we're always looking at and making trade-offs, and that's where we're getting our operating leverage in the two biggest head count areas of the Company.

And then Mike, from a big picture level, you know, custom IC, digital, they both seem to ebb and flow, in terms of being good or not in a given quarter, but verification has been the kind of the most stable contributor to the success over the last however many quarters.

Just from your sense and talking with customers, and looking forward, how much legs does this kind of verification lead have for Cadence?

Two comments there.

One, the ebb and the flow on a quarter basis across digital or custom is exactly the reason why we try to look at it on an annual basis, because they're both growing nicely, especially the digital stuff, and I don't think that is all share game, but there is certainly some share shift, it is also capability.

The verification, you're right.

The reason we termed it an adjacency, is because an old computer designer here knows how important that is to being able to get it right, before you implement it.

We used to say correct by construction.

Impacted architecturally, you can make bigger and bigger gains.

And I think we're just at the tip of the iceberg of what we can do.

Now, that doesn't mean that everyone who says they have something in verification shares the same passion or success that we do.

Because they could tend to have point technology niches, and if you can't put those pieces together in a meaningful way, at a minimum, you will commoditize yourself and at a maximum, you will ride the wave of the guy who takes the holistic view, which is us.

I think we have taken a very thoughtful and structured approach to doing it.

We laid it out.

And the integration of Verisity was a very calculated thing.

It behaved just like Bill and I told you it would.

And I think there is an awful lot of opportunity to up that abstraction, and that ought to be a powerful contributory our business, as Bill laid out on Analyst Day.

Last question.

Last year, it was Synopsis with the IC compiler, this year it is kind of Magma with Talus and some other new product introductions, and can you just comment in terms of how you see the new competitive introductions from the product side, relative to, you know, the current product set from Cadence?

I haven't seen anything that surprised us.

So that's good.

I mean, a thoughtful person is doing competitive intelligence.

And our road map process is even more disciplined now than it was two years ago.

Our features, as we've been able to size them up, are extraordinarily competitive at where we thought they would be, and our road map is rosy, across all of the different pieces of our business.

So hey, I like our road map.

It is supported by excellent customer feedback.

And in some of the small niche areas, where, you know, maybe we could tune it up a little bit, they are either in flight, or we're taking the feedback, and we're concentrating on them.

And so, I think you can only really react to what the competitors do, based on what you think is going to happen.

And that's why we take such a structured and thoughtful promotion about the road map, that's what leadership companies do, we are the leadership company in the industry, in our industry, and I think I like our chances for continuing progress across all product areas.

Thank you.

Your next question comes from Rohit Pandey with HSBC Securities.

Thank you.

Bill, you spoke about an uncertain environment.

Can you elaborate on that, like what uncertainty are you seeing from your customers outside the macro talk?

Rohit, I think that's why we indicated that there is, I think uncertainty that the market is seeing in the semiconductors, and there are macro uncertainties that we've all looked at, in terms of what may happen with interest rates and energy costs.

But as we then take a closer look at our customers, we have been seeing steady increases in R&D spend, which is to me one of the most important indicators, and that seems steady at the high-single digit rate.

So we haven't seen customers change behavior there.

And then the other area, as we look at design starts, and just talking to customers, we haven't seen them change their behavior, in terms of those that need to move fast, to new geometries are doing it, those who need to get products out quickly and competitively are doing it, so I think what we're couching is that the market is saying that there is a lot of uncertainty, and we're telling you we're paying attention to that, and in particular, we're paying attention to our customers, but we haven't seen anything that is making us change our outlook, and our customers haven't told us anything that is going to change the way we behave, and work with them.

And going to the guidance, actually, the midpoint of the annual guidance is a little below Consensus.

Are you trying to be conservative, or is it just uncertainty you're trying to plan there?

No, I think again, I think we're trying to be conservative.

As we do better, we expect that to flow through.

And we're not reducing our second half outlook as we outperform, that's something that we're adding, so I would take it as conservative, in an environment where the market tells us, we should just be paying attention.

But operationally, things haven't changed, the fundamentals are good, and we continue to plan to execute, or to execute to our plan.

You had some cash paid for business acquisitions this quarter.

What was that?

We will always have some small activity that we just don't talk about, because in some cases, it is payments on earn-outs, or prior acquisitions, and some cases it is some innovative technology that just is underneath the radar, it is not big enough to talk about publicly.

In many cases, some of the smaller stuff is in the areas around DFM, as people would expect, so I guess that's where I would say that the investment is happening, and when we have products to bring out, that's when we will talk about the technologies associated with those.

But what you saw this quarter, was it acquisition or was it an earn-out?

I think we saw a mix across both.

Some technology that we acquired.

And some payments for earn-out.

Okay.

And just the last one, on the stock option expense, it was lower this quarter, primarily, was it the lower stock price, or something else?

No, I think it has been pretty consistent with what we expected in terms of the, you know, the FAS 123-R expense.

We had indicated for the year we thought it would be around 100 million, and cumulatively, I think we're sitting right about that level.

So no, it is just pretty much as we had expected.

Okay.

And we are managing of course carefully, the amount that we give out, and I told I think people, we are trying to manage to 2% net, and we're just doing that very thoughtfully.

Okay.

Thank you.

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

Yes, good afternoon.

Thanks for taking my questions.

I guess first a question for Mike in terms of the mix by geography, Japan was strong this quarter, would you expect that to continue in the second half?

Japan was a target for us.

It is a very interesting place in the world, because have you a lot of computer companies, not just semiconductor companies, so there are system designers, they relate very nicely to our segmentation, and moving up into the verification adjacency, the team there is incredibly strong that we have, and it makes for a wonderful combination of building on a base that we had, and I think continuing to do that.

It has not only been strong this quarter, though, it has been strong the last few quarters.

Okay.

That's helpful.

And then in terms of DFM, there is a lot of talk at DAC on DFM.

Do at what point do you think DFM, in terms of a percentage of revenues will kind of break out of that 8 or 9% level?

That's a good question.

I think it could be a while.

And the tricky part, though, for you guys, is that you may have companies whose total life projection is around DFM, and in our case we're a lot more integrated across our implementation flow, and I think D in DFM stands for Design, and it is a big D, and so you want to get it right the first time, as opposed to to all the way to the end to manufacturing and measure it, and you did a lousy job.

So our approach is very inter-operable with the implementation flows that we have, and that could mask itself a little bit.

I think the third thing to watch out for in a DFM, I don't think it will be just the license subscriptively, I believe there will be opportunities to participate in a risk/reward proposition, as customers do, as they try to constantly increase yield, it's early days to be able to accrue if that's the case, and it probably requires a big mature entity to work with, to have that level of sophistication.

That's why we are out trying it, and taking our current prowess as a catalyst, almost a predisposition for it, and it will be harder to measure that, because you just won't see how many tools got sold into what by Thursday.

But those are the three things that I would think about.

It is going to be a long maturing category.

Because it isn't a category now.

It is a collection of points of light.

And it is going to take someone to bring it together, by method, methodologically, I was going to say, to really have it have a huge impact on the customer's productivity and output.

Okay.

Thanks.

That's helpful.

Well, we have time for one more question.

Your next question comes from Vishal Saluja with Seligman.

Hi, Bill, this is Vishal.

Hello.

Two quick questions for you.

First, on the current portion of deferred revenues, can you talk about why that was up high single digit, and what generally goes into that category?

And how we should expect that to trend going forward?

And then on the share count, I see, correct me if I'm wrong, but the share count was still up quarter-over-quarter.

And so was that primarily because the buybacks were tilted towards the latter part of the quarter?

And where should we see it sort of on a quarter end basis?

Let me answer your second question first.

Yes, the timing essentially what we saw in the quarter was exercises in the early part of the quarter and the stock buyback a little bit more weighted towards the end of the quarter.

So that's why the share count went up.

It was just the weighting of what went in, went in earlier, and what came out, came out later.

Okay.

In terms of the deferred revenue, that is really a mix of different things.

There's some customers, as we do more subscriptions, will pay for those in advance of taking revenue, so we will see some of those depending on the individual negotiation with customers, some increases in deferred revenue, where we get payments in advance of revenue.

And that's something that we have been working for some time.

It is just to encourage cash where it makes sense.

And then we will continue to see some customers also in the area of maintenance, pay that, and in some cases before the revenue gets taken.

So just as simple as that.

Where we have payments in advance of taking revenue, and those are hard to predict, because it doesn't always go in a trend, so there could be some variability in deferred revenue.

Generally, my assumption is, it is pretty steady to slightly up, but I've seen it vary based on just the customers making payments, with different operating schedules.

So just a minor clarification on that, so on what basis do you decide, whether it goes in the current portion or the long term portion?

Oh, sure.

If it is expected to turn to revenue within one year or an operating cycle, it goes into short term, if it is something that is going to be coming out greater than a year, it goes into long term.

Okay.

So all things being equal, if it does trend up, it does add to your level of visibility coming into a quarter?

Yes, slightly.

Okay.

Slightly.

Thanks a lot.

You're welcome.

Thank you.

This concludes Cadence Design Systems second quarter earnings conference call.

You may now disconnect.