益華電腦 (CDNS) 2006 Q4 法說會逐字稿

Good afternoon.

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

At this time, I would like to welcome everyone to the Cadence Design Systems fourth quarter 2006 earnings conference call. [OPERATOR INSTRUCTIONS].

At this time, I would like to introduce Ms. Jennifer Jordan, Corporate Vice President of Investor Relations for Cadence Design Systems.

Thank you.

Ms. Jordan, you may begin your conference.

Thank you, Melissa.

And welcome to our earnings conference call for the fourth 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 discussions 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 September 30, 2006.

In addition to financial results prepared in accordance with Generally Accepted Accounting Principles, or GAAP, we also will 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 financial measures, and to both of our earnings press release and our Web site for reconciliations of GAAP and non-GAAP financial measures used in today's discussions.

Now, I will turn the call over to Mike Fister.

Thanks, Jennifer.

Q3 was a fantastic quarter for Cadence.

Revenue grew 14% over the prior year period.

For fiscal 2006, revenue grew 12% over fiscal year 2005, led by 20% or better year over year growth in verification and custom IC.

Before I get into details of the quarter and the year, let me give you some sense of what we see in the environment.

While there are a lot of changes in our customers' environment, design activity remains steady.

Industry forecasts for semiconductor growth in 2007 spans from 2% to 10%, with an average at around 8.4% The fastest growing segments continue to be consumer around 11% and wired and automotive each about 14%.

Analysts estimate semiconductor R&D spending growth in the high single digits for 2007.

Some activity at the 65-nanometer process node is picking up, an many analog customers are moving directly to 65-nanometers.

In addition, leading edge customers are already working at 45-nanometers.

The most recent evidence of this was in last week's news articles about Intel, IBM, and TI's advanced activities around the 45-nanometer node.

Still there are more nodes in production today than at any other time in history of the semiconductor history reflects the breath and depth of the semiconductor market and the challenges of managing the economics of timing, volume and demand.

Now for a few details.

During 2006, we introduced a significant upgrade of our custom IC platform, we continue to bring differentiation to our verification and digital platforms and we completed a segmentation of all of our products platforms.

Since the last time I talked to you, we've introduced cross platform capabilities such as our Low Power and Logic Design Team solutions, which helped customers manage the vectors of time to market, complexity, and productivity.

Both these solutions emerged from Torino, which is our next generation implementation technology.

The Cadence Low Power Solution is the first combined design, verification, and implementation flow for low power.

Industries' growing need for low power design is an important opportunity for Cadence.

Because low power design crosses several engineering domains, with our breadth of technology, we're uniquely positioned to offer an integrated end to end solution that supports the multiple design teams working on a single low power IC.

The Cadence Low Power Solution is the first complete system to capture low power design intent and manage it seamlessly from architecture to manufacturing.

Because we believe standard data formats will accelerate the adoption of low power design methods in the industry, we've also contributed a key piece of technology, the so-called Common Power Format, or CPF.

It is a larger industry standards movement.

In this case, the silicon integration initiative, or Si2.

This fulfills a commitment we made last summer.

Early adopters of the Cadence Low Power Solution have already saved significant time and expense.

Anecdotally, our solution identified major architectural challenges required for the success of low powered designs, much earlier than they would have been found using other methods.

The Logic Design Team Solution combines technology from our Incisive verification and Encounter digital design platforms into an integrated front end environment for logic designers.

Today most front end logic designers have to contend with a portfolio of tools from multiple vendors.

We believe they are looking to streamline their design environment and increase the predictability of the product development process.

Increasingly, our ability to deliver these complete solutions is becoming a significant differentiator for our customers in winning business for Cadence.

For example, in the fourth quarter, NEC electronics significantly expanded its use of the Encounter low power digital flow.

As we had anticipated, functional verification was the fastest growing segment of our business in the full year, driven by our segmented Incisive verification solutions.

No one else in the industry offers as complete and robust a solution for verification management from planning to closure.

In the fourth quarter, we released our enterprise system level, or ESL verification capability.

ESL combines automated hardware software co-verification, system wide closure management and high performance SystemC simulation and hardware.

Another step up the stack in terms of helping hardware, software and systems engineering teams manage the risk caused by system complexity.

We achieved a major milestone with respect to System Verilog adoption within the Cadence customer base.

Over 150 customers are now using our system Verilog solution with Incisive Design Team and Enterprise offerings, up from the 40 early adopters about a year ago.

Many of these customers are deploying a mixed language environment, leveraging e, System C and System Verilog to meet the full breadth of demand of verification across their organizations.

And we also extended our lead in emulation by improving ease of use, performance and integration, with a release of Xtreme III and Palladium III in the fourth quarter.

Taking advantage of this improved capability, a leading graphics processor company adopted Palladium III in the period.

In Custom IC, we saw a strong year over year performance.

Very successful early adopter program for our new Virtuoso platform helped seed demand, which continued following the general release in October.

As I mentioned before, this is the most significant upgrade to the custom product line in many years and clearly helped us to expand our business to many customers in the fourth quarter.

As an example, Qualcomm selected the new Virtuoso platform because it recognized that success at 45-nanometers and below will require a breadth of technology and a level of integration that only Open Access and Cadence could provide.

I believe this is a nice harbinger for the custom upgrade cycle this year.

Custom simulation added over 80 new logos in 2006, reflecting an increase in customer demand driven by smaller geometries.

More wireless design starts and increased mixed signal content.

We delivered great digital technology during 2006, putting us in a position to have a much greater differentiation in 2007.

Once the solutions like lOgic Design Team, the Cadence Low Power Solution, and the integration of our Catena technology in Encounter GXL.

We had a very successful entry into the timing sign-off market with the Encounter timing system, or ETS.

A number of customers and the speed at which they are integrating ETS in their design flows is very encouraging.

During the fourth quarter, Renesas adopted RTL compiler for its customers' ASIC design at 90-nanometers and beyond.

Hitachi began consolidating its digital flow to the Encounter platform.

And IBM, that is already -- has announced that it has incorporated RTL compiler and Encounter test technologies into the IBM 65-nanometer ASIC design kit.

To design for manufacturer ability, our strategy of tight integration in the design environment, I sometimes say a big D in DSM remains on track.

Consistent with this, we have integrated Chip Optimizer into Encounter GXL, and the Space-based router into Virtuoso GXL.

Our focus on Kits this year was primarily in the wireless market with small and midsize customers seeking to speed up their adoption of new technology and design method.

However, kits are not limited to small customers.

Freescale Semiconductor has deployed the AMS methodology kit across its design centers worldwide.

Freescale anticipates that the verified methodologies within the kit will help it more rapidly document and deploy these leading-edge mixed signal design flows, reducing flow development time by up to 20%.

In the Silicon, Package Board business, we had a strong performance for the quarter and the year.

In the Advanced IC Packaging market segment, we continued to increase our market segment share position.

Zarlink Semiconductors, a communications company, selected Cadence's SiP solution and RF SiP methodology Kit, recognizing that these solutions could quickly raise the skill level of their entire team.

In addition, the industry's top four Assembly and Test providers worldwide is standardized on Cadence.

Overall, I'm extremely pleased with the results of the fourth quarter and for the full year 2006.

I look forward to sharing what we have planned with you, what we have planned in 2007 at our analyst day in New York City on February 28, and now I will let Bill take you through some numbers.

Thanks, Mike.

Cadence completed another successful year with strong financial results.

For the year, total revenue was up 12%, non-GAAP operating margin improved 300 basis points to 27%, and operating cash flow was $421 million.

Book to bill exceeded one for the year, and backlog grew to $1.9 billion.

We expect backlog to grow again in 2007.

For Q4, GAAP earnings per share were $0.16 compared to $0.08 in the same quarter last year.

For the full year 2006, GAAP earnings per share were $0.46, compared to the $0.16 earned in 2005.

Non-GAAP earnings per share were $0.38, for the quarter, compared to $0.29 in the same quarter last year.

Up 31% year-over-year.

For the year, non-GAAP earnings per share increased 30% to $1.08, from $0.83 for 2005.

Total revenue for the fourth quarter was $431 million, compared to $378 million in Q4 of 2005, up 14%.

Product revenue was $298 million, maintenance revenue was $98 million, and services revenue was $35 million.

Revenue for the year totaled $1.48 billion, up 12% from $1.33 billion, in 2005.

Revenue mix by geography in Q4 was 60% for North America, 19% for Europe, 10% for Japan, and 11% for Asia.

Business levels exceeded plan across all geographies for Q4, and 2006.

One customer in North America accounted for 28% of revenue in Q4.

Approximately two-thirds of the revenue for this customer was up front, and one-third from backlog.

No customer accounted for 10% or more of revenue for the full year.

In the quarter, approximately 83% of our product business was represented by ratable licenses and 74% for the full year.

Approximately two-thirds of product revenue is generated from backlog for 2006, a trend we expect to continue in 2007.

Contract life, calculated on a dollar weighted average basis, was approximately three years.

In Q4, total cost and expenses on a non-GAAP basis, were $290 million, up $25 million from $265 million in Q3.

The increase was primarily due to higher commissions and incentive compensation, driven by our strong operating results.

The non-GAAP operating margin in Q4 was 33% and 27% for the full year, 2006.

For the full year 2007, we are looking for another 300 base improvement, basis point improvement to approximately 30%.

Year-end head count was approximately 5200.

Double DSOs for Q4 were 81 days, better than our target of the mid 80s.

The quality of our receivables remained high with receivables 90 days past due at 1%, the low end of our historical range of 1 to 3%.

Operating cash flow for Q4 was $205 million, compared to $177 million in the fourth quarter of 2005.

For the year, we generated $421 million, in operating cash flow.

For 2007, we expect to generate operating cash flow of approximately $450 million.

This year, we are beginning the construction of a new state of the art engineering building in our San Jose campus.

Reinforcing our commitment to the San Jose community, and allowing us to consolidate on a single location.

The building will take approximately two years to complete, and is funded by the sale of a portion of our San Jose campus.

The sale closed last week for $47 million.

Capital expenditures for 2006 were $68 million, yielding free cash flow of $353 million.

For 2007, we are targeting normal capital expenditures in the $75 million range, plus $22 million for work on the new engineering building.

Cadence repurchased 12.9 million shares of stock in Q4 at a cost of $236 million, including 5.9 million shares repurchased in connection with our 500 million convertible bond offerings in December.

Approximately $528 million remain under our current stock repurchase authorizations at year end.

We intend to use the $100 million that remains from the net proceeds of the convertible notes issues to repurchase stock.

In conjunction with the new convertible bond offering, we also repurchased approximately 45% of our convertible bonds due in 2023, which removes 12.1 million shares from the diluted share count beginning in Q1.

The weighted average diluted share count for Q1 should be in the range of 290 to 294 million shares.

Cash and cash equivalents were $934 million at year-end.

Now, I will turn to our outlook for Q1, and the year 2007.

For Q1, we expect revenue to be in the range of 355 to $365 million, reflecting the normal seasonal decline from Q4.

GAAP EPS should be in the range of $0.10 to $0.12, and non-GAAP EPS in the range of $0.23 to $0.25.

For the year 2007, we expect revenue to be in the range of 1.575 to $1.625 billion.

GAAP EPS should be in the range of $0.69 to $0.77, and non-GAAP EPS in the range of $1.26 to $1.34.

For the seasonal pattern in 2007, we expect to generate 22 to 23% of annual revenue in Q1, 22 to 25% in Q2, 23 to 26% in Q3, and 28 to 31% in Q4.

Other income and expense for 2007 should be in the range of 28 to $32 million.

As I look back at 2006, and forward to 2007, I'm pleased with the growing strength of our technology and our track record of achieving our operating goals.

Looking beyond 2007, I believe we'll be able to continue to grow our business, while expanding operating margins beyond 30%.

Operator, I will now take questions.

[OPERATOR INSTRUCTIONS].

Our first question comes from Jay Vleeschhouwer with Merrill Lynch.

Good afternoon.

Bill, could you comment more on the one large customer in the quarter, 28% of revenues, is unusual, both as proportion certainly in terms of the absolute amount, the upfront portion of that, also seems unusual, given the targeted model, anyway, and we saw something similar in Q3, of course, with the below nominal model range for subscription business, so just help us understand why this is not an ongoing divergence from the model, as welcome as it might to be have a large customer do this much business with you and then some follow-ups.

Sure, Jay.

Well, I think the thing that I focus on that we're making real good progress in demonstrating the differentiation and the value of our solutions at a number of our largest customers.

I think you saw that in the past, in Q4, and I think you've seen it this year.

So I think that's the first point, is that we're having good success with some of the larger customers in the industry.

The other point that I would make is that there was a portion of this particular customer's revenue that was up front, two-thirds of it, as well as a third was coming from backlog.

And as we look at the model, we traditionally will have about two-thirds of our revenue coming from backlog, and we will have about a third that is generated in the quarter.

And we're still staying comfortably within that model.

And as you saw, based on our total bookings, which you can imply from the backlog growth as well as our revenue growth, that we had a banner year, as well as keeping our model with 83% of our bookings in the fourth quarter being ratable.

So we're right within our target range, and for the year, our ratable percentage was 74%.

So I think the model is holding real well.

I think what you are seeing is occasionally we will have success with a big customer, and that's welcome because we hope to have success in the future with other large customers, and still operate within the model that we have been working for the last three years.

What's your forecast for the backlog increment for '07?

Do you think you can grow it again by at least another $100 million?

And Mike, when you look back at 2006 in the entirety, at the components of growth, how would you distinguish the contribution from either additional license capacity, just more seats, and users, versus pricing, the packaging, incremental payment for new technology?

Jay, let me just start off on your question on just total business growth for 2007.

I think one of the things that we try to do is plan conservatively, so we're not going to go out and try to get too big of a stretch, you can see in our revenue range for 2007, that it is going to be in the mid -- the midpoint is around 8%, and we do that consciously, because we think that the planning model gives room for our team to evaluate opportunities with customers, and take the business at the right time.

So I do expect we will grow our backlog next year.

I'm not going to put a specific number on it.

Because I think it allows us, like we did this year, to work with customers, to find the right time.

We think we will win, but it is better to plan conservatively, hit our model and then have the opportunity to overachieve, if we see that that is ready for us, and I think you've seen that we can do that.

Hey, Jay, when I look back at 2006, I concur, this with what Bill said, when do you these consolidations, every once in a while, you land a monster.

And those things are going to come and go as we do, and in the biggest companies, those are very significant, and it is not just a seat expansion, it is an expansion of the business, sometimes it is a market segment share shift position for us, but the ones that are I think the most telling of the way the industry is going to go are the progress that we made in expanding the universe and the whole verification segment was that way.

What we're doing with analog and moving into the RF and the microwave region is that way.

And I don't think we get any credit for it but what we're doing down to the manufacturability of the chips, and the pro-action and the design environment, is that way.

So there is a core component of business that we have -- Bill and I have constantly pointed out that is fairly linked to the average R&D spending, and that is going along nicely, but we're growing faster than that, constantly, that through last year, and all through my time here, and I think we've just scratched the service of where we can go.

And then lastly, what's going on in Japan that was a fairly low percentage of total revenue this last couple of quarters?

There, I just comment, and as I talked about the geographies, in Japan, in particular, we beat our plan across all geographies in 2006, and quite frankly, in Japan, it is the highest business level we've ever achieved.

So the business is growing very well, and as you know, we're focused primarily directly with the top 11 customers and we're continuing to have very good success also with our geographic base there.

We will see the normal seasonality with large customer contracts, and so there is some volatility between regions, as well as sometimes between product lines but I think that is really what we're seeing in Japan, good traction across the board with the Japanese customers.

The testimonials from Hitachi and NEC bode very nicely for us, I'm super excited about what we've done there.

And that part of the world is expanding, Jay, as kind of a percentage of the law of large numbers and the fourth quarter was huge, as a relative piece of the business and that's the fraction that Bill was pointing out.

Banner year in Japan, it going to happen again next year, as far as I'm concerned.

Thank you very much.

Your next question comes from Harlan Sur with Morgan Stanley.

Hi, good afternoon.

Great job on the fourth quarter execution.

Mike, any updates as to the adoption rate of your next generation Virtuoso platform?

And maybe your views in terms of the total upgrade opportunity and over what period of time?

It seems that activity for custom is accelerating pretty significantly, we've got aggressive note shrinks by the memory suppliers and aggressive digital analog integration with your logic customers so any updates on next gen Virtuoso would be great.

We have certainly done very well.

We had a deliberate A to C program and early adopter program.

It led to not only early release of the product, but that I was quite pleased with, but the uptake through Q4 was spectacular.

It shows up in the numbers, as Bill said, and I think it bodes very nicely for us to upgrade some of the base, a large part of the base next year.

I don't know how long it will take us to drive the cost, the whole base, and quite frankly what we're doing is engaging the most read customers first, and sooner or later they will all move, as is my confidence.

It is the strength of the technology and as you say, Harlan, the features that we have across that are just required, as people move along the process node migration, whether it is a memory designer or a full custom person or a mixed signal person.

So I'm super excited about what the team did there.

The early customer feedback is nothing but glowing.

And I think it bodes very nicely for us this year, and for a couple of years to come.

Good to hear.

And then, as it relates to the full-year outlook just your thoughts at a high level often what are going to be the key top line drivers for the year?

Should we anticipate continued strong growth in digital and verification?

And then we also get some accelerated contributions from your custom mixed signal segment as well?

Well, certainly, to the conversation we were just having, mixed signal is going to be -- and custom is going to be a significant piece of it.

I think we just scratched the surface of what we can do with verification, and steadily announcing new capabilities and kind of moving up that stack, and as I said before the things like low power, logic design team, are forbearers of the strength, when you consider that in a holistic fashion.

The digital are very well positioned with doing all of the hardest designs in the world, and I think that gives us a nice runway to be able to proliferate down, and had good success throughout the year, with the segmented product, coming in at the entry level, too, and showing the customer's seamlessness across that.

There's no weak parts.

So we're going to announce it in the -- in the middle of the year, and a revolution in what we've done in the printed circuit board packaging business, from a technology standpoint.

So I think I'm quite excited about doing it, and I see a lot of feedback from the customers that is encouraging us, just to keep hitting our stride in the business that is going to come forward.

Great.

And then my last question, as it relates to one of the company's new initiatives, which is your Kit strategy and so obviously we saw the Freescale announcement on the adoption of the AMS Kit.

I'm just wondering, is this a product which is being adopted across the entire Freescale organization?

Certainly what it has done is allowed Freescale, which is globally divergent in the design teams, that is, they're located all over the place, to use that as a methodology kind of kickstart, integrate some of their best practices, and deploy very uniformly, and kinds of what you read in the announcement.

I think that is an opportunity, and other big companies, too, and we just don't have them as testimonials yet and certainly for small companies who may not even be globally diverse, its best methods, integrated into their design process, and that's exactly why we do it, and we're going to keep doing that, and sort of unlimited how high up the stack we can go or broad we can do that, it is only limited by our imagination and work force to gather those best methods and package them.

So no, I am -- I am kind of super optimistic about that strategy.

I think the IT industry teaches us to do that and we're going to keep doing it.

Great.

Thank you.

Good job on the quarter, guys.

Thanks.

Your next question comes from Tim Fox with Deutsche Bank.

Hi, thank you.

Good afternoon.

Just a quick question on the deal pushouts from last quarter that you had tried to work into the fourth quarter.

Obviously your mix came in right on target.

Could you just talk a little bit about whether those deals that you did push out in the fourth quarter to work harder, did they all close?

And if you can just comment generally about how the pricing came in after reworking those contracts?

Sure, Tim.

The -- I think Q3 was a bit of an anomaly because I think as we've all talked, we generally will see some business that we always continue to work between quarters, and it just so happened in Q3, we got more of them, which was unusual, and that's why we chose to work them.

Not try to close that business, try to keep that secondary metric in line with what our practice is, and we are confident that if we did have the time, it would come back and the half would be where we expected it, which it did.

So just to punctuate that point, 74% for the year and really strong for the half.

We did just take a little bit more time, we closed the business that we were targeting, and I think that's just really -- it shows up in the great results we had in Q4.

So we were able to close that and work on top of it a number of other pieces of business that just happened to be ready for the quarter.

And second question, maintenance jumped pretty dramatically, quarter over quarter, and year over year, it is actually one of the highest ranges in some time.

Is that due to the maintenance associated with the up front portion of that large deal?

It was a little higher than normal, Tim, it is not necessarily with the up front portion.

I would, on a go forward basis, think it is going to come down a couple of million.

There was a little bit of back maintenance that came in, in the fourth quarter, which gave us the pop.

Okay.

Actually one more for you, Bill, sorry.

Your cash flow from operations guidance for '07 of about 450, I think you said, it is up about 8% year-over-year.

Could you talk about why that is not going to track with earnings growth?

Yes, I think Tim, that we are seeing a little bit of a need to have some working capital in the business.

So I've toned that back just a bit.

We will continue to see cash flow growth.

And there is just some working capital items that we're going to have to take care of in the next couple of years so you will see it grow with the business.

It just may not grow as fast as earnings, but you will see good growth.

Okay.

And Mike, this one for you, talking about some new products in the digital area, obviously digital was a little bit more disappointing in '06 than you had planned.

And looking out into '07, this is arguably the most competitive space from a pricing perspective, could you just comment on the competitive environment there, and do you expect digital to outgrow your '06 base?

Well I think not even arguably, it is the most commoditized element of the EDA core.

It is one of the reasons that we segmented that technology first, because that allowed us to stratify or draw some lines in the sand about what would be valuable and kind of project the technology fit, along either a node or a time basis.

I don't even know -- certainly, it wasn't disappointing to me.

I think it is another law of large numbers, we just had fantastic results in verification and analog, and like you say, Tim, I continue to like our position, kind of taking a very conscious strategy, feeding in from the top, doing all of the tough stuff, and as far as I can get it from customers, got great pull-through across the analog, and digital, because the products are optimized to work between each other.

And now I'm showing you how the verification products and digital are linked and optimized to work between each other and I think it bodes very nicely for us to grow that presence and grow the value of the digital offering.

That may be the more important, because some of the element of commoditization either by maturity or time leads to some wild competitive practices, and that I think are value degenerating, and so a lot of our focus is to show a customer how we can help them differentiate their business in time or productivity, or complexity and management and demonstrate some value, and that's the ones that we're pursuing.

Tim, this is Bill.

I guess I would just add on, because that is one of the areas, as you know, with our segmentation, that we spent some time, and that is a multi-year aspect where we're changing packaging and pricing strategy, particularly in digital, which is the most competitive space.

But I think we have seen some good results so far for example, as we sift through the numbers, and we will spend a little bit more time at analyst day, we are seeing some technology differentiation, is helping us to improve pricing in our GXL line and digital.

We're also seeing that having the ability to have the L or the lower end version is helping us preserve value in competitive situations.

So these things will take, again, years to play out.

But the foundation of the product and packaging, along with the strength of the technology, will help us as we continue to take that journey.

So we will spend a little bit more time.

It is just that it is harder to see the appearance of it in digital right now because it is just a little bit more commoditized or competitive.

That is fair.

Thank you, both.

And nice quarter.

Thank you.

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

Thank you.

And congratulations on a nice finish to the year.

Mike, just wondering if you could talk about the business environment of '07.

From your comments you sounded like you viewed it as largely unchanged from '06.

Just wondering what you would need to see in your customer base to make it more cautious or more optimism.

It sounds like there have been some cautionary notes from some of the semiconductor companies.

Just wanted to get your take on that.

Kind of a mix is the word that everyone uses and a lot of consolidation in and around the semiconductor guys.

A lot of small companies growing up to be bigger faster and in general, the way that I think about it, is we are looking at the vertical segment, by a breakdown finer than standard industry code, and so wireless is a category, consumer is a category, and automotive application is a category, and all double digit growth.

So those bode nicely for mixed signal, and the verification kind of technologies that we bring, and some of them require extremely complex digital logic design.

And so I think where we can see the growth, we're very focused on those.

And to demonstrate value, and I think that is some of the reason why we've grown faster than the market in the last year, and a possibility it to continue that kind of torrid pace moving into it.

As Bill said, I think, very well, the thing in kind of conditioning the market, or reconditioning is to really be thoughtful about trying to show that value and differentiation of the customer, maybe that -- in contrast to a competitor, but more so that those companies can evolve.

So I really see us at the heart of that semiconductor evolution.

And if we do that well, not only will we be very valuable, and continue to grow our business, by market segment shift, but we will grow the total available universe that we can participate in.

And that's what we're, Bill and I, we got lots of different ways of looking at it.

Certainly, we're both optimistic about not only the close of '06 and '07, but I think for the future, we don't know how fast to be more optimistic on that market expansion than just, kind of letting it gestate for a little while.

As Bill said before, some of these things are multiple year journeys so there is no instant event on the positive that you want to see, because I do think it is an evolution of the industry.

Rich, the thing that I also look at is we have been seeing consumers becoming a bigger piece of semiconductor consumption.

That is requiring more activity, faster.

And I think that is a trend that is here for a while.

I don't think that is going to change quickly.

Even though some of those markets move up and down, the need to get products faster and faster in those markets, I think, is going to continue, and as we look at R&D, expense growth rates, they still see it sitting at the high single digits, so that seems to be a pretty good indicator for more activity, faster, and the spend is going to be there to see that happening.

Great.

And Bill, looking at your three major product segments, relative to the midpoint of your revenue target growth of 8%, can you say which of the three segments you expect to sort of grow above, below, or sort of in line with that rate and if any of them would require market share gains in your estimation to achieve those rates.

I think I will categorize it in the way Mike was talking, which is I think custom, which is going to be pretty much rolling out that new product line, that is not going to require any share shifts.

It is just going to be a nice take-up.

It will be over several years, but you can see that there is a lot of demand for our customers, for that new technology, as you can see the first full quarter of production release, and grew over 30%.

So I think that will probably number one in my stack.

I think we're going to see the functional verification continue to grow, and I think it will grow double digits.

And then I think the wild card for me has been trying to predict digital, as you know, and analyst day last year, I thought that was going to grow double digits and as it turned out, custom outperformed.

So there is a little bit of variability, in trying to make these predictions.

But I think that is kind of -- I think because we have a very strong portfolio, we are going to see a little ebb and flow amongst the three, but the demand from customers 1 there, and I think between the three, that gets us to that growth rate that we've got out there, and it also allows us the opportunity to do better than that when the opportunity presents itself.

I wouldn't think that the system inter connect, even though it has a very, very good quarter that is 1 still a smaller piece of the business, and we're not going to see that growing at 20% again next year, I don't think.

It has the ability to probably grow double digits, but you know, traditionally it is a slower-growing market.

So I think we can do great things there, and SiP, and the pack, the team has done a great job, but I don't think that is going to be a big driver for our growth, and quite frankly I think the DFM is still -- we've got some work to grow to show that number growing, but it is really -- we're having great traction in our implementation and that will pull over time into what is defined today as DFM.

Great, that's helpful.

Thanks, guys.

The next question is from Raj Seth from Cowen and Company.

Thank you very much.

Bill, you have I think in the past talked about a perspective of the design starts have picked up.

And I think in part around the consumer activity and I'm just curious if you think that this is something that is sustainable or do you think this is driven by the no transitions and investments around 65 and I guess 90.

In other words, do you think that design starts are up sustainably?

Raj, I haven't seen new data, but I do think what I was mentioning, to Rich, is I think that trend is continuing.

We are seeing more design activity, because there just are more consumer applications.

I think that is what is driving more of the design starts.

But again, that was the last data we saw.

And the other thing that we were seeing was some of the high bandwidth requirements, was driving customers to the very small process nodes.

But that is probably the extent of my vision into --

Forgive me if you discussed this already.

I just jumped in.

One more if I could, for either you or Mike.

Mike, you talked in the past about potentially exploring some alternative business models, maybe royalty-based model, around X, or some of the other stuff have you coming out.

Is this still something that you're interested in?

Is it something that we should expect over time?

Or has your appetite for those kinds of models cooled for some reason?

No, my appetite hasn't cooled because in some of the sparks of the development process, especially in the manufacturability thing, that is the only way to make real money, I think even now, some of our colleagues who pursued DFM as a category are seeing that.

And we had said for the last few years that we were successful in taking some revenue from customers.

That requires a progressive customer relationship.

And it bodes well for us in the consolidated relationships.

And I believe that will continue to happen.

So in some respects, it was also a demonstration of sharing risk and reward.

Which in my experience had not been traditional in EDA, and so I think this is another one of those things that takes a while to do.

With the X technology, we did try that, because it was a very good demonstrable of causality.

That is, what it did produced a result.

And we're still out there flogging that a little bit.

But nothing new to report.

And as those technologies become mature, like you actually can see it sooner or later we will integrate it in for preference in some of the products like the high end of the digital platform.

So you can never be static about it.

But no, I remain convinced that that is a -- not only interesting, but a necessary element of either demonstrating, risk reward sharing with a customer, which they need to do to evolve, and penetrating some of the market segments for financial effects.

So given that context, and I realize it takes a while, how long would those kinds of business models take within Cadence to sort of make a material impact to your financials or contribute materially, I guess?

That is a good question.

I don't know.

What we will do is we will mull it over, and think about it.

The way that we -- that Bill and I characterized it, is we try to do it by product or by segment.

And so let's say it has a DSM penetration strategy, and in that case, if it is, I think that there is another two years kind of tee to green on DSM, and maybe that will be the basis to do it.

But nothing new to report on that.

Let us think about it and get back to you.

Roger, I think at this stage what I would say is we are open and we do quietly do some experimentation, where it seems to be a good balance within the core.

But I wouldn't try to project it as a meaningful part of the business in the core at this stage.

So I kind of leave it at that.

We're still looking at it but I don't think we've cracked the code on variable pricing models at this stage.

Got it.

And appreciate your perspective.

Your next question comes from [Muhesh Sanjin Hareare]

Thank you very much.

I wonder if you can help me and defend this booking fluctuations.

You had to do a quick calculation, you had the big customer booking close to $200 million, and you had, it looks like, maybe a record booking quarter.

So if I moved that $200 million back to September, that probably becomes more normalized rate.

Is that a correct way to look at it?

Well, I think if you go ahead and look in total at the full year, and as many of you know, I don't get into a lot of specifics on booking, but I think once a year, we do talk about business level, because we talk about backlog.

And just some of the building blocks, since we grew the top line, for the year about 12%, and you can see we grew our backlog $100 million, you can see the total when you look on a percentage basis is in the high teens.

So I don't think that is a generally sustainable way that we're going to grow our business, because it is probably twice the growth rate of the industry, but I think we do take advantage of opportunities and I think it puts us in good stead as we go forward because we do have the opportunity to over achieve.

But I think that just gives you the way that we look at the total business for the year.

And it is driven by the real strong technology that we've had across in 2006, primarily functional verification and then also custom, and I think it sets us up well in digital, which the business did well, but it didn't show that same level of growth.

Just one more clarification.

When I look at your backlog, does it -- is it -- the back break of the backlog, is it proportional to individual numbers?

For example, say product revenue and service revenue, are they in the right proportion in the backlog or one is higher than the other?

Actually, I don't get into that level of specifics on backlog.

The level is about two-thirds of our business in 2007, will come out of backlog and I think that is the right level to think about as opposed to trying to figure out individual components because then we kind of get tied up.

Okay.

Thank you.

You're welcome.

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

Davidson & Company.

Hi, good afternoon.

Most of my questions have been answered.

But Mike, I was wondering if you could be a little bit more specific in terms of perhaps new competition you're seeing both in your emulation market and then from a broader perspective, in the custom analog mixed signal market?

Yes, in the -- we really enjoy a great market segment share position in the analog and Matt, to me, analog or full custom is custom analog, mixed signal, memory, RFR moving to microwave, so it is a lot of different things.

That exposes I suppose niche positions for some of the companies that you see coming along.

It is -- to me, it is -- one of the reasons that we made such a big kind of to-do out of the Virtuoso launch last year, because we're not giving up anything there.

That is a strong position, and built over many, many years.

And it is hard for someone to penetrate that with any real breadth, because it is compensated stuff, and it is integrated into lots of little pieces, but if you analyze any of that competitive offering that we did, you find it incredibly strong, but beyond a few niche positions, it may be geographic or some kind of a unique product focus, like TFT is, and in Taiwan, and I don't see a lot of exposure there.

On the emulation business, we do have a big competitor there, and I don't know that I think of it as just the emulation business.

We think of it as the verification.

And there is a reason why, I know probably it is hard -- some people dismiss it as my philosophical approach, but it is not.

The real value of that, to a customer, is when you can bundle the emulation, the simulation, the verification process method that you do, and that stack of stuff and that's the way we segmented the business, we're certainly getting great pull across those, and with the addition of the Xtreme to the product line, we're very seamless by the construction of what we've done from acceleration all the way through emulation.

So I really like our position there, gotten a lot of great corroboration from customers and once again, the way that we do it is we set road maps and we try to execute to our road maps and if we do then we're pretty confident we are going to succeed in our goals.

There is always a competitive analysis but we are not looking over our shoulder at anybody, we're just setting our targets and trying to hit them so I guess that would be my comment on those two areas.

Okay.

And then I was wondering if Bill, you guys could be any more specific in terms of how you're looking for compensation plans, maybe to change next year, especially in the sales and marketing part of the business, or if you feel like you guys are well positioned there in terms of how you are executing to plan.

And maybe more specifically, on this issue from a just percentage of revenue basis, marketing and sales did not see a ton of leverage in the most recent quarter, so I'm wondering if you can kinds of address that.

Sure, Matt.

I think the -- at the highest level, I think, our plans are constructed very well, and so I don't see any fundamental changes in how we have been constructing our compensation arrangements.

So I think that works well.

I think what you saw, quite frankly, in the fourth quarter was we had such a strong business performance that the teams earned some very good incentive compensation, and as we were talking a little bit about the level of business, that is very well rewarded for a great performance both on the product side as well as on the delivery of it.

So generally, if you can take it for the year, I don't think it is that big, but I think you just saw the impact in the fourth quarter because it was a monster quarter.

My two cents is I think we have demonstrated great scale in the sales application engineering, and associated marketing.

We've grown the business in my time a couple hundred million dollars and not materially grown the size of the company.

Those people, men and women, are working hard, demonstrating and taking great productivity goals, and we will talk about it at the analyst day but it is something like 11% productivity, in that channel, and boy, I think we've got some more scale to go, so the fact that we're -- that we're holding the line relatively on the number of employees in the company, continue to grow the business, I think bodes very nicely to the kind of capability we have for scale.

And Matt, I would just follow on to that, occasionally we will get a question, can the business continue to scale past the next target we have for 2007 of 30% operating margin and I think it can.

One of the big reasons is we do have great leverage in the channel.

As Mike was explaining, we're pretty well where we need to be.

We have great people in the field.

So a lot of what we bring to the top line comes right down from a channel perspective.

Okay.

Great.

And then just one more final question, Bill.

You had mentioned earlier the need perhaps to expand your working capital requirements next year.

Can you be a little bit more specific in terms of what you might be funding?

No, Matt, I'm not going to be more specific.

I think as I said, we will grow our cash flow from operations, but there is just some working capital that we just need to take care of.

I think having something that is at the 450 level is very good results, we're not seeing anyone in the industry putting anyone where near those kind of numbers, and so we're very happy with that and we will just continue to make progress growing it, but at a little bit of a slower pace.

Okay.

Thanks a lot.

Sure.

Your next question comes from Vishal Saluja with Seligman.

Thanks for taking my question and Bill, great backlog number, I think you conditioned us for a flattish backlog so nice to see.

I just had a question on operating margins for '07 and beyond.

I think you mentioned that there was still room for improvement, but maybe you could just give us a sense of what level of improvement we can expect in '08 and beyond.

So that's one.

And then can you just walk us through the new convert structure in terms of when exactly does -- at what share price does the convert become dilutive?

Thanks.

And then I have one follow-up.

Sure Vishal.

In terms of the operating margin progress, I think there, having an increase of 300 basis points in '07, and then continuing progress like that, beyond, into the next few years, I think is very possible for us.

I don't see anything structural that would change that.

So getting into the mid-30s, over two to three years is something that I think is very possible.

We will look to see, as we're continuing to grow the business, particularly in the areas of the adjacencies, at some point maybe to make some trade-offs between accelerating growth and margin expansion.

And that would be the -- I think a nice trade-off and we expect to have that trade-off, but I think for the next few years, being able to expand margins, 2 to 300 basis points, beyond '07, I think it is a reasonable goal.

We work hard at it.

We do a lot of prioritization, but if we see growth we will fund it even at slowing down some of the growth of the operating margin but we see the ability of the mid to get to the mid-30s in terms of the next target range.

And then in terms of the convertible, let me just take that one off, because I think that information is in the press release.

But it basically, if you look throughout a $30 stock price we start to get dilution and I don't have the specifics with me here.

And last question, just for Mike, the verification franchises, been a real tail wind for overall growth, and can you just give us some sort of qualitative assessment of why you think that you could sustain that over the next 12 to 18 months?

There are two simple reasons.

One, it is an expansion of the total universe that we participate in.

Most simply categorized by appealing to people who are software designers or system designers and there is 10 to 100 times more people who do that than there are the number of people who design chips in the world.

Strange to say, but it is absolutely a fact, and I think that is the goal and the leverage that we see with Kits, and whole-ism and all of those kind of fancy words that we use that are semi-technical.

I suppose.

The second is that companies that are specifying ICs have an exposure to even a supplier, if they don't get a very good melding of the minds on the specification, and that is the process of verification, not validation, and validation in the semiconductor would be improving the logic design for the chip goodness and so the verification becomes an architectural tenet.

And that's why Bosch was such an interesting testimonial a couple of times last year to us.

And it bodes very nicely for verticals, like automotive, or industrial applications and that whole-ism makes that melding of the minds even more complete.

I believe it's got a lot of value embedded in it.

Certainly cements a broader customer relationship.

Sometimes I call it the customer of a customer, becomes valuable.

And those combination of things make it a very fruitful place to go put a lot of effort.

So the thing that is unique for us is that we bind that market drive to the implementation in the core, digital, analog, packaging, very seamlessly, and so it makes the melding even more complete all the way down and I think over time we will demonstrate the manufacturability of a chip.

And so I don't say this lightly as a philosopher, I say this with experience, having done it 20-some years of my life, and the resonance of that either with my or some of our collective experiences or with the progressive customers is just I think a lot of reason for the tail wind.

So we're going to keep going, and I'm anticipating some very nice results to show you in the future.

Thank you.

Sure.

This concludes the Cadence fourth quarter and fiscal year 2006 earnings conference call.

Thank you for participating.

You may now disconnect.