益華電腦 (CDNS) 2016 Q3 法說會逐字稿

Good afternoon. My name is Mike and I will be your conference operator today. At this time I would like to welcome everyone to the Cadence Design Systems third-quarter earnings conference call.

(Operator Instructions)

I will now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence Design Systems. Please go ahead.

Thank you, Mike, and welcome, everyone, to our third-quarter 2016 earnings conference call. With me today are Lip-Bu Tan, Present and CEO; and Geoff Ribar, Senior Vice President and CFO.

The webcast of this call can be accessed through our website, cadence.com, and will be archived through December 16, 2016. A copy of today's prepared remarks will also be available on our website at the conclusion of today's call.

Next, please note that today's discussion will contain forward-looking statements and our actual results may differ materially from those expectations. For information on the factors that could cause a difference in our results, please refer to our filings with the Securities and Exchange Commission. These include Cadence's most recent reports on Form 10-K and Form 10-Q, including the Company's future filings and the cautionary comments regarding forward-looking statements in the earnings press release issued today.

In addition to the 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 in addition to using these GAAP results in evaluating our business, it can also be useful to measure results using certain non-GAAP financial measures.

Investors and potential investors are encouraged to review the reconciliation of non-GAAP financial measures with our most direct comparable GAAP financial results, which can be found in the quarterly earnings section of the investor relations portion of our website. Additionally, a copy of today's press release dated October 24, 2016 for the quarter ended October 1, 2016 and related financial tables can also be found on the investor relations portion of our website.

Now I will turn the call over to Lip-Bu.

Good afternoon, everyone, and thank you for joining us today.

We were pleased by our results for the third quarter, as Cadence continues to execute on the System Design Enablement strategy. For the third quarter revenue was $446 million. Non-GAAP operating margin was 26%. Non-GAAP EPS was $0.30, and operating cash flow was $84 million.

Let me start with the environment today. Semiconductor business conditions continue to be mixed, with some sectors performing better than others. Favorable trends, include cloud and datacenter, automotive, artificial intelligence and video.

While semiconductor consolidation has not had a material impact on our business this year, it may present challenges over the next few years. And at the same time, our relentless focus on innovation, execution and helping our customers succeed, is driving our momentum in the marketplace. And our opportunities continue to grow with systems companies.

Which leads me to our System Design Enablement, or SDE strategy. SDE opens up additional growth opportunities, as it takes us beyond a horizontal focus on semiconductors and moves us to a systems company focus on end-market products and vertical market segments, thus increasing our customer base.

One important SDE trend is the adoption of our market-leading IC packaging solutions for applications, in which the IC package is becoming a primary system integration platform. In Q3, we expanded our business with BAE Systems, including system-level integration using our IC Packaging solution and with significant adoption of our Innovus and Genus Digital IC design flow for SoC design.

And we delivered a comprehensive system design solution for TSMC's advanced wafer-level Integrated Fan-Out packaging technology, known as InFO. TSMC awarded Cadence with a Partner-of the-Year award for development of this solution.

Our System Design and Verification group delivers a holistic verification suite of connected solutions that are based on strong core engines and optimized for total verification throughput which include Palladium for emulation, Incisive for simulation, and JasperGold for formal verification.

In Q3, Palladium Z1 continued its strong momentum, adding nine new customers. Continuing with the SDE theme, five of the new Palladium customers were systems companies, including a major aerospace company. Mobileye adopted the Palladium Z1 for the development of automotive vision technology for ADAS applications. And Fujitsu adopted Palladium Z1 for the development of its ARM v8-based Post-K supercomputer, the next generation flagship supercomputer in Japan.

Overall, verification is especially critical in automotive applications. And to that end, in Q3 we expanded our business with Infineon in the area of automotive functional safety.

Our digital and signoff products continued to gain momentum with the Top-20 semiconductor companies. Overall we had six full digital flow wins in Q3. A global systems company is deploying our Innovus implementation solution for advanced node designs. And a market-shaping semiconductor company, pleased with the performance of our digital solutions, exercised the growth option in its contract to begin proliferation across its design groups.

Tempus, our timing signoff solution, now has nearly 150 customers with rapid growth in mixed-signal timing signoff. The number of 10-nanometer tape-outs with our solutions is growing rapidly. And we worked closely with TSMC to certify our implementation and signoff tools and integrated flow for 7-nanometer designs.

Next, I will move on to IP, which is a strategic business for us, a key component of the SDE strategy. First, I will discuss our strategy, then provide highlights for the quarter. During the quarter we completed our review of our IP business strategy. The result of the review is that we significantly increased our focus on: standardized, off-the-shelf IP; certain strategic vertical markets; and the most advanced process nodes while deemphasizing more customized IP.

IP remains an important business for us. The IP market opportunity is strong as the outsourcing trend continues, thus creating opportunities for future growth. We are confident that these refinements will drive sustainable and scalable growth, and we expect our IP business to return to modest sequential growth for Q4.

We had some great IP product highlights for Q3. Virtual and augmented reality are exciting new technologies that I am watching closely. The Tensilica architecture provides unmatched performance and power efficiency of this type of application. I am thrilled that our Tensilica processors are at the heart of the holographic processing unit in Microsoft's HoloLens AR headset, using 24 Tensilica Xtensa cores.

Cadence has worked closely with TSMC to develop some of the first design IP offerings for the 7-nanometer process, offering early access to protocols that are optimized for mobile and high-performance computing applications. We have already delivered 7-nanometer DDR IP to a top-tier Asia-Pacific customer.

We also introduced a broad portfolio of interface and memory design IP solutions for automotive applications using TSMC's 16-nanometer FinFET Compact process. Cadence delivered the first design IP for MIPI SoundWire Version 1.1 for high-quality audio solutions and demonstrated interoperability with Realtek.

So now in summary, we are executing on our strategies and Cadence delivered good operating results for Q3. Interest in the Palladium Z1 remains strong, with adoption by nine new customers in Q3. Our digital and sign-off solutions maintained their momentum with market-shaping customers.

We completed the review of our IP business strategy. And with our new focus, we expect the business to return to modest sequential growth in Q4. Our IC packaging solutions are growing in importance as a key component of System Design Enablement.

And we won four TSMC Partner-of-the-Year awards for collaboration on both 7-nanometer mobile and high-performance computing design flows, InFO IC packaging solution; and our analog and mixed-signal IP. Now I will turn the call over to Geoff to review the financial results, and provide our outlook.

Thanks, Lip-Bu, and good afternoon, everyone.

Execution was good in Q3, with key operating metrics meeting or beating our expectations. Total revenue was $446 million, in-line with our expectations. Non-GAAP operating margin was 26%. GAAP net income per share was $0.23 and non-GAAP net income per share was $0.30. Operating cash flow was $84 million, and we repurchased 9.6 million shares of stock for $240 million, over 3% of the shares outstanding at the end of the prior quarter.

Also note that the weighted average contract life was 2.5 years. The recurring booking and revenue mix has remained approximately 90% for the past year. DSO was 34 days, down one day from Q2. Due to an increase in hardware leases driven by strong hardware sales, DSO has increased by six days and long-term receivable has increased by $13 million compared to Q3 of 2015.

Now let's turn to our outlook. There are no changes to our FY016 outlook for the midpoints of bookings, revenue, operating margin, EPS or cash flow. We have narrowed the ranges on bookings, revenue and EPS.

We expect bookings in the range of $2.03 billion to $2.07 billion, which equates to 8% growth at the midpoint. Revenue in the range of $1.81 billion to $1.82 billion, which would be a 7% growth at the midpoint. Non-GAAP operating margin of approximately 26%. GAAP EPS in the range of $0.74 to $0.76. Non-GAAP EPS of $1.19 to $1.21 and operating cash flow in the range of $380 million to $420 million.

And for Q4 we expect revenue in the range of $463 million to $473 million. Non-GAAP operating margin of approximately 27%. GAAP EPS in the range of $0.18 to $0.20 and Non-GAAP EPS in the range of $0.32 to $0.34. Approximately 90% of the revenue is expected to come from beginning backlog.

Also note that we are launching a voluntary retirement program in Q4 and we have included the estimated costs of $12 million in our GAAP outlook. You can find guidance for additional items in the CFO Commentary.

Now with that, operator, we'll take your questions.

(Operator Instructions)

Jay Vleeschhouwer, Griffin Securities.

Yes, thank you, good evening. Lip-Bu, let me start with you with a couple of related market questions. You noted in your prepared remarks that you so far have been able to avoid the anticipated adverse effects of semiconductor customer consolidation. Remind us why you've been able to avoid that so far.

And relatedly, it would seem that EDA as a percentage of semiconductor R&D has remained fairly steady. That relationship has held more or less the same. But could you talk about other current or leading indicators that you are relying upon now to forecast or anticipate your business? What else would you be looking at besides semi R&D to gauge the environment?

Thank you, Jay, for a good question. A couple of things. One, first of all I think maybe you got some (inaudible). So I think we all know that semiconductor business is still very challenging and some of the statistics shown that this year will not have growth for semiconductor overall as a sector.

Meanwhile, I think there is some great opportunity for longer term. And I mentioned the mobile video [releases] machine learning artificial intelligence for automotive. And it will be significantly increase some of the design opportunity, especially in the systems companies and also in the IT growth area.

Back to your question on consolidation, clearly I think this year it's been slower than last year in terms of the large consolidation. And then clearly, we are very mindful, we pay a lot of attention about the consolidation [activity]. We do not expect any material impact to our business in 2016. But the next couple of years are challenging for us to forecast (inaudible) some of the impact.

And then the question about how do we avoid, clearly we are engaging with our customers (inaudible) with the customer and make sure whatever the new design, new product development were steadily increasing, especially from (inaudible) development. And also some of the new advanced node that are [embarking on], either the 10 or 7.

So those are the things that we try to really engage steadily with the customer. And that is the best way to avoid some of these consolidations.

Then the other part is impact. On the other part in some of your questions about the indications, the best indication for me is when we view it -- as you know, rarely do we [leave] with the customers. They see our new technology, new developments and new products and (inaudible) embarking on something that is really exciting like machine learning is going to be a huge impact to our overall industry across all the different verticals, either in [automobile] or the search engine or income of the genomic or sequencing developments.

We are easily engaging with our customer in R&D development and as a trend we are seeing (inaudible). And that we make sure that our products and our tools provide differentiating solutions that they are looking for in order for success in the marketplace.

All right, thanks. Let me finish up with just a couple of related product questions. When we look at the industry data over the last number of years, we see a number of product categories, each of which you participate in, that have had fairly steady growth on a trailing 12-month basis. In some cases for a couple of years or more.

For example, custom layout has been consistently a good category for a number of years. Placing around parts of physical verification have been doing pretty well on a steady basis.

On the other hand, analog mixed signal has been flat to down, RTL simulation, an important category, flat to down, and synthesis as well. So you participate in each of these categories to varying degrees.

My question is what headwinds or impediments would you anticipate for those categories that have been consistently good so far? On the other hand, what possible tailwinds would you anticipate for those categories like AMS and RTL and so forth, that have otherwise been lagging for the last couple of years?

Yes, a very good question. Let me touch on some of the topics that you mentioned earlier about the category of products. As I mentioned earlier, we are very focused on the customer engagement in some of their new product developments and that is where tool come in and our IT come in.

Clearly, in the complexity of some of this design and opportunity to become very clear to us. For example, in the machine deep learning, our Tensilica [e-cost] to shine and a lot of customers are very interested in our Tensilica-related area.

In some of this aggressive either in machine learning or graphic or the CPU-related place and route and then synthesis and the verification becomes critical for them in terms of get to market quicker, and the complexity of the design and the layout. And also they are worried about the power and signal integrity issued in terms of the end-to-end. So our IC packaging that I highlighted becomes very critical and then the PC port in terms of in terms of security, in terms of power, signal integrity, becomes very, very compelling for them to engage with us.

So I think overall I would say that across the board all the products, looking forward, we are excited about the opportunity and the customer feedback. And then they really like the performance that we have and then the engagement model that we continue to stay humble, working with them. And then with a can-do attitude to really drive success for the customer, they love it.

And that's why I think across the portfolio that you look at, even the custom analog side, we see a continued growth, especially in the mixed-signal side. And then we are the de facto standard for the last decade. And a lot are moving into the advanced node so we are really aggressive more on the 10 and 7. And also moved proactively more than 100 customers right now are using our virtual, so in the most advanced FinFET.

So I think I see continual growth because of mixed-signal requirements. And actually in the automotive side and in some of the power-related concern that they have, they're starting to really embrace our solution that we can really drive the low-power solution they need to meet their analog requirement.

Thanks very much.

Krish Sankar, Bank of America.

Hi, thanks for taking my question. I have a few of them. Just to follow up on the semi R&D impacting the industry down the road, it's still voluntary the retirement program you announced tied to that, where you expect the growth to slow? Along the same path, you've done about, in the past couple of years, this year you're going to grow about 7%. The last couple of years it's been between 8% to 10%. On a go forward basis, what do you think is the right growth rate for the industry? And I had a few other questions to follow up. Thank you.

Yes, good question. And I think you mentioned about the R&D impact and some of the retirement programs that Geoff will be able to highlight to you. But clearly we continue to drive the innovative part in terms of driving the solution, the performance of the tool, the PPA power performance area. And the run time drives the productivity for the customer to work with them to really drive some of this efficiency time to market.

Like for example, our Palladium is a very good one that we can really drive some of this verification requirement they need and also the Incisive with our Rocketick acquisition, we can really drive some of this run time and then the build time requirement the customer needs. So I think all in all, it's not just to help our customer to drive efficiency and we also look at ourselves, how we can drive efficiency in terms of our own organization? So that we can really drive the customer engagement so that make sure that we can not just continue pull a lot of AE and support and we drive some of product quality performance.

We have a big quality effort so that we can really drive efficiency across the organization. And then Geoff can highlight a little bit more about the retirement program.

So on the voluntary retirement, it is something we have done from time to time in the past for our employees. It does allow us to, of course, focus on our return to our shareholders also. So I think it is a win-win solution.

Got you. And then I had a couple of other quick questions. On is, you guys are gaining traction in the emulation market. Curious to know your view on the physical prototyping. Perhaps this will be something of interest you focus a lot of the customers are being outsourced. Would this be of interest, your flat -- the emulation hardware platform? Or is it too small a market?

And then along the same path for Geoff, you guys have done about $240 million a quarter share buyback pretty consistently. It is going to get done by Q4 this current quarter. So I want to know your thoughts on capital returns when you look into 2017, buybacks, any dividend or plans to take on any more leverage. Thank you.

Yes, good question. Let me address the first question you have about the emulation and the prototyping. Clearly our Palladium Z1 is the most successful launch for our emulation business. We continue to see a lot of growth and then use model. We continue to drive some of the new use models that are very exciting for us.

And then the other part is clearly besides selling a lot to our clear leading semiconductor company. And anything below 40 nanometer process design, this is a must have and it is very scalable to capacity. It's very strong [9.2 million gigs] over 2,000 concurrent users. And that is a scale that we have and also is a very data-center class reliability that we have. I think customers just love it. We continue to see more new customers and we've mentioned about aerospace, Mobileye and Fujitsu for the super supercomputer now are using ours.

I think that clearly we also [top the dial] on the prototyping side we have the Protium and the series of products family. And we're adding our FPGA prototyping in a scale and capacity and performance. And stay tuned and we're going to continue to drive that in a mixture that is a fully-integrated verification, not just a Palladium prototyping Protium.

And then with our Incisive Rocketick and then also our very successful formal verification JasperGold. And in fact, this quarter is the best quarter we have. We continue to drive success. And then some people think that by verification they think about Cadence verification suite of products and that drives the performance that they need.

Krish, on the buyback, we remain committed to the $1.2 billion repurchase program which, as you point out, ends in Q4. So far we have repurchased over 45 million shares for $916 million. That is approximately 15% of the shares outstanding when the program began in July 2015.

As always, we look at how our program balances our need for investment in our business, the appropriate level of risk for our business model and operating environment, and of course opportunities to return cash to shareholders. We regularly review our capital structure along those same lines and will continue to do so. At this time we are not commenting on 2017.

Thanks, guys.

Thank you.

Farhan Ahmad, Credit Suisse.

Thanks for taking my question. My question is regarding your revenues, the break up between semi versus systems. You have noted in the past about 40% of the revenues for you guys come from systems. I was wondering if you can provide some color on your system group. How is the growth for semi versus systems tracking this year? And is one section of the business growing faster than the others?

Hi, Farhan, welcome to the call. Our ratable model means that we don't see large swings in revenue-based metrics from quarter to quarter, period to period. Our system business was strong in Q3, as Lip-Bu pointed out in some of the prepared remarks and it's growing nicely.

But also our semi business is growing and so the differential isn't as great as you would expect. We remain approximately 40% of our business is in systems business and we will let you know when that changes materially.

Got it, thank you. And then one question on your IP. Lip-Bu noted in the prepared comments that Tensilica, the [whole levance] when it was pretty significant. I was wondering if you could provide some color on what's the long-term opportunity of RDS because of high-performance computing or a visal processing, if you guys have done any kind of market sizing related to that, that would be helpful.

Sure, let me touch on that topic. I think clearly Tensilica, as you know, is a DSP programmable processor engine and very low-power. And so this is really suitable for all of the vertical computing engine, something that really, really excites me, this whole machine learning, deep learning and vision processing-related area for EDA and also for genomic sequencing and for search engine. I think this is going to be a really open up a lot of opportunity for us.

Clearly not just the hardware itself, and also the software, the algorithm, the library that can be playing a very important role, providing a solution. I think overall we are excited about it, and this Tensilica is area that we are doubled down in that investment. Meanwhile we did some refines in our strategy refinement that we make to the design IP to integrates with our Tensilica, providing that kind of interface we need and high-speed and an intermodal memory that they need to drive some of these applications. Overall we are excited about this opportunity for Tensilica, opportunity for us.

Thank you, that's all I have.

Thank you.

Mitch Steves, RBC Capital Markets.

Hey, guys. Thanks for taking my questions. Two quick ones. The first on the semiconductor IP segment, can you talk about when you expect that piece to start showing some growth? And then maybe some share change that's happening in that segment?

Your question is when? I mentioned with the refinement of our strategy and our multiple [growth] on the standard off-the-shelf IP and then some of the vertical markets, particularly for us and also the most advanced process. And then deemphasize the customized IP.

And we believe that this is going to be a return to that moderate sequential growth for Q4. This is also the trend that is happening and it will grow even further future growth. I mentioned earlier some of the highlights that make in the VR, ER machine learning, deep learning, and the most advanced node 7-nanometer process, the design IP with our partners at TSMC and our IP partners.

And then also in the automotive applications side on the 16-nanometer FinFET. Then some of the audio standard and the VIP [10 neel] critical new standard protocols. So I think those are the things that we are going to help driving the future growth.

Hey, Mitch, and welcome to the call. This is Geoff. As we always do, we normally provide our 2017 outlook when we do our Q4 earnings. So stay tuned for the January-February time frame.

Got it. And then one small one on the cash flow. If we were to look out into 2017, is there any reason why you guys can't continue to grow that line. I know it hasn't really upticked for the full year. And maybe talk about the dynamics there.

Yes. Stay tuned for our 2017 guidance in January, February. We'll let you know then.

Monika Garg, Pacific Crest Securities.

Hi, thanks for taking my question. First on the R&D line, Geoff, if we look R&D's percentage of revenue is like 38.4% this quarter. Year over year definitely it used to be 23% to 24% of revenue. Do you see it normalizing from here? Or is it a new normal? And factors leading to such high revenue, especially in 2016.

A couple points. Obviously in Q3, revenue stepped down from Q2 which obviously changed the denominator of the equation. The second thing I want to point out is we've focused from the beginning of this year and talked about this being an investment year for we're investing in our innovative solutions. I think you're seeing that show up in R&D expense. We will comment on the future in the future.

Got it. Then if I look at acquisitions, what Cadence has historically made its most tuck-in smaller acquisitions, going forward would you comment on the scale of acquisitions that you have adjusted to? Is it similar scale we should think about? Or could it be much larger than you previously have done?

Monika, let me address that issue. I think clearly, if you follow our last eight years, we are very disciplined in terms of approach to M&A. Clearly the acquisitions have to meet some of the key criteria. One is to fit and further our strategy, SDE strategy that we embark on. And then secondly, clearly we want to look for products that are different shading technology.

And a lot of time our leading customer will indicate to us what are the new technologies we need to integrate into ours. And then clearly the top talent, either managerial and technical talents, if you look at executives we all spot for the good talents for the managerial or technical leadership that we are looking for. And of course, we hold ourselves accountable to our team and also to our Board and then income of the ROI, the return on investment, the synergy that we're looking for and we hold ourselves accountable for that.

With that in mind, wither it's a big or small acquisition, we apply the same strategy, same criteria. And then we work very close with our Board then and our executives work as one team. We debate and decide what is the right thing to do for the Company and what is the product enhancement to meet our customer -- at the end of the day it is really meet the customers and satisfy our customers in helping them design the best products they can do a timely fashion.

Got it, thanks. Then as a follow-up on the IP integration. If you look year to date IP revenue year over year it is down high single-digits, 70%. So first of all, is it in line with your expectations? And then IP is secular group market, as you also highlighted, do you see it going back to the industry growth rate over the next couple of years?

Yes. I think, as I mentioned in my remarks, and this is very important business IP to us. Clearly there's a lot of growth opportunity because also some trends. Many of my top customers, they would love to outsource some of them to us, especially the industry standard off-the-shelf IP and also the most advanced node process.

And then just to meet and to fulfill the various protocols that keep changing, they will prefer to outsource. It's a very heavy investment. I think we are very good in terms of trying to do that and meet our customer requirement. What we did is the refinement is to deemphasize some of the one-off customized IP and then really focused on some of the standards in the market that we are pursuing. We mentioned quite a few of that and then also in the most advanced nodes.

So I think overall we look at the IP business, it should be a growing business because of the trend, because of the portfolio we have in Tensilica, the design IP and VIP. Those, I think, have the foundation for us to grow in some of the verticals that we are pursuing and the advanced node and mixed signal we are pursuing.

Thank you so much.

Thank you.

Rich Valera, Needham & Company.

Thank you. Lip-Bu, you mentioned the term system design enablement several times in your prepared remarks. I understand this is part of your focus on system customers. But is there anything more to that than a marketing statement? Are there actual products you are developing or channels or infrastructure within the Company that you're developing incrementally to pursue this system design enablement strategy, as you put it?

Very good question, Rich. A couple of points I just want to highlight. It's not just the marketing campaign work. As you know, for the last eight years we have been very focused on executions. And then the system design enablement, what it really means is to provide the solutions that system companies can optimize for their differentiations and then with the end product in mind.

That is something that I think we have a unique position besides the tools, besides the IP, we also have the PCB and IC packaging uniqueness that I highlight in my earnings script this time. Because a lot of these systems companies and service providers, they are looking for that software, hardware co-design, co-verification and also the packaging to come end to end solutions that provide the power, signal integrity, the interference, all within the envelope of the systems company. They have that requirement they need to meet.

And of course the time to market is critical. And also they need to have that scalability they are looking for and that is why you see Palladium has that kind of scalability and performance checking that they need in terms of complex systems. I mentioned earlier this one major aerospace company sees the benefit of using our Palladium and it can really testing the system, our solution that meets their requirements of their design.

And then same thing, this Fujitsu on their supercomputer design, is starting to see the benefit of we not only providing the tool, the hardware, the IP portfolio. And so those are the things that we're going to continue to highlight. Previously last quarter we mentioned about [modern granite] and this time we mentioned about BAE Systems. They are not only using our digital flow and then also using our IC packaging that are uniquely qualified for the aspect, the requirement that they need.

Got it. Thank you for that, Lip-Bu. And the, Geoff, I think this one's for you. You mentioned you are seeing more leasing of emulators. Can you talk about how that could impact your model in revenue and otherwise if that continues to become a bigger piece of your business?

Yes, we've had a lot of strength in our hardware business, as you know, this year. It has been a very good year and Z1 has been a very successful product. I think though, the point is our DSO will go up and so will our long-term receivables go up, as we sell more hardware and as we lease more hardware. I think that's the key point that I want to make.

Got it, okay. Thank you. That's it for me, gentlemen.

Thank you.

Sterling Auty, JPMorgan.

Yes, thanks guys. I had a couple of questions. Hopefully it is not a repeat of the prepared remarks, but, Lip-Bu, you were difficult to hear. I couldn't really catch much of what you were saying in the beginning.

Yes, we're sorry. We understand that we have had audio problems today so we wanted to remind you that our prepared remarks will be posted on our website after the call. Thanks for mentioning it.

Great, thank you, we appreciate it. Following on what Rich was talking about in terms of functional verification, or the emulation specifically, I think the functional verification revenue line only grew 7%, if I'm not mistaken, year over year, as compared to 40% last quarter and 23% for the quarter before that. How much of that was something that was happening in emulation versus the rest of it? Can you give us some more color as to what is driving that significant deceleration?

Yes. As you would expect, and as I think we said in our Q2 call, we expected Q3 to be actually have lower revenue than Q2. Certainly functional verification and emulation was a large piece of that.

What goes into that? Is it leased versus sales? Is it lead time on emulators?

Yes, it is the fact that we are taking our business as it naturally occurs. We don't want to change our dynamics or our value calculations in any way, so we want to take it when our customers want the product.

By the way, that came after two record quarters in both Q1 and Q2. So I think we expect a little bit of a downturn and that's what happened in Q3.

And on the lease idea, can you give us a sense of what portion of that emulation business is leased? I think Rich started to allude to it, but is that recognized ratably when you are leasing the equipment? Just start with those two.

Yes, leasing is recognized, the revenue is recognized up front because it's a lease, but we collect the cash over a period of time. I think that's key for us.

Okay, and what percentage of that emulation business is leased?

It remains a small portion. We don't break out the details, but it remains a small portion of it. We do want to point out that we've had a very good year and we expect that to continue in Q4. The guidance at this point for Q4 includes everything we know.

Product mix has certainly been a factor this year. Hardware has been better than expected for us, offset by IP revenue that was a little bit below our expectations. We do also expect in Q3 we saw some and in Q4 we will see some of the cost at the end of the life of Palladium XP.

Got it. And then last question, since it is a public forum and I know you can't answer too directly around Mentor Graphics some of the comments and thoughts around possible acquisition, et cetera. I wouldn't expect you to say yes, you're interested in buying the whole company, but wondering if I could ask the question this way. Given the history with the company, I think there has always been an attractiveness for the Calibre line from the other vendors in EDA, but your product portfolio has changed over time. Is Calibre as a technology as interesting as, complementary to Cadence today as it was in 2007?

Yes, I think, Sterling, first of all, and we have a lot of respect for our friend, Mentor and then the management team. They are a very important industry player and clearly, as you know, we don't comment on some of these topics. We have a lot of respect for them. Their product is, Calibre is well known in the industry. So I think we just stop there and we are not going to comment on any of the specifics.

Okay. Thank you, guys.

Sure, thank you.

(Operator Instructions)

Tom Diffely, D.A. Davidson.

Yes, good afternoon. One more IP question. Could you quantify how your change in focus affects the served available market that you are going after in IP directly?

Yes. I think as you know, IP is a new business a few years ago. And we embarked on that and we grew nicely to 10%, 12% of the revenue for our Company. This is very strategic for us in our whole key component to our SDE strategy.

We reviewed recently IP business strategy and as I mentioned earlier, we are going to be focused on standard off-the-shelf IP, pursuing the vertical market that we want to pursue and then the most advanced process nodes. And we're deemphasizing the customized IP, that more once off and it's not many of the IP reuse and that is where you are going to make money.

I think long-term we like that. It's very important this outsourcing trend continues because a lot of companies, our customers we talk to just catch up and then follow these various protocol that keeps coming up. And if they have Tensilica-proven IP and then they would love to outsource that, so we see that as an opportunity.

We are going to be really disciplined, just like when we do the M&A. Again, this is a refined strategy. We are focused on scalability, sustainable, and are more focused on the profits and more focused on the quality of the customer and more focused effort into this whole vertical market we're going to go after and the most advanced nodes and deemphasizing some of this customized IP.

From a strategic point of view that makes a lot of sense, but what percentage of your IP business historically has been in the customized part that you're moving away from?

Tom, we don't break out that. We don't break out the segments of our IP business.

Okay. I was just wondering if you would expect another leg down in that business and then growth from that point on.

All we can say is clearly this is a refocus. As you know, when you grow to 10%, 12% and then you are starting to look at okay, now you grow to 10%, 12%, is this scalable? Is it sustainable? And is it profitable?

And then we can refine the strategy for the next phase of growth. And then are more focused and more IP reuse and more repeatable, scalable business model going forward.

Again, we expect sequential growth from -- modest sequential growth from Q3 to Q4.

Okay so moving over then on a geographical basis, Asia ticked up in the quarter. I was curious, is that hardware-driven? Or is that an increase in the level of software that the Asian customers are starting to use?

We don't break down the segments by geographic, but obviously Asia continues to be a strong market for us and a strong driver for us and we anticipate that going forward.

Just to add on to it, this is Lip-Bu here. The China semiconductor sector actually this year growing at 26% compared with the overall global market is kind of not growing. And so the government have put a lot of effort into it and Cadence is very well-positioned for the two designs in IP. So we are excited about the opportunity and you see that over time, that region is growing.

Okay, and finally here then, when you look at the end markets, Lip-Bu you talked a lot about how semis is a very little or no growth this year. I'm curious, what are you seeing in the growth in the key areas for you, like in the logic area? And then what do you see in overall design activity for your customers?

A very good question. In terms of the growth in the semiconductor and systems company area, the thing that I like a lot is the cloud data center. That's a sea change in terms of the workload requirement and then how to optimize some of the hardware and then the container software. I think that is going to be a sea change.

And then the IoT and all this data is going to be in the cloud. So the cloud infrastructure is going to be a very great opportunity for us.

And then the other part is clearly the machine deep learning. And that is a very broad application to the ADAS and automotive, to sequencing genomics, single-cell sequencing, to the search engine from the eye to the brain function, that whole neuroscience is intriguing to me. And then I think those are going to be driving some of these growth opportunity going forward. And then of course the security-related to across all this vertical will be very interesting to me.

And all too is try to optimize to address some of these design challenges and order different applications of different challenges. And also our IP and that the refinement that we make will be focused on some of this vertical market. And then also some of this application opportunity for Tensilica to explore and then with the DSP programmability and low-power, it will be really [shy] on the Microsoft HoloLens, as an example.

Okay. In general do you see design activity picking up because of the complexity? Or is the softness with some of the memory divisions and stuff slowing down overall design activity for you?

In fact, one of the indicators I always look at is how much new design engagement we have. And our hard-working, capable employees, they are working really hard. I have not seen any time in the last eight years they work harder than today. That tells you a good indication that we're so heavily engaged with some of this new product development.

Great. Thank you for your time.

Thank you.

Krish Sankar, Bank of America.

Hi, thanks for giving me a follow-up. I have two of them. One is, Geoff, you mentioned systems is about 40% of revenues. Can you help us understand how much is auto as a percentage of total revenues, as opposed to (inaudible) systems?

The second question is there any update on this whole ratable accounting thing that you guys have been working with KPMG and the SEC? It looks like things are going to be fine for 2017. Curious to know, is the ratable revenue model at risk when you look into 2018 and beyond, wither for Cadence or the EDA industry? Thank you.

Yes, we don't break out auto. We just say with system companies as about 40% but we do believe it's growing is a portion of our business. On the revenue recognition, my favorite topic, we are still working through the details with our advisors to determine how we'll implement it and what will be the impact, if any. There's still a lot of work to be done, not just by us but my most companies. And we expect to retain recurring revenue treatment. I think that's the take-away I want you to have.

Thanks, Geoff.

Jay Vleeschhouwer, Griffin Securities.

Thank you. I just wanted to follow up on Tom's earlier geographic line of questioning. First, it looks like you have Americas revenue was down sequentially for the second consecutive quarter, and also down slightly year over year. Was that largely a function of variability in hardware?

And then similarly, your Japan business was down year over year for the first time in a year. There had been some hope that Japan might be bottoming for EDA as a whole and perhaps that was a little premature. If you could comment on both those regional trends.

And then lastly, Geoff, to continue with the triangulation of your emulation business, would it be fair to say that the sequential decline of emulation Q2 to Q3 was larger than the corporate decline of revenue? In other words, you declined by more than $5 million or so in total corporate in emulation. But you also seemed to have had a pretty significant increase in the gross margin year over year. You had a decline in cost of revenues for the first time in over a year but revenues had to have grown in emulation. So it looks like you had a pretty substantial increase year over year on the gross margin there, even with a sequential decline of revenues.

Yes, Jay, to take the geographic question first, I wouldn't read too much into the Americas or Japan or Asia or whatever else. I think the long-term trends remained intact. Asia will continue to grow. Japan, I think, has probably bottomed out. North America will fluctuate sometimes from quarter to quarter. And clearly hardware always place a portion in that because that is the part of our revenue that's up front. So don't read too much into it.

As far as emulation, I think the key thing is the math isn't simple here because we are going through a big change in product mix. We are moving from the Palladium XP, the old generation product, to the Z1. And we have said the Z1 will have higher margins than the XP. I think it is complex to do the accounting from within; it's is probably even more complex from you. Please don't read too much into that either.

I will now turn the call over to Lip-Bu Tan for closing comments.

In closing, we are continuing to innovate and deliver system design enablement solutions to our customers. And we're looking forward to continue to execute our strategies and creating value for our shareholders. I want to take this opportunity to thank all our hard-working employees, shareholders, customers, and partners for their continued support that makes this possible. Thank you all for joining us this afternoon.

This concludes today's conference call. You may now disconnect.