新思科技 (SNPS) 2006 Q2 法說會逐字稿

Ladies and gentlemen, thank you very much for standing by and good afternoon.

Welcome to the Synopsys Incorporated's earnings conference call for the second quarter fiscal year 2006.

At this time, we do have all of your phone lines muted or in a listen-only mode.

However, after the executive team's presentation today, there will be opportunities for your questions and those instructions will be given at that time.

Just as a note, ladies and gentlemen, if you should require any assistance during the call, you may reach an AT&T Operator by pressing star then zero on your phone keypad.

Asa reminder, today's call is being recorded for replay purposes and that information will be announced at the conclusion of our call.

Just as a note, today's conference is scheduled to last for one hour.

Five minutes prior to the end of the call, I will announce the amount of time remaining for today's conference.

With that being said, let's get right to the second quarter agenda and here with our opening remarks is Vice President of Investor Relations, Ms. Lisa Ewbank.

Please go ahead, ma'am.

Thank you, Brent.

Good afternoon, everyone.

With us today are Aart de Geus, Chairman and CEO of Synopsys, and Brian Beattie, Chief Financial Officer.

During the course of this conference call Synopsys may make predictions, estimates, and other forward-looking statements regarding the Company.

While these statements represent our best current judgment about future performance and events, the Company's actual performance is subject to significant risks and uncertainties that could cause actual results to differ materially from those that may be projected.

In addition to any risks that we highlight during this call, important factors that may affect our future results are described in our quarterly report on Form 10-Q for the first quarter and in our second quarter fiscal year 2006 earnings release.

In addition, all financial information to be discussed on this conference call, as well as the reconciliation of the non-GAAP financial measures to their most directly comparable GAAP financial measures can be found in our second quarter earnings release and financial supplement.

Our earnings release, financial supplement, and quarterly report on Form 10-Q are all currently available on our Web site at Synopsys.com.

With that, I'd like to turn the conference over to Aart de Geus.

Good afternoon and thank you for joining us.

Q2 was yet another very solid quarter.

For the third quarter in a row, business came in notably above our targets and our technology continues to demonstrate strong momentum.

This outstanding performance was driven by all our product groups, but especially implementation, analog and digital verification and design for manufacturing.

We also executed very well against our financial goals, meeting or exceeding all our targets and making good progress on our operating margin.

Let me begin with some financial highlights.

Revenue was 274.8 million, 12% growth year-over-year and exceeding our guidance range.

Non-GAAP earnings were $0.17 per share at the high end of our target range.

Non-GAAP operating margin was 12.9%, which is excellent progress towards our original '06 annual target of 12 to 13% and our stated '07 objective of 20% plus.

We continue to have one of the most predictable license models in the entire software industry and we are entering Q3 with more than 90% of our revenue target already in hand.

Given the very solid results of the first half and the predictability of our numbers, we are raising fiscal '06 guidance for revenue, operating margin and earnings.

Brian will go over those numbers in a moment.

First, let me update you on the business, starting with the overall environment.

Based on many recent discussions I've had with customers around the world, the semiconductor landscape appears stronger than three to six months ago.

Across the globe our customers are more positive about their business outlook and volumes continue to grow.

We've even seen the issue of manufacturing capacity began to crop up which, in turn, enhances the value of our solutions to improve yield.

The move to 90 and 65-nanometer design is in full swing.

Meanwhile, consumer applications continue to require lower power and more on-chip integration.

All these trends bode well for Synopsys.

Customer interest in our technology is accelerated as our new products deliver tangible benefits, especially IC Compiler, SystemVerilog based verification and design for manufacturing.

As an example, attendance at our user group meetings worldwide from San Jose to Israel to Europe to India next week has increased notably in the last year.

In addition, more than 500 engineers participated in our recent design for yield seminars where we showcase the many yield improvement features in IC Compiler.

Since the beginning of the year, a number of major customers have standardized on Synopsys.

The benefits of our complete integrated flows are making a visible impact.

Earlier in the year, a very large consumer electronics company consolidated on Synopsys implementation and verification to enable their move to 65-nanometer.

Second, [Micronos], a world leader in high definition TV chips selected Synopsys as its preferred vendor for its digital design flow.

Third, a top global fabless semiconductor company chose Synopsys as its main EDA provider to help them move aggressively to 65-nanometer.

In Q2, Cypress Semiconductor was able to reduce its total design time by as much as five weeks using our Galaxy implementation.

Cypress is consolidating its digital design flows and methodologies on our platform.

Also in the quarter, Agere announced that it's standardized on both the Galaxy and Discovery platforms for digital designs.

Agere chose Synopsys as its primary supplier because of our technology strength and our ability to help them meet their complex design requirements.

They will work with us to increase their use of our design for manufacturing tools as well.

Let me now provide some specific technology highlights from the quarter.

First, our Galaxy implementation platform was again strong and came in above target.

IC Compiler continues to deliver impressive results for customers, 8 to 10% better timing area and power and 40 to 50% faster time to results.

To date, multiple tapeouts have been completed, including a multi-cord ESB for telecom applications at Agere and an ultra-low power version of ST's most advanced nomadic multimedia processor.

As IC Compiler has quickly gained momentum, it is already featured in four important reference flows.

One example, Stark, the influential consortium of Japan's semiconductor manufacturers, adopted IC Compiler in 2002 for its Star Cap 21 production flow.

The number of evaluations of IC Compiler jumped markedly in Q2 for both current PC Astro users and a dozen brand-new logos.

For competitive reasons, we don't disclose product-specific counts, but I can tell you that our installed base more than doubled in Q2.

The large number of IC Compiler evaluations and adoptions is fully utilizing our present field capacity.

In synthesis, Design Compiler won nine out of ten technical benchmarks in Q2.

Our new topographical features are delivering substantial gains in layout, correlation and performance.

Companies such as NVIDIA are deploying this technology because of its productivity gains, fewer design iterations and faster time to market results.

As we predicted, designs at 65-nanometer are ramping a bit faster than most others had anticipated.

In a survey of designers at last month's Silicon Valley's Synopsys users group meeting, representing the majority of North American semiconductor companies, 19% of designs were already targeted at 65-nanometer, a big jump from last year. 45% of designs were aimed at 90-nanometer.

At this time, we are tracking 191 active 65-nanometer designs, an increase of almost 19% over last quarter.

Tapeouts continue to grow rapidly with 71 completed to date, an increase of more than 30% sequentially.

The majority of those tapeouts use Synopsys physical implementation tools.

Now to manufacturing, where we had another solid quarter.

Customers recognize both the broad scope offer our solution and the rapid progress we are making towards creating a bridge between design and manufacturing.

Our unique position is making a difference in our technical and business engagements.

No one else has the necessary technology in both manufacturing and design to develop a fully integrated design to manufacturing solution.

Driven by the requirements of 65 and 45-nanometer design, Proteus mask synthesis continues to excel.

The majority of 65-nanometer fabs use Proteus today.

Sony adopted our Phase Shift Masking technology, or PSM, to enhance manufacturability of its high performance chips at 65-nanometer and beyond.

Hercules physical verification was selected for a 32-nanometer design project during the quarter.

Our yield management solution is generating a lot of customer interest, both as a standalone product, and as part of the integration of our DSM platform.

One of the top global fabless companies just adopted our solution to facilitate more rapid yield diagnosis and yield improvements.

Stay tuned for more product announcements in this area as we move through the year.

Moving on to Discovery, our verification platform, we had another very strong quarter for digital and an outstanding quarter for analog mixed signal.

The combination of insatiable customer demand for faster verification and our different shaded technology drove our results.

SystemVerilog momentum continued with recent adoptions by companies such as Agere, Sequence and S3.

During the quarter, we announced the first ever complete SystemVerilog flow supported by Discovery for verification, Galaxy for implementation and a strong collection of verification ID.

On the analog mixed signal verification side, Synopsys continues to be the clear choice with products that cover the spectrum from very high accuracy to very high speed.

A great example comes from a large communications chip company that reduces verification time for a 65-nanometer mixed signal design from 17 hours to just one hour with NanoSim.

In addition, a major Japan company has standardized on 8-sim for verification of the their mixed signal design.

Now to IP and services.

As customers move to larger, more complex chips, successful IP [inaudible] use greatly improves their productivity.

Utilization of commercial IP is becoming commonplace and Synopsys' ability to provide complete and, most importantly, the highest quality IP solutions puts us in a great position to grow this business.

Q2 represented the best ever bookings quarter for DesignWare blocks with particular strength in our newest mixed signal course.

In system level design, we just announced the acquisition of Virtio, a creator of virtual platforms for embedded software development.

This technology will gradually expand our customer base to include software development engineers.

They will be able to begin [code] development much earlier than with prior methods, thereby accelerating hardware and software development.

In services, our team continues to be very highly utilized on some of the most advanced designs in the world.

After completing several projects of 65-nanometer, we have already started our first design at 45-nanometer.

There is strong evidence that leading edge services projects continued to drive Synopsys tool up at option.

In March, we told you about our new Pilot Design Environment.

It provides a ready-to-use optimized design flow, as well as a way to systemically measure and improve productivity.

There's been a lot of interest, as you can imagine, by both mainstream and leading edge designers.

One major fabless company, after an initial engagement at one site, is exploring how to deploy Pilot nationwide.

While we do not expect Pilot to contribute materially this year, we are excited about the long-term possibilities.

I do have one personnel transition to report.

Vicky Andrews, our head of sales will be leaving the Company next month to spend time with her family.

I'd like to take this opportunity to thank Vicky for her great contributions to Synopsys.

She leaves behind a strong team and we plan to appoint a successor within the next several months.

In conclusion, we continue to execute very well in all key respects.

Business was notably higher than targets, our strong technology continues to expand adoptions around the world and we executed well on our financial goals.

With that, I'm pleased to turn the call over the Brian for the financial update and guidance.

Thank you, Aart.

Let me start with an update on my first 100 days.

As you recall, my priorities during the first few months were to get a good handle on the financials and the expectations going forward, analyze the operation of the Company and focus on cost management.

During these 100 days, I have found a widespread commitment to improving operating margins and earnings power.

We have already identified it and implemented actions that we expect will drive improvement in our operating margin from 7% in 2005 to our original 12 to 13% target this year and to 20% plus in 2007.

Furthermore, we have the most stable and predictable revenue model in the industry, as well as a strong balance sheet and cash flows.

These allow us to make the right long-term decisions to help us grow our business.

We're working to identify new ways to drive the business forward by focusing on top line growth and increasing cash flow.

In short, I've been happy with the results I've seen so far and we have an excellent foundation for further progress.

Now to the quarter's excellent results.

As a reminder, I'll be discussing certain GAAP and non-GAAP financial measures.

We have provided a full reconciliation in the press release and financial supplement posted on our Web site.

Total revenue for the quarter was 274.8 million, a 12% increase year-over-year and the sixth straight quarter of revenue growth.

This exceeded the high end of our target range.

Our revenue mix remains stable with licenses at 86% and services, which includes maintenance and consulting, at 14%.

About 90% of Q2 revenue came from beginning of quarter backlog.

Just over 9% of Q2 revenue was up-front, slightly higher than anticipated due to a one-time license of phase shift masking intellectual property.

From a product perspective, 75% of revenue came from our core Galaxy design and Discovery verification solutions. 20% came from our IP and manufacturing businesses, and 5% came from professional services.

Geographically, Japan and North America were the strongest regions in the quarter in terms of orders.

Revenue distribution reflected a very strong business in Japan, which came in at 18% of revenue.

North America was 54%, Europe was 15%, and Asia Pacific came in at 13% of the revenue.

One customer accounted for more than 10% of revenue in the second quarter.

GAAP earnings for the quarter were $0.04 per share with costs and expenses totaling $267 million.

GAAP results include 13.6 million of amortization of intangible assets and 13.8 million of stock-based compensation expenses in compliance with FAS 123R.

Non-GAAP earnings per share of $0.17 were at the high end of our guidance range.

Non-GAAP operating margin was 12.9%.

Q2 non-GAAP costs and expenses were 239 million, an expected increase of 7% sequentially.

This increase was driven primarily by Q1 expense benefits that were non-recurring and timing related.

As you may recall from last quarter, these benefits included greater than anticipated employee vacation and shifting out of hiring.

Q2 expenses were also affected by increased variable compensation due to the strong quarter.

Other income net for the quarter was approximately $1 million.

The non-GAAP tax rate was 33%, slightly higher than last quarter due to a state audit accrual.

We still estimate the annual tax rate at 31% for the year.

We continue to execute well on contract mix. 92% of the product orders in the quarter were booked as time-based licenses with 8% as up-front.

The average length of our renewable customer license commitments remained healthy at 3.2 years.

Turning now to cash.

Operating cash flow was 27 million in Q2.

Capital expenditures were $16 million.

Cash and short-term investments increased 20 million to 535 million.

We also repurchased about 800,000 shares of our stock during the quarter for $18 million at an average price of $21.57.

We have approximately 338 million left on our authorization and will continue to evaluate the best use of cash each quarter, including company operations, investments, and stock repurchases.

Q2 net accounts receivables totaled 138 million, an expected increase from last quarter driven by seasonal billings.

DSOs were 46 days, up from last quarter as expected and within our historic range.

Deferred revenue at the end of the quarter was 520 million, a slight increase sequentially.

Head count totaled 5,031 full-time employees at the end of Q2, a slight increase sequentially due to continued additions and lower-cost geographies.

And as Aart mentioned, we just announced the acquisition of Virtio, a small developer of virtual platforms for embedded software development.

It was an all-cash deal valued at up to $15 million depending on the ultimate level of earn-out.

Now I'd like to give you a brief update on the progress we're making on improving the Company's operations and cost structure.

As I'd mentioned at our investor day in March, we're committed to improving our earnings power through a combination of top line growth and expense control.

On the expense control side, we're well on the way towards making concrete changes throughout the Company, starting with infrastructure.

For example, we are concentrating hiring in lower-cost geographies.

We're also beginning to institute changes that will streamline our systems and processes in both infrastructure and sales and marketing.

In R&D, in addition to the workforce globalization, we're evaluating quality and product and development processes to identify cost-effective improvements.

All of us are committed to top line growth and expense control to drive our long-term earnings power.

Now looking forward to Q3 and fiscal 2006.

In general, we expect revenue to grow 8.5 to 10% in 2006.

We expect that cost and expenses will be up approximately 2.5% over 2005, slightly higher than anticipated due primarily to very strong business in the first half of the year, as well as the impact of the Virtio acquisition.

We expect Virtio to have a small, dilutive impact on its first two quarters, but be roughly neutral to earnings for the first full year.

At this point, R&D expenses are expected to increase sequentially in Q3 and Q4.

Sales and marketing expenses are expected to be about flat in Q3 and up sequentially in Q4 to reflect the end of year commissions with G&A declining sequentially through the rest of the year.

For the third quarter, our targets then are: Revenue between 270 million and $278 million; total GAAP costs and expenses between 261 million and 274, which includes approximately 17 million of stock compensation expense; total non-GAAP costs and expenses between 232 million and 242 million; other income and expense between 0 to 4 million; a non-GAAP tax rate of 30%; outstanding shares between 144 and 150 million;

GAAP earnings of $0.02 to $0.07 per share, and non-GAAP earnings of 17 to $0.20 per share.

We expect more than 90% of the quarter's revenue to come from backlog.

For the full year, we are increasing our revenue, operating margin and earnings targets.

Revenue between 1.075 billion and 1.090 billion; a non-GAAP tax rate of 31%; outstanding shares between 144 and 150 million;

GAAP earnings per share between 8 and $0.17, which includes the impact of approximately 66 million in stock-based compensation expense and non-GAAP earnings per share between $0.68 and $0.74.

This implies a non-GAAP operating margin of 12.5 to 13.5%, an increase from our previous target range.

We expect to continue to see cash flow from operations to be greater than $175 million and over the next four quarters we expect approximately 930 million of our beginning of quarter backlog to turn to revenue.

More than 90% of our revenue for the remainder of fiscal '06 is already committed.

In summary, I'm pleased with our excellent execution this quarter and look forward to the rest of the year.

With that, I'll turn it over to the Operator for questions.

Thank you very much, Mr. de Geus, Mr. Beattie for your time and that over today.

We do appreciate that.

At this point, we do turn towards your questions and comments. [OPERATOR INSTRUCTIONS] And first in queue, we go to the line of Harlan Sur with Morgan Stanley.

Please go ahead, sir.

Thank you and good afternoon.

I noticed that your Asia Pac revenues declined for the second quarter in a row here in April.

Just your thoughts on the business activity there and do you expect to return to growth soon?

In general, our Asia Pac business is actually quite strong.

And so how revenue gets recognized is a little bit of a function of how the deals came in, what the deals from the past was and it can vary greatly from quarter-to-quarter.

Having just being there, literally, what was it, two weeks ago, I can tell you that there's actually a lot of activity specifically in China and I also know that a business with some of the very large foundries, not just in Taiwan, are very strong.

Great.

Thanks.

And then you talked about the 65-nanometer projects in your services business and I think last quarter you said that you had three in the pipeline.

I'm just wondering, what are the issues or problems these customers are facing as they transition to this technology mode?

Well, there's a very clear issues.

Fundamentally, there are three.

One is a 65-nanometer, you have a lot of functionality there for verification, it's just a very, very large [staff].

Secondly, at 65-nanometer, power is the toughest optimization criteria to meet while you simultaneously try to get to the speed and power is not just dynamic power but also a [linkage] power.

And third, as you move down towards these geometries, now watching out for yield issues is essential and we have already today in our tools quite a number of techniques to optimize for yield as we will be even beyond 65 variations are going to become more important.

Okay.

And then, one last question for you.

On IC Compiler, I know you talked about a doubling of the installed base, can you just give us an idea of how many tapeouts your customers have completed using IC Complier?

Well I think we communicated the ones that we had authorization to communicate.

People are still very reluctant to communicate where they are exactly with 65-nanometer because they view it as quite competitive.

We've had multiple tapeouts at this point in time and so we're well versed in it and we're actually already moving to the next smaller geometry.

Okay.

And then last question for you, Brian.

On the accounts receivable DSOs they jumped by about 17 days sequentially.

Again, can you just help us understand that and where you would expect DSOs to trend going forward?

Yeah, we had 29 days in the first quarter and then it went to 45 and when you look at the trend over the last eight quarters with us, we've been ranging, really, a 29 was an absolute low.

So this is really in line with our typical flows on receivables.

It also just reflects an increase in our business activity in the second quarter as well.

So we're in good shape, both anything over 90 days appropriate provisions against it and a big focus on cash and we'll continue to drive it in the range of 30 to 45 days type of thing.

Okay, all right.

Thank you.

You're welcome.

Thank you very much, Mr. Sur.

Next representing Needham & Company we go to the line of Rich Valera.

Please go ahead, sir.

Thank you.

Aart, in your comments, you talked about I think the overall semi environment being stronger than it was three to six months ago.

Can you just talk about your confidence level that the overall EDA market will actually grow this year based on the stronger semi environment?

It's difficult to see exactly what the other guys are going to do.

We certainly feel that we are in a good position at this point in time by virtue of the technology that we have to offer and by virtue of the fact that it's almost like the race on technology is picking up again.

In many ways after the '01 downturn, people focused so much on cost for a while, and then that's gradually shifted back to, well, how do you differentiate on products and now it feels like people are really racing forward with technologies, with more integration, with more complex IP et cetera.

All in all, I think the large EDA vendors have done okay recently and I think we just had a very good quarter.

And Brian, the size of that phase shift intellectual property transaction, can you give us any more granularity on that?

The customers really wouldn't like us to disclose the amount of that particular transaction but it was one-time.

And you know, the range we have always identified as to be at 10% of the less of the quarter coming in in terms of up-front revenues, so that popped us up to just over 9% and we anticipate being less than that for the rest of the year.

Okay, that's helpful.

And with respect to Vicky leaving, Aart, do you have any sense, yet, if you plan to replace her with someone internally, or do you actually plan to engage in a search to look outside as well?

Well, you know, I think we need to work that out internally before we communicate that externally.

But it is true that we have a very good team and right now we're all very busy already on Q3.

So that's where I like to see them focused.

Great.

Just one final one, Brian.

On Virtio, just wanted to clarify, I think you said 50 million was the total potential.

Can you say how much of that is up-front versus earn-out and over what period of time that earn-out might be over?

Just to clarify the number, it's 15.

Oh, thank you.

It's $15 million and there's several million at the end of it over just roughly a one-year period to determine what our final payments will be and we'll start booking that.

The deal closed yesterday and we'll start accounting for that here in the third quarter.

Great.

Thanks very much, guys.

You're welcome.

Okay and thank you very much, Mr. Valera.

And our next question then, we go to the line of Jay Vleeschhouwer representing Merrill Lynch.

Please go ahead, sir.

Thanks.

Good afternoon.

Aart, I'd like to ask as well about IC Compiler.

When you consider the results to date [and] it went into production last year, are you seeing that in absolute or proportionate terms IC Compiler is growing within your overall pools with customers, but perhaps other parts of the pools, DC or anything else might be perhaps declining in value, so that there's relatively little net increase in the total size of the pools for the run rates, even with IC Compiler gaining momentum?

You know, we have, obviously, very complex pools where you have many tools.

In general, IC Compiler is, I would say, right on track where we thought it would be in the [inaudible] of replacing PC Astro to the tune of about 80% in three years.

I believe that right now our engagements of IC Compiler versus PC Astro are running about four to one.

And so that tells you immediately that's only our field support has completely shifted there.

A hidden positive is that one of the reasons we've been able to shift well is that PC Astro is doing very well as a product.

And so that helps in terms of supporting that.

But it's very clear that the shift to IC Compiler is moving.

Have you seen any examples where a customer or customers have done a complete replacement thus far or migration from PC Astro?

No, they typically go gradual.

Typically they start with one block, then multiple blocks, and then gradually complete chips.

And so we're now in the migration from multiple blocks to complete chips.

And with respect to the sales management change, it's been quite a number of years, I think, five or more since you've had a meaningful change like this in sales management.

Whether it's someone internal or external that you put in this position, do you anticipate this as an opportunity maybe to make some kind of orientation or structural changes at all in sales in terms of how you approach or manage global accounts, the feel, pricing, product packaging, any of that sort of thing?

Well you know, whenever there's any management change anywhere in the Company, we always look at the question of are there things that we could do differently or is this a good time to ask the question if one would like to shift things.

It is clear that the relationship with the global accounts is very important and very complex because these are large deals and they will continue to get a lot of attention.

The other thing is, is that our selling is gradually moving more and more towards much more complete solutions and I think the good news is that Vicky prepared her team extremely well for an understanding of that and in many ways, I think we're well positioned by the way we do business today, but change is always an opportunity to change things that you wouldn't do any more the same way as five, six years ago and accelerate others.

A couple of last ones.

You've highlighted in your comments, strength in Japan again, as you had in the previous calls since the Summer.

I assume that's because we're now pretty much in the heart of the renewals of the Japan deals you did three years or so ago, so those names are now coming up in order.

But again, the typical run rate question, are you in fact seeing with those Japan deals, which perhaps include any [seed] Toshiba [inaudible] and the rest, are you in fact seeing meaningful increases upon the renewal?

Typically when I refer to strength, that's exactly what I mean, it's the opportunity to grow the business.

Obviously, sometimes there are some waves of renewal and whenever renewal comes in one is always thankful that things went well.

At the same time, the objective is to grow the run rate with the companies and in general, I think Japan has been doing very well for us.

And then lastly for Brian, is there a measurable benefit thus far from the new geographic disbursement of R&D?

Can you give us what the difference is perhaps over the last year from having made this head count shift?

I think you'll see that as we indicated at our investor day as well that we're leading in the industry relative to getting some top people in some of the lower-cost geographies and anticipate that by the end of this year about 29% of our employee base will be located in those geographies.

We are seeing this year a reduction in our average cost per employee and, of course, that is one of the key deliverables to driving our operating margin and being able to increase our targets for this year to 12.5 to 13.5% and then to this 20% plus in '07.

Thank you.

Thank you very much.

Mr. Vleeschhouwer.

Next representing Cowen and Company we go to the line of Raj Seth.

Please go ahead, sir.

Hi.

Thanks very much.

On IC Compiler, you mentioned a lot of ongoing evaluations.

I'm curious, how long, I know there's probably not a uniform length of time it takes, but how long do these typically take, at least those first within your existing customer base?

Well, the question has to always be triggered by what is the thing that makes them start.

Typically it's a few months and the starting point has to be the moment where they actually have a major block that is ready to go to place en route.

And so, there may be blocks readily available or there may one needs to be waiting until that train arrives.

Once one or more blocks have been tried out, that's when things move up.

Secondly, within organization, typically there's one place where it starts.

People do a block then do a chip and then it spreads to the divisions.

And so we've had already a number of larger companies that are completely committed to spreading to all their divisions.

That typically takes, I would say, 12 to 18 months.

Okay.

You also mentioned some new logos, I think, in the evaluation process.

At this point, in IC Compiler, you generally mostly focused on your current installed base or are you beginning and feeling a pull for evaluations in accounts where there have been competitive solutions as the incumbent solution?

When do you think that starts happening if it isn't yet?

Actually, very good question because initially, invariably, you start in your existing accounts because that not only reduces your own support costs, it is also accounts that you can work with as a new product stabilizes.

At this point in time, we have entered the phase where we are in two accounts that before we were not in where a competitor was doing the place en route.

That's a very good sign because I think in the ones we're in, things will expand naturally.

In the new ones that's clearly a new opportunity space for us.

Good.

One last one, if I might.

You talked a little bit about some of the phase shift product.

When numerical, you still licensed that technology, they did it on a royalty basis, wafer-based royalties with folks like UMC and some other.

Are you still licensing that technology in that way and are royalties meaningful in your financial results now, or no?

Typically, there's only a small portion that's part of the royalty equation and, yes, we have some customers that do that.

We have swiftly learned the lesson that people love royalties for small volume and so it's essentially pushing a rope with most of the customers and therefore we work mostly on a licensing basis which makes for much better relationship with our customers.

Great.

Thank you, Aart.

You're welcome.

Thank you very much, Mr. Seth.

Next in queue is Dennis Wassung representing Canaccord Adams.

Please go ahead.

Thank you.

Actually, quick first follow-on to that phase shift question.

If you look at the design for manufacturing and your revenue would jump to 12% this quarter, up from 10, I think it's the largest it's been in the last year and a half or so.

Are you seeing a, I guess, would you expect to see that percentage to keep moving higher, or was that really kind of a one-time effect of this phase shift deal you did in the quarter?

Yeah, well, there is some variability from quarter-to-quarter and so something like the phase shift deals can be fairly big blimps in a given quarter.

In general, though, it is clear that the whole connection down to silicon, the DSM connection, and it's actually fairly broad, it extends into our implementation tools as well.

It will grow in importance because a lot of the practical problems reside there.

And so I would not be surprised even if it's not necessarily from quarter-to-quarter all the time that gradually the DSM contribution to our company will increase.

It's one of the growth areas for us.

You talked about Proteus as well on the call and a lot of the fact that 65-nanometers moving the Proteus.

Has that been, I guess, a steadily growing piece of revenues for the Company and can you quantify that at all?

And also on the phase shift side, is that something that you see as a growth market?

I know it's sort of been off and on, we've heard about the phase shifting piece, but is that something that's taking more acceptance in the industry at this point?

Well, if I may just change your words a little bit, it's not so much that Proteus is moving to 65-nanometer, it's that 65-nanometer is moving into much more volume production.

And in many ways we have to prepare Proteus already a long time ago to make sure that it was completely ready and set it and optimized for these technologies.

And now that the volume is increasing, the need for more copies increases with it.

And so and that sounds, it is well placed in the present need set.

But I would say in aggregate, all of DFM is doing very well for us.

And as much as one could look at individual products, we have very much followed a strategy that says, how do you actually provide what increasingly is a complete DFM platform that ultimately has one objective, yield.

Okay, great.

A couple of other quick ones.

First off on the operating margin target, you talked about 20% plus in fiscal '07, is that you're target for the full fiscal year or is that to achieve it at some point during the year?

We've been extremely consistent and said that it would be the second.

We've also been consistent to say that it's not limited to 20%, it could be higher, but our commitment has been that we would arrive at 20% during the year.

Okay, great.

And I guess last question, more of a macro question and I guess environment question, any changes in the pricing environments and you talked about the fact that your semiconductor customers and just customers in general seem to be feeling better about themselves in their markets, volumes as well, are you seeing that as any sort of expansion in their EDA budgets at this point, or would you kind of expect the vendor consolidation theme, just more money for Synopsys at these accounts, how would you couch that at this point?

It's a little bit off because we did notice that there was a little bit more pricing pressure this quarter.

At the same time, we also see I think that some of the budgets are growing, and because we're seeing both, I think that is good for us.

My suspicion is that some folks are getting a little bit more nervous about being around at the table when the deals close and as customers tend to focus on fewer suppliers and that's what's pushing the pricing a little bit.

At the same time, we absolutely see a desire to grow the number of copies that customers have and that's a good sign for us.

Great.

Thanks, Aart.

You're welcome.

Our next question we go to the line of Mahesh Sanganeri representing RBC Capital Markets.

Please go ahead, sir.

I'm calling for Stuart Muter.

I'd like to go back to the question on the DFM.

So when I look at or talk to people there's most DFM applications are OPC and PSM.

Is that a meaningful adoption for CMP?

I know you mentioned that in your TSMC press release, and also how about other more involved applications of DFM, like process variability, bringing process variability into design.

If you can elaborate on that, the adoption of those.

Sure.

Actually, one of the larger categories you did not mention that should be mentioned first is TCAD and that has been a very good business for us.

And at least for us being connected to TCAD is also the test chip business that helps calibrate what comes out of the manufacturing back into a variety of the tools.

In regard to CMP, that is a fairly narrow niches today that we will add capabilities gradually in our tools as they become necessary at the different geometries.

Already today in our implementation tools, we have techniques that compensate for what's called some of the dishing problems due to CMP.

So we're well connected to that, but we're looking at really as a long collection of many, many techniques that all have to come together in a flow that ultimately either yields good yields, pardon the pun, or not, and our objective, clearly, is to connect those things well together.

Is it CMP, [inaudible] you have, is it more tangible than just having a designed that you have it on middle line or how does -- what I don't understand is, how is it that different from doing your modeling and coming up with designs [inaudible]?

Maybe we should take this question offline, because, again, go very deep technically, very quickly.

I would make two comments.

One is that the some of the dishing issues can have profound impacts on the stability of chips, in other words, if you don't compensate for them, your chips don't work, period.

Secondly, some of those techniques affect the timing because the capacities on a chip are not what you expected them to be.

So these are just two aspects to us, but there are many, many more.

If you -- if we can help at some point in time giving a little bit broader background, we can put you in contact with the GM that is in charge of that and that's handled the modeling and optimization.

That would be great.

I have a different question.

How should we look at year-over-year growth in [survey] sites, looking at the last two quarters, I would say it's trending down from '05, '06 over '05.

Is that going to be the trend going forward?

On the services, first there's actually quite a bit of variability quarter-to-quarter because of whenever the milestones are reached, whenever projects are finished.

Secondly, we have purposely not grown the service business very much as we are driving the profitability of the Company and services is not at the higher end of what we do.

However, it's very important in that it really has helped pioneer and drive forward some of the new technologies, so it's a business that is essential, but not growing very rapidly.

So I think flatish is probably the best prediction here.

Maybe I could add something just on the numbers related to that.

What you have to look at in the '06 is really the completion of the model transition where maintenance is typically included in our time-based license activity compared to several years back when the up-front and the maintenance piece was separated out.

So this is a pretty consistent level and to add to what Aart said, we're also seeing our services team be pretty busy these days and working a lot of new activities.

That's helpful, thanks a lot.

You're welcome.

And next we'll go to the line of Rohit Pandey representing HSBC Securities.

Please go ahead, sir.

Thank you.

Aart or Brian, when I look at the TBL line on the income statement, that revenue from TBL declined slightly, [inaudible] but I'm trying to understand why should this line go down?

Yeah, it -- we identified back in the first quarter that there was one payment that was in the area of 4 to $5 million which we consider a due and payable account.

So revenue is recognized when the amount of billings are due and that was a 4 to 5 million.

If you look over a trend period, that trend is continuing to go up and also if you excluded that from Q1, you can see a very nice progression from Q3, Q4 into Q1 and Q2.

So we are seeing a nice progression, but there's just a one-time transaction identified in Q1 which was categorized as a TBL license appropriately.

So about a 4, 5 million transaction in Q1 which was not a previous transaction but was a TBL.

It was a TBL that's, they don't happen very often.

It's really one where a payment stream is what was negotiated with the customer and because they extend beyond the one-year period, that revenue is recognized when the cash is payable and that was 4 to 5 million in Q1, as I said, with one customer.

And when I look at the revenue from backlog for the next four quarters, that number has gone up from 890 to about 930 million from Q1 to Q2, so an improvement of about $40 million.

So the visibility has gone up, but this $40 million, is it driven by better bookings in this quarter or is it driven by more amortization coming in from the [inaudible] now have, now that you are already at Q [inaudible], one more quarter of amortization?

Yeah, I think, again, we continue to have the most predictable visibility to our revenue streams going forward.

It's a very significant number.

As you saw, we have also more than 90% of Q3 revenue completed and also more than 90% of the rest of the year, the next six months fully completed as well.

So that extra visibility is something we've continued to build on.

It was a good quarter, I mean our bookings were strong, the business was strong for the quarter and it allowed us to build up that backlog that's going to be profiled over the next four quarters.

But what drove it more?

Was it that 40 million increase?

Was it driven more by bookings in the current and [inaudible] quarter, or because you have one more, I mean because you had [inaudible] four quarters of backlog?

It's really both.

It's just a strong quarter that continues to build and takes into account the new business that's already been contracted for the next twelve months that's already been factored in so very good, nice, strong growth.

Okay.

And how big was the team acquired, how many people?

I think the number was like 35, yeah.

35.

Yeah.

And again, remind me, where are they based?

They're based here in Silicon Valley, in Campbell, I believe, and partially in Great Britain.

Yeah, there's a small group in Texas too, as well.

So that would offset somewhat what your move to the low-cost geometry?

Well, not to go across geometries, but maybe geographies.

We are in all of these locations with the exception of Scotland and so the move to lower-cost geometries -- the lower-cost geographies is a gradual one and we use every attrition as an opportunity to sort of revisit, should we replace at the same place or can we move and we're very conscious to want to make sure that we maintain a very effective continuation of product developments, business picture, et cetera, but it is very gradual.

Do you estimate this ESL market to be in, what are the growth you're kind of starting to see in this segment?

One of the reasons that we've been fairly low key about this is that we want to spend a lot more time on looking at this entire market.

ESL has been such an unexplained word and so misused by so many parties in the past to set expectations that were either close to zero or close to infinite that's it's just not a very useful way to define things.

Maybe the best way to present is that we've always said that our move toward system design would be through the building blocks of IP where we have a strong position, we are gradually with the IP comes more and more embedded software.

With the collections of IP comes more and more the need for platforms that tie it together and what this is, is really an opportunity to move from our IP collection to our verification IP to now system IP.

And that is just, I think, a very elegant way to start touching the embedded software developers.

And on the expenses, this one is for Brian.

The original goal was to keep expenses flat.

Now you expect them to go up about 2.5% for this year.

So what are the basic operational challenges you're facing when you try to lower the cost further down, like, I mean you've done a good job in controlling expenses, but it's a little higher than what you thought it would be originally, so what are the fundamental problems you're facing there?

I'd say, first of all, recognizing that our business is growing now based on our new guidance at 8.5 to 10%, and that as you see a growth of approximately 2.5% in spending that that's basically a four to one ratio.

So it's minimized the spending while you can really drive through the revenue and the higher level of business.

So what we're seeing in the rest of the year is number one, our compensation for overachieving the plans in both bookings, revenue and earnings.

Of course, it has to be taken into account as we go through the rest of the year.

We have a small increase there now associated with the Virtio acquisition that we closed on yesterday.

Really, mostly driven towards higher specific spending, at the same time, of course, continue to lower the ongoing costs.

So it's just some of these, basically, you call it direct costs that grow with the incremental level of business.

And again, we've now been able to increase our operating margin as we just did from 12 to 13% now to the range of 12.5 to 13.5% for this year.

So again, getting closer to the targets that we've been establishing for next year as well.

Thank you very much.

Mr. Pandey.

Ladies and gentlemen, just as a note.

We are at our five-minute mark before the conclusion of the call today.

Next, representing Deutsche Bank we go to the line of Tim Fox.

Please go ahead.

Thank you.

Good afternoon.

First question, Aart, you had some very nice growth in the Discovery platform and in DFM, but the Galaxy growth has been in kind of the low single-digits here for a couple of quarters.

When do you anticipate that we'll start to see some year-over-year growth in the Galaxy platform and, you know, where could we see that for the full-year?

Well I think that if there is a growth opportunity it would be more towards the second half or early next year as some of the products that we've rolled out do better and better.

Revenue varies quite a bit from quarter-to-quarter so I wouldn't be able to say that it's systematic.

The other thing is the position in Galaxy helps our DFM position.

The DFM position helps our Galaxy position and so in that sense, as much as we report in these major categories, we ourselves always question ourselves if it's the right thing to do given that there are quite a number of interdependencies.

Nonetheless, I think that the core of the business is now very solid and I think with the market up and the technology strong, we should be able to do well.

Okay.

And the second question is around backlog growth.

You talked at the beginning of the year about your intention to grow backlog for the full-year and given the two quarters that you've reported here with bookings ahead of plan, I'm wondering if you could comment on whether you still do intend to grow backlog for the full-year and whether you're willing to quantify that at this point?

So the answer is yes to the first, which is, yes, we are continuing to be very much on target in growing backlog and what we have said is that we would give you the backlog numbers at the end of each fiscal year as being the most meaningful.

But so far I thing we are very well on track and the reason we are raising guidance on a variety of metrics is because things have become much more solid [inaudible].

Very good.

That's all I have.

Thank you.

Thank you, Tim.

Thank you very much, sir.

And next we go to the line of Matt Petkun with D.A.

Davidson & Company.

Please go ahead.

Hi.

Thanks for taking my call and, of course, most of my questions have been answered.

I'm curious, actually, on the Virtio acquisition.

You guys sort of had a chance to try before you buy having, I believe, integrated that product suite with your Discovery platform towards the beginning of last year.

How many customers do you have currently working with Virtio and, you know, kind of what are your expectations for growth in that business for the next couple of years?

There are a number of very important, very large customers working with Virtio, and you're absolutely right, we had the opportunity to try it out, so to speak, or to be close to it and saw the impact.

I think Virtio, at this point, I have communicated already that they were doing business with TI and Freescale, both of those companies, of course, have very, very strong broad system and chip platforms that benefit greatly from this type of technology.

As so it is precisely because we saw the impact and we knew that this was a very good team that we felt this would be a very good addition.

And the complementarity with our existing system tools and our IP I think is really remarkable.

So from that perspective, there's actually, for right now, still a small announcement, but I think has the potential to be very important as we move now much more into this general system or embedded software arena.

Okay.

And then others have sort of asked the question in a variety of ways but the bulk of your DFM business came from [NAS] data prep and OPC.

What's going on with the integration of HPL and how do you see the market for, really, yield enhancement, you know, starting to unfold and do you get customers coming at you for that technology or is it more still about just, you know, getting the design down on the chip?

So first and different people give different titles to their field, not always correctly but we still put TCAD in the general arena of design for manufacturing, although it's really much more tools for manufacturing.

Secondly, we have other products such as the fracturing products, [CATS] that have done very well.

And third, on the HPL acquisition, that is moving along very nicely because it's connecting to so many things that we do and, as a matter of fact, we are already working with some key fabless semiconductor vendors to see if we can help them connect better to their foundries and thus first, diagnose and then improve their yield.

So this is all part of very simple to state strategy which is, how do you close the loop on yield.

In practice, of course, there are many pieces, but so far all the pieces appear to be right in place.

Okay.

Maybe the more direct question is, you're working with those customers in regards to HPL but have you figured out how to get paid for that?

The answer is yes.

Okay.

Great.

Thanks so much.

Nice quarter.

Thank you.

Thank you, Mr. Petkun.

We go to the line now of Saket Kahlia representing JPMorgan.

Please go ahead.

Hi guys.

I'll make my questions quick, here.

Two specifically.

First on the guidance.

Correct me if I'm wrong, but it seems like the third quarter guidance as well as the full-year seems to imply roughly a flat fourth quarter and I just wanted some more color on that.

Second question was just another clarification on the PSM customer that you had.

Was that indeed the 10% customer as well?

And that's all I have.

On the second question, the answer is no.

That was not a 10% customer.

In terms of flatness for the year, we have raised the overall number a little bit.

I said, quarter-to-quarter things can vary quite a bit.

We do feel that the first half was stronger than originally planned, therefore, we feel more solid about projecting the ending.

The variability on Q4 invariably tends to be fairly large, therefore, we want to be careful on how set the targets and we'll do that next quarter.

Okay.

Thank you.

You're most welcome.

And that you very much, Mr. Kahlia.

Well with that, Mr. de Geus, Mr. Beattie, I'm gong to turn the call back to you.

There are no further questions.

Well, thank you very much for participating today.

As usual, Lisa, Brian and myself will be available after the call and I think we're looking back on a strong quarter and looking forward to a very solid outlook.

Thank you.

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