Cadence Design Systems, Inc.

Good afternoon. My name is Josh, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence First Quarter 2020 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. I will now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence. Please go ahead.

Thank you, Josh, and I would like to welcome everyone to our first quarter 2020 earnings conference call. I am joined today by Lip Bhutan, Chief Executive Officer, and John Wall, Senior Vice President and Chief Financial Officer. The webcast of this call is available through our website, cadence.com, and will be archived through June 12, 2020. A copy of today's prepared remarks will also be available on our website, at the conclusion of the call today. Please note that the discussion today will contain forward-looking statements and that 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 financial results prepared in accordance with generally accepted accounting principles, or GAAP, we will also present certain non-GAAP financial measures today. Cadence Management believes that in addition to using GAAP results in evaluating our business, It can also be useful to review results using certain non-GAAP financial measures. Investors and potential investors are encouraged to review the reconciliation of non-GAAP financial measures with their most direct, comparable GAAP financial results. The reconciliations are available at the Investor Relations section of Cadence.com. Copies of today's press release, dated April 20, 2020, For the quarter ended March 28, 2020, related financial tables and the CFO commentary are also available on our website. I would also like you to note that we are adhering to social distancing practices and therefore are conducting today's earnings call from remote locations. Apologies in advance if there are glitches or handoffs take a little longer than usual. And now I'll turn it over to Lipu.

Good afternoon, everyone, and thank you for joining us today. I am pleased to report that in a difficult environment, we didn't achieve excellent financial results for the first quarter of 2020. We are all going through truly unprecedented times, and I hope that you and your families are safe and healthy. I will start by commenting on the rapidly evolving COVID-19 situation. Our first priority continues to be ensuring the safety and well-being of our employees, customers, and communities. At this time, the vast majority of our global employee base is working from home, and that transition has gone very smoothly. From the business continuity perspective, Our infrastructure collaboration of platform and tight communication have enabled us to maintain a high level of productivity. And our R&D innovation projects and customer deliverables continue to track well. Our sales and application engineering teams have also adapted well to this new work model. and have continued engaging productively with customers on the business, training, and support front. As I stated earlier, there has been a silicon renaissance in the industry, with strong design activity being driven by generational technology drivers, such as 5G, AI, hyperscale computing, and industrial IoT. So far, even in the current environment, we do not see any slowdown in design activity. And I do believe this period is to be an opportunity, especially for market-shaping customers, to further invest in R&D and accelerate their innovation. Our business is predominantly tied to semiconductor R&D, and in addition, our broadly diversified customer base, over $3.7 billion of backlog, and highly reputable business model all serve to highlight the resiliency of the business, particularly in challenging times. Very resilient of our business, particularly in challenging times. After careful accessing the situation, at this time we feel comfortable reaffirming our revenue guidance for the year. In a few moments, John will provide more details and commentary on our Q1 results and guidance for Q2 and the year. Our intelligent system design strategy enabled us to maximize these opportunities by tripling our TAM to proliferation in our foundation design excellence segment and expanding beyond EDA into system innovation and pervasive intelligence. Now, let us look at some of the design excellence highlights for the quarter, starting with digital and sign-off. Our Kaizen digital workflow, which has been proven through hundreds of advanced node tape-outs, have significantly enhanced to further optimize power, performance, and area, or TPA, results across multiple application areas. The new full flow featuring our innovative iSpecial technology, which includes unified placement and physical optimization engines, plus machine learning capabilities, delivers up to three times faster throughput and up to 20% improved . The new full flow is being used by several leading customers and was endorsed by MediaTek and Samsung Electronics. Additional digital and sign-off highlights for the quarter include a major Asian hyperscale company successfully used Aden's digital full flow to tape out a machine learning inferencing chip, and is deploying full flow at seven and five nanometers. A marquee Asian electronic system company completed its first production Aden digital full flow tape out on five nanometer low power process, beating its power targets. and a market-shaping semiconductor automotive customer committed to Cadence as its primary EDA vendor for digital design. Our Cadence Verification Suite wins in the marketplace because it delivers the best verification throughput, driven by its four best-of-class engines, Axelium, Jasper, Palladium, and Proteum. In Q1, we had multiple verification wins across various verticals, including cloud, data center, automotive, and networking. Our hardware family had a banner quarter, with Palladium Z1 adding four new customers and nine major expansions. Our Proteum SDGA-based prototyping platform Continuo is strong momentum, adding six new customers and six repeat orders, as the X1 is increasingly deployed in Palladium accounts. Sodium X1's strong momentum is a result of its unique differentiation in having a common front-end compiler with the Palladium Z1, but also provides superior performance and opacity scalability for earlier software development and hardware regression. Both the Z1 and X1 platforms show particular strength at hyperscale system companies, in addition to momentum at market-shaping semiconductor customers. Our IT business delivers double-digit revenue growth as our compelling offerings continue to benefit from the ongoing IP outsourcing trend with design wins and expansions at several top-tier companies as well as startups. PanSilica did particularly well and was adopted for multiple audio applications as well as by surveillance and mobile customers. In design IP, There was a strong demand for our DDR portfolio, as well as our high-speed service and PCIe IP, particularly in data center, AI, and high-performance computing segments. Now I will highlight our progress in system innovation segment of our intelligent system design strategy. Earlier this year, we completed the acquisitions of AWR and Integrin, and we have received very positive response to the acquisitions from many of our partners and potential new customers. The integration is progressing well on all fronts, and we are combining this technology with our Virtuoso and Allegro platforms, which will enable us to offer a comprehensive platform for designing high-frequency RF millimeter wave products. Our system analysis tools carry forward their strong momentum into the new year, and we now have more than 30 customers, including Venasys, Roam, and NFrame, in addition to providing significant better performance and capacity without compromising accuracy. Verity and Celsius also provide a tighter integration with our flagship Virtuoso and Allegro design platform. With that, I will now turn the call over to John to review the financial results and provide an updated outlook.

Thanks, Lupu, and good afternoon, everyone. Let me begin with a few comments on the COVID-19 pandemic. Our first priority remains the health and safety of our employees, partners and customers. And while some of our employees in China are already back working from our cadence offices in the region, a vast majority of our global workforce are currently working in a remote environment. Our team continues to be very effective, even though many are working from home. For this, we are very proud and very grateful. Even with the global disruption and uncertainty created by the COVID-19 pandemic, I am pleased to report we met or exceeded all of our key operating metrics in Q1. Now let's review the key results for the first quarter, beginning with the P&L. Total revenue was $618 million. Non-GAAP operating margin was 32.2%. Gap EPS was $0.44. And non-gap EPS was $0.60. Next, turning to the balance sheet and cash flow. In mid-March, we borrowed $350 million under our revolving credit facility as a precautionary measure to provide additional liquidity in light of the recent global economic uncertainty caused by the COVID-19 pandemic. As a result, at the end of the quarter, Our cash balance totals $946 million, while the principal value of debt outstanding was $700 million. Operating cash flow for Q1 was $218 million. DSOs were 42 days. And during Q1, we repurchased $100 million of cadence shares. Before I provide our guidance for Q2 and fiscal 2020, I'd like to take a moment to address some points that I think are important to understanding the assumptions embedded in our outlook. Our guidance continues to assume that the export limitations that exist today for certain customers remain in place for all of 2020. The shelter-in-place orders that are in effect today as a result of the COVID-19 pandemic create some logistical challenges related to fulfilling some hardware and IP product orders. for which we recognize upfront revenue upon completion of delivery. At the low end of our revenue range for Q2, we are assuming that the government mandated or recommended shelter in place orders in effect today will remain in place for the remainder of the quarter and any hardware or IP products that we cannot deliver before the end of our Q2 will be delivered in the second half of the year. On the other hand, If starting sometime in May we can get sufficient physical access to complete hardware and IP deliveries, we expect to be closer to the high end of our revenue range for Q2. Assuming we have sufficient physical access to complete hardware and IP deliveries by the end of Q3, we do not expect any negative impact to our full year guidance from the delivery delays we are assuming for Q2. For Q2, our guidance is as follows. revenue in the range of $580 to $600 million, non-GAAP operating margin of 30%, GAAP EPS in the range of 28 to 32 cents, non-GAAP EPS in the range of 50 to 54 cents, and we expect to repurchase $75 million of cadence shares. For fiscal 2020, our guidance is as follows. Revenue in the range of $2.545 to $2.585 billion. Non-GAAP operating margin of 32% to 33%. GAAP EPS in the range of $1.58 to $1.68. Non-GAAP EPS in the range of $2.40 to $2.50. We expect operating cash flow to be in the range of $775 to $825 million. And we expect to use approximately 50% of our free cash flow to repurchase Caden shares in 2020. You will find guidance for additional items as well as further analysis in the CFO commentary available on our website. In summary, I am pleased with the results we delivered in Q1 and I have been impressed by the resilience of our business model and the agility and capability of our global team at Cadence to continue to operate so effectively in this environment. The world is facing unprecedented times, and we are all deeply sympathetic to anyone who has been impacted by the COVID-19 pandemic. We are clearly all in this together, so I would like to close by thanking our customers, partners, and our hardworking employees for all that they do. Please note that we are adhering to social distancing practices and therefore are conducting today's earnings call from remote locations. My apologies in advance if there are glitches or handoffs that take a little longer than usual. And with that, operator, we'll now take questions.

At this time, I would like to remind everyone who wants to ask a question to please press star, then the number one on your telephone keypad. Your first question comes from Rich Valera from Needham & Company. Please go ahead.

Thank you. And congratulations to the cadence team for delivering some very solid results and obviously challenging conditions. With that, I just wanted to ask about your China revenue in the quarter, which was actually up as a percentage of revenue year over year, despite a very tough comp since last year, you didn't have the entity list restrictions on Huawei or several other likely Chinese customers. So just wondering if you could talk about what drove the strength in China and This quarter, was it new customers? Was it sort of a ramp in demand from existing customers? And if there's any color in terms of which products were in high demand there?

Yes, I'm Mr. Lippo here, so let me start. Our business enables design of future electronic products. China business remains quite good for us. Q1 was aided by both hardware and IP business, which has mostly upfront revenue. And John can provide more colors and details here.

Yeah, Mitch, I would say this isn't unusual. Our China revenue over the past nine quarters has fluctuated between a low of 8% back in Q2 2018 and a high of 13% both this quarter and in Q4 2018. Q1 revenue was higher due to both hardware and IP business, which are mostly up front for revenue.

Great. And then just a question on the new system product ramp. I heard your new customer count sounds like that's up to 30, which is great. Just wondering if you can provide any anecdotal evidence of customer penetration, i.e., customers that have ordered, you know, a single license, have proved it out, and then have come back to order multiple licenses, and if you've seen any customers sort of scaling up the way presumably you'd like to see.

Yeah, I think so far, I think we're very pleased with our system analysis tool that carries momentum into Q1. As you already pointed out, we have more than 30 customers. on the quality and Celsius product line. And clearly, I think we're providing fair, high performance, better results, and then the scalability, and then not compromising any accuracy.

Great. And just one quick one for you, John. I noticed your non-GAAP EPS stayed the same, but your GAAP EPS actually went up. Just to quickly explain the delta there.

Yeah, just a slight difference in our assumptions for the M&A integration between what we had in the forecast at the start of the year and where we are now.

Got it. Okay. Thanks very much, gentlemen.

Thank you. Your next question comes from Jay Fleeshower with Griffin Securities. Please go ahead.

Thank you. A couple questions. First, on China and geographic mix generally, according to the 10Q report, This evening, your China revenues were a record at about $84 million. You explained the reasons why it was so strong. But looking out over the next number of years and thinking about all the issues that surrounded China over the last year and where U.S. government policy may go, how are you thinking about perhaps geographic risk mitigation, again, notwithstanding the very good results in China this quarter this How do you think about perhaps mitigating the dependency there by perhaps focusing on other parts of the world? Europe, for instance, had a very strong year in 2019 for EDA. So perhaps that would be a region to think about refocusing on as an example. So that's question number one. Question number two, you highlighted the newer products, Clarity and Celsius. How would you compare your experience thus far with those two products with the previous generation of HUS and UM products, Tempus, Voltus, Pegasus, which we frankly haven't heard a great deal about? Is your experience in terms of customer adoption meaningfully different or would you expect it to be different than the prior generation of sign-off tools that you introduced?

Yeah, so let me get started, and then John can fill in some more details. So first of all, I think we will expect to do everything we can to support customers by complying with all the application law and regulations. And we want to provide the best tool for our global customers. That includes China, Asia Pacific, EMEA, and US. But that is our philosophy, give them the best product and then support them in their design. You know, in terms of the new products, and clearly I think we are very pleased with the system analysis product, the tool that came out, and clearly showed the differentiation, and we are delighted. You know, quarter by quarter, we have more and more customers coming with us. It's a big temp market for us. These two products, you know, the temp is about $700 million, so I think we are aggressively pursuing that, and clearly we have a big advantage in terms of performance. In terms of the voters and pickers, we continue to do well, and then we will continue to update you from time to time. Pickers are most important with the foundries. Make sure that the various process nodes are certified, and I think over the last few quarters, we highlight a couple of process nodes that different foundries have been certified, and then now we are starting to really driving some of the customer success, and then stay tuned in the coming quarters.

Yeah, and Jay, I would add to that that I think you can see from our results and from our guidance for the year that our business benefits from the diversification we see across products and platforms and geographies. And as much as we encourage investors not to look at any one quarter, I mean, China contributed 10% of our annual revenue in 2018 and 2019, and we're happy to get off to a strong start for 2020. But hardware and IP are lumpy for revenue. And so you should never focus on any one single quarter.

Okay, just a quick detail question for you, John. If I'm reading the queue correctly, it looks like you took some inventory reserve on hardware. If so, could you comment on that?

Hi, Jay. I presume you're referring to the section where we say we include inventory reserves in our hardware COGs. Yes. But we consistently do that. I mean, I don't think there's any significant change in inventory reserves from quarter to quarter. But generally, if we have a hardware system that's out being demoed or on loan, we'll take depreciation or amortization for that into our P&L and include it in COGS, even though we haven't sold it yet.

Very good. Thank you.

Okay. Your next question comes from Mitch Steeves with RBC Capital Markets. Please go ahead.

Hey, guys. Thanks for taking my question. I really had two. The first one's a little bit more for Lipu. When I look at your comments about design activity, Some of the checks, at least we're picking up, is that they're trying to actually accelerate the design activity. So can you maybe give us a little bit of a broad overview of what you're seeing in China and in data centers and, I guess, any sort of way you want to splice at the market in terms of what design activities are looking like across the different end markets or however you want to do the verticals?

Yeah, so let me try to give you a little bit more color. As I mentioned earlier, we are going through this silicon region renaissance in the industry, clearly we see strong design activity driven by this generational technology driver, like the 5G in the RF fund, and then the AI and machine learning across different platforms. And then the hyperscale, in this environment, actually they deploy even more, and they are all quietly building up their own silicon team. And then the whole digital transformation from the industrial group, we see a lot of, so I think clearly, so far, as we see today, we don't see any slowdown in activity, especially, I call it the market-shaping customer, they double down, triple down in their R&D, and we're delighted to support them, and that's kind of, we see the opportunity in the design activity, and in some way, our business very much predominantly tied with the semiconductor R&D, and that really benefits us. And then we have been very focused on the market-shaping customers, and we are really excited to support them in all their various designs.

Got it. And the second one is for John, just a little more on the financials. So China is up pretty significantly. Is there any way to talk about if that's just going to be sustainable or if that's some pull-in from hardware? I mean, what do you guys think about this? the China percentage of revenue. I think that was a little bit surprising, but maybe you can maybe give us maybe a high-level comment of what a full year should look like, if it should be around that type of revenue percentage or not.

Sure. Yeah. I mean, it was large in the first quarter, and it was mainly due to hardware and IP business, IP revenue business. At the start of the quarter, I mean, I think it's IP that surprised me in Q1 to the upside. At the start of the quarter, we thought that we would have lower royalty revenue in the region, and we were a bit too conservative in Q1, I think. So IP outperformed based on my expectations for Q1. And then in terms of China for the year, like I said, it's ranged by quarter from a low of 8% in Q2-18 to a high of 13% now this quarter and as well back in Q4-18. But we're happy to get off to a strong start for 2020, and I'm thinking – double digits in terms of continuing at least double digits with the China contribution to our annual revenue is reasonable.

Okay, perfect. Thank you. I don't know how you guys could have done much better than that, so a great quarter.

Thank you. Your next question comes from John Pitzer with Credit Suisse. Please go ahead.

Yeah, good afternoon, guys. Congratulations on the solid results. John, you did a good job with the June quarter revenue guide kind of helping us understand the puts and takes around COVID between the low end and the high end of the range. But I'm just kind of curious, was there any absolute impact to June revenue from COVID that you've also included? Because even at the high end, you're coming in sort of below where the street was. And then when you look at the full year number, would you have raised the full year revenue outlook had it not been for COVID, i.e., are you building in some cushion on an absolute dollar basis there as well?

Thanks, John. Thanks for the question. It's a great question. Thanks for the opportunity to clarify. I guess when I sit and look at Q2, I think it's fair to view our guidance for Q2 as being a little bit conservative and maybe more conservative than normal. But when I look at the impact of COVID-19 on our revenue, like for hardware, we don't have our usual physical access to customer sites to deliver product. And then it's hard to predict when we'll get that access, but if we deliver some hardware in the last week of June, it becomes Q2 revenue. If those hardware products slip to the first weeks of July, it's Q3 revenue. In both cases, they're 2020 revenue, so I have more confidence in the year than I do for Q2 in terms of making those deliveries in time to fit Q2 revenue. When we said that we're prioritizing the health and safety of our employees and our partners and our customers. We don't want to try and drive for too early delivery, particularly if we don't have physical access. We can't control it if we don't have physical access to a customer site. On the IP side, the physical access is to our own cadence sites because that's where our labs are for IP. And IP revenue is generally determined by just how much IP we can deliver in the quarter from our labs. We're already a little bit behind because we haven't had access to our labs. And it's not like a demand issue. It's one of timing in terms of the delivery of revenue. And then, so like I say, Q2 is I suppose the paradox of having a predictable revenue stream. It's very predictable for the year, but it's just less predictable in terms of what we can get done in June versus July at the current moment.

That's helpful. And then maybe you can help me better understand. A lot of us out here are trying to figure out how the next several quarters might play out for the overall semi-industry. And for better or worse, we're kind of using the global financial crisis as a starting point. But there are some significant differences. But when I go back and look at Cadence's performance through the global financial crisis, you know, you were going through sort of an accounting change, which I think heightened sort of the volatility through that. But you also saw a situation where things got bad enough where customers were cutting sort of R&D. And I guess just given sort of the magnitude of the economic impact we're all expecting from COVID, why shouldn't that be kind of a baseline assumption as we go into the back half of the year? Or are there enough sort of incremental drivers like hyperscale that really didn't exist back during the global financial crisis or China that didn't really exist that you think offsets that? Because right now, at least how you're playing out the year, is June is sort of the trough in revenue, and it's a pretty shallow trough. And I understand, you know, the business is just a lot more predictable than the global financial crisis. But what other puts and takes do you see out there?

Yeah, so a couple of things. I think clearly, you know, we are going through an unprecedented time in terms of economy and unemployment and this virus across all the different regions. And so I think, you know, first of all, I think most important for us is to protect our employee and customer safety and well-being. And then saying that I think clearly the impact of the economy and the semiconductor really range on product to product. Clearly the hyperscale and, you know, video conference related area and then e-commerce and area I think is really beneficial. And some of the sector will be a little bit harder, especially in the consumer area, and also in terms of the automotive-related area will be more challenging. And so I think it's not across the board. I mean, there are some really exciting areas. And then clearly, I think we are more tied in with the R&D budget. And so I think good news is all the market-shaping customers in various areas a hyperscale player and in various high computing area, we see the benefit of it and experience that infrastructure side. And so I think that part we continue to benefit and we trip down on it. And then clearly, you cannot look at quarter by quarter. Some order may be a little bit more in China, some area may be geographically higher. Overall, I think we have a very, very strong you know, the resiliency of our business, especially the retable model and also the backlog and a very diverse customer base that really put Caden in a very well position to do that.

And then last, Philipp, just as a follow-on, you know, there was a couple earlier questions that touched upon the strength in China, and it was up nicely, albeit it seems to make sense relative to the ambitions that the Chinese semiconductor industry has. But I'm just kind of curious, given... the heightened rhetoric around U.S.-China relations and the idea that the U.S. might actually make foundries or licenses to ship to certain customers. Is there a risk that some of your Chinese customers are buying ahead? And how would you handicap that risk, or how would you help us think about that?

Yeah, it's a good question. Overall, I would say that China's business remains quite good for us. And then, like John mentioned earlier, we assume the export restriction will remain. And we're complying to that. And then meanwhile, we are doing everything we can to support the customer globally and then for all their new innovating design. And so I think all in all, I think we have a careful assessment of the situation. We felt that we can reaffirm the whole year because it's a retable model. and we have a very 3.7 billion of backlogs, and so we can manage much better that way. And then, again, by partnering with customers deeply and then be their trusted partner and work with them, and that is the best way to really drive success together.

And, John, this is John here. I would just like to add to that that, you know, 85% to 90% of our revenue is recurring in nature, so any additional or kind of any pull-forward buying opportunities wouldn't increase our revenue, because the revenue is time-based. That would occur maybe on IP and hardware, and there was no evidence of that in Q1.

Perfect. Thanks, guys.

Your next question comes from Gary Mobley with Wells Fargo Securities. Please go ahead.

Hey, guys. Thanks for taking my question, and let me extend my congratulations on the strong results as well. I wanted to start out asking a follow-up question to John's line of questioning about, you know, what's different this time versus the financial crisis of 08 and 09, and just thinking about how you diversify your customer base to include system OEMs. I see your backlog metrics continue to grow about 15% year over year, much faster than revenue growth. Is it the new class of system OEMs who are taking control of their own IC designs, the leading driver, of that growth? And as well, are the average deal sizes for system OEMs materially different than what you would traditionally license to merchandise the customers?

Okay, Gary, I think a good question. So let me touch on the first and then John can give you more detail on the deal size and others. And so I think overall, we are excited about this generational technology drivers. 5G is deploying and then the hyperscale and the infrastructure is really deploying. And then the other part is also the high computing area for AI machine learning. Either it's a startup or a mature big company, they are all diving in big time into the whole, not just semiconductor silicon, also to the whole system level. So the packaging also will benefit from it. And so I think all in all, I think We see strong design activity, doesn't slow down at all. And then clearly, we continue to build the backlog because the right of both business. And so there will not be dependent on quarter to quarter. So far, that model has worked out very well for us.

I had a follow-up question.

Oh, sorry. Gary, just adding there that I think the biggest difference between where we are now and where we were back in 08-09 is that, I mean, we've incredible visibility now into our backlog. I mean, we've got $3.7 billion worth of backlog. We're very, very diversified. And we have a lot of visibility into the second half for 2020. Okay.

And in the last time you gave fiscal year 20 guidance, I believe you mentioned that the extra week in the fiscal year and the two acquisitions you recently closed on were adding additional in some about 300 basis points to the 10% growth you were expecting. I presume that the extra week impact hasn't changed, but are you still looking for the same amount of contribution from the acquisitions?

Yes. So, Gary, it's about $40 million. The extra week is worth about $40 million of additional recurring revenue to the year in 2020. And we're expecting about $20 million from the combination of AWR and IntraGrant, the two acquisitions we completed in early Q1. So, yeah, $60 million to the year. Yeah, I'm not expecting any more or less than that for the year right now.

Okay. All right. Thank you, guys.

Our next question comes from Joe Brewink from Baird. Please go ahead.

Great. Hello, everyone. Just in regards to some of the product discussion and the new product offerings, is it possible to say with things like full digital flow or maybe the case of adding simulation to Allegro or Virtuoso workflows, how much this is increasing average contract value with a customer versus maybe a traditional measure of, say, wallet share with your customers?

Yeah, it's very difficult to bifurcate.

Okay, so no sense other than like on simulation, it's helpful to maybe define that as a $700 million opportunity between Clarity and Celsius. But other than that, no sort of uplift guidance maybe you can provide?

I think it's too early to tell right now. But certainly, I mean, it's very welcome by our customers, and our customers are very happy with the products we provided. But it's very difficult to kind of bifurcate the value of one product versus others in an arrangement where there's multiple products being provided to customers.

But the only thing I can add on to that is basically these two acquisitions clearly give us a lot more opportunity in terms of more comprehensive solutions. to provide to some of our key customers.

Okay, great. And on your operating margin outlook for the year, I believe the second half is implied to be closer to the 34% level. Is that really just a reflection of the revenue guidance and maybe the particular revenue mix that you anticipate for the back half of the year? Or are there maybe some other op-ex items or costs that are more in your control that factor into this view as well?

There's two real drivers there, Joe. One is the M&A that we lost some of the revenue in the purchase accounting. We lost some of the deferred revenue in purchase accounting and it impacts the first half of the year more than the second half of the year, so it can excuse some profitability towards the second half of the year on the acquisitions we brought in at the start of the year. I guess the other impact is because we're assuming some deliveries that would normally happen in Q2 fall over into Q3, that you kind of have a slightly more back-end loaded margin profile for the year. I mean, originally I was thinking it would probably work out something like 31.5 and 33.5, and now I know we're guiding to 31 and 34. Okay, great. That's helpful. Thank you.

Your next question comes from Tom Diffley with DA Davidson. Please go ahead.

Yes, good afternoon. So, John, you talked about how access to customers provided a little bit of conservatism in your second quarter outlook. But I'm curious, what are you seeing on the actual manufacturing front with emulation? Are you seeing any supply chain difficulties?

No, not right now. I mean, we have a strategic sourcing group that have been working closely with all our suppliers. We think we have ample inventory and we have good second source suppliers. The issue we have with revenue and predicting revenue for Q2 is really down to whether we can have physical access to customer sites to be able to deliver the physical product. I mean, that's where we've got some uncertainty. And because of the uncertainty, I'm assuming some of that will naturally fall into the second half of the year.

Yeah, that makes sense. And then, Libu, I'm curious, you know, through this crisis, have you seen or any of your customers talk about acceleration to the cloud?

Yeah. So I think, you know, clearly, you know, we provide our tool in multiple ways. And then cloud is one of the big areas that we focus on. We are delighted that, you know, we're clearly extending our leadership in the cloud offering, providing customers with compelling, you know, productivity, flexibility, and scalability benefits. And so, you know, we mentioned that we passed a funded customer box, and so I think we're continuing to make progress on that.

Okay, and is that bigger on the emulation side or on the design tool side?

I think, you know, the costs are multiple different products and will depend on the product offering we will provide them.

Okay, thank you.

Thank you. Your next question comes from Adam Gonzalez with Bank of America Securities. Please go ahead.

Hi, guys. Congrats on the results and thanks for taking my question. Just wanted to follow up on, you know, some of the comments that my peers have made on your China sales and how strongly they've grown. Can you talk about the availability of domestic substitutes in the region and how far behind China is in EDA in terms of being able to provide a complete competitive full-flow suite of products? Thanks.

Yeah, I think so far we're monitoring closely. In China, there's a couple of small 0.2 solution providers. And clearly, from Synopsys and Caden, we're doing 25, 30 years of accumulating and able to provide the full flow and the most advanced nodes. But clearly we don't underestimate that because clearly they get a lot of government funding and so we keep a very close eye on that and not only from their progress and also from their recruitment point of view and make sure that our team is committed with us and then we can continue driving the R&D in China, Beijing, Shanghai side.

Great. And my follow-up is on the digital IC design and sign-off segment. I saw there's been a deceleration in year-on-year sales growth in the last three or four quarters. I don't know if that's just a rounding error with the percentage of sales that you give. But is deceleration just a function of tougher comps, or is it the timing of bookings? Do you expect the trends in that segment to turn around in the near term? Thanks.

So, Adam, one thing I'd point out is certainly for Q1 and Q2 this year, we're lapping very tough comps because Q1 and Q2 last year were not impacted by the export limitations we currently have in China.

That makes sense. And if I can sneak in one last question, you know, you talked about the Q2 outlook and how it really reflects just a few different scenarios and how, you know, how long you have – whether or not you have access to customer facilities. If these work-from-home orders were to be put in place longer than people currently think, is there a chance that customers might switch their consumption of these hardware products more to a cloud-based model?

I think it's too early to tell. We're quite happy that we had a really solid bookings quarter in Q1 with particular strength in Japan. And I think we've had 15 new Cadence Cloud customers in Q1 already. including several larger customers, but I think it's too early to tell right now. But, yeah, I think that's as much as we can say.

Okay. Thank you.

Your next question comes from Jackson Adder with J.P. Morgan. Please go ahead.

Hey, guys. Thanks for taking my question. The first is I realize that the impact on revenue is just about logistically getting on site, but what about – the difficulties or maybe some execution challenges you've had on getting deals across the finish line, maybe for software deals. I would expect, or I think a lot of people would expect, that there would be more moving pieces for larger deals, just moving around internally at your customers with everybody working from home. So I'm curious to hear whether you've seen any impacts on that side.

Jack, our ability to close business hasn't changed. We have very, very close contacts with our customers, a very customer-driven company. We always stay close to our clients. Also, I think we got a little bit lucky. Toward the end of last year, Lipu and I talked with the management team, and when there was a yield curve inversion back in August, we looked at the data. for previous recessions, and the data suggested that a recession often happens within 8 to 14 months following a yield curve inversion. So at the end of last year, we made it our business to try and close as much strategic account business early in the year as possible, and we managed to do that.

Excellent. Thanks for the comment. Then the follow-up question on Is it possible that there could be maybe any trickle-down effects from the delayed either hardware or IP delivery? Would that change maybe activity later in the year if people aren't able to get their tools in time?

So basically the delivery – I don't think we've had any problem with closing business. The challenge is being in executing and delivering the – on the business, demand continues to be strong. And it's just really getting access to a customer's facility to be able to deliver hardware. And in our case, in the IP case, getting access to our own facility into the Cadence Labs to complete the IP deliveries that we've already contractually signed up to.

Okay. Thank you.

Your next question comes from Ruben Roy with Benchmark. Please go ahead.

Hi, thanks for taking my questions. John, you've had a lot of questions on China, and I think I understand the near-term dynamics, but I was wondering if you could refresh my memory on export restrictions. Obviously, there's been some chatter in recent weeks around potentially tightening rules for some sorts of high-technology product shipments into not just current entity-less companies in China, but potentially to a broader swath of Chinese And I'm wondering if you could remind us what portions of your product lineup are subject to export restrictions. Are the hardware and IP products, some or all, subject to those restrictions? Or if you've heard anything new on potentially tighter rules for your product specifically? Thanks.

Well, most of our products are U.S. origin, so they're impacted by the export limitations. Our ability to deliver products and services to certain customers, the entity list, is limited. So, therefore, we would expect our revenue in China to be higher if we didn't have those export limitations. But for the purposes of guidance, we just state our assumptions that we assume nothing will change. And right now, like I say, because most of our technology is U.S. origin, we are impacted by those export limitations across the board.

Right. Okay. Okay. Okay. And then just a quick follow-up, John, on sort of the assumptions. You walked through the assumptions on, you know, how to think about C2 guidance, low-end to high-end on, you know, the potential of getting back to work. How were you thinking about your own operating expenses and margins? Obviously, you've kept your clear guidance static, but do you have any embedded assumptions in sort of when you expect things to normalized, if there will be a normalized coming up, embedded in those assumptions for the year?

Yeah, sure. I mean, effectively, we're continuing to hire, although hiring has slowed because it's more difficult to complete the whole interview process and the onboarding process. But we're continuing to hire. And typically, we hire after getting contractual commitments from customers. But Lipu and I are very careful about adding investment dollars until we see the commitment from customers. So in our guidance, there is impact, of course, with if hardware falls into the second half from the first half, the cost of goods sold associated with those hardware products will also fall into the second half. Originally, I was expecting like 31.5% margin in the first half of the year, followed by 33.5% margin in the second half. That's more skewed now towards 31 first half, 34 second half, because of an expected shift of some hardware and IP revenue from Q2 into Q3, really.

Got it. It's very helpful. Thanks, John. Okay.

Our next question comes from Jason Salino with KeyBank. Please go ahead.

Hi. Thanks for taking my questions. You know, in terms of operations in China, you know, obviously those were impacted from kind of coronavirus first and your global workforce. And what types of learnings were you able to apply to your other segments in North America and Europe once you saw kind of those restrictions put in place?

Well, so one thing I learned is, I mean, last quarter I thought there would have been a bigger impact to our royalty revenue. And as it turned out, it wasn't as big an impact as I thought because in some cases, you know, some products – do better and some products do worse. And I think we benefit from a diversification across our products and platforms. Another thing we learned is that there's a lead time, I guess, in terms of hardware orders. We were able to complete hardware orders in the latter part of the quarter in China because the hardware was already on site and being demoed by the customer. So we didn't have any additional physical delivery to complete the the revenue cycle to be able to take revenue. Whereas if we haven't got the hardware on site for the customer, we have to wait for the customer sites to open. So that was the learning that we had. And therefore, the impact to our Q2, you see that in our Q2 guidance. We're expecting that some revenue that we would normally be taking in Q2, we're expecting to fall into Q3 now.

Gotcha. Okay. You know, a progress standpoint, customer engagement standpoint, you know, is there anything else that mirrors or differs from what you saw in China customers versus, you know, North America or Europe?

I don't think so. I think, you know, we're a company that operates in, like, in the technology industry, and, you know, we can never predict the future, but... But we always assume, we work in an industry where we always assume that tomorrow will be very different from today and so we operate very, very closely with our customers and that close client relationship allows us to be resilient, flexible and agile and very, very effective in times of change. I think we're also very diverse. We have people in 47 sites across 22 countries, all very, very close with our customers. So we're able to navigate with change. We're able to move with change very easily. And I'm delighted with how effective the teams have been.

Okay. Thanks, John. I appreciate it.

Your last questions come from Krish Sankar with Cohen & Company. Please go ahead.

Yeah, hi. Thanks for taking my question. I had a couple of them mainly for John. John, thanks for all the color on the China sales. I was just trying to figure out You said some of the outperformance was in IP in China. Within IP, can you say, was it more on the cloud data center? Was it mobile? Was it auto? Any color would be helpful.

It was certainly on the IP side, but I don't think we give any further color in terms of which part of IP. But IP was very strong in Q1, and we were delighted with that.

Got it, got it. And then, you know, obviously some of your emulation and prototyping hardware is assembled and tested by the subcontractors. Which specific geographies are your subcons in right now?

So most of our hardware is made in the U.S., in the Americas. But, yeah, we're very close relationships with our suppliers. We have second-source suppliers. We also have ample inventory. I don't think we have any supply chain issues.

Got it, got it. And then just a final question. I'm guessing it's not an issue, but if you look across your whole customer spectrum, If you look at some of the smaller customers, do you worry about potential payment issues for them in the second half or so if the economy goes into recession?

That's a very good point. In our guidance, we're anticipating some natural credit deterioration, particularly in the longer tail of customers. We've said many times in the past that our top 40 customers, we generate 55% to 60% of our revenue from those customers, and thankfully, they're in a very strong position. many of them read like a who's who of the strongest balance sheets in the world. But in the longer tail, naturally we would be concerned about some credit deterioration. So we built in some anticipation for natural credit deterioration in the long tail. Now, if the shelter-in-place order remains in place for much longer than the end of Q2 and we don't see improvement in the second half, that could impact the businesses of our customers and our customers' customers and and cause credit quality to deteriorate more than we're currently anticipating. I haven't got that. I haven't anticipated a Great Depression or anything. But we have assumed that there may be some credit deterioration if this lasts through the end of June. And that's all. I mean, we can't predict the future. I can only share with you what's in our assumptions.

Got it. Can you quantify that credit deterioration?

Oh, it's only slight. Like I say, it's... you know, maybe kind of 5% to 10% slower payments because that could impact our revenue timing because you become more variable, you have variable consideration. So we have a typical recurring revenue pool, and if you assume everyone's credit worthy, that's very even every quarter. If there's any credit deterioration, that can cause a little bit of a delay because you have to wait until you collect cash to recognize revenue. Got it. Thanks a lot, John. Thank you.

No worries. There are no further questions. I'll call back to LitVu for closing remarks.

Thank you all for joining us this afternoon. Our intelligent system design strategy is playing out very nicely as we benefit from new opportunities in design excellence, system innovation, and pervasive intelligence in an expanded, totally addressable market. In this time of uncertainty, I'm very impressed and of the dedication and commitment shown by our employees to continue innovating and delighting our customers. We are all in this together, and I'm convinced that we will collectively come out of this unfortunate situation stronger as a company, as a community. And lastly, on behalf of all our employees and our board of directors, I want to give our heartfelt thanks to the extremely brave and courageous healthcare workers, and others on the front line, and they are tirelessly working to fight this pandemic. Have a wonderful day.

Thank you for participating in today's Cadence First Quarter 2020 Earnings Conference Call. This concludes the call, and you may now disconnect.