Cadence Design Systems, Inc.

Good afternoon. My name is Mike and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence third 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. Thank you. I will now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence. Please go ahead.

Thank you, Mike, and I would like to welcome everyone to our third quarter 2020 earnings conference call. I am joined today by Lipu Tong, 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 December 18, 2020. A copy of today's prepared remarks will also be available on our website at the conclusion of today's call. Please note that the discussion today will contain forward-looking statements and that actual results may differ materially from those expectations. For information on 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 we 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 October 19, 2020, for the quarter ended September 26, 2020. Related financial tables and the CFO commentary are also available on our website. Note that Cadence is continuing to adhere to social distancing practices, and therefore we are conducting today's earnings call from our respective remote locations. Apologies in advance if there are glitches or handoffs that take a little longer than usual.

Good afternoon, everyone, and thank you for joining us today. I'm pleased to report that Cadence achieved outstanding financial results for the third quarter of 2020. We exceeded our financial outlook on all key metrics as the Cadence team continues to successfully navigate through challenges posed by the pandemic. We also raised our outlook for the year. John will provide more details in a moment. The data-centric revolution led by AI, data analytics, hyperscale computing continues to fuel strong semiconductor and system design activity. And our intelligent system design strategy uniquely positioned us to enable our customers to accelerate their innovation. Now let us move on to the major highlights for the third quarter. Design excellence is the foundational layer of our strategy and includes our all EDA chip design solutions and IP portfolio. We significantly deepen our partnership with the global marquee customer. through a wide-ranging expansion of our EDA software and hardware portfolio. This customer is now accelerating the proliferation of our digital full-flow across their design teams. Momentum continues for our digital sign-off solutions. With nine full-flow wins and a major market-shaping automaker tip-out, They are highly innovative, complex, 7 nanometer design using our digital full flow. Our verification suite comprises of best in class core engines across simulation, formal analysis, simulation, and prototyping. It's particularly well suited to address our customers' mounting verification challenges. hardware at its highest-ever revenue quarter, with Palladium Z1 and Protium X1 continuing to get new design wins and significant expansions, particularly at AI and hyperscale customers. We introduced Exilium ML, which used machine learning to improve the regression throughput of our premier logic simulator by up to 5x. On IP front, the top vertical end markets for our design IPs in this quarter were hyperscale, enterprise, and automotive, with a major hyperscaler adopting our PCIe and high bandwidth memory IP for use in 3 nanometer design. and silica have strong loyalties and wins for true wireless stereo and functional safety applications and was adopted by an automotive company for ADAS. In system innovation, I'm very excited by the strong momentum of our new system products, both organically developed as well as those we obtain through the AWR and Integron acquisitions earlier this year. Earlier this month, we expanded our system analysis portfolio with the addition of the Curvity 3D function solver that delivers up to 10x faster system-level PMI simulation. Curvity and Celsius continue to ramp nicely with broadening adoption. particularly in verticals such as AI, mobile, and hyperscale segments. System companies like Paradigm and Rockley Photonics are deploying our Clarity EM simulator for production use. In the 5G millimeter wave area, integration of our AWR and integrand acquisitions continue smoothly And the business is tracking ahead of our internal expectations. In Q3, we added more than 15 new customers in the end market that included 5G, automotive, and aerospace and defense. Kaden has a long, successful history in advanced packaging, which has become a linchpin technology for many system companies, particularly automotive and hyperscalers, to deliver complex system-level chip designs. In Q3, our innovative Allegro technology was used by a market shipping automaker for their wafer-level system packaging needs. Now, let us turn it over to John to go over the results in more detail and to update our outlook.

Thanks, Lipu, and good afternoon, everyone. I'm pleased to report we exceeded all of our key financial metrics for the quarter. We had a strong revenue quarter in China as a result of better-than-expected hardware and IP sales in the region. This was the main driver of the improvement in our profitability for the quarter, contributing approximately 2% to our non-GAAP operating margin. Looking at the key results for the third quarter, starting with the P&L, total revenue was $667 million. Non-GAAP operating margin was approximately 36%. GAAP EPS was 58 cents, and non-GAAP EPS was 70 cents. Next, turning to the balance sheet and cash flow, our cash balance was approximately $1.3 billion, while the principal value of debt outstanding was $700 million. Operating cash flow for Q3 was $207 million. DSOs were 41 days, and during Q3, we repurchased $75 million of Caden shares. Before I provide our updated outlook for the remainder of fiscal 2020, I'd like to take a moment to share the assumptions embedded in our outlook. Fiscal 2020 is a 53-week year, and the extra week will add approximately $45 million of revenue to Q4. We have seen higher than expected levels of hardware and IP sales activity in China during Q3, and we have assumed this will continue into the middle of Q4. As a result, our outlook includes approximately $40 million for this increased level of hardware and IP sales activity in the second half. You will recall that we had removed $70 million of bookings from our backlog at the end of Q2 due to COVID-19 related customer credit risk. The credit situation slightly improved during Q3 and we revised that estimate down to $58 million. And as usual, our outlook continues to assume that the export limitations that exist today for certain customers remain in place for the remainder of 2020. Embedding the aforementioned assumptions, our updated outlook for Q4 is as follows. Revenue in the range of $720 to $740 million, non-GAAP operating margin of 34% to 35%, gap EPS in the range of 48 to 52 cents, non-gap EPS in the range of 72 to 76 cents, and we expect to repurchase $130 million of Cadence shares. And for fiscal 2020, that means we now expect revenue in the range of $2.643 to $2.663 billion. non-GAAP operating margin of 34% to 35%, GAAP EPS in the range of $1.97 to $2.01, and non-GAAP EPS in the range of $2.68 to $2.72. We expect the operating cash flow to be in the range of $840 to $870 million, and we expect to use approximately 50% of our free cash flow to repurchase Cadence 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, Cadence delivered another quarter of strong revenue growth and expanding profitability And naturally, I'm pleased by this quarter's results, but we always recommend that you shouldn't focus too much on the results of any single quarter. What I'm most pleased about is the improvement in our three-year revenue growth tracker, the fact that our team continues to operate very effectively during a pandemic, and we're on track to achieve greater than 50% non-GAAP incremental margin for the fourth year running. I would like to close by thanking our customers, partners and our hardworking employees for all that they do. And I'd like to remind them all that their health and safety continue to be our first priority. And with that operator will 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. Now we will pause for a moment to compile the Q and a roster. Your first question comes from Gary Mobley from Wells Fargo.

Hey, guys. Let me first extend my congratulations on strong second half progression. Related to the second half of the year, I wanted to ask about what seems to be about $65 million in extraordinary China-related revenue that maybe you didn't otherwise expect when the fiscal year started coming in the second half. To what extent is that influenced by some of the latest export restrictions and perhaps some customers over in China trying to get under the wire, so to speak, and then related to some of the no-aero-related export restrictions? Have you further done some top-down analysis on your existing customers and the serviceability of those existing customers?

Don, we can't hear you.

Sorry, I was on mute. Hi, Gary. That's a great question. In terms of China, the strength in China was higher than expected. We valued it at about $40 million. We think the second half of the year benefits from like $45 million for the extra 53rd week of revenue and probably $40 million for this kind of spike in China revenue that we believe is mostly non-recurring revenue. But you saw that the China percentage is about 17% in Q3. That's 4% higher than the previous record level. And like I say, our valuation of that is about $40 million to the second half. split about two-thirds, one-third between Q3 and Q4. But I understand the concern about, you know, is there a pull forward from next year? It's too early for us to say right now. What we can say is that extra revenue is generally and predominantly non-recurring in nature. But I won't know until early next year when I look at the pipeline whether it impacts 21%.

Just to add on, clearly hardware and IT are the big growth for us. And again, we comply with all the U.S. export control regulations. And China's semiconductor is still a very strong growth engine.

Okay. And related to margins, I mean, you guys are just killing it on the operating margin, and I guess that's contrary to what we would have thought given the higher mix of hardware-related revenue. What's sort of the, I guess, inner workings there as it relates to hardware mixes, the China-related hardware mix, you know, that much more profitable than, say, you know, domestically-originated hardware sales?

Yeah, Gary, naturally, I mean, we're continuing to invest in R&D, but hiring was slower than expected in Q3. And also the pandemic is helping margins with a little less T&E. We seem to be creeping up into the like 33% to 34% range. We're probably at the high end of that range for as long as the pandemic helps us to keep certain expenses lower. But for Q3, we got an additional margin benefit of about 2% for that extra hardware and IP revenue in China, which is mostly non-recurring at one time in nature. I've assumed that continues into the middle of Q4 and we get about 1% extra benefit in Q4. And the extra week is actually about 0.5% of a headwind to margins in Q4, which at the baseline for margins is probably in the 33% to 34% range. And there's some one-time things that are helping us in Q3 and Q4. Gotcha.

All right. Thank you.

Your next question comes from John Pitzer from Credit Suisse.

Yeah, good afternoon, guys. Thanks for many asked questions. Congratulations on solid results. John, just to follow up on that, can you help us better understand how much of a tailwind kind of the pandemic has been relative to OpEx, i.e., when we get back to a more normal state, how do we think about kind of op margin-related targets?

Yeah, John, great question. Like you say, I think we're probably solidly into the 33% to 34% range for operating margins right now. But with the pandemic-related items, kind of lower T&E and things like that, helping us to land at the higher end of that range. If we didn't have a pandemic, we'd probably be toward the lower end of that range. And then when you look at kind of the bridge from our Q3 performance at 36% margin, which had the benefit of like 2% for that extra China revenue, For Q4, I'm assuming 1% for the extra China revenue and then about half a percent of a headwind because of the extra week. If you back out the extra week and Q4 was in a normal 52-week year, we'd probably be at 35%, but it'll come in at about 34.5%, we think, at the midpoint, including the extra week.

That's awful. And then just going back to China, I'm sure you saw, I think, on Thursday evening of last week, the Department of Commerce, this came out with some new emerging technologies to put on the export list. And it's oftentimes difficult to translate government language into industry language. But there was some commentary around computational lithography software. I'm just curious, is there anything that came out of that ruling last week that would impact sort of EDA. And I guess as you looked out over the course of calendar year 21, what are the puts and takes as U.S.-China tension continues to impact the business?

It's a good question. As I mentioned earlier, we're complying with all the export control regulations. And clearly the situation is very fluid as of last week. And we continue to monitor closely about this computation and any impact to the EDA And clearly, you know, we continue to drive, you know, global customer success and providing the best to an IP. But meanwhile, we're complying with the regulations. And it's very fluid. We're just monitoring closely with the best thing that we can.

Just to follow on, is there any benefit from Chinese customers to order more than they need now if they're concerned about potentially being cut off later? Or does that not really help them in a situation where the band's tightened?

Hi, John. You can certainly speculate on that, but we can't really tell what the motivation for our customers is for the additional purchases during Q3. At the moment, we can't really tell with a high degree of certainty if the strength in China in the second half is a shift from 21 revenue into 20. I think you're right to be cautious about it, but we can't tell if it's a shift or if it's just... What I can tell you is that it is one-time generally in nature. Most of it is one-time revenue. because it's coming from hardware sales and IP. But whether it impacts 21 or not, I don't know. We'll know more in January, I'd say.

Thanks, guys. I appreciate it. Congratulations again. Thank you.

Your next question comes from Mitch Steves from RBC Capital Markets.

Hey, guys. Thanks for taking my question. I've got two. I'm going to start with the proverbial kind of M&A question. Assuming that NVIDIA ARM closes, do you guys see any impact from that and maybe some comments on kind of the speculation around AMD and Xilinx as well? I think that that was a big topical point several years ago, but I just want to get a rehash on any sort of impact you guys think from the recent M&A transaction may occur. Yeah, I think that let me try to answer that. And first of all, We are not able to comment on any speculations on the, you know, NVIDIA and Arm, and then clearly they are a great company, and Arm is a very important partner for us, for Cadence, and we are well positioned with Arm to serve our common customers. I think, you know, clearly time will tell, and I'll get approval, and so I think that's on the NVIDIA and Arm. And then on the, you know, AMD and Xilinx, They are all very good company, and we like them a lot. And clearly, you know, over the years, we manage well with consolidations, and we have very proactive engagement with the companies. And any consolidation, they are all unique respect to the vendor. They are all good company, and I think I cannot go beyond the comment any beyond that. Okay, maybe just to clarify that, so I guess on the ARM NVIDIA piece, In a scenario, so we'll just go through the scenario, that RISC-V loses market share to ARM. Does that impact at all the EDA space? Yeah, and again, you know, we are supporting customer and then depend on whether they go with ARM or RISC-V. But clearly, you know, ARM is very well positioned with that ecosystem in place in the software, and we continue to work closely with ARM. And then, meanwhile, keep a close eye if the customer wants to have risk-fied, and we will support the customer. Okay, perfect. And then my second one is just going back to kind of the 3D solver opportunity. From what we've seen, chiplet architecture is continuing to take off, and that requires a lot of RF. And it seems like you guys are very well positioned on that. So I guess why is there not more, I guess, more – marketing or more logos to talk about on that front? Because it seems like the product you guys have is significantly better than ANSYS. So maybe you could talk about what you guys are seeing now. Is that COVID issue in terms of getting more sales, or is it just not something you want to highlight yet? Yeah, I think, you know, this system design and analysis is a very important growth engine for us. And, you know, clearly, You know, we're excited about the system complexity on the advanced design, like 5G, automotive, and HPC application. And so clearly, the system level analysis is very critical for them. We're delighted with the organically developed and also the AWR integrated acquisition that we have. So we have a very nice portfolio that the customers are delighted with us. And then clearly, you know, the 15 new customers, more than 15 new customers in this quarter for Curlity and Celsius is very exciting for us. And then we also announced the Curlity 3D function solver that shows 10x faster system-level EMI, you know, the simulation. So I think all in all, we're excited about, you know, the opportunity. And, you know, we like to be under-promised, over-delivered. And meanwhile, you know, we do the right, you know, the marketing at the right time. But so far, I think we take one step at a time. And then, you know, to support our customers, that's more important.

And, Mitch, I would just like to add to that that we recognize revenue ratably on our systems analysis products. It's still early days. Our plan is to win mindshare first and then market share will follow.

um yeah we've got plenty of repeat orders from new system companies and more than 15 came from awr and integrant okay perfect another great quarter so i'll jump out of the queue thank you your next question comes from vivek are you from bank of america oh thanks for taking my question and congratulations on on the strong um results uh for my first one I'm curious about how you think about your non-China growth this year. It's about 6% year on year so far this year. Would you call that trend growth, above trend, below trend? Just how does that compare to what you thought the non-China growth would be at this point of the year? Just anything that has surprised you in terms of the non-China aspect versus what you thought before, whether it is customers or end markets or what have you.

Hi Vivek, this is John Wall here. I'll take that question. But certainly 2020 was always going to be a very unusual year. I mean, we have the extra 53rd week for revenue, you know, that we're operating in the middle of a pandemic. You know, you're seeing some China revenue spike in the second half of the year for us. And we always tell people not to focus too intently on any one quarter. Personally, the way I look at it is I tend to track the three-year CAGR. If you look at our CFO commentary, you'll find on page two of the commentary, I put the three-year CAGR view on there because I find that view particularly helpful myself. But, I mean, adjusting for the impact of the occasional 53rd week, that impacts our numbers. You'll see there that our three-year revenue CAGR was showing a consistent level of about 8% revenue growth per year up to about 2018. It ticked up to 9% last year in 2019. And then based on our guidance for the remainder of this year, 2020 now looks like it's going to be a solid 10% three-year CAGR growth year, albeit with a China tailwind. But even if you assume that $40 million China revenue spike is one time only and back that out of our second half, Our three-year CAGR is still close to around 9.5%. So I think our typical contract cycle is two to three years. So if you stand back and take like a three-year view of things, you'll probably get a more discernible trend in terms of what's happening with each line of business. But it's difficult to look at any one quarter and extrapolate from that.

Right, and I appreciate that, John. I was actually looking just year-to-date. The non-China growth was about 6% and was 9% last year, and what I'm trying to discern is, you know, is there some macro impact there, i.e., if, let's say, next year, you know, hopefully the global economy picks up, does the non-China growth also start to re-accelerate? That's what I was trying to get a better sense for.

Oh, sorry. Yeah, we're certainly seeing strong design activity in China that... I don't know, Lipu, would you have anything to add to that?

Yeah, I think, you know, Vivek, in terms of longer run, I think I'm quite bullish about the semiconductor and system design. You know, clearly, you know, the opportunity, and I call it the five generation wave, and they're going to increase the design activity. And then meanwhile, we continue to work with the market shipping customer. I will highlight, you know, this quarter we you know, expand and deeper our partnership with the global marquee customer and, you know, in the proliferation of our digital flow. So I think all in all, I think we have to take a longer-term view rather than look at quarter to quarter.

All right, Libu. And just a follow-up, as you look at next year, outside of hyperscale, what are the other two or three end markets that you are seeing the most growth level of kind of, you know, increasing design activity outside of hyperscale. Thank you.

Yeah, as I mentioned in my remarks, you know, clearly the AI, data analytics, and the hyperscale are the good drive engine for Cadence. And clearly, besides the hyperscale in terms of massive infrastructure scaling, and then the other part is, you know, some of these... industrial automations and also the automotive, some of this we highlight in the ADAS and the system level requirement. I think those are all priced for. I mean, it's very hard to predict quarter to quarter or next year, but I think in the long run, I'm very excited about the opportunity and we are well positioned for cadence.

Thanks very much.

Your next question comes from Joe Brewing from Baird.

Great. Hello, everyone. I'll maybe be guilty of analyzing one particular quarter, but it does look like a pretty meaningful acceleration in growth for systems analysis. And I'm just wondering, it sounds like the new solver products are moving in the right direction, but because of the ratable recognition, maybe not contributing as much to that number. So are we really just seeing kind of the broader secular trend in terms of companies spending more on their PCB modeling tools? And, of course, that benefits Allegro. And, you know, as the other products start kicking in or as you continue to get momentum on AWR, you know, you're looking at above company rates of growth continuing. Is that the right way to think about recent performance?

Yeah, I think we are very excited about this system design and analysis space. And this is one of the, if you recall, we have this design excellence as a foundation. And then now we are moving up into this, I call it the intelligent system. And we are very delighted with the acquisition of AWR and the integrin. And then with integrating with some of our current tools and make it very compelling to our customers in terms of driving some of the system analysis and the performance EM solver-related area and thermal-related in the design. And then meanwhile, we continue to drive some of the organically-developed clarity and Celsius that are able to show clearly a differentiating performance. And now we also announced the addition of the clarity 3D transient solver that are able to show the performance on the EML EMI, the system-level simulation. So I think all in all, I think this is a growth engine for us. We're excited, but stay tuned.

Okay, great. Thanks, Lipu. And then one more question in thinking about kind of the interweaving of tailwinds and Maybe next year's environment, because it sounds like China could see some normalization. You know, $40 million is 200 basis points worth of growth. But one interesting thing that came up is some of the end markets that are adopters of your IP, things like automotive aerospace. are markets that obviously have had a pretty difficult 2020. So along the lines of an earlier question, just in terms of maybe cyclical recoveries in some of your end market exposure, do you think there's enough there where, you know, while China perhaps normalizes, you actually get a bit of an improvement in other areas and it essentially is a wash? So we're still looking at kind of the targeted high single digit growth profile?

John, you want to answer?

Yes, of course. So this is John. Generally, you don't get too dramatic a shift in our results given the rateable revenue model that we have and that most of our contracts are time-based and over two to three years. That's why I included the three-year CAGR view on page two of the CFO commentary because that tends to be the way how I look at it. I'm always looking to see can we improve that three-year CAGR three-year CAGR view. But, you know, I mean, if I'm looking out to 2021, of course, we're not giving guidance. We'll be in a better position to give guidance for 2021 in the new year when we have a better visibility into the pipeline. But, you know, 2020 has been a great year. It's been a bit weird, but wonderful. But I'd be more inclined to kind of extrapolate for 2021 off of prior year numbers and look at three-year CAGRs than try to extrapolate anything off of a a 2020 year that's impacted by so many one-time things. But that's kind of the way I'd look at it.

Okay. Great. Thank you.

Your next question comes from Jason Salino from KeyBank.

Hey, guys. Thanks for taking my questions. You know, one clarifying point on that marquee customer you talked about at the beginning. You know, it's been a full year since we've heard of another marquee customer expanding on the IP side. You know, this expansion today, you know, what does that entail and any other details maybe you could clarify?

Yeah, sure. So I think, you know, this global marquee customer, we are very excited. You know, this is a wide-ranging expansion of our EDS software and hardware portfolio. and they are accelerating proliferation of digital full flow across their design team. So this is something we are very excited about this partnership and we are delighted. Clearly our product is really stand out in terms of performance. And then the other part is also clearly demonstrate the trusted relationship we have and also our technology leadership of our deep software and hardware solution for their most advanced challenging design.

And Jason, I'd like to add there that we have many marquee customers, and this one is a different marquee customer to the one we talked about last year.

Great. Thank you for the clarification. And then one question on the system analysis customer. wins you talked about, you actually mentioned two end markets, automotive and aerospace and defense. You know, this is the first time you talked about those verticals for clarity and Celsius. Is this the case? And then are these more of net new customers, the cadence, or are they kind of cross-sell wins?

Yeah, I think we mentioned two customers, Teradyne and Rockley Photonics, using our QWERTY EM simulator. And we also mentioned about clearly 5G automotive and aerospace. We have traction in terms of 15 new customers. As you recall, these are the new organically developed products. So we don't have a new product in the past. So this is exciting for us.

know we are you know this is just the beginning and so stay tuned we will have more okay great thank you your next question comes from jackson hater from pp morgan hey guys thanks for taking my question um just following up on the uh the marquee customer win that you talked about and and litho i mean in your in your prepared remarks you went through a number of of um different digital full flow wins and in customers and expansions um and i i guess i'm just curious you know what should we maybe be expecting from that digital design segment because even even john if i look at your three-year kegger on that uh on the digital segment it's um slowed down this year relative to 2019. so just seeing whether we should be expecting some acceleration as we head into 2021, given all the strength you've seen in digital full flow.

Yeah, so I think enough, let me kick start and then John can fill in. So we're delighted, you know, we have, you know, nine full flow wins and also this marquee, global marquee customer proliferation. And the other part, you know, earlier part this year, we're talking about the innovative iSpecial, that provide the unified placement and physical optimization engine that are able to show the 20% improvement, PPA, and three times faster throughput. Those are good. And then meanwhile, we are very laser focused on the market-shaping customer, working with them in the different design group and then also different tools that right now we are pushing more the full flow. And we are very excited the progress we've made. And stay tuned.

Yeah, and Jackson, again, we wouldn't focus too heavily on any one quarter. Q2 and Q3 for digital were particularly impacted by the pandemic. the customer credit situation that we had. Now, that's slightly improved during Q3, where we had about $70 million of bookings at the end of Q2 that we took out of our backlog because we didn't expect to get paid. Updating that $70 million, about $30 million of that is gone, of the other $40 million that's left. but we expect to recover about 12, and we still think there's about 28 that we won't recover. So that's improved the situation slightly in Q3, but I'm expecting a strong Q4, and you can see that in the guidance, not just from the extra week as well. And if you look at the entire year, we're expecting all of our product categories to grow high single digits or double digits.

Okay, great. And how about just to follow up, checking in on the cloud, on cloud adoption? any kind of either usage metrics that you guys track or maybe a revenue contribution from cloud usage, given 2020 has been such a remote year?

Yeah, we're not disclosing the cloud revenue separately, but we did book our largest cloud order so far in Q3, and we have good momentum with 150 customers that have adopted our cloud solutions now.

Okay, awesome. Thank you.

Your next question comes from Tom Diffley from DA Davidson.

Yes, good afternoon. Thanks for the question. So, Woodbo, I just want to jump back to the processor question earlier. Just the fact that we're seeing the industry move just from Intel-based to all these other players, AMD, the graphics chips, ARM-based, that has to be good news for you. The more designs you have of the leading edge, the better, I would assume. Is that correct?

Yeah, that's correct. And clearly the You know, the general purpose, the TPU and GPU will continue to do well. And you can reflect that in NVIDIA performance. But I think the workload has changed a lot into not just the compute. There's a lot of application domain specific and then the optimization. So you'll see a different class of processor in the AI machine learning, in the training, inference. And so there's a lot of new suite of development, either from startup or the established company. And also the hyperscale guys also really drive some of the processor, optimize for their specific application and solution and the services to try to drive. So those are great news for us. That means that we have more design activity and not only for our tool and also our hardware emulation because some of them are really complex designs. And then also some of the system analysis, because of the system-level know-how, we highlight in my remarks some of the hyperscale guides, also try to drive wafer-level packaging challenges. So I think we are excited about all this opportunity.

Okay. And I also wanted to get your view on just consolidation in general and what that means to EDA. Okay. And over the last five years, there's been several high-profile customers of yours that have consolidated, and it seems like it had very minimal impact on EDA and your radical business with them. I'm curious, is that the way you think it is going forward as well, where you don't worry too much about consolidation among your customer base?

Yeah, I think in the consolidation, always I pay attention to it, and we try to be proactive engagement for the acquirer or the being acquired company. and we make sure that we are creating a win-win, continual business. And, you know, clearly on all this consolidation, you know, R&D is the last place they want to cut. So they're going to continue to drive innovation, continue to drive efficiency, and that's why we want to be a great partner for them. And so far, we manage well through consolidation in our customer base that have been taking place. And then each consolidation has their own unique business

way in terms of respect to vendors but we are very respecting of what they try to do and we try to be a great partner work out with win-win and then we are very proactive with them okay and the final follow-up here uh john when you talk about the extra week and i thought it was 43 or 45 million of revenue did i understand you correctly that the actual cost impact is more than that

No, it's not more, but it is a headwind for margins, though. The extra week is about $45 million to revenue and about $33 million to non-GAAP expense. So if you back those out, you'll find that the margin for 52 weeks is higher, but we're kind of running at a 33% to 34% kind of baseline for margin, closer to the high end of that range because the pandemic is helping margins at the moment. And then for Q3, we're 2% higher than that 34% because of the benefit of that spike in revenue in China that we've seen. We expect that to continue into the middle of Q4. So at about 1% to that, you get to 35% for Q4 for a normal 13-week quarter Q4. But when you add the 14-week, if you add in the $45 million of revenue and the $33 million of expense, you'll find that the margin impact backs it back down to a midpoint at 34.5%.

Okay. No, thanks for the detail.

No worries.

Your next question is from Jay Flickshour from Griffin Securities.

Thank you. Good evening. Lipu, let me start with you in terms of a question about the long-term implications of your intelligent system design and computational software strategy. And then for you, John, a shorter-term question about hardware. so lipu we heard a good deal over the summer and again last week at the cadence live events about uh your computational software strategy in terms of system design you've spoken of it honoruda has spoken about it of course and the the question is uh threefold uh which is What are the implications in terms of your R&D, specifically the organization or methodology of your R&D as you orient Cadence towards this new strategy or opportunity? Similarly, in terms of sales and pricing, that might be for you too, John. And then last and certainly not least, the role and competencies that you look for in applications engineers, which I believe are your second largest part of headcount after engineering vis-a-vis the new strategy.

Good. Jay, thank you so much for the good questions. So a couple of things. So clearly, you know, our core component is computation software. and then the intelligent system design is something that we believe is the right thing for us, you know, adjacent to us, and also customers need that. So besides just providing the EDA silicon development, and now they were looking at the whole system analysis in terms of EM, you know, the thermal envelope, and then as you already pointed out, you know, clearly, you know, the the application, the domain-specific optimization are required. And so those are things that fit into our computation software really well. And we'd like to gradually expand into that area that is adjacent to us. So in terms of your first question, in terms of R&D methodology, clearly we are very laser-focused on the Initially, it's focused on the tools that are really important to our customers, like Celsius and Currity. And we clearly have the advantage to be able to show multiple improvement. Those are important to the customer. And we validate that. We repeat orders. That means they love it. They like to buy more and then proliferating more. And so we're going to double down on that. And we're delighted with the addition of the 3D you know, clarity, a transient solver that show, again, tremendous improvement to our customer and they're delighted on that. In terms of the pricing, I think John can talk to you more. We're very disciplined. We want to make sure that we provide the best solution to the customer. We want to price it correctly and then to serve the customer. And so I think in terms of talent, we are very laser focused on some of the talents that Anirudh, myself, and the team looking for the best talent in that space, you know, clearly from the R&D, and then also the FAE, they're able to effectively serve the customer. Those are our priorities. And then, John, back to you.

Yeah, I think, Lipu, you covered most of it there. Was there something that you were asking, Jay, that Lipu hasn't already covered?

No, no, that's fine. So turning to you, John, the shorter-term question, you noted record hardware for the quarter, and that's certainly substantiated by the increase in hardware cost of revenues that you show in the 10-Q. Interestingly, though, your inventories increased from the second quarter, which I assume are most, if not entirely, hardware. So in spite of the revenue upside in hardware, did you sustain an inventory build, anticipating perhaps Q4, Q1, 21 ship scheduling by one or both of the marquee customers?

Yeah, Jay, I mean, we continue to maintain our inventory levels due to ongoing strong demand for the hardware products. You know, we don't want to be caught short of inventory with the demand that's out there. The Palladium Z1 emulator is doing so well, and so is the Palladium X1 platform, that prototyping platform. So we're continuing to build inventory.

Okay. And lastly, if I may, the physical verification and the yield optimization category has been doing very well for a number of years now. Obviously, Mentor is the market leader there, and their numbers have been quite strong. But could you update us on what's going on with Pegasus? Anirudh was quite definitive about that opportunity a year ago, in fact, when he talked about the prospective changes in physical verification over the next number of years. So, you know, what's actually happening for you there?

Yeah, so I think that let me try to answer that. We are very excited about the Pectus' solution. It took quite a few years for us to develop, and the engine is really good. And then first of all, we want to make sure that the advanced nodes in the foundry partners are certified, because this is right into their manufacturing side. So make sure that the foundry partners certify this is a tool that they will support. We're very delighted, you know, the key foundry partners are certified in the whole range of certification on the different process nodes, in the most advanced process nodes. And then now we're also starting to have multiple customers starting to embrace it and then starting to use it. And then stay tuned. I think 2021 will be a very important year for us with all the certification in place for the most advanced nodes. And then now customer can confidently using that for their production design. So I think stay tuned.

Thank you very much.

Your next question comes from Pradeep Raman from UBS.

Hi, thanks for being my question. I had a couple. First, just in terms of your memory exposure, how, I guess, In terms of your share, do you feel like you have more share in memory versus logic, or are they sort of comparable? And the reason I ask is there's a lot of M&A speculation going on, and this is not specific to an M&A question, but in general I'm trying to understand your exposure to memory.

Yeah, I think you're not – let me try to answer your question. So I think memory is more and more important. in this whole data analytics. And you want to be close to the memory and the storage. So this is one of the big area for the hyperscale, hyperscalers, and also the whole infrastructure play. So memory is very essential. And so fairly from NEMS to HBM to some of the new memory development. And so clearly, we have a very strong foothold. And then we work with multiple of the memory customer. I think in the past, we highlight some of the memory success we have, and not only on the tool and the solution, and also in the IP, some of the, you know, the DDR, the PCIe memory controller and PHY, and we have well positioned some of the key IP we have. So I think, stay tuned. I mean, this is area we have good position. We're going to continue to expand on it.

Okay, and... My follow-up is a little bit more on system analysis. I mean, we are hearing positive feedback on clarity, especially versus competing tools. But I guess with the AWR and Integra acquisition, one, how does your prior 700 million PAM sort of inflect, how much higher does it inflect? And two, Where are we with respect to the share gain on the organic side? Are you close to, like, 5% share already? Or how should we think about share in this space as well?

Yeah, so I think, you know, first of all, I think it's, as you've already pointed out, for the currency and Celsius market we are addressing, the temp market is about $700 million, and we are just at the beginning. you know, some of the big incumbents. I think clearly, first of all, we have to demonstrate the performance is better, make sure that the customer really validated. One of the key excitement for me is repeat orders. And when the customer using them and they're starting to come back and buy more, that is a very clear validation of performance is good, they like it. And then now the customer starting to suggest all of the tools that they require to have And we're working closely with them. And that's why we have the 3D transient solver come out. And then we have more exciting things we are working on internally developing. And then John and I, we always have a very disciplined in terms of investing the R&D. When we see the customer interested and then give us feedback what they want. And then we can really look at ourselves. We can really developing that, have a clear differentiating opportunity. And then plus the two acquisitions we make, you know, the AWR and then the Integra, clearly in the whole 5G and millimeter wave area and the system level, they're starting to like automotive, starting to see that this is a really good value they want to have. And we are delighted to have continued the, you know, to exceed our internal expectation that is very encouraging for me.

okay and a quick follow-up i i guess i just want to clarify this so you said there were 15 greater than 15 customers for clarity and selfies this quarter and that independent from 15 customers for aw and integrand awr and integrand or are they the same or i just want to understand that yeah i think we mentioned about 15 new customers uh you know clearly something that we are very proud of and uh you know clearly

this opportunity, and, you know, we add on this end market that we go after, and this is all together on this whole system analysis.

Okay.

Thank you.

Your next question comes from Rich Valera from Needham.

Thank you. I wanted to ask a question on your remarks, John. You mentioned that system design and analysis was one of the drivers of your increased full-year guide, and I was wondering if you could say was it the new system, the new organic system simulation tools, or the AWR Integrand acquisitions that was driving that?

Oh, it's the combination of both. And the commentary really stemmed from the fact that we expect that to be our fastest growing segment for the year now.

Got it. That's helpful. And then you mentioned that you were actually behind plan in terms of hiring in Q3, but you look like you added about 300 heads, which is the most you've added in a while. Just wanted to try to understand that dichotomy there.

Yeah, we're continuing to invest in R&D, and a lot of that investment is in headcount. The reason I called out slower-than-expected hiring is that that was part of the reason why we had such a strong operating margin in Q3 in comparison to what we guided, which is slightly slower on hiring. That was part of the contribution to lower expenses in the quarter than we expected.

Got it. Makes sense. Okay.

Thanks very much. Our next question comes from Joshua Tilton from Barenburg.

Joshua Tilton Hi, guys. Thanks for taking my question. I just wanted to follow up on the system design and analysis segment maybe from a different perspective. Given that clarity and stealthiness are still in very early innings, when we look five years out, how should we think about this segment as a percentage of revenue?

Yeah, I don't think we We did close that, but clearly, you know, we're excited about this opportunity. As we mentioned, this is kind of an early ending, and then we have some encouraging from our customer repeat orders. And then over a period of time, we will build a broader portfolio and so that we have a whole solutions to provide. So we are just in the beginning. So we are excited about the very nice growth area. and we're going to continue to innovate and continue organically develop and through acquisition to build out this opportunity. I think it's a system design and analysis, something that part of our intelligent system design strategy.

That was helpful. And then I kind of just wanted to follow up. In terms of the clarity and selfies went to date, are you seeing them being more competitive replacements, or are your customers allocating incremental budget to supplement their existing simulation capabilities?

Yeah, I think this is a new business for us, and we're always excited to see that, you know, all this new opportunity and design win is new to us and for this category of products. And I think more important, we are excited about the repeat orders from the customer. John, do you want to add on?

Yeah, I agree with you, Lipu. I mean, given it's such a new business for us, it's hard for us to tell in terms of what budget is coming out from customer space. I suspect it's additional budget, but it's very, very difficult to tell, and it's difficult for us to speculate on that.

Thanks, Ed.

Our final question comes from Chris Stunker from Cowan.

Yeah, hi, thanks for taking my question. I had two of them. First, I think, you know, there were some questions on consolidation, and clearly your customer consolidation has not really impacted you or even Synopsys for that matter. How much of it is a fact that your customers, as they consolidated, did not cut EDA budgets or even raise the EDA budgets versus as your customers consolidated, even the suppliers consolidated between you, Synopsys, and Mentor, that kind of was the tailwind that you had?

Yeah, that's a good question. You know, we're monitoring very closely, as I mentioned, on the consolidation. And you're correct, we manage well on all this consolidation. One thing is, you know, clearly I mentioned, you know, R&D is the last place to start. And then usually, like I mentioned earlier, this five-generation of waves, and there's so much design activity, we don't see any slowdown. And then some of the talents, when they consolidate, they become somewhere else and then they showed up. And so, you know, R&D is, you know, clearly the EE computer science is very badly needed, you know, in terms of university. We'd love to see more because a lot of design activity and we don't see any slowdown at all.

Got it. That's very helpful. And then as a follow-up, I don't know if we can answer this either Libbo or John. Can you disclose if you've gotten any letter from the government requiring a license to ship to any Chinese customer?

John, you want to answer? I don't think – go ahead.

Yeah, so, Krish, we're doing everything we can to support our customers, but we're not disclosing any specific communications with the government.

Right. Thanks, John. Thanks, Libby.

And I will turn the call back over to Lipi Tan 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, auto-addressable market. I'm very delighted to share that Cadence has been recognized by Fortune and the Great Place to Work Institute as one of the world's best workplace for big time. This recognition is the result of our global employees' commitment and dedication to innovation, to delighting our customers, and to taking care of our community and each other. And lastly, on behalf of all our employees and our board of directors, we give our heartfelt thanks to those, all of them on the front lines, who continue to work tirelessly to fight this pandemic. Thank you all for joining us this afternoon.

Thank you for participating in today's Cajun's Third Quarter 2020 Earnings Conference Call. This concludes today's call. You may now disconnect.