Cadence Design Systems, Inc. (NASDAQ:CDNS) Q4 2022 Earnings Call Transcript

Cadence Design Systems, Inc. (NASDAQ:CDNS) Q4 2022 Earnings Call Transcript February 13, 2023

Operator: Good afternoon. My name is Julianne, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Fourth Quarter and Fiscal Year 2022 Earnings Conference Call. Thank you. I will now turn the call over to Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead.

Richard Gu: Thank you, operator. I would like to welcome everyone to our fourth quarter of fiscal year 2022 earnings conference call. I am joined today by Anirudh Devgan, President and Chief Executive Officer and John Wall, Senior Vice President and Chief Financial Officer. The webcast of this call and a copy of today’s prepared remarks will be available on our website cadence.com. Today’s discussion will contain forward-looking statements, including our outlook on future business and operating results. Due to risks and uncertainties, actual results may differ materially from those projected or implied in today’s discussion. For information on factors that could cause actual results to differ, please refer to our SEC filings, including our most recent Forms 10-K and 10-Q and today’s earnings release.

All forward-looking statements during this call are based on estimates and information available to us as of today and we disclaim any obligation to update them. In addition, we will present certain non-GAAP measures, which should not be considered in isolation from or as a substitute for GAAP results. Reconciliations of GAAP to non-GAAP measures are included in today’s earnings release. Today’s earnings release for the fourth quarter of fiscal 2022, related financial tables and CFO commentary are also available on our website. Now, I will turn the call over to Anirudh.

Anirudh Devgan: Thank you, Richard. Good afternoon, everyone and thank you for joining us today. I am pleased to report that Cadence delivered record results for 2022 as we exceeded our guidance yet again, achieving 19% revenue growth and over 40% non-GAAP operating margin. Cadence’s innovative solutions are essential and especially relevant in the current environment, enabling customers to achieve their increasingly challenging design goals. Secular megatrends such as 5G, hyperscale computing and AI/ML that are driving sustained long-term semiconductor and system growth remain unchanged. Amid ongoing macroeconomic uncertainty, companies continue making significant investment in their next-generation products, resulting in robust design activity.

We expect our pioneering solutions to continue fueling broad-based business momentum in 2023, driving strong revenue growth and profitability. John will provide more details in a moment. Our Intelligent System Design strategy greatly broadens our total available market and leading end-to-end EDA IP, hardware and expanding system analysis portfolio uniquely position us to capture a wide range of market opportunities. During the year, we introduced 9 significant innovative products across all of our business groups and we expect these to be key drivers of our future growth. The age of AI is upon us and Cadence provides several groundbreaking computational software-driven generative AI technologies at both the chip and system level unified by JedAI, our differentiated big data analytics platform.

Our customers are seeing dramatic results, with these solutions delivering highly optimized designs and unprecedented efficiency gains. Additionally, by automating repetitive tasks and producing new ideas, our generative AI frees up engineers to focus on more advanced high-value activities, opening up more opportunities for innovation. During the year, we also materially expanded our core EDA, IP and system solutions footprint and market-shaping customers. In Q2, we extended our collaboration with AMD to a far-reaching commitment to our innovative core EDA hardware, design IP and system software solutions. In Q3, we deepened our partnership with BAE Systems across our core EDA and systems portfolio, including proliferation of our digital full flow and analog products and a broad expansion of our PCB and multi-physics system analysis solutions.

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And in Q4, we have broadened our relationship with a global leader in memory and storage solutions through an extensive proliferation of our custom, digital and system solutions. We also expanded our strategic partnership with a global leader in networking and telecommunication through their renewed commitment to our core EDA, IP and system solutions. In addition, we further our partnership with leading foundry, IP and cloud service providers and won six Open Innovation Platform Partner of the Year awards from TSMC. Now, let’s talk about some of the product highlights for both Q4 and 2022. Our digital IC business finished another strong year, with 17% revenue growth. Deployment of our digital full-flow delivering industry-leading quality of results at the most advanced nodes continue to accelerate, with nearly 50 additional customers adopting it during the year.

Our digital software is now deployed in all top 20 semiconductor companies. We are pleased with the accelerating growth of our front-end Genus and Joules Tools and signoff products such as Tempus and Qantas, complementing the board proliferation of Innovus. Our transformative Cadence Cerebrus AI-driven solution continued to deliver impressive PPA and productivity gains across a wide range of designs, resulting in broader adoption and accelerating proliferation. Among others, it is now deployed at 10 of the top 20 semiconductor companies, including 7 of the top 10 semis and at several major hyperscalers. In Q4, GUC successfully delivered an advanced HPC design and a CPU design using our digital full flow and Cadence Cerebrus on TSMC N5 process technology, delivering 8% reduced power and a 9% area improvement while significantly improving engineering productivity.

In 2022, several market-shaping customers, including Intel, NVIDIA, Broadcom, Samsung and Renesas shared their remarkable successes with Cadence Cerebrus at our CadenceLIVE user conferences. Escalating system and software bring-up complexities, combined with relentless first-pass silicon requirements, continued to drive strong demand for our essential Functional Verification solutions. Our Verification business grew 28% year-over-year, fueled by secular trend for hardware, which had another record year. Our dynamic duo of Palladium Z2 and Protium X2 platforms, providing best-in-class system verification and software bring-up solutions, saw accelerated growth and strong momentum across mobile, hyperscale, HPC and increasingly, auto EV segment.

Our hardware family added 30 new customers and over 160 repeat orders during the year. Due to the compelling value offered by common front-end compiler, demand for the pair greatly exceeded our expectations, with more than two-third of the orders in the year, including both platforms. Our new Cadence Verisium AI Verification Platform enables dramatic improvements in debug productivity. And in early production usage at several market-shaping customers, Verisium delivered up to a 30x improvement in efficient root cause analysis. Our custom IC Virtuoso and Spectre franchise solutions tackled the toughest challenges in analog, mixed signal, RF design and circuit simulation. And as electrification and digital transformation trends gain momentum, they are becoming increasingly crucial to our customers.

Building on our market leadership, our custom IC revenue grew 13% year-over-year in 2022, with Virtuoso growth spurred by demand in advanced nodes, heterogeneous integration and the emerging silicon photonics segment. We added 200 new Virtuoso logos and more than 150 logos for Spectre, with Spectre FX making strong headway in FastSPICE memory applications. Increasing usage of preconfigured IP blocks to reduce risk and time to market, coupled with our star IP portfolio, led to a strong year for our IP business, which grew 12% year-over-year in 2022. Demand was particularly strong in HPC, 5G and automotive segments, with our silicon proven, high-performance PCIe Gen 5, LPDDR5 and Ethernet interfaces helping secure key wins in advanced node designs.

Our Tensilica DSP portfolio continued expanding its footprint in smart speakers and True Wireless Stereo headsets, imaging and machine learning applications. Rising system complexity and challenges stemming from the growing hyperconvergence of the electrical, mechanical and physical worlds are driving the strong need for a seamless platform solution across design, packaging, simulation and analysis. Our System Design and Analysis business that is expanding our TAM beyond EDA continued its strong momentum, delivering 27% year-over-year growth. Industry interest in advanced packaging solutions notably spiked in 2022, with customers embracing our revolutionary Integrity 3D-IC solution, the industry’s only comprehensive platform providing tightly integrated system planning, implementation and analysis technologies.

Our multi-physics portfolio comprising of leading electromagnetic, electrothermal, signal and power integrity and CFD solutions continued ramping strongly across multiple end-markets. Our in-design analysis solutions had several significant wins with HPC and hyperscaler customers, while our CFD Fidelity platform proliferated with market shaping aerospace and defense customers. During the year, Fidelity CFD’s software meshing capabilities were chosen by Toyota Motor Europe to be their standard workflow for CFD preprocessing. And in numerous customer engagements, Optimality Explorer, the industry’s first AI-driven multidisciplinary system analysis and optimization solution has demonstrated up to a 10x efficiency improvement in design space exploration, leading to faster time to results.

Lastly, in keeping with our transition plan, Lip-Bu Tan has notified the Cadence Board that he will not seek reelection at our upcoming 2023 Annual Stockholders’ Meeting in May. He will continue to serve as an advisor to me. We will return to an independent chair structure with ML Krakauer becoming our next Board Chair following that meeting. The rest of the Board and I look forward to working closely with ML in her new role. In closing, we are pleased with our strong execution in 2022 and are thrilled by the business momentum and market opportunities ahead of us in 2023. Now, I will turn it over to John to provide more details on the Q4 results and our 2023 outlook.

John Wall: Thanks, Anirudh and good afternoon, everyone. I am pleased to report that we exceeded all of our key financial and operating metrics for the fourth quarter and 2022. Robust customer design activity and demand for our strong technology portfolio continued to drive growth across all of our businesses. Cadence had an excellent 2022 and we began 2023 with a lot of confidence and strong momentum on the back of the stability and resilience you would expect from a predominantly recurring revenue model. Here are some of the financial highlights from the fourth quarter and the year, starting with the P&L. Total revenue was $900 million for the quarter and $3.562 billion for the year. GAAP operating margin was 23.5% for the quarter and 30.1% for the year.

Non-GAAP operating margin was 35.6% for the quarter and 40.3% for the year. GAAP EPS was $0.88 for the quarter and $3.09 for the year and non-GAAP EPS was $0.96 for the quarter and $4.27 for the year. Next, turning to the balance sheet and cash flow. Our cash balance was $882 million at year end, while the principal value of debt outstanding was $750 million. Operating cash flow in the fourth quarter was $264 million and $1.24 billion for the full year. DSOs were 49 days and we repurchased $1.05 billion worth of Cadence shares during the year. Before I provide our outlook for Q1 and 2023, I’d like to share a few comments. Our most recent fiscal year ended on December 31, 2022. This fiscal year will also end on December 31 as we have now moved our fiscal year to a calendar year.

Approximately 15% of our annual revenue for fiscal 2022 was upfront with 85% recurring. At the midpoint of our 2023 revenue outlook, we are expecting a similar revenue mix for the year. And our outlook for 2023 assumes export control regulations remain substantially similar for the remainder of the year. In our outlook for 2023, we expect revenue in the range of $4 billion to $4.06 billion, GAAP operating margin of 30.5% to 32%, non-GAAP operating margin of 40.5% to 42%, GAAP EPS in the range of $3.24 to $3.34, non-GAAP EPS in the range of $4.90 to $5, operating cash flow in the range of $1.3 billion to $1.4 billion. And we expect to use approximately 50% of our free cash flow to repurchase Cadence shares in 2023. For Q1, we expect revenue in the range of $1 billion to $1.02 billion, GAAP operating margin in the range of 31% to 32%, non-GAAP operating margin of 41% to 42%, GAAP EPS in the range of $0.84 to $0.88, and non-GAAP EPS in the range of $1.23 to $1.27.

And as usual, we published the CFO commentary document on our Investor Relations website, which includes our outlook for additional items as well as further analysis and GAAP to non-GAAP reconciliations. In conclusion, I am pleased that we achieved double-digit revenue growth across all of our businesses, increased 3-year revenue CAGR into the mid-teens. And I am especially pleased that we continue to expand annual operating margins. As always, I’d like to thank our customers, partners and our employees for their continued support. And with that, operator, we will now take questions.

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Q&A Session

Operator: Our first question comes from Charles Shi from Needham & Company. Please go ahead. Your line is open.

Charles Shi: Hi, thank you for taking my questions. Maybe the first one is kind of like a two-part question. Maybe this is to John. John, your fiscal year and Q1 guidance seem to imply a relatively flat revenue profile through the year. And I am sure you heard €“ it will appear there seems to be seeing a slightly upward trending profile through their fiscal year. Although I know the fiscal year, yours and theirs end slightly different months. Is the difference just a matter of more conservatism on your side or is it a matter of different end market mix or product mix? Maybe let me ask the second part. I think they are kind of related. I will ask all at once. I think one quarter ago, you were cautious, your hardware sales into fiscal €˜23 because 2022 like you just said, it’s a record year for the hardware sales.

So what is your assumption in the full year guidance for fiscal €˜23 on your hardware revenue profile in the year? Is it flat? Or is it that €“ are you assuming there is some recovery in the second half of the year? Thank you.

John Wall: Hi, Charles. Thanks for the questions, those excellent questions. The €“ yes, we’re expecting another strong start to the year as we continue to see strength in our hardware business. You did pick up some caution ahead I think the last quarter because hardware was proving not to be discretionary at all for our customers, and hardware demand was outpacing our ability to produce the hardware. And that was the case for the entirety of last year. We were not able to keep up with demand. Demand is really, really strong as we head into the new year for 2023. But we’ve increased our production capacity and we feel more confident in our ability to meet that demand for 2023. And as you can see from the outlook, we’re expecting that last year, the 85-15 split in recurring revenue to upfront revenue mix, we expect that to continue.

Now the second half of the year is harder to predict for hardware, so typically, I wait until the middle of the year. And if we see continued strength into the second half of the year, we can increase the second half later. And then I think that impacts the quarterly profile because you started your question with why the year felt a little bit flat. And that’s because we expect to deliver a lot of hardware in the first half of the year. And in the second half of the year, we’ve kind of de risked the second half of the year for hardware. If we see continued demand at this pace, we will have to take the second half up.

Charles Shi: Thank you. That’s excellent. Maybe my second question, maybe this is for Anirudh. I think some investors are worried about hyperscaler spending on EDA, I mean, both on a near-term and a long-term sense. I mean, in the near-term, I mean, obviously, the layoff in tech, well, some people think it could reduce the chip design projects and lost jobs for design engineers. And in the long-term, I mean, there is a smaller portion of the investors are kind of worried about the sustainability of the hyperscale spending strength, although I think chatter around AI recently seems to suggest that, that strength is probably not going to €“ going down but probably going to accelerate. So can you share your observation or any insights, the real demand coming from hyperscaler side? And what’s your thought €“ what’s your current outlook going into like a 2, 3-year horizon? Thank you.

Anirudh Devgan: Yes. Hi, Charles, thanks for the question. Our demand is broad-based, right, across both our semiconductor customers and our system customers. So as we mentioned before, right now, about 45% of our business is coming from system companies. That includes hyperscaler and other kind of system companies. And I’m very cautiously optimistic that this trend is continued for a long time, okay? Because I think some of these trends are a reversible of system companies doing silicon design. They are already having a lot of success. If you look at whether they are social media companies or phone companies or data center companies or car companies, they have multiple design projects in different stages of development. And overall, we see strong design activity on the systems side and on the semi side.

Now there is always some reports here and there. This is not a straight line, right? Some customers may do more. Some customers may do less. But overall, like there will be more and more designs done by system companies. And as you know, the other part of our interaction with system companies is also expanding our portfolio to include System Design & Analysis products, our SDA segment. So we are working with system companies, not just on the silicon side but on the system side, whether it’s 3D-IC or thermal simulation or CFD. And you can see that part of our business is also growing very strongly. So last year, we reported about 27% growth in the system business, which is beyond our traditional EDA business. So overall, I am pretty pleased.

And I think design activity remains very strong, driven by 3-nanometer and other things and the expansion of our portfolio to System Design & Analysis.

Charles Shi: Thank you, Anirudh. Thank you, John.

Operator: Our next question comes from Jason Celino from KeyBanc Capital Markets. Please go ahead. Your line is open.

Jason Celino: Great, thanks and good quarter. When I look at the guidance, 12% to 14% growth to start the year, best growth guidance I’ve seen and you invest last year’s on a much tougher comp. John, any change to philosophy in terms of how you set guidance?

John Wall: That’s a great question, Jason. No, we’ve approached guidance the same way we normally do. Last year, if you recall, we wanted to wait until we had increased visibility into the hardware pipeline, so we were a bit more conservative about the second half for hardware. We’re approaching this year very similarly, but we had €“ we just finished with really, really strong momentum through the year. And the guide, I mean, there is so much of it coming out of backlog, we feel very confident in the year.

Jason Celino: Okay. And then I think you mentioned on the hardware side, you increased capacity. How hard is it to toggle that up and down? I’m just trying to understand what this means in terms of confidence level and pipeline? Thanks.

John Wall: Yes, Jason, it’s €“ we’ve got access to more production capacity now. We have added additional lines to build the hardware. For the last year, we couldn’t build it fast enough. We did ramp up production capacity, I think, 40% last year, but we sold more than that so we didn’t keep up with demand. So we ramped up production capacity again for 2023, and we feel very confident that we have access to the inventory and the components we need to meet that production demand. But also to the extent that we can produce extra systems, we have a number of underserved or unserved customers that want access to our hardware in the cloud. So any excess capacity we can generate or any excess production we can generate, we can put into the cloud for that offering.

Jason Celino: Thanks, John. Thank you.

Operator: Our next question comes from Gary Mobley from Wells Fargo Securities. Please go ahead. Your line is open.

Gary Mobley: Hey, guys. Thanks for taking my question. Want to ask about JedAI and all the related machine learning and AI-enabled tools. We’ve been getting a lot of questions from investors in terms of how to think about how that becomes accretive to your growth rate and how it becomes accretive to your average deal size. Maybe if you can just share with us where you’re at in this price discovery phase and how you plan to, I guess, mass market price it? And if I’m not mistaken, this will all be included in digital IC, which according to the finish to the year was dilutive to your overall revenue growth. So how should we read into that? Is AI/machine learning simply just not impacting that line item yet?

Anirudh Devgan: Hi, Gary, great question. So first of all, I’m very optimistic about AI, and we always have talked about applying AI for optimization. I mean, in EDA or in chip design or system design, it’s more about automating the design process and producing better results. So even if you look at €“ the way I look at it, even if you get it right now, some of these chips have 100 billion transistors, right, on 1 inch by 1 inch. And if you look at by 2030, they will have 1 trillion transistors, okay? So just in terms of size, it will be 10x more. And then the chips are more complicated and then you add software on top of it. So the design complexity that our customers need to do will go up by at least 20, 30x in the next 5 to 7 years.

So the only way to meet that is by more automation. That’s the history of our industry. And the best way to do more automation right now is using AI, okay? And of course, we have done other ways to do automation in our industry. We started by doing more higher level design, moving from transistor level to gate level. Over the last 5, 10 years, we have done a lot of massive virilism, running things on more CPUs, using cloud. But going forward, one of the biggest ways to improve productivity is using AI. And you see that across our product portfolio. And the real benefit is that a lot of the mundane tasks can be done by the repetitive tasks and mundane tasks can be done by AI, so the designer can move to more higher-value tasks, right? And so the way we approach it through is a very comprehensive €“ we build this JedAI data analytics because data is critical, too, as you know, to a data analytics and AI platform.

And then we have multiple applications on top of it, okay? So Cerebrus is a key one for implementation. We also launched, a few months ago, Verisium for verification, which is another very difficult and all-consuming problem for our customers. And then we are not only focused on the chip side but also on the system side. So we have optimality, which is having great success on the system side. And typically, the system customers are not used to optimization or this level of automation that the chip industry has seen. But we are getting dramatic improvements with the optimality as well. So taken together, I believe that we have the most comprehensive AI portfolio. And we have always focused AI on optimization, which, of course, now called generative AI.

And we have been working on it for 5 years. I think the products introduced were about 2 years ago. And even for Cerebrus, I mentioned in my prepared remarks, several leading companies like Intel, NVIDIA, Samsung, Renesas, they all talked about the results they are seeing. We have more than 160 designs that we are tracking on Cerebrus. And if you include Verisium and optimality, we have hundreds of designs being done by AI. And because I believe in the next few years, almost all designs will have some AI component. And that is driving the growth that you’re seeing in our business and the outlook.

Gary Mobley: Thank you for that, Anirudh. And a quick follow-up for John, backlog up again. Nice job on that, up 32% in the year, next 12-month backlog up 26% on the year. Was there a large deal or renewal that came into the fray in the fourth quarter? Or maybe you could just speak in terms of the diversity of that growth?

John Wall: Yes, Gary, great question. I mean, we had a really strong finish to the year. And as you know, I mean, contract timing typically impacts the cRPO in any one quarter. But if you look over a typical contract cycle, you’ll see that we’re particularly pleased with the 3-year CAGR on cRPO. It’s tracking to mid-teens growth now, and that’s very consistent to the mid-teens growth we achieved over the last 3 years to 2022 and the mid-teens growth that’s implied at the midpoint of our guidance for 2023.

Gary Mobley: Thanks, John.

Operator: Our next question comes from Jay Vleeschhouwer from Griffin Securities. Please go ahead. Your line is open.

Jay Vleeschhouwer: Thank you. Anirudh, a wise man once said that silicon companies are becoming increasingly like systems companies, and systems companies are becoming increasingly like semiconductor companies. You alluded earlier to some of the additional opportunities that systems companies represent for you, for example, in CFD and so forth. In what other ways would you say that these two classes of customers do still remain different or different enough for you, even though they are becoming more alike and in ways that perhaps influence your €“ either your R&D or your go-to-market? And then the second question is if you could talk about where your R&D priorities go from here? The last number of years, you and, for that matter, Synopsys have significantly ramped up, for example, your investments in synthesis, verification, AI, you mentioned, of course. And from here, how are you thinking about the R&D priorities in areas like custom and CFD and of course, in AI?

Anirudh Devgan: Yes. Thanks, Jay. Very valid questions. And of course, great point that system companies are becoming semi companies and semi companies are becoming system companies. And like I said before, this is irreversible trend, okay? This is irreversible. And for us, we invest heavily in R&D, as you know. I mean, about 35% of our revenue is invested in R&D. That’s one of the highest percentages of any S&P 500 company. Just for your reference, you may know this already, we have 10,000 people in the company. 9,000 are engineers or computer scientists. Either they are in customer support roles or in R&D. And we always make sure that the core is good, okay, because the core has to be best-in-class. So whether that is synthesis, like you mentioned, place and route, circuit simulation, analog, verification, so that’s a given, making sure that the core is best in class.

And then on top of that, there are certain thematic things that we are investing in. And then the three that I want to highlight, which is €“ which I think will be thematic for years to come. One is, of course, AI. AI will have a big effect on, like I mentioned, design work. And that’s true for both semi and system companies. Second is 3D-IC, the emergence of chiplets and heterogeneous integration, and Cadence is the best positioned to take advantage of this. And then the third area is this move to systems, system design and analysis and our engagement with system companies are similar, to a lot of extent, with semi companies. Everybody wants to do more with less now, so the benefits of AI and productivity and better results are there in both set of customers.

But of course, our emerging portfolio and system design and analysis provides unique value to our system companies because we are no longer talking to the chip designers. We’re talking to the system designers, the architect, the coupling of the mechanical and the electrical designs uniquely positions us. This convergence is going to happen between system and semi, between electrical and mechanical. And there is no other company better positioned than Cadence to take advantage of this, okay? So overall, to answer your question, these are the three big themes on top of the base. See the base is always important, the best-in-class of the basic algorithms. But AI, 3D-IC and systems will be with us for years to come.

Jay Vleeschhouwer: Thanks, Anirudh.

Operator: Our next question comes from Harlan Sur from JPMorgan. Please go ahead. Your line is open.

Harlan Sur: Yes. Good afternoon. Thanks for taking my question. So on hardware verification, you guys have, sounds like, very good visibility to the first half of the year. I know the team still has some concerns on maybe more discretionary-type spending pullback here. But we’ve also talked about how these hardware platforms are becoming a need-to-have, right, not a nice-to-have but a need-to-have as it relates to these very complex digital SoC platforms. We’re well into the semiconductor industry downturn. I would have assumed that you would have already seen some cancellations in orders or pushouts in hardware shipments if customers were concerned. So has the team seen any of this type of activity? I’m just trying to figure out what’s driving the conservatism here on hardware.

Anirudh Devgan: Well, thanks for the question. This is Anirudh. I think you said it. I think what we see is the hardware is no longer €“ I know it could be part of CapEx, but it’s no longer discretionary spend for our customers. I mean, any chips that are designed today, any complex chips, you have to use these hardware platforms to verify them. And if you don’t verify them properly, then you spend all this money, the chips comes back and it doesn’t work. I mean, that’s a big no-no, right? It delays the whole product and the expense. So hardware platforms, both Palladium and Protium are no longer nice-to-have. You need to have them, okay? And then we have also strengthened our portfolio by not just chip verification but software bring-up.

Chip verification has been traditional sense of Palladium. And now with bring us with Protium, we provide a unique. So, so far, the demand is strong. And we had a record year last year. These days, we have €“ I think we had the record year, year after that, too. But we see continued growth in hardware. And we are very pleased where our competitive position in hardware. We are very pleased with the demand as €“ it’s no longer nice to have. It is no longer discretionary. And also in multiple end markets, so what happened is like we talked about automotive, right? So automotive also has much higher complexity chips now. So the other thing with hardware is it is also expanding to other end markets, whereas traditionally, the big chips used to do it like data center chips.

But now even automotive chips are almost networking. Almost all kinds of chips will require the use of these hardware systems. And we are very well positioned to take advantage of that.

Harlan Sur: Perfect. And then my follow-up, the team has done a great job on integrating machine learning-based methods as a part of your customer’s digital SoC design and verification Although different but nevertheless, still needing many iterations around many variables, is your custom cell and IT design and analog simulation and verification, seems like the team could take advantage of your ML frameworks and apply it to your custom and analog franchise. Is the team working on integrating ML into Virtuoso also and other parts of the analog and custom portfolio?

Anirudh Devgan: That’s a very good point. So I mean, like I mentioned, we have more than 30 projects in all aspects of AI. AI inherently is computational software, right. It’s computer science plus math, which is what we’re very good at. So you can assume that we are working throughout our design flow. And then we announce products in a more conservative way now. We want to make sure they are working with several customers, with different end markets and then we announce them. So last year, the year before, we talked about digital implementation. Last year, we talked about JedAI and verification. And I think this year, you will hear more from us in other parts of the business. The analog custom business is ripe for more automation and packaging PCB. So please stay tuned. But you can be rest assured, we are applying AI wherever it is possible and it is possible to apply it everywhere.

Harlan Sur: Okay, insightful. Thank you.

Operator: Our next question comes from Joe Vruwink from Baird. Please go ahead. Your line is open.

Joe Vruwink: Hi Anirudh. Hi everyone. I wanted to go back quickly to the current RPO topic. So, fourth quarter was very good, finished north of 25% growth. And then even if I appreciate that probably has some hardware in it, John, as you said, that the trend growth is closer to a mid-teens type number now. Can you just help reconcile that mid-teens growth with the implied outlook for recurring revenue? I think it would be more like 12% or 14% growth. It does seem like starting visibility to come from backlog is higher than usual. And so is there an implicit bookings assumption in 2023 that’s factoring into this, or those conservatism, like it applies to hardware also may be applied to software bookings entering the year?

John Wall: Great question, Joe. I mean as Gary mentioned earlier, that he was asking about the number of customers, was there any big customer, there wasn’t one big customer in Q4. We just had a very strong finish to the year. Very strong finish across all lines of business and particularly hardware was very strong as we closed out the year in terms of bookings. I think our hardware systems are just not discretionary spend. As Anirudh said earlier, they have become indispensable part of our customer spend on the R&D side, and people wanted to get their orders in before the end of the year. So, we have a lot of visibility into the next year. And as you know, cRPO, from a quarter-to-quarter basis, can be lumpy in nature. And I think like if you want to reconcile between where the growth in cRPO, say, for the last year is probably up closer to 20%.

But if you look over 3 years, it’s mid-teens. And if you look over 3 years for our revenue CAGR, that’s mid-teens to €˜22, and we are guiding to mid-teens for €˜23. So, I think you can take out some of the noise by looking over a 3-year kind of average period.

Joe Vruwink: Okay. That’s helpful. And then I guess I will stay on the topic of AI. And obviously, Cadence is already using a lot of reinforcement learning and design flow and verification. I guess any thoughts on kind of the recent attention around large language models. You have started to see, I think some tinkering with like RTL code generation or maybe within certain aspects of verification. Does this maybe supplement what you are already doing, or does it have the potential to bring about entirely new products?

Anirudh Devgan: Yes. Good point. I mean one thing to mention is, we always look at all the kind of AI technologies. We have a pretty talented team. And like I mentioned, for us, the biggest application is simulation plus optimization, because you can generate much better results for the customers. So, we are using reinforcement learning and all kinds of other kind of ML techniques for a while now. And to give you an example, like some of the results we are seeing, the PPA can be improved by 10% to 15%, okay. That’s a lot of improvement. And typically, you see this improvement from €“ going from one node to the next, okay, spending billions of dollars, okay. You can get that from better kind of AI algorithms. Now, some of the language models, there could be other applications, especially with the interface of our tools for customer support.

There could be applications. But the main customer-facing applications are when we give better results, better productivity, which we are already doing in multiple ways, as I mentioned, and we will continue to look at all possible ways to improve that.

Joe Vruwink: Okay. Great. Thank you very much.

Anirudh Devgan: Yes.

Operator: Our next question comes from Vivek Arya from Bank of America Securities. Please go ahead. Your line is open.

Vivek Arya: Thanks for taking my question. Anirudh, when I look at the relative growth in your different segments, the System Design and Analysis seems to be the fastest-growing segment, obviously, off a lower base over the last 5 years. What do you think has driven that outperformance? And as you get bigger in that market, does the competitive landscape change? Can you continue to outgrow the market, or just how do you think about that particular aspect of your growth drivers?

Anirudh Devgan: Yes. Hi Vivek. I just want to pointed out first that all businesses are doing great. If you look at even our analog business, that’s grew 13%, okay. That was used to be a stable business a few years ago, okay. Digital business, 17%, okay. These are very remarkable numbers, okay. Verification business, 28%, okay. So, I mean just to put that in context to what was happening in EDA and chip design like 5 years ago to now, I mean this is a remarkable growth in our business, and at the same time, very good profitability. We have more than 40% operating margin. So, I think we focus on growth and profitability. And to come to your question on systems, I mean that had a very strong year with 27% growth. And that’s because our products are just better.

And the customers want this integration like I mentioned, like Jay mentioned earlier, system companies and semi companies. So, I think this is, again, an irreversible trend. There is a need for power analysis, thermal analysis. When you look at 3D-IC, one of the biggest things I have mentioned before is thermal simulation. Cadence is in the best position to provide that. Electromagnetic simulations, our products will run like 10x, 20x faster and higher performance because of our computational software trend. So, I don’t see anything in the near-term that will change that. I mean this is going to continue, right. So, we are pretty confident where we are. And as you know, we are expanding to other areas using the expertise, whether it’s computational fluid dynamics or biosimulation.

And I think this is another irreversible trend, the need of simulation. And the other thing that we are investing heavily in that space, which I mentioned in my prepared remarks, is AI and optimization. That area still, they could barely simulate things in that €“ you could barely simulate a wing or a car properly, right. Forget about optimization. But with optimality, not only we can simulate, we can put that in the inner loop of a reinforcement-based AI engine to give results automatically that, that space has not seen. So, I am actually very optimistic about AI-driven optimization in the system space because it’s entirely new to that set of customers, along with like regular simulation performance and capacity improvement. So, I think we are still a small part of the market, but growing rapidly.

I think we crossed $400 million in revenue in that important segment. And I think there is a lot of room to grow there.

Vivek Arya: Understood. And for my follow-up, John, not complaining at all, but when I look at the implied incremental EBIT margin for this year, it seems somewhat lower than the average incremental margins that you have managed to achieve over the last few years. Just wanted to make sure we are not missing anything from a cost perspective that could restrain incremental EBIT leverage this year.

John Wall: That’s a great question, Vivek. I mean and thanks for pointing incremental margins. As you know, we focus very carefully on those. Over the last €“ I mean we are very pleased that I think 2022, I think was the sixth year in a row we achieved over 50% incremental margins. And the range that we have achieved over that period of time have ranged from 52%, I think to 58% incremental margin over the last 6 years. So, very, very pleased with that. And we are starting this year with slightly less in the guide. I think it’s 48.5% is what is implied in the guide. But that is the largest and strongest €“ the largest initial guide and the strongest start to any of the 7 years €“ of the last 7 years, right. So, very, very pleased to be in this position starting off the year.

And as you know, throughout the year, we tried to find profitable and sustainable revenue growth to improve that through the year. And we have managed to achieve that 6 years running, feel confident about doing that for a seventh year.

Vivek Arya: Understood. Thank you very much.

Operator: Our next question comes from Blair Abernethy from Rosenblatt Securities. Please go ahead. Your line is open.

Blair Abernethy: Thanks very much and great quarter, guys. Just wanted to see if there is anything to update on the Future Facilities acquisition last summer. You have had it for a couple of quarters now. How is that trending? And are you seeing opportunities to cross-sell your other simulation software into that space?

Anirudh Devgan: Yes. Great point. I mean our , very excited about Future Facilities because I think that the way to differentiate in the system space is also through differentiated vertical offerings. because if you look at the simulation space, there are only few like kind of unknown algorithms. There is finite element, there is CFD and now we are doing molecular simulation. But there are a lot of end markets, okay. And the one way to even further differentiate CFD, one way we differentiate CFD is by our compute power, right, doing things bigger things and faster. But the other way to differentiate it is building a vertical kind of end market. And in CFD, one of the biggest thing is this data centers and smart buildings. So, with Future Facilities, not only the thermal simulation is good, the core CFD engines and we can couple it with the rest of the CFD products.

But they also have built like a lot of models for like, if you go into a building or a data center, they have models for all the components, whether they are AC vents or AC systems and racks and all that. So, the customers can get very, very accurate digital twin for the data center. And that technology can be actually applied to any building, not just a data center. Now, we started with data center because that’s a big market. And as you know, they consume a lot of power. So, right now, data centers consume as much energy as like the whole airline industry, okay. So, that’s a lot of energy that they are consuming. And we have a lot of engagements that have picked up since we €“ because they are now in a bigger home with the whole Cadence reach.

So, we have a lot of engagements which are picked up with the hyperscalers, and with other companies, even in other industries because a lot of companies have big data centers, whether they are internal or on the cloud. So, you will see more of that from us, and I am pretty optimistic about it. That’s why we made that acquisition of this verticalization of having these vertical solutions in the CFD space.

Blair Abernethy: That’s great. Thank you.

Operator: Our next question comes from Ruben Roy from Stifel Financial. Please go ahead. Your line is open.

Ruben Roy: Thank you. Anirudh, you got a bunch of questions on hardware, and I think Carlin’s question hit on most of the things that I wanted to ask about. But I guess one thing that stood out to me from your commentary was that the two-thirds of your, I think new orders in €˜22 were for both Palladium and Protium. And that was interesting to me because it seems like as we are moving to more SSD designs, more firmware and software on those designs, that that sort of selling Palladium and Protium together is likely to move up. So, I guess if you could just comment on that and how you are thinking about that as either TAM expansion or a revenue growth driver kind of longer term behind hardware would be interesting. Thank you.

Anirudh Devgan: Yes, absolutely. Great point. I mean the thing with hardware, first of all, it’s in a secular growth trend like we mentioned, but it’s always good to have multiple products. And that’s why the addition of Palladium and Protium that are complementary, but address different parts, which both of them are growing, it also provides more predictable growth for our business. So, like even though we had a record year last year we still see growth this year and in the future because of this product mix, because software bring-up, I don’t need to tell you, most of the designs now are software-defined hardware design. Software is what is driving the requirements for the hardware design. So, initially, they actually start with the software model and that is run on Protium to figure out what kind of architecture to do.

And then once you do the chip design, then Palladium comes in and then at the end, Protium comes in again. So, there is a lot of back and forth between software bring-up and chip design. And therefore, having a common compiler gives a unique value that you can move it seamlessly between the two platforms. But I also believe that just like our customers have different silicon platforms, we need to do that too, okay. So, Palladium, the reason it is well differentiated is we use our own Cadence silicon. We design it ourselves, built with one of our foundry partners. And that gives advantage in terms of compile time that is unmatched, right. But for software bring-up, FPGA is good. So, we use FPGA platforms, and then we have built a differentiated offering with Protium.

And same thing on like our regular verification systems like Formal with Jasper and XLM logic simulation. We also offer multiple hardware platforms. Of course, x86, that has been traditional, but we have also ported all our software platforms, especially in verification to ARM-based systems because they can offer price performance. So, not only we have multiple products with Palladium and Protium, we are always looking at the right hardware to run them on. So, in case of Palladium, it’s a custom silicon. In case of Protium, it’s FPGA. And then in logic simulation and Formal, we look at both x86 and ARM, so to give a full variety of options to our customers.

Ruben Roy: Thanks for all that detail Anirudh. If I could just ask a quick follow-up for John, I don’t think you were asked on the pricing environment, John, and just watching the backlog move up again and kind of all the megatrends that you are talking about is understandable that things are going well. But I am just wondering, in light of the macro, etcetera, if €“ how you are thinking about pricing as in the context of the guidance that you have given for €˜23? Thank you.

John Wall: Thanks. The €“ yes, I mean we are very focused and disciplined on driving value for Cadence and for our customers. As like I said, on our hardware side, we don’t believe that’s very much on the software side too, that a lot of our customers spend with us is not really discretionary. It’s quite indispensable tools that they need from us. And everybody these days wants to focus on improving productivity, and all the tools we provide help our customers to drive that. So, I think we are in a sweet spot at the moment. So, we are disciplined on pricing. But the pricing that we are extracting for our tools has come from the increased value that our customers are getting from the use of our tools.

Ruben Roy: Makes sense. Thanks John.

Anirudh Devgan: Yes. One thing to add to what John said, I think you know this already, but one thing to emphasize, like typically, when people move from one node to another, right, so we are at 5-nanometer, a lot of the design’s at 3-nanometer, then 2-nanometer, 1.4-nanometer, 1-nanometer. So, we have like 10 years of node migration ahead of us. So, any time you go from one node to the next node, the number of transistors effectively doubles in the chip. So, number of blocks effectively doubles and complexity doubles. So, for the same chip being done, it has more things in it so that normally requires more use of our software. So, that’s one thing just to emphasize to our investors is that whenever there is a node transition, and this is happening in the past, but this will continue to happen for next 10 years.

So, that also requires more hardware capacity. That requires more simulators. That requires more place and route runs to be done. And of course, with AI, we can make that even more productive. So €“ and Moore’s Law is not slowing down for at least 10 years, okay. And on top of that, you add 3D-IC. That adds another 10 years of. So, we have a lot of sustained growth that the customers will build amazing products, and they need more and more of our software and hardware to do that.

Ruben Roy: Yes. Thanks Anirudh. I guess that’s where I was going with the question. I mean obviously, with Cerberus going €“ running on top of Innovus. And I am just kind of trying to think about how €“ it seems, and you guys have talked about this, greater portion of R&D budgets from both semiconductor and systems companies just going into kind of the suite of tools that you offer. So, anyway, thank you very much, and congrats on a great quarter.

Operator: Our final question will come from Andrew DeGasperi from Berenberg. Please go ahead. Your line is open.

Andrew DeGasperi: Thanks for taking my question. I guess first in terms of the analytics products that you mentioned, I was just wondering in terms of your customers, how steep of a learning curve is it for them to adopt us? And what is the kind of timeline that it typically takes from when you introduce it to them to when they are kind of using it in terms of their day-to-day processes?

Anirudh Devgan: Yes, that’s a very good point. So, I think it’s something like Cerberus AI, our use model is very similar to what they are doing right now, okay. So, we don’t change any of the interfaces. And if they are used to running Innovus, then Cerberus will run on top of it, almost like a cockpit, but it will do those experiments that they were doing manually, they will do it in an automatic way. But the interfaces are similar. The commands they are used to running are similar. But instead of manually running and trying different things, Cerberus will do that automatically. So, typically, we have seen €“ that’s why you have seen a lot of kind of uptick to Cerberus and these AI-based tools because they don’t fundamentally require a new working model.

It just takes away some of the mundane tasks that the customers were doing. And similar things are true for optimality, similar things are true for Verisium. There is always some learning gap, but it is, our customers are very smart users anyway, right. They are designing all these complex chips. So, this is nothing that they can’t pick up in a pretty quickly.

Andrew DeGasperi: Yes. That’s helpful. And then one question for John, in terms of the share repurchases, I think you bought 1 billion or so last year. This year, you are guiding for a bit below that. I was just wondering, what was the thinking behind that? Is it a function of investing in the R&D in terms of the different €“ the three different themes you mentioned earlier, or is it potentially for additional M&A that you are planning for the year?

John Wall: Yes. Andrew, our approach for capital allocation hasn’t changed and share repurchases, that effectively for this year again, we are expecting to use 50% of our free cash flow to repurchase shares. That’s the way we started last year, too. We have a number of repurchase programs. We have our baseline repurchase program. We had an accelerated share repurchase last year to offset dilution from the general stock refresh in the middle of year because we do merit in the middle of the year. But also, we have an opportunistic repurchase program that kicks in when certain price levels are met. And last year, that kicked in, in Q1, Q2 and Q4. So, we bought back shares when the prices were lower. We typically don’t guide to that right now, but we assume using at least 50% of free cash flow to repurchase shares. This year, if our opportunistic repurchase program kicks in, we will buy back more.

Andrew DeGasperi: Great. Thank you.

Operator: I will now turn the call back over to Anirudh Devgan for closing remarks.

Anirudh Devgan: Thank you all for joining us this afternoon. It’s an exciting time for Cadence as we enter 2023 with strong business momentum and robust design activity offering tremendous market opportunities. Our exceptional execution of the Intelligent System Design strategy, customer-first mindset and a high-performance and inclusive culture are driving accelerating growth as we grow our core EDA business while expanding our portfolio with new innovative solutions. Fostering sustainable innovation is a top priority, and we are thrilled to have been included in the newly released 2023 top-rated ESG Company List, ranking number 18 out of over 1,000 companies in the software and services group. And on behalf of our employees and our Board of Directors, we thank our customers, partners and investors for their continued trust and confidence in Cadence.

Operator: Thank you for participating in today’s Cadence fourth quarter and fiscal year 2022 earnings conference call. This concludes today’s call. You may now disconnect.