Good afternoon. My name is Abby, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Q3 2022 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 Richard Gu, Vice President of Investor Relations for Cadence. Please go ahead.
Thank you, operator. I'd like to welcome everyone to our Q3 of fiscal year 2022 earnings conference call. I'm 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 in 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'll present certain non-GAAP measures which should not be considered in isolation from or as a substitute for GAAP results. Reconciliation of GAAP to non-GAAP measures are included in today's earnings release. Today's earnings release for the Q3 of fiscal 2022 related financial tables and CFO commentary are also available on our website. For the Q&A session today, I would ask that you observe a limit of one question and one follow-up. You may requeue if you would like to ask additional questions and time permits. Now I'll turn the call over to Anirudh.
Thank you, Richard. Good afternoon, everyone, and thank you for joining us today. I'm pleased to report that Cadence delivered excellent results for Q3, driven by our technology leadership, strong execution, diversified customer base, and resilient business model. We beat our Q3 guidance on all key metrics and are raising our financial outlook for the year yet again to 19% year-over-year revenue growth and 40% operating margin. John will provide more details on our Q3 results and updated outlook for the year. Notwithstanding the prevailing macroeconomic uncertainties, hyperscale computing and AI/ML driving robust design activity over the long term remains intact. These secular trends are accelerating the digital transformation across several end markets. While the growing hyperconvergence across multiple domains, mechanical and electrical, hardware and software, and systems and semis, is driving the strong need for continued innovation in compute, connectivity, and storage.
Customers are investing heavily to differentiate their next-generation platforms, with system companies increasingly developing purpose-built silicon and semiconductor companies benefiting from expanding silicon content. Our comprehensive offerings comprised of leading end-to-end EDA solutions, IP, hardware, and expanding systems portfolio uniquely position us to support our customers while providing us with ample growth opportunities. In an environment of increasing design complexity, tighter time to market requirements, and growing shortage of talent, sophisticated AI/ML solutions can greatly help to democratize chip and system development while dramatically increasing productivity and quality of results. Customers deploying our game-changing AI-driven Cadence Cerebrus and Optimality solutions are realizing amazing results. In Q3, we augmented our portfolio with the transformative Verisium AI verification platform and the JedAI data platform. Verification continues to be the critical path in system time to market, consuming the vast majority of resources, with debug being the largest component.
Verisium provides a generational shift in verification, moving from a legacy single run, single engine approach, to algorithms that leverage big data and AI to optimize multiple runs across multiple engines, leading to a 10x boost in debug productivity. Several customers, including Samsung and STMicroelectronics, have observed impressive results with Verisium for automatically triaging and root-causing bugs. JedAI is our revolutionary AI driven big data analytics platform that is foundational to unifying our AI innovations across Cadence Cerebrus, Optimality and Verisium. JedAI operates on vast amount of data, including all types of design, verification, analysis and methodology information to facilitate smarter design optimization and enhanced productivity. In Q3, we significantly expanded our footprint with market-shaping customers as they increasingly embrace our optimized platform offerings.
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. Additionally, in Q3, we strengthened our collaboration with Teradyne, which included a broad proliferation of our core EDA software across digital, analog and verification, as well as a significant expansion of our PCB and system analysis business. Demand for our core EDA software remains strong and broad-based. Our digital business had another strong quarter with 22% year-over-year growth, driven by key competitive wins and continued proliferation at market-shaping customers. 13 new customers adopted our digital full flow in Q3.
It's been just over a year since we launched Cadence Cerebrus, and it's fast becoming a linchpin technology for customers as they derive incredible productivity and PPA results on a wide variety of their most advanced SoC designs. Several leading customers have major multi-design, multi-pro-project production deployments underway and are reporting up to 30% improvement in quality of results and 30x productivity improvements. Additionally, we see accelerated growth in our front-end and signoff offerings, in part due to the Cadence Cerebrus pull-through effect. We launched the Certus closure solution, which dramatically accelerates complete design closure by using an innovative hierarchical architecture and a fully automated environment for concurrent full chip optimization and signoff. Using Certus, Renesas observed 6x faster chip level signoff closure versus current methodologies. MaxLinear experienced overnight full chip signoff closure while realizing up to 5% of untapped power savings.
Our custom IC business continues to define the analog market with its bold vision, market-leading technology and comprehensive portfolio. In Q3, it grew 12% year-over-year, driven by best-in-class Virtuoso platform and by strong growth in our Spectre simulation solutions. Now moving on to functional verification. In Q3, our business grew 31% year-over-year, led by hardware and Xcelium. Our Palladium Z2 and Protium X2 hardware platforms, providing industry-leading system verification and software bring up capabilities, added three new customers and had 20 repeat orders, including from high-end mobile, AI, and hyperscale customers. Our IP business, led by our IP offerings at the most advanced nodes, continued to benefit from ongoing IP outsourcing trend and from customers increasingly embracing IP reuse for risk reduction and faster time to market.
During Q3, we signed our largest IP contract ever with a marquee US semiconductor company and had a major expansion at a leading US 5G company. Tensilica extended its leadership in the true wireless stereo market while proliferating its functional safety and infotainment solutions with automotive companies. We also had multiple design IP wins across our leading PCIe, DDR, and die-to-die portfolio. Our system design and analysis business is a key tenet of our growth strategy to leverage our computational software expertise and expand our TAM by growing in near adjacencies. This business continued its strong momentum, delivering 29% year-over-year growth as we increased our footprint in several verticals, including aerospace and defense and high-tech electronics.
Our broad systems portfolio, providing tightly integrated platform solutions across the design, simulation and analysis, is resonating strongly with customers as they increasingly choose a broader set of our solutions across these domains. In Q3, we broadened our collaboration with Emerson, a global industrial technology and software leader, as they significantly expanded their use of our system solutions, notably our PCB, AWR, and system analysis technologies. Fidelity CFD software that was announced earlier this year is ramping nicely and facilitating customers in verticals such as aerospace, marine, and turbomachinery to do design optimization, leading to efficiency improvement and meaningful reduction in emissions and energy consumption. The addition of Future Facilities, digital twin-based thermal and power optimization technology will further help data center customers to reduce their carbon footprint. Lastly, we completed the acquisition of OpenEye Scientific, a leader in the computational molecular design space.
We are very excited to bring our system-level simulation and AI ML expertise to the life sciences market to help improve the speed and accuracy of biosimulations, thereby enhancing the efficiency and success rate of drug discovery process. Integration of both our Future Facilities and OpenEye acquisitions is progressing well. In closing, Q3 was an outstanding quarter as we advanced our intelligent system design strategy and continued to closely collaborate with our customers on their next-generation designs. We are managing our business with an intense focus on innovation and operational excellence to drive both revenue growth and margin expansion, and are very well positioned to capitalize on the massive opportunities ahead of us. Now I will turn it over to John to provide more details on the Q3 results and our updated 2022 outlook.
Thanks, Anirudh, and good afternoon, everyone. I'm pleased to report that we completed the acquisitions of OpenEye Scientific and Future Facilities in the Q3 of 2022. Cadence exceeded all key financial and operational metrics for the quarter. Here are some of the financial highlights from the Q3. Total revenue was $903 million. GAAP operating margin was 29% and non-GAAP operating margin was 39%. GAAP EPS was $0.68 and non-GAAP EPS was $1.06. Operating cash flow was $317 million. We used $150 million of cash to repurchase Cadence shares. At the end of the quarter, our cash balance totaled $1 billion, while the principal value of our debt outstanding was $800 million.
Before I provide our updated outlook for the remainder of fiscal 2022, I'd like to take a moment to share certain key assumptions embedded in our outlook. We expect the impact of the recent changes to US trade restrictions on our business to be limited and manageable. The impact is included in our outlook. Our outlook also assumes that the export limitations that exist today remain substantially similar for the rest of the year. Embedding these assumptions into our outlook for fiscal 2022, we now expect revenue in the range of $3.532 billion-$3.552 billion. GAAP operating margin in the range of 29.7%-30.7%. non-GAAP operating margin in the range of 39.7%-40.7%.
GAAP EPS in the range of $2.71-$2.75. Non-GAAP EPS in the range of $4.20-$4.24. Operating cash flow of approximately $1.2 billion-$1.26 billion, and we expect to use approximately $1.05 billion of our free cash flow to repurchase Cadence shares in 2022. For Q4, we expect revenue in the range of approximately 35%. GAAP EPS in the range of $0.50-$0.54. Non-GAAP EPS in the range of $0.89-$0.93. We expect to use approximately $300 million of cash to repurchase Cadence shares in Q4.
Our CFO commentary, which is available on our website, includes our outlook for additional items as well as further analysis. I'd like to thank our Cadence team for their exceptional execution and financial discipline. At the midpoint of our outlook, we expect our annual non-GAAP operating margin to exceed 40% for the first time, which is especially pleasing. As always, I'd like to thank our customers, partners, and our employees for their continued support. With that operator, we'll now take questions.
At this time, I would like to remind everyone, in order 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 question-and-answer roster. Your first question comes from Jason Celino from KeyBanc Capital Markets.
Great. Thanks for taking my question. Can you hear me?
Yes, Jason, go on.
Okay, perfect. Sorry to be, you know, straight to the point here, but, you know, China's on everybody's minds. You know, it was 50% growth in the quarter. You know, to some extent it was an easy comp, but, you know, it was the largest revenue that you've seen in this period. I guess, where did you see the strength, and then how would you describe the linearity of that strength? Was it all throughout the quarter or was it front-loaded or back-loaded? Curious. Then I'll have a follow-up.
That's a great question, Jason, and thanks for the opportunity to clarify. In Q2, you saw 13% of our revenue in Q2 came from China, and that jumped to 17% in Q3. Most of the increase, the vast majority of that increase was a result of hardware sales in the quarter. Hardware revenue that was recognized from deliveries into China during Q3. That uptick in China revenue is all from up-front revenue sources.
Okay, perfect. I did notice that backlog was kind of sequentially, you know, down a smidge in the quarter. You know, how much of that was due to the inclusion of some of these new restrictions? Thanks.
Yeah, another great question, Jason. That last quarter, I think it was $2.75 in terms of our current RPO, and that's down to $2.7 now. That's partly as a result of that hardware delivery into China. It also includes this quarter we've included the impact of the new U.S. export regulations. On backlog in total, I think it went from $5.6-$5.5. The current or the RPO piece, that was slightly down more, and we had an increase in IP. We signed our largest IP contract ever, and that's in the noncancelable commitment portion of our backlog.
Okay, great. I'll get back in queue. Thanks, John.
Thanks, Jason.
Your next question comes from the line of Charles Shi from Needham & Company.
Hi. Good afternoon. Anirudh, John, I really just wanna go back to the China question. Maybe not immediate, Q4 or fiscal 2022, but to try to look a little bit ahead. Among you, like, kind of like mid-teens of the total revenue coming from China, I know you sell to China to various kind of customers. You got multinationals, you got the large semiconductor companies, domestic, you got AI startups, Chinese system companies. But across this wide spectrum of the different kind of customers in China, what kind of customer the sales to the customer could be the most impacted by the export control?
Can you kind of quantify to us how much of the percentage of your revenue is gonna be impacted because of the latest round of export controls? I have a follow-up to that.
Hi, Charles. This is John. Yeah, good point there. We did call out that the impact is limited. We believe the impact is limited and manageable. That's not just for Q4, but for the foreseeable future going forward.
Any thoughts on any specific type of customers that you may see the greater impact in your China market?
Yeah. Hi, Charles. This is Anirudh. Overall, you know, China is, you know, diversified customer base, and we have a lot of design activity in China. You know, good thing about Cadence is, you know, we participate in all kinds of designs, right? Whether analog or digital or memory and different market segments. Overall, I feel that will be intact. I think there is some effect on local like China foundry in the latest regulations, as you probably know. Overall, our business is very, very diversified, not just in China, but other geos. Therefore, we feel the impact is limited and manageable. Like what John said, not just for the remaining of the year, but also going forward.
Okay. Thank you.
Mm-hmm.
Your next question comes from the line, Gary Mobley from Wells Fargo.
Hey, guys. Thanks for taking my question. I wanted to talk about perhaps the indirect impact from the China export restrictions and as well as the general semiconductor market backdrop and the challenges this may present for companies like Cadence. You have some of your large customers who cannot ship product to China because of various export restrictions, one of which can't ship $400 million worth of product because of these export restrictions. To what extent long-term might the R&D budgets of those types of companies be impacted?
Related to that, the chip design activity as they can no longer sell to various and large end markets like China. Related to the overall market backdrop, are you seeing any change in customer behavior with respect to the time it takes to get sign-off on any large license deals?
Hi, Gary. That's good. They're good points, you know, especially the indirect effect and also overall macroeconomic uncertainties. You know, we are carefully, you know, monitoring the situation on both of these fronts. As you know, we are more on the, you know, design side than on the you know, volume or shipments. On the macroeconomic trends, of course, there's a lot of news, in the press, and we are carefully monitoring it. Right now, you know, we see robust design activity. As you know, we participate in all the market verticals. Even if some verticals may be weaker on their shipment side, they will still do design. Then some verticals are still good on the shipment side as well.
With this combination of us being on the design side and then us being very diversified across multiple verticals, right now we still see very robust, you know, design activity. That's reflected in the results that we are reporting today, right? Our outlook for rest of the year. Now, on the indirect effect on China, you know, that's to be observed also, but again, we are pretty diversified. Yeah, there's always some effect on some of our customers, but again, we are pretty diversified and then, you know, but we will carefully monitor that, you know, going forward. Yes.
All right. Thanks for that color, Anirudh. I wanted to switch topics to your JedAI-based AI machine learning tools, including Cerebrus and some of the others you recently announced. I know you're in the early days of price discovery and introducing those products to market. What has been the feedback as it relates to quote-unquote, "price discovery" and related to that, how deeply you know you may be seeing penetration at some of your early days customers there?
Yeah. Hi, Gary. That's a great point. You know, we are super excited. The EDA has always been like, we have done a lot of great productivity improvements for our customers, but it has always been like a single run environment, right? You run our tool one time, and then the multiple runs have been managed by the customers. You know, typically, when you do the design, you're not running our tools one time, you're running it multiple times. With this data analytics and AI, we can really offer solutions in this multi-run environment. AI is a key part of that. In a multi-run environment, you also have to manage the data, you know? Because AI tools run on top of all the data that's generated. We're very proud of this new JedAI platform.
It's a new data analytics platform to capture all kinds of data in the design process, and that unifies our solutions across this space. Then we have three, like, big apps on top of JedAI, you know, on top of this data analytics. One you already know, like Cadence Cerebrus, which was launched last year. Optimality, which is on the system space using some of the similar technology as Cerebrus, but applied to system simulation. Now Verisium in verification, which by the way, verification, as you know, is one of the most time-consuming parts of the design flow and also the one that generates the most data. You know, logic simulation, hardware, you know, verification generates the most amount of data in EDA.
That's why it was critical to have JedAI, you know, to unify all these things, but also get ready for more data like in verification. The adoption has been actually surprisingly good, you know, and all the big customers are engaged. You see in Verisium we have endorsement from several big customers. We talked about Cerebrus last time, you know. At this point, all the major customers really do want to deploy these solutions. Like I mentioned in the script, not just for one or two designs, we are seeing broader and broader adoption. We are very happy with the progress so far.
Thanks again.
Mm-hmm.
Your next question comes from Jay Vleeschhouwer from Griffin Securities.
Thank you. Good evening. Anirudh, for you first, when you look back the last one or two years, how would you rank the contribution to your bookings growth and/or share gain in what we define as core EDA from the various products that go under your UVM and UML nomenclature? I assume Innovus has been part of that given its size, but when you look at some of the various other sign-off and other tools that you've introduced under that nomenclature, again, how would you rank the new momentum or incremental contribution from those? Perhaps even look out ahead over the next one to two years in that respect. Secondly, for you, John, what has been your experience to date in terms of the predictability of your IP business?
This is not a China-specific question, but feel free to talk about China. Specifically in terms of the increasingly material upfront component that we've seen for IP rev rec, as well as for your services engagements related to IP. Thank you.
Yeah. Hi, Jay. That's a good question. Actually, I'm very pleased with our strength of portfolio in core EDA. As you know, we have been doing, you know, increasingly well over the last couple of years. I can say that Cadence core EDA portfolio is strong as it has ever been. You know, we want to apply our expertise in computational software to new areas like system analysis and system design and analysis. But it's super critical to maintain the leadership in the core, because core always comes first, and then, you know, we take those expertise and apply to new areas like systems. We are always focused on the core first. You know, core parts are, let's say, three big areas, right? In core EDA, you know, digital, analog, and verification at a high level.
I feel that we have a very strong portfolio now. In terms of contributions of growth, you know, in analog we were always strong, and I think there were some areas to improve in Spectre simulation, which have been fixed over the last two years. I think analog is more steady, and you can see even this quarter it grew a healthy 12%. A lot of the growth has come from digital and not just Innovus, which is place and route, but also now with synthesis and sign-off and Cerebrus. I would say, you know, digital is growing very well also in terms of, you know, strengthening the position in the market. Then I'm especially pleased with verification.
Now, verification, there is systemic growth drivers that is helping hardware, but I think that some of it is strength of our portfolio and some of it is hardware becomes more critical to the design portfolio. In verification, I actually also pleased with Verisium, our logic simulator. You know, I think that's doing really well this year and over the last couple of years. That completes our overall verification platform, because we are now strong in hardware with Palladium and Protium. Jasper, we have always been the leading solution in formal verification. With the strength of Xcelium, it completes our verification platform. I would say the growth in core EDA is driven by digital, number one. Verification, you know, close second, and then maintaining and strengthening our position in analog.
Yeah. In relation to your IP question and particularly the predictability of IP revenue, our focus remains on profitable growth through differentiated star IP that's highly reusable and easier to scale. I've been very pleased with the discipline from the management team that run that business for us and their ability to target more profitable and sustainable revenue growth. That's what we ask for. We always ask them to, you know, to run IP like it's our family business. Sign us up to business that you'd want to do if this was your family business, not just a public company. Of course, with IP in amongst that profitable, sustainable, regular recurring revenue, there's also some upfront components to IP that can have more variability.
Naturally, we're cautious on that going forward, but we'll have to look at the macroeconomic environment and on the impact of that for next year. We see a lot of upfront revenue this year in our numbers. I think upfront revenue for 2022 is on track to be, you know, almost 50% growth year-over-year. That sets up some pretty tough comps for next year. We'll look at that carefully. Now, most of that's coming on the hardware side. When I look at all of the business, all the businesses across Cadence, they're all on track to grow by low teens or more growth this year.
like I said, very, very pleased with the predictability of the IP business, particularly because they're focused on profitable and sustainable revenue growth for us.
Okay. Thank you both.
Thanks.
Your next question comes from Vivek Arya from Bank of America Securities.
Thanks for taking my question. I wanted to ask a China question in a different way. How much of your 17% of sales to China were to customers that were involved in or, you know, would eventually be involved in sub-14 nanometer logic design or leading edge NAND or DRAM? I guess it's just not intuitive that leading edge design is not possible without your tools. You know, China just got restricted from doing leading edge, yet you're not seeing the restriction in any way. It's just not intuitive to me at all.
Hi, Vivek. I mean, we've taken the necessary steps to be in full compliance with the new export regulations. Our guidance includes the full impact, but we haven't broken out, you know, how much of our China revenue is sub 14 nanometer. We do believe the impact to the company is limited and manageable.
Is that a near-term view, John? In that, is it because you are, you know, more involved in analog? Is it because, you know, you are in 2- or 3-year contracts? Or is it because you think that there is other revenue sources outside of China that can help you know, kind of offset that deficit?
Well, we also feel it's limited and manageable going forward. Again, I mean, we're applying these rules, these new U.S. export restrictions. We've applied them. We've included the impact in our guide. We believe it's limited. I'd say, like I say, manageable from an R&D perspective. We have to look at some resources and maybe redeploy some of those resources.
Okay. For my follow-up, I'm curious, what happens if semiconductor sales go down 10% or 15% next year? What happens to the budget for EDA? Like, even if you don't decline, is it possible that the growth rate you know slows down from the mid-teens? Or I guess asked in a different way, under what scenario would Cadence's growth rate slow down next year?
Yeah. Hi, this is Anirudh. First of all, I think you know already, I just want to remind you that, you know, we believe our business is more resilient and but of course we are not immune to, you know, macroeconomic situation, right? It will depend on. At a high level, it'll depend on, you know, if there is a recession, how severe the recession is, right? Is it a mild recession or is it like a very, very severe recession? If it's a very, very severe recession, then of course nobody is immune to it. In general, you know, from our kind of business, I think there are three factors that makes it more resilient.
One, as you know, we are essential part of the design process, so we are not tied directly to, you know, volume or shipment, more to design activity, and then design activities there both in the semi companies and of course the system companies, and we are also expanding our portfolio into systems. I think first part is we are more essential and tied to R&D. Second part, as you know, we are very ratable, you know, most of our revenue is ratable. Third part is we are very diversified, you know, in multiple geographies and verticals. That gives us more resiliency than other companies in this environment. Of course like I said, we are not immune to it, especially if there's a very severe kind of correction. We are carefully monitoring that.
I think when we talk to you next time in January, we'll have more information on the macro situation and can provide more color for next year. Yeah.
Yeah. The macro will really impact upfront more. I mean, we're very resilient, robust stream of recurring revenue. I think that's what Jay was getting at in his earlier question about the predictability of the IT business. I feel very confident in the IT business 'cause we've been focused on profitable and sustainable revenue growth there. But we've had a really strong hardware revenue year this year. I don't know myself if there's a severe downturn in macroeconomic conditions, you know, IT budgets are one of the first things that you look at in terms of, you know, do you need to purchase hardware and capital equipment and things like that, and that could impact us on the upfront side.
Thank you.
Your next question comes from Harlan sur with J.P. Morgan.
Hi, good afternoon. Thanks for taking my question. Yeah, maybe as a follow-up to the last question. You know your functional verification portfolio, which includes hardware emulation and prototyping, right? That's up 25% for the first nine months of this year. Very strong growth. If I think about a weaker semi industry next year and think about where the risks could be, you talked about some of the upfront portion of your revenues, and I think about hardware emulation and prototyping platforms. On the flip side, we continue to hear that design verification and early software development continue to be very significant bottlenecks in these next generation digital SoC chip design, so actually very critical to your customers' overall design process. Do you guys agree with this?
Given your pipeline visibility backlog, do you see your hardware emulation and prototyping pipeline, at least as you're looking at it now, remaining relatively strong into next year?
From a backlog perspective, you know, we probably have 6 months of hardware revenue in backlog. You know, any kind of increased issues on the macroeconomic front will probably slow down hardware purchasing going forward. We'll need another few months to assess what the climate's like there. Hardware is really a pipeline business. You get about, you know,three or six months kind of visibility into what that pipeline looks like. Again, I think on the hardware side, it's been a phenomenal year.
Mm-hmm.
Functional verification group has had a tremendous year this year. We'll be lapping some tough comps next year, but we need a few more months to assess before we can guide anything to next year.
In general, your thesis is correct. I mean, hardware almost become indispensable to the design of chips and electronic systems. Without these emulation and prototype platforms, it's almost impossible to design that. As the chips get bigger, you know, as you go to newer nodes, you know, the chips in terms of number of gates, right? The next node always has more gate than the previous node, even if the chip size is same as you know. As the chip number of gates gets larger, it requires more and more verification and emulation. Overall, I think there is a systemic kind of support of how much emulation and verification needs to be done.
Mm-hmm.
It just depends on, you know, how that overall baseline growth required, you know, gets affected by any large macroeconomic shift. In general, these hardware platforms are almost indispensable now as you do design, and almost all our big customers are relying on them. Yes.
From a business perspective, I mean, we're building out our cloud infrastructure to be able to provide that hardware in the cloud. That changes, you know, spend for emulation capacity from being CapEx to OpEx spending. Now from a revenue standpoint though, emulation capacity that's used in the cloud, we would have to recognize that revenue ratably. We do have a business solution if there is cutbacks on CapEx spending.
Oh, thank you. I appreciate that. Maybe just a longer-term question, because we're hearing more and more about this, but on the move to 800 gig and higher optical speeds in the data center, this is driving a pretty strong focus on more integrated silicon photonics-based solutions, either optical module-based or co-packaged electro-optical. You know, Intel, Marvell, Broadcom, Nvidia, Cisco, all of some of your big customers are all working on viable solutions. I know you guys have a pretty strong portfolio here. You got Virtuoso Photonics. I think you've got some of your advanced packaging and module design solutions, thermal and power modeling solutions as well. You guys also have pretty strong partnerships with some of the manufacturing guys. How do you guys see this market opportunity unfolding for the team over the next few years?
Yeah, that's a great point. I mean, photonics is big, and then you also touched on, you know, package level integration. I mean, these things again play to the. You know, we are in a good position there based on the strength of Cadence. You know, a lot of these things are done in Virtuoso platform, which is the flagship platform, and then also Allegro, which is again, flagship platform for advanced packaging. Then over the last four years, you know, we have built all these analysis tools, you know, like Clarity and Celsius for electromagnetics and thermal, which are critical for photonics and 3D IC. We have a pretty broad solution.
That's the other exciting part, is there are multiple vectors of growth that are possible with Cadence, and this is definitely a very, you know, exciting area, as you know. We are working with all the you know, because of our position in Virtuoso and Allegro and the new analysis tools.
Mm-hmm.
You know, we're working in this very important market. Yeah.
Yeah. Great. Thank you.
Mm-hmm.
Your next question comes from Gal Munda with Wolfe Research.
Hi. Thank you for taking my questions. Maybe the first one, John, for you. When I think about the guides heading into Q4, especially around the OpEx, what's implied to get to that level of profitability, is there anything accelerated, anything that we need to kind of factor in that in terms of the hiring or on cost side, or do you think you know, I think incremental margin implied is kind of low 30s% to get you to that number. Is it more conservative? How would you kind of assess that part of the guide?
Yeah, sure. Good question, Gal. On the operating expense side, of course, it includes a full quarter now of expense for OpenEye Scientific and Future Facilities, plus incremental hiring that we did during Q3 and intend to do again in Q4. You get the full bow wave effect of, you know, any hiring in Q3, you have a full quarter of that expense in Q4. Also on the bookings front, we've seen substantial increase in bookings compared to our forecast this year, that sales have been very good. There will be increased commission costs embedded into that Q4 guide as well.
Okay. That's helpful. As a follow-up, you know, obviously hardware's done really well this year, but if you think about back when you introduced the Q4 guide for the year, and then, you know, this is the third raise in a row, you know, look back nine months, what is the thing that surprised you most? Was it the hardware itself, how strong it's been this year, or has it been anything else that's allowed you to keep raising the guide on the top line throughout the year?
Gal, I've been very, very pleased with the performance of all the businesses. Like you say, every single one of our businesses is performing exceptionally well. The lowest performing business is showing teen growth year-over-year. Absolutely tremendous. Now, what I wasn't expecting was upfront revenue to grow by almost 50% over 2021. I don't think any of us would ever have predicted that. But you're seeing a lot of that upfront revenue coming through from hardware. It's the popularity of our emulation systems has just been off the charts. You know, long may it continue, but it's very hard to determine how long that will continue for.
We do have substantial backlog already and a long lead time, and we're making those systems as fast as we possibly can. I think if you have a look at the inventory, you know, we've less than $10 million of finished goods there. You know, the vast majority of that is already out on demonstration with customers. You know, there's a triage situation that goes on every system that comes off the production line. There's a plan for getting that out to a customer as quickly as possible.
That's really helpful. Thank you so much.
Your next question comes from Gianmarco Conti from Deutsche Bank Securities.
Hi, everyone. Yeah, thank you for taking my questions, and congratulations on delivering another great quarter. Now, given the strong clear performance that you've had in system design analysis, and JedAI and Cerebrus, could you perhaps give some color on how your customers are reacting to budgetary decisions regarding spend in this category, you know, given the current economic climate? Are you seeing customers sticking similar to that with EDA consumption, or is this bucket of software spend more volatile to economic downturns? I'd imagine companies, particularly for this bucket, are more defensive, generally speaking. I'll ask a follow-up after. Thank you.
Yeah, hi, this is Anirudh. I mean, good question. We are, like I mentioned, pleased with the adoption of these AI-based solution because I think it can provide more automation than what EDA tools have done in the past. To some extent, they are also deflationary. They have opportunity, I think, for the entire industry to move more of the work from people to automation, from people to tools. This is possible because with JedAI and then Cerebrus, Optimality and Verisium, a lot of the lower level tasks, which were very mundane, can be automated and the designer can focus on more value at higher tasks. Okay?
That's the theme of our kind of AI-based solution is to remove the mundane work, make the designer focus on higher value work, help in terms of, you know, with the same resources you can do more work. That theme is very popular, and I've met all these CEOs over the last, you know, 3-6 months. That's even popular in a tough environment because there's need for more automation, and it's even more. This is actually very timely, the launch of AI-based solution, launch of Cerebrus, because the productivity of the organization goes up. Also productivity of the talent, because a lot of companies, you know, one big issue is they have large teams which are deployed across multiple countries or locations.
The question always is, are you getting enough value from all the locations? Something like Cerebrus or AI-based solution naturally uplifts the talent of your whole organization because these algorithms, you know, are the same whether they run in one part of the world or the other. I think these AI-based solution is very timely and appropriate in this kind of tough environment. I think we have a very good platform with JedAI, and then we have three major solutions on top of it. We will do more. I mean, you'll see more from us next year in this area. We are very pleased with the progress, and I think it's very timely to the situation we are in, the macro situation. Yeah.
Right. Thanks. Just could you shed some color on whether there have been any changes to the backlog growth, pipeline conversion, lengthening of sales cycles, given all of what's happening in software? Are your expectations unchanged to that reported in Q2, whereas two-thirds of the backlog is expected to flow in revenue for the next 12 months? Maybe any commentary here on, you know, sort of the economic impacts for next year would be fantastic. I'm just trying to understand if there's any, you know, material changes to your backlogs or pipeline conversion in how you're looking at it, you know, compared to three months ago. Yeah, any kind of color there would be great. Thanks.
Fair point, Johnny. That, when I look at the current RPO, I'm, you know, despite the fact that it's slightly down from Q2 to Q3, but slightly down including the impact of the latest U.S. export restrictions, but also including the fact that, you know, we ship more hardware into China in Q3. I feel very, very confident in the current RPO and the RPO and very, very pleased with the growth that we've seen there. Typically, I know you've just started covering us, but typically what we tend to see is about 55% of what we have in backlog turns up in revenue in the next 12 months. And generally, Q4 is a good kind of add-on quarter for us for growing that current RPO.
I feel very pleased in terms of where we are. Annual value is about $2.7 billion now off of a backlog, total backlog of $5.5 billion. The annual value, 2.7, 5.5 represents time, but two point seven is the annual value there. I would anticipate that that should grow through to the end of the year and set us up well for next year for our recurring revenue. The upfront revenue is a lot more difficult to predict 'cause it tends to be more lumpy.
Right. That's very fair. Yeah. It's interesting to see how much upfront revenue you actually generated this year. Yeah. Fair enough. Thanks a lot. I'll jump back in the queue.
Thanks.
Your next question comes from Joe Vruwink from Baird.
Great. Hi, everyone. I wanted to go back to the IP topic and specifically ask about the record award. If I look at your non-cancellable access arrangements, it looks like that value went from $171 million to $434 million. Is that primarily reflecting this award? And then is there anything unusual or is this a normal term length? Kind of reading between the lines, this big step up and kind of what's visible in backlog, we should see that kind of hitting revenue next year.
Yes, Joe. That's that record contract in IP is included in our non-cancelable commitments, in our number in our backlog. We're delighted with the performance of the IP team and how well they're doing. What's interesting, what I always find is kind of not intuitive when you look at Cadence's results, is that sometimes in the biggest bookings quarters, you may not have a great increase in your current RPO for that particular business. I find when you have big renewals coming around, we tend to play defense on the renewal and then leave room for add-on opportunities later.
Often you can have a, you know, a big bookings quarter may not generate a huge amount of growth in current RPO. Then in contrast, you might have lower bookings quarters where there's a lot of add-on opportunities get booked in those quarters, and that can increase your current RPO and drive growth for the company. In this particular case, it's a record contract, so you're inclined to play more defense on something like that. You haven't seen huge uptake in current RPO for IP this quarter, but I think that will come later.
Okay. Okay, that is helpful. Then, you know, I appreciate you're not guiding to next year, but there has been some conversation just around how good upfront deliveries have been this year, and obviously that creates a tough comp. I wanted to take the other component and then just focus on recurring revenue. John Wall, I think in the past you kinda framed recurring revenue on a three-year CAGR basis. You know, last quarter the number was I think 12%-13%. Then you mentioned how you thought that rate of growth was sustainable going forward.
Just a quarter later, some things have changed, but given the visibility you have in hand today, any difference that you would comment on kind of 12, 13 or some other rate on a kinda three-year CAGR basis as it just pertains to recurring revenue?
Great question, Joe. I think I would characterize my opinion on our recurring revenue. I'm more confident now. Now that we know what the U.S. export restrictions are, I think I'm more confident in our recurring revenue going forward now than I was this time last quarter. I think the challenge from a macroeconomic standpoint is, you know, how the macro climate does to our upfront business for next year. I mean, that's the toughest one to predict. That's why we need an extra few months just to figure out what that means for next year.
Okay. Great. Thank you very much.
Your next question comes from Blair Abernethy from Rosenblatt Securities.
Hi, nice quarter guys, and thanks for sliding me into questions here. Just wanted to talk a little bit about the Cadence on cloud and in particular the Palladium Cloud. Can you just walk us through sort of how you're looking at this cloud-based emulation? How, you know, as a customer coming to you having to make a decision between an on-prem hardware solution versus, you know, Palladium Cloud. Just walk us through that a little bit and maybe you know how you are thinking about or how you are approaching pricing?
Yeah. Hi, Blair. This is Anirudh. Thanks for asking this question. That's a very important point. In general, you know, we really like these cloud offerings, especially for hardware, you know. Because even if you think about in the regular cloud, right? With the CPU cloud by the big cloud vendors, what they're doing is they're amortizing hardware, you know, across multiple customers and, you know, moving from a more CapEx to OpEx model. The cloud model has been successful in hardware first, right? You build all kinds of software solutions on top. This is the same hope for our Palladium business. You know, we would want more and more customers to go to our cloud offerings because that also makes the hardware business more and more ratable.
It also gives a lot of flexibility to our customers, because, you know, one of the issues with either Palladium and Protium being even more popular than they are now is that sometimes the smaller companies are not able to deploy as much as some of the big companies because there is an upfront cost to get like a full Palladium rack. Whereas if you have them on the cloud, it gives access to a lot of small companies also to use hardware emulation as they're doing more and more complicated designs. The second reason, of course, it makes it more and more ratable. We prefer, you know, we encourage all our customers, you know, to move to the cloud.
You know, we have built infrastructure in data centers, you know, together with some big data center partners to have this capacity in the cloud. Now it depends on customer choice, right? Now, if the customer wants to buy more for in-house use, then of course we support that. But I think IP customers are becoming more and more flexible in terms of whether they want to deploy on-prem or on the cloud, I mean, the hardware that they buy from us. Like what John was saying earlier, you know, in this kind of tough environment, you know, if they want to reduce CapEx and use more OpEx, then, you know, Palladium Cloud gives that opportunity. Okay. I mean, this is something we have been building for several years, and we'll see, you know, how it goes.
In general, we wanna encourage all our customers to move to the hardware cloud. On the cloud, which is on the software piece, I think, like we talked about in the last earnings call, that's also great for startups and also for system companies that don't have big IP department, I mean, IT departments and data centers. We really feel that on cloud, that's why we started first with system products from Cadence, is suitable for. Because system companies, there could be like 50,000, 70,000 customers in that space. Then some of them are big of course, and have their own data centers, but a lot of them are not as big and they prefer this kind of cloud.
It also helps us go to the long tail in a much more, you know, smarter way. You know, we want to innovate not just on the product side, but go-to-market side. Especially innovating on the system side, the long tail on cloud is great. Palladium and Protium Cloud are even good for the EDA big customers because it gives more ratability and flexibility and choices on how they buy hardware. Overall, I think these are two very strategic areas for us, and we want to encourage our customers to use more and more of these cloud options.
That's great. Thanks for the color, Anirudh.
Yes. Thank you.
Our final question comes from Ruben Roy from Stifel Nicolas.
Hi. Thanks. Anirudh, I think you have answered just about every question there was. I wanted to maybe drill into the new customers on the digital design flow. Can you maybe talk a little bit about what type of customers you're seeing? Is that competitive displacements for traditional semiconductor companies or non-traditional, a combination of both? I guess attached to that, are you seeing a higher attach rate in either semiconductor companies or systems companies for hardware these days as you sign up these new deals on digital design? Thanks.
Hi, Ruben. Great points. In general, in terms of the digital business, I think it's both, you know, new customers and existing customers and, you know, taking share. In general, I think what's great about Cerebrus, you know, one is like I mentioned earlier, it does more automation of mundane tasks. It's almost like having automatic driving versus manual driving, right? You don't have to control all the knobs and all the tedious work. The tool does it for you. It also unifies the platform. You know, we've been talking about unified synthesis, placement, and sign-off from, I don't know, 2014 or 2015. I think Cerebrus naturally unifies the whole platform too, because it can work across the whole synthesis, placement and route, and sign-off.
Like I mentioned in my comment, there is a pull-through of synthesis and sign-off along with place and route through Cerebrus, and we are seeing that. We are pleased with the progress we are making in synthesis and sign-off along with, you know, place and route implementation. It does help in terms of full flow. This drives like full flow wins, right? You know, not just place and route. I think in 2022 we have more than 40 new full flow wins. Okay. That's helping our digital business. You see this quarter we had good growth in digital just like we had last quarter.
Now on the hardware side, I mean that attach rate is there in the large kind of semi companies, but also there's a lot of hardware being used as system companies design semiconductors. Because by nature, as you know, system companies have more software, right? That's why they're a system company. When you have software, you naturally need these hardware platform for software bring up. I think we are very pleased to see the growth of hardware, not just in the traditional large semi, but also in the large system companies. We try to do these new offerings like I talked about, cloud, to help to lower barrier to entry for smaller companies, whether they're system or semi for hardware.
Overall, I think we are pleased with the progress of both digital and hardware, and we just carefully monitor it, you know, going forward.
Thanks for all that detail, Anirudh. I'll leave it there for now. Thanks.
I will now turn it back to Anirudh Devgan for closing remarks.
Thank you everyone for joining us this afternoon. We are excited about our business momentum and the tremendous market opportunities ahead of us. We are proud of the innovative and inclusive culture we have built at Cadence, and we are grateful for the recognitions we have received over the years, including most recently being named as one of the world's best workplaces for seventh time by Fortune and Great Place to Work. We're also honored to be included in the Investor's Business Daily's 100 best ESG companies for 2022, the fourth year in a row that we have achieved this recognition. On behalf of our employees and our board of directors, we thank our customers, partners, and investors for your continued trust and confidence in Cadence. We look forward to speaking with you again on our Q4 2022 earnings call. Thank you and have a great evening.
Thank you for participating in today's Cadence Q3 2022 earnings conference call. This concludes today's call. You may now disconnect.