Afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Design Systems Third Quarter 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.
Thank you. I will now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence Design Systems. Please go ahead.
Thank you, Mike, and welcome, everyone, to our Q3 2016 earnings conference call. With me today are Lip Bu Tan, President and CEO and Jeff Rebar, Senior Vice President and CFO. The webcast of this call can be accessed through our website, cadence.com, and will be archived through December 16, 2016. A copy of today's prepared remarks will also be available on our website at the conclusion of today's call. Next, please note that today's discussion will contain forward looking statements that our actual results may differ materially from those expectations.
For information on the factors
that could cause a difference in our results, please refer to our filings with the Securities and Exchange Commission. These include Cadence's most recent reports on Form 10 ks and Form 10 Q, including the company's future filings and the cautionary comments regarding forward looking statements in the earnings press release issued today. In addition to the financial results prepared in accordance with Generally Accepted Accounting Principles or GAAP, We will also present certain non GAAP financial measures today. Cadence Management believes that in addition to using GAAP results in evaluating our business, it can also be useful to measure results using certain non GAAP financial measures. Investors and potential investors are encouraged to review can be found in the quarterly earnings section of the Investor Relations portion of can be found in the quarterly earnings section of the Investor Relations portion of our website.
Additionally, a copy of today's press release dated October 24, 2016, for the quarter ended October 1, 2016, and related financial tables can also be found in the Investor Relations portion of our website. Now I'll turn the call over to Lipford.
Good afternoon, everyone, and thank you for joining us today. We were pleased by our results for the Q3 as Cadence continues to execute on
Let me start with the environment today. Semiconductor business condition continues to be mixed with some sectors performing better than others. Billable trends, including Cloud and Data Center, Automotive, Artificial Intelligence and Video. Our semiconductor consolidation has not had a material impact on our business this year. It may present challenges over the next few years.
And at the same time, our relentless focus on innovation, execution and helping our customers succeed is driving our momentum in the marketplace, and our opportunity continues to grow with system companies, which leads me to our system design enablement or SDE strategy. SDE will bring us additional growth opportunity as it take us beyond a horizontal focus on semiconductors and moves us to a system company focused on end market products and vertical market segments as increasing our customer base. One important SDE trend is the adoption of our market leading IT packaging solutions for applications, in which the IT packaging IT package is becoming a primary system integration platform. In Q3, our expanded we expanded our business with BAE Systems, including system level integration using our IT packaging solution and with significant adoption of our enormous and generous digital IT design flow for SoC design. And we delivered a comprehensive system design solution for TSMC advanced wafer level Integrated Fan Out Packaging Technology, known as INPO.
TSMC awarded Cadence with a Partner of the Year award for development of this solution. Our system design and verification group delivers a holistic verification suite of connected solutions that are based on strong call engines and optimized for total verification throughput, which includes Alladium for inhalation, Incisive for simulation and JasperGold for formal verification. In Q3, Palladium Z1 continued its strong momentum, adding 9 new customers. Continuing with the SDE theme, 5 of the new palladium customers were system companies, including a major aerospace company. Mobileye adopted the Palladium D1 for the development of automotive vision technology for data applications.
And Fujitsu adopted Palladium D1 for the development of its ARM V8 based post k supercomputer, the next generation flagship supercomputer in Japan. Overall, verification is especially critical in automotive applications. And to that end, in Q3, we expanded our business with Infineon in the area of automotive functional safety. Our digital sign off products continue to gain momentum with the top 20 semiconductor companies. Overall, we had 6 full digital flow wins in Q3.
A global system company is deploying our Innovus implementation solution for advanced node design. And a market shaping semiconductor company, pleased with the performance of our digital solutions, exercised the growth option in this contract to begin proliferation across its design groups. Campus, our timing sign off solution, now has nearly 150 customers with rapid growing mixed signal timing signal. The number of 10 nanometer Kvaux with our solutions is growing rapidly, and we work closely with TSMC to certify our implementation and sign off tools and integrated flow of 7 nanometer design. Next, I will move on to IP, British strategic business for us, a key component for our FTE strategy.
First, I will discuss our strategy and will provide highlights for the quarter. During the quarter, we completed our review of our IP business strategy. The result of the review is that we significantly increased our focus on standardized off the shelf IP. Certain strategic vertical markets and most advanced process nodes, while deemphasizing more customized IP. IP remains an important business for us.
The IP market opportunity is strong as the outsourcing trend continues, thus creating opportunities for future growth. We are confident that these refinements will drive sustainable and scalable growth, and we expect our IP business to return to moderate sequential growth for Q4. We have some great IP product headwinds
for Q3.
Virtual and augmented reality are exciting new technologies that I am watching closely. The Tensilica architecture provides unmatched performance and power efficiency of this type of application. I'm thrilled that our 10th silicon processors are at the heart of the holographic processing unit in Microsoft HoloLens AR Headset using 24 Hensiliqar extensors cores. Cadence has worked closely with TSMC to develop some of the first design IP offerings for the 7 nanometer process offering earlier access to protocols that are optimized for mobile and high performance computing applications. We have already delivered 7 nanometer DVR IP to top tier Asia Pacific customers.
They also introduced a broad portfolio of interface and memory design IT solutions for automotive applications using TSMC's 16 nanometer FinFET Compact Process. Cadence delivered the 1st design IP for midi sound wire version 1.1 for high quality audio solutions and demonstrated interoperability with Realtek. So now in summary, are executing on our strategies and Cadence delivered good operating results for Q3. Interest in the palladium Z1 remains strong with adoption by 9 new customers in Q3. Our digital and sign off solutions maintained their momentum with market shaping customers.
We completed the review of our IP business strategy and with our new focus, we expect the business to return to moderate sequential growth in Q4. Our IC Packaging solutions are growing in importance as a key component of system design enablement. And we won 4 TSMC Partner of the Year Awards for collaboration on both 7 nanometer, mobile and high performance computing design flows, InFO IT Packaging Solutions and our analog and mid signal IT. Now I will turn the call over to Jeff to review the financial results and provide our outlook.
Thanks, Lip Bu, and good afternoon, everyone. Execution was good in Q3 with key operating metrics meeting or beating our expectations. Total revenue was $446,000,000 in line with our expectations. Non GAAP operating margin was 26%. GAAP net income per share was $0.23 and non GAAP net income per share was $0.30 Operating cash flow was $84,000,000 and we repurchased 9,600,000 shares of stock for $240,000,000 over 3% of the shares outstanding at the end of the prior quarter.
Also note that the weighted average contract life was 2.5 years. Recurring booking and revenue mix has remained approximately 90% for the past year. DSO was 34 days down one day from Q2. Due to an increase in hardware leases driven by strong hardware sales, DSO has increased by 6 days and long term receivable has increased by $13,000,000 compared to Q3 of 2015. Now let's turn to our outlook.
There are no changes to our fiscal 2016 outlook for the midpoints of bookings, revenue, operating margin, EPS or cash flow. We have narrowed the ranges on bookings, revenue and EPS. We expect bookings in the range of 2.03 to $2,070,000,000 which equates to 8% revenue or 8% growth at the midpoint. Revenue in the range of $1,810,000,000 to $1,820,000,000 which would be a 7% growth at the midpoint. Non GAAP operating margin of approximately 26 percent, GAAP EPS in the range of $0.74 to 0 $0.76 non GAAP EPS of $1.19 to $1.21 and operating cash flow in the range of $380,000,000 to $420,000,000 And for Q4, we expect revenue in the range of $463,000,000 to $473,000,000 non GAAP operating margin of approximately 27%, GAAP EPS in the range of $0.18 to 0 point and non GAAP EPS in the range of $0.32 to $0.34 Approximately 90% of the revenue is expected to come from beginning backlog.
Also note that we are launching a voluntary retirement program in Q4 that we included the estimated cost of $12,000,000 in our GAAP outlook. You can find guidance for additional items in the CFO commentary. Now with that, operator, we'll take your questions.
Your first question comes from Jade Leshower from Griffin Securities.
Thank you. Good evening. Let me start with you with a couple of related market questions. You noted in your prepared remarks that you've so far been able to avoid the anticipated adverse effects of semiconductor customer consolidation. Perhaps remind us why you've been able to avoid that so far?
And relatedly, it would seem that EDA as a percentage of semiconductor R and D has remained fairly steady. That relationship has held more or less the same. But could you talk about other current or leading indicators that you're relying upon now to forecast or anticipate your business? What else would you be looking at besides semi R and D to gauge the environment?
Good. Thank you, Jay, for all good questions. So a couple of things. 1, first
of all, I think maybe touch on a little bit about the environment. So I
think we all know that semiconductor business is still very challenging and quite mixed. And some of the statistics show that this year will not have growth for semiconductor overall as a sector.
But meanwhile, I think clearly there's some great opportunity in terms of longer term. And I mentioned the mobile video related machine learning, deep learning, artificial intelligence,
automotive and it will be significantly increase some of the design opportunity, especially in the system company
and also in the IT growth area. And so just back to your
question about consolidations, so clearly, I think this year is slower than last year in terms of the large consolidations.
And then clearly, we are very mindful, we pay a lot of attention about the consolidation activity. We do
not expect any material impact to our business in 2016. But the next couple
of years and it's challenging for us to forecast and it's too early
to make some of the impact. And then a question about how do we avoid and clearly
we are engaging with our customer, collaboratively with the customer and make sure that whatever the new design, new product development, we are heavily engaging, especially some of the new product development and also some of
the new advanced nodes they are embarking on either the 10 or 7. And so those are the things that we try to really engage daily with the customer and that's the best way to kind of avoid some of these consolidations. And then the other part, the impact. And then the other part in terms of your question about the indication, the best indication for me is when we deal with and I'm
actually very heavily with the customers with their new technology, new development, new product and then what are they embarking on something that's really exciting like machine learning, deep learning is going to be
a huge impact for our overall industry across all the different verticals, either in automotive or in the search engine or in terms of the genomic, the
sequencing development. And we are easily engaging with the customer in R and D development and then the
trend they are working and they brainstorm with us. And then we make sure that our products and our tool providing the differentiating solutions that they are looking for in order to success
in the marketplace.
All right, thanks. Let me finish up with just a couple of related product questions. When we look at the industry data over the last number of years, we see a number of product categories, each of which you participate in that have had fairly steady growth on a trailing 12 month basis, in some cases for a couple of years or more. For example, custom layout has been consistently a good category for a number of years, place and route, parts of physical verification have been doing pretty well on a steady basis. On the other hand, analog mixed signal has been flat to down, RTL simulation important category flat to down and synthesis as well.
So you participate in each of these categories to varying degrees. My question is, what headwinds or impediments would you anticipate to those categories that have been consistently good so far? On the other hand, what possible tailwinds would you anticipate for those categories like AMS and RTL and so forth that have otherwise been kind of lagging for the last couple of years?
Yes, very good question. So let me touch on some of the topic that you mentioned earlier about the category of products. And so as I mentioned earlier, we are very focused on the customer engagement in some of their new product development and that's where our 2 coming and our IT come in. And so clearly, the complexity of some of this design and the opportunity become very clear to us. For example, in the machine deep learning, our Tensilica start need to shine and a lot of customer very interest in our Tensilica related area.
In terms of the some of this aggressive either in machine learning or graphic or the CPU related place and route and then synthesis and then the verification become critical for them in terms of get to market quicker and the complexity of the design and the layout. And also they are worried about the power and signal integrity issue in terms of the end to end. So our IC packaging that I highlight become very critical. And then the PC board in terms of security, in terms of power, signal integrity become very, very compelling for them to engage with us. So I think overall, I would say that across the board, all the product looking forward, we're excited about the opportunity and the customer feedback and then they really like the performance that we have and then the engagement model that we continue to stay humble working with them and then with a can do attitude to really drive success for the customer, they love it.
And that's why I think across the portfolio that you look at, even the custom analog side, we see continued growth, especially in the mixed signal side. And then we are the de facto standard and for the last decade and a lot are moving into the advanced node. So we are really aggressive more on the 10 and 7 and also move proactively more than 100 customer right now are using our Virtuoso in the most advanced FinFET. And so I think I see continued growth because of mixed signal requirement and especially in the automotive side and then some of this the power related concern that they have, they're starting to really embrace our solution that we can really drive the low power solution they need to meet their envelope requirement.
Thanks very much.
Thank you.
The next question comes from Krish Sankar from Bank of America.
Yes. Hi. Thanks for taking question. I actually had a few of them.
Lip Bu, just to
follow-up on the semi R and D impacting ED industry down the road. Is the voluntary retirement program you announced kind of tied to that, where you expect the growth to slow along the same path you've done about in the last couple of years, this year you're going to grow about 7%, the last couple of years between 8% to 10%. On a go forward basis, what do you think is the right growth rate for the industry? Then I had a few other questions to follow-up. Thank you.
Yes, good question. I think you mentioned about the R and D impact and then some of the retirement program that Jeff will be able to highlight to you. But clearly, we continue to drive the innovative part in terms of driving the solution, the performance of the tool, the PPA power performance area and the runtime drive the productivity for the customer to work with them to really drive some of this efficiency time to market. Like for example, our Palladium is a very good one that we can really drive some of this the verification, the requirement they need and also the incisive with our Rocklatac acquisition, we can really drive some of this time the run time and then the build time requirement the customer need. And then so I think all in all, not just to help our customer to drive efficiency.
We also look at ourselves how can we drive efficiency in terms of our own organization and so that we can really drive the customer engagement. So that makes sure that we cannot just continue to pull a lot of AE and support and we drive some of the product quality performance. We have a big quality effort so that we can really drive efficiency across the organization. And then Jack can highlight a little bit more about the retirement program.
So on the voluntary retirement, it is something that we've done from time to time in the past for our employees. It does allow us to, of course, focus on our return to our shareholders also. So I think it's a win win solution.
Got you. Got you. All right. And then I had a couple of other quick questions. One is for Libbu, you guys are gaining traction on the emulation market.
Curious to know your view on the physical prototyping. Would the HAPS business be something of interest to you folks? Looks like a lot of the customers are beginning to out source. Would that be of interest for your the emulation hardware platform or is it too small a market? And then along the same path for Jeff, you guys had done about $240,000,000 a quarter share buyback pretty consistently that's going to get done by Q4 this current quarter.
So I want to know your thoughts on capital returns when you look into 2017 buybacks, any dividend or plans to take on any more leverage? Thank you.
Yes, good question. So let me address the first question you have about the emulation and the prototyping. So clearly our Palladium Z1 is the most successful launch for our emulation business. We continue to see a lot of growth and then use models. And so we continue to drive some of the new use models that are very exciting for us.
And then the other part is clearly beside selling a lot to our clear leading semiconductor company and anything that below 14 nanometer process design, this is a must have and it's very scalable. The capacity is very strong, 9,200,000,000 gates over 2,000 concurrent user and that is the scale that we have. And also it's a very data center class reliability that we have. I think customer just love it. We continue to see more new customer and we mentioned about the aerospace, MobileEyes and Fujitsu for the super, supercomputer, they are all using ours.
But saying that, clearly, we also doubled down on the prototyping side. We have the Proteum and the series of product families and we are adding our FPGA prototyping in a scale and capacity and performance and stay tuned and we're going to continue to drive that and make sure that is a fully integrated verification, not just the Palladium prototyping Proteum and then with our incisive Rocklatech and then also our kind of very successful the formal verification Jasper Go. And in fact, this quarter is the best quarter we have. And so we continue to drive success. And so people think about verification, they think about cadence verification suite of products and that drive the performance that they need.
And Krish, on the buyback, we remain committed to the $1,200,000,000 repurchase program, which as you point out ends in Q4. So far we've repurchased over 45,000,000 shares for $916,000,000 That's approximately 15% of the shares outstanding when the program began in July of 2015. As always, we look at our how our program balances our need for investment in our business, the appropriate level of risk for our business model and operating environment and of course opportunities to return cash to shareholders. We regularly review our capital structure along those same lines and we'll continue to do so. At this time, we're not commenting on 2017.
Thanks, guys.
Thank you.
The next question is from Farhan Ahmad from Credit Suisse.
Thanks for taking my question. My question is regarding your revenues, the breakup between semis versus systems. You have noted in the past that about 40% of the revenues for you guys come from systems. I was wondering if you can provide some color on your overall growth. How is the growth for semi versus systems tracking this year?
And is one portion of the business growing faster than the others?
Hi, Farid. So welcome to the call. So our ratable model means that we don't see large swings in revenue based metrics from quarter to quarter, period to period. Our system business was strong in Q3 as Lip Bu pointed out in some of the prepared remarks and it's growing nicely. But also our semi business is growing.
And so the differential isn't as great as you would expect. We remain approximately 40% of our businesses in systems business and we'll let you know when that changes materially.
Got it. Thank you. And then one question on your IP. Libbu noted in the prepared comments that Tensilica, the HoloLens win, it was pretty significant. I was wondering if you could provide some color on what's the long term opportunity of DSP cores and high performance computing or like in visual processing, So
I So I think clearly Tensilica as you know is a DSP programmable processor engines and this is a very low power. And so this is really suitable for all the kind of vertical computing engine, something that really, really excites me is this whole machine learning, deep learning and vision processing related area for ADAS and also for genomic sequencing and for search engine. And I think this is going to be a really opened up a lot of opportunity for us. And so clearly not just the hardware itself and also the software, the algorithm, the library that can be playing a very important role providing a solution. So I think overall, we are excited about it.
And this Tensilica is area that we are double down in that investment. And meanwhile, with this refinance, in our strategy refinement that we make to the design IP can integrate with our Tensilica, providing that kind of interface we need and the high speed. And then in terms of the memory that they need to drive some of this application. So overall, we are excited about this opportunity for Tensilica opportunity for us.
Thank you. That's all I have.
Thank you.
The next question is from Mitch Steves from RBC Capital
Markets. Hey guys, thanks for taking my question. Just two quick ones. So first on the semiconductor IP, so I think can you talk about when you expect that piece to start showing some growth and then maybe some share change that's happening in that segment?
Your question is when? So I think clearly we yes, so clearly as I mentioned with the refinement of our strategy and are more focused on the standard off the shelf IP and then some of the vertical markets strategically for us and also the most advanced process and then deemphasize the customized IP. And we believe that it's going to be return to that moderate sequential growth for Q4. And this outsourcing trend that is happening and that will grow even further future growth. And I mentioned earlier some of the highlights I make in the VR, AR, machine learning, deep learning and then the most advanced node, the 7 nanometer process, the design IP with our partners, the TSMC and our IP partners.
And then also in the automotive application side on the 16 nanometer FinFET and then some of the audio standard and the VIP 10 new with the critical new standard protocols. So I think those are the things that we're going to help driving the future growth.
Hey, Mitch, and welcome to the call. This is Jeff. So as we always do, we normally provide our 2017 outlook when we do our Q4 earnings. So stay tuned for January, February timeframe.
Got it. And then just one small one in the cash flow. If we were to look out kind of into, I guess, 2017, is there any reason why you guys can't continue to grow that line? I know it wasn't really uptick for the full year and just maybe talk about the dynamics there?
Yes. Stay tuned for our 2017 guidance in January February. We'll let you know then.
And the next question is from Monika Garg from Pacific Crest Securities.
Hi. Thanks for taking my question. First on the R and D line, Jeff, if we look R and D's percentage of revenue is like 38 0.4% this quarter. Year over year, definitely, it used to be 33% to 34% of revenue. So do you see it normalizing from here or is it a new normal and kind of factors leading to such high revenue, especially in 2016?
So a couple of points. Obviously in Q3 revenue was stepped down from Q2 which obviously changed the denominator of the equation. The second thing I want to point out is we've focused from the beginning of this year and talked about this being an investment year for we're investing in our innovative solutions. And I think you're seeing that show up in R and D expense. We'll comment on the future in the future.
Got it. Then if I look at acquisitions, what Cadence has historically made is more tuck ins, smaller acquisitions. Going forward, could you comment on the scale of acquisitions which you would be interested to? Is it similar scale we should think about? Or could it be much larger than previously you've done?
Yes. Monica, let me address that issue. I think clearly, if you follow our last 8 years, we are very disciplined in terms of our approach to M and A. And clearly, the acquisition have to meet some of the key criteria. One is the fit and further our strategy, the SDE strategy that we've embarked on.
And then secondly, clearly, we want to look for products that are differentiating technology. And a lot of time, our customer our leading customer will indicate to us what are the new technology we need to integrate into ours. And then clearly, the top talent, either managerial and technical talent, If you look at our executive, we all spot for the good talents for the managerial or technical leadership that we are looking for. And of course, we hold ourselves accountable to our team and also to our Board. And then in terms of the ROI that we turned on investment, the synergy we're looking for and we hold ourselves accountable for that.
So with that in mind, either it's a big or small acquisition, we apply the same strategy, strain, criteria, and then we work very close with our Board. And then our executive works as one team. We debate and decide and what is the right thing to do for the company and what is the product enhancement to meet our customer. At the end of the day, it's really meet the customer and satisfy our customer in terms of helping them design the best product they can do in a timely fashion.
Got it. Thanks. And just as a follow-up on the IP question, if you look year to date IP revenue year over year is down high single digit 7%, 8 percent. So first of all, is it in line with your expectations? And then IP is a secular growth market as you also highlighted.
Do you see it going back to the industry growth rate over the next couple of years? Yes.
I think as I mentioned in my remarks, and this is very important business IP to us. And clearly, there's a lot of growth opportunity because of outsourcing trend. Many of my top customer, they would love to outsource some of them to us, especially it's the industry standard, off the shelf IP and also the most advanced node process. And then just to meet and to fulfill the various protocol that keep changing, they will prefer to outsource. It's a very heavy investment.
So I think we are very good in terms of trying to do that and then meet our customer requirement. But what we did is that refinement is to deemphasize some of the kind of one off customized IP and then really focus on some of the standard and then the market that we are pursuing. We mentioned quite a few of that and then also in the most advanced notes. And then so I think overall, we look at the IP business, it should be a growing business And because of the trend, because of the portfolio we have in Tensilica, the design IP and VIP, And those I think will have the foundation for us to grow in some of the vertical that we are pursuing and the advanced node and the mixed signal we are pursuing.
Thank you so much. Thank you.
The next question is from Rich Valera from Needham and Company.
Thank you. Lip Bu, you mentioned the term system design enablement several times in your prepared remarks. And I understand this is sort of part of your focus on system customers, but is there anything more to that than sort of a marketing statement? Are there actual products you're developing or channels or infrastructure within the company that you're developing incrementally to kind of pursue this system design enablement strategy as you put it?
Yes. Very good question, Rich. And a couple of points I just want to highlight. And it's not just the marketing campaign work. As you know us for the last 8 years, we have been very focused on executions.
And then the system design enablement, what it really mean is to provide the solution that system company can optimize for their differentiation and then with the end product in mind. And that's something that I think we have a unique position beside the tool, beside the IP. We also have the PCB and IC packaging uniqueness that I highlight in my earnings script this time. And then because a lot of this system company and service provider, they're looking for that software, hardware, code design, code verification and also the packaging and become end to end solution that providing the power, signal integrity, the interference all within the envelope of the system company and that they have that requirement they need to meet. And of course, the time to market is critical.
And also, they need to have that scalability they're looking for. And that's why you see Palladium had that kind of scalability and performance checking that they need in term of complex system. And like I mentioned earlier, this one major aerospace company see the benefit of using our Palladium and it can really testing the system level solution that meet their requirement of their design. And then same thing, this Fujitsu on their supercomputer design is starting to see the benefit of we not only providing the tool, the hardware, the IP portfolio. And so those are the things that we're going to continue to highlight.
Previously, last quarter, we mentioned about Northern Grumman. And then this time, we mentioned about BAE Systems. And then are not only using our digital flow and then also using our IC packaging that are uniquely qualified for their spec spec, the requirement they need.
Got it. Thank you for that, Lip Bu. And then Jeff, I think this one's for you. You mentioned you're seeing more leasing of emulators. Can you talk about how that could impact your model revenue and otherwise if that continues to become a bigger piece of your business?
Yes. I mean, we've had a lot of strength in our hardware business. As you know, this year, it's been a very good year and Z1 has been a very successful product. I think the point is our DSO will go up and so our long term receivables go up as we sell more hardware and as we lease more hardware. So I think that's the key point that I want to make.
Got it. Okay. Thank you. That's it for me, gentlemen.
Thank you.
The next question is from Sterling Auty from JPMorgan.
Yes. Thanks, guys. Had a couple of questions. Hopefully, it's not a repeat of the prepared remarks, but Lip Bu, you were very difficult to hear. I couldn't really catch much of what you were saying in the beginning.
Yes. We're sorry. We understand that we've had audio problems today. So, we wanted to remind you that our prepared remarks will be posted on our website after the call. So thanks for mentioning that.
Great. Thank you. We appreciate it. So just following on what Rich was talking about in terms of functional verification or the emulation specifically, I think the functional verification revenue line only grew 7% if I'm not mistaken year over year as compared to 40% last quarter, 23% the quarter before that. How much of that was something that was happening in emulation versus the rest of it?
So just can you give us some more color as to what's driving that significant deceleration?
Yes. As you would expect and as I think we said in our Q2 call, we expected Q3 to be actually have lower revenue than Q2. Certainly, functional verification and emulation was a large piece of that.
But what goes into that? Is that lease versus sales? Is it lead times on emulators?
Yes. It's the fact that we're taking our business as it kind of naturally occurs, right? We don't want to change our dynamics or our value calculations in any way. So we want to take it when our customers want the product. By the way, that came after 2 record quarters in both Q1 and Q2.
So I think we expect a little bit of a downturn and that's what happened in Q3.
And on the lease idea, can you give us a sense of what portion of that emulation business is lease? And I think Rich started to allude to it, but is that recognized ratably when you're leasing the equipment? So maybe just start with those 2.
Yes. So leasing is recognized the revenue is recognized upfront because it's a lease, but we collect the cash over a period of time. And I think that's key for us.
Okay. And what percentage of that Emulation business is leased?
It remains a small portion. We don't break out the details, but it remains a small portion of it. We do want to point out that we've had a very good year, right? And we expect that to continue in Q4. The guidance at this point for Q4 includes everything we know.
Product mix has certainly been a this year as hardware has been better than expected for us, offset by IP revenue that was a little bit below our expectations. We do also expect in Q3, we saw some and in Q4, we'll see some of the cost at the end of the life of Palladium
XP. Got
it. And then last question since it is a public forum and I know you can't answer too directly around Metro Graphics and some of the comments and thoughts around possible acquisition, etcetera. I wouldn't expect you to say yes, you're interested in buying the whole company, but wondering if I could ask the question this way. Given the history with the company, I think there's always been an attractiveness for the Caliber line from the other vendors in EDA, but your product portfolio has changed over time. Is Caliber as a technology as interesting and as complementary to Cadence today as it was say in 2,007?
Yes. I think the steering, first of all, and we have a lot of respect for our friend, mentor and then the management team and very important industry player. And clearly, as you know, we don't comment on some of these topics. And we have a lot of respect for them. Their product is Caliper is well known in the industry.
And so I think we just stop there and we're not going to comment on any of this specific. Okay.
Thank you, guys. Sure. Thank you.
The next question is from Tom Diffely from D. A. Davidson.
Yes. Good afternoon. One more IP question. There's could you quantify how your change in focus affects the served available market that you're going after in IP directly?
Yes. So I think as you know IP is a new business a few years ago and we embarked on that and we grow nicely to 10%, 12% of the revenue for our company. And this is very strategic for us in our whole key component to our SDE strategy. We reviewed recently IP business strategy And as I mentioned earlier, we're going to be focused on standard of the shell IP, pursuing the vertical market that we want to pursue. And then the most advanced process notes.
And with deemphasizing the customized IP that kind of more once off and it's not many of our IP reuse and that's where you're going to make money. And so I think with long term, we like this. It's a very important this outsourcing trend continue because a lot of company, a customer we talk to just to catch up and then follow the various protocol that keep coming up. And if they have a silicon proven IP and then they would love to outsource that. So we see there's opportunity, but we're going to be really disciplined just like when we do the M and A.
And again, this refined strategy, we are focused on scalability, sustainable and are more focused on the profits and more focused on the quality of the customer, the more focused effort into this whole vertical the market we're going to go after and the most advanced nodes and then de emphasizing some of this customized IP.
From Tom, we don't break out that. We don't break out
the Tom, we don't break out that. We don't break out the segments of our IP business.
Okay.
I was just wondering if you expect another leg down in that business and then growth from that point on?
All we can say is clearly this is a refocus And as you know, when you grow to 10%, 12% and then you're starting to look at, okay, now you grow to 10%, 12%, how is it scalable? Is it sustainable? And is it profitable? And then we kind of refined the strategy then for the next phase of growth and that are more focused and more IP reuse and more repeatable, scalable business model going forward.
And again, we expect sequential growth from modest sequential growth from Q3 to Q4.
Okay. All right. So I guess moving over then on the geographical basis, Asia ticked up in the quarter. I was curious is that hardware driven or is that an increase in just the level of software that the Asian customers are starting to use?
Yes. We don't break down the segments by geographic, but obviously Asia continues to be a strong market for us and a strong driver for us and we anticipate that going forward. And just to
sector actually this year growing at 26% sector actually this year growing at 26% compared to the overall global market is kind of not growing. And so government have put a lot of effort into it and Kadant is very well positioned for the tool design and IP. And so we are excited about the opportunity. And you see that over time, the region is growing.
Okay. And I guess just finally here then, when you look at the end markets, Lip Bu, you talk a lot about how semis is a very little or no growth this year. But I'm curious what are you seeing in the growth in the key areas for you like in the logic area? And then what are you seeing just for overall design activity with your customers?
Yes, very good question. And in terms of the growth in the semiconductor and system company area, thing that I like a lot is the cloud data center. There's a sea change in term of the workload requirement and then how to optimize some of the hardware and then the container software. I think that's going to be a sea change. And then the IoT and all this data are going to be in the cloud.
So the cloud infrastructure is going to be a very great opportunity for us. And then the other part is clearly the machine deep learning and that is very broad application to the ADAS and automotive to sequencing, genomics, single cell sequencing to the search engine from the eye to the brain function that's whole neuroscience is intriguing to me. And then I think those are going to be driving some of this growth opportunity going forward. And then of course, the security related to across all these verticals will be very interesting to me. And our tool is try to optimize to address some of these design challenges and all the different application have different challenges.
And also our IP and that the refinement that we make and we focus on some of this vertical market and then also some of this application opportunity for Tensilica to explore. And then with their DSP programmability and low power, you will be really shy just like Microsoft HoloLens as an example.
Okay. I mean, in general, do you see design activity picking up because of the complexity? Or is the softness with some of the memory divisions and stuff slowing down overall design activity for you?
In fact, one of the indicator I always look at is how much the new design engagement we have. And our hardworking, capable employees, they are working really hard. I mean, I haven't seen any time in the last 8 years they work harder than today. And that tell you the good indication that we are so heavily engaged with some of this new product development.
Great. Thank you for your time.
Thank you.
The next question is from Krish Sankar from Bank of America.
Yes. Hi. Thanks for taking my follow-up. 2 of them. One is, Jeff, you mentioned systems is about 40% of revenues.
Can you help us understand how much is auto as a percentage of total revenues or as a percentage of systems? And the second question is, is there any update on this whole accounting thing that you guys have been working with KPMG and the SEC? It looks like at least things are going to be fine for 2017. Kind of curious to know is the ratable revenue model at risk when you look into 2018 and beyond either for Cadence or the EDA industry? Thank you.
Yes. So we don't break out auto. We just stay with system companies at about 40%. But we do believe it's growing as a portion of our business. On revenue recognition, my favorite topic, we are still working through the details with our advisors to determine how we'll implement it and what will be the impact if any.
There's still a lot of work to be done not just by us but by most companies. And we expect to retain recurring revenue treatment. I think that's the takeaway I want you to have.
Thanks, Jeff.
And the next question is from Jay Vleeschhouwer from Griffin Securities.
Thank you. I just wanted to follow-up on Tom's earlier geographic line of questioning. First, it looks like your Americas revenue was down sequentially for the 2nd consecutive quarter and also down slightly year over year. Was that largely a function of variability in hardware? And then similarly, your Japan business was down year over year for the first time in a year.
There had been some hope that Japan might be bottoming for EDA as a whole and perhaps that was a little premature, but if you could comment on both those regional trends. And then lastly, Jeff, to continue the triangulation of your emulation business, would it be fair to say that the sequential decline of emulation Q2 to Q3 was larger than the corporate decline of revenue? In other words, you declined by more than $5,000,000 or so in total corporate in emulation. But you also seem to have had a pretty significant increase in the gross margin year over year. You had a decline across revenues for the first time in over a year, but revenues had to have grown in emulation.
So it looks like you had a pretty substantial increase year over year on the gross margin there, even with a sequential decline of revenues.
Yes. So Jay to take the geographic question first. I wouldn't read too much into the Americas or Japan or Asia or whatever else. I think the long term trends remained intact. Asia will continue to grow.
Japan, I think, has probably bottomed out. North America will fluctuate sometimes from quarter to quarter. And clearly, hardware always plays a portion in that because that's a part of our revenue that's upfront. So I don't read too much into it. As far as emulation, I think the key thing is the math isn't simple here because we're going through a pretty big change in product mix.
We're moving from the Palladium XP, the whole generation product to the Z1. And we've said the Z1 will have higher margins, right, than the XP. And I think it's complex to do the accounting from within. It's probably even more complex from you. Please don't read too much into that either.
And I will now turn the call over to Lip Bu Tan for closing comments.
In closing, we are continuing to innovate and deliver system design enablement solutions to our customers and we're looking forward to continue to execute our strategies and creating value for our shareholders. I want to take this opportunity to thank all our hardworking employees, shareholders, customers and partners for their continued support that make this possible. Thank you all for joining us this afternoon.