Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Design Systems third quarter 2016 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 1 on your telephone keypad. 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 third quarter 2016 earnings conference call. With me today are Lip-Bu Tan, President and CEO, and Geoff Ribar, Senior Vice President and CFO. The webcast of this call can be accessed through our website, cadence.com, and will be archived through December 16th, 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-K and Form 10-Q, including the company's future filings and the cautionary comments regarding forward-looking statements in the earnings press release issued today.
In addition to 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 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 the reconciliation of non-GAAP financial measures with their most direct comparable GAAP financial results, which 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 24th, 2016, for the quarter ended October 1st, 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 Lip-Bu.
Good afternoon, everyone, and thank you for joining us today. We were pleased by our results for the third quarter as Cadence continues to execute on third quarter revenue was $446 million GAAP operating cash flow was $84 million. Let me start with the environment today. Semiconductor business conditions continue to be mixed, with some sectors performing better than others. Favorable trends including cloud and data center, automotive, artificial intelligence, and video. While semiconductor consolidation has not had a material impact on our business this year, it may present challenges over the next few years. 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 open ups additional growth opportunities as it takes us beyond a horizontal focus on semiconductors and moves us to a system company focus on end market products and vertical market segments, thus increasing our customer base. One important SDE plan is the adoption of our market-leading IC packaging solutions for applications in which the IC package is becoming a primary system integration platform. In Q3, we expanded our business with BAE Systems, including system-level integration using our IC packaging solution and with significant adoption of our Innovus and Genus digital IC design flow for SoC design. We delivered a comprehensive system design solution for TSMC advanced wafer level integrated fan-out packaging technology, known as InFO. 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 core engines and optimized for total verification throughput, which include Palladium for emulation, Incisive for simulation, and JasperGold for formal verification. In Q3, Palladium Z1 continued its strong momentum, adding nine new customers. Continuing with the SDE theme, five of the new Palladium customers were system companies, including a major aerospace company. Mobileye adopted the Palladium Z1 for the development of automotive vision technology for ADAS applications. Fujitsu adopted Palladium Z1 for the development of its ARMv8 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 six full digital flow wins in Q3. A global system company is deploying our Innovus implementation solution for advanced node designs. A market-shaping semiconductor company, pleased with the performance of our digital solutions, exercised the growth option in its contract to begin proliferation across its design groups. Tempus, our timing sign-off solution, now has nearly 150 customers, with rapidly growing mixed signal timing sign-off. The number of 10-nanometer tape outs with our solutions is growing rapidly, and we work closely with TSMC to certify our implementation and sign-off tools and integrated flow for seven-nanometer designs. Next, I will move on to IP, which is a strategic business for us, a key component for our SDE strategy. First, I will discuss our strategy, then 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 de-emphasizing 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 highlights 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 am thrilled that our Tensilica processors are at the heart of the holographic processing unit in Microsoft HoloLens AR headset using 24 Tensilica Xtensa 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 DDR IP to top-tier Asia-Pacific customers. We also introduced a broad portfolio of interface and memory design IP solutions for automotive applications using TSMC's 16-nanometer FinFET contact process. Cadence delivered the first design IP for MIPI SoundWire version 1.1 for high-quality audio solutions and demonstrated interoperability with Realtek. Now in summary, we are executing on our strategies, Cadence delivered good operating results for Q3. Interest in the Palladium Z1 remains strong with adoption by nine 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. 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. We won four TSMC Partner of the Year Awards for collaboration on both 7-nanometer mobile and high-performance computing design flows, InFO IP packaging solution, and our analog and mixed-signal IP. Now I will turn the call over to Geoff to review the financial results and provide our outlook.
Thanks, Lip-Bu. Good afternoon, everyone. Execution was good in Q3, with key operating metrics meeting or beating our expectations. Total revenue was $446 million, in line with our expectations. Non-GAAP operating margin was 26%. GAAP net income per share was $0.23, non-GAAP net income per share was $0.30. Operating cash flow was $84 million. We repurchased 9.6 million shares of stock for $240 million, 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 six days. Long-term receivable has increased by $13 million 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 billion-$2.07 billion, which equates to 8% growth at the midpoint. Revenue in a range of $1.81 billion-$1.82 billion, which would be a 7% growth at the midpoint. Non-GAAP operating margin of approximately 26%, GAAP EPS in the range of $0.74-$0.76, non-GAAP EPS of $1.19-$1.21, and operating cash flow in the range of $380 million-$420 million. For Q4, we expect revenue in the range of $463 million-$473 million, non-GAAP operating margin of approximately 27%, GAAP EPS in the range of $0.18-$0.20. Non-GAAP EPS in the range of $0.32-$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, and we included the estimated cost of $12 million in our GAAP outlook. You can find guidance for additional items in the CFO commentary. With that, operator, we'll take your questions.
At this time, I would like to remind everyone, in order to ask a question, please press star, then 1 on your telephone keypad now. We will pause for a moment to compile the Q&A roster. Your first question comes from Jay Vleeschhouwer from Griffin Securities.
Thank you. Good evening. Lip-Bu, 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&D has remained fairly steady. That relationship has held more or less the same. 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&D to gauge the environment?
Thank you, Jay, for a good question. A couple of things. One, first of all, I think, let me touch on a little bit about the environment. I think we all know that semiconductor conditions feel very challenging and quite mixed, and some of the statistics show that this year will not have growth for semiconductors overall as a sector. 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 IP growth area. Just back to your question about consolidation. Clearly, I think this year is slower than last year in terms of the large consolidation. 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. The next couple of years, and challenging for us to forecast, and it's too early to make some of the impact. The question about how do we avoid, and clearly we're engaging with our customer, collaborate deeply 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 node they are embarking on, either the 10 or 7. Those are the things that we try to really engage heavily with the customer, and that's the best way to kind of avoid some of these consolidations. The other part, the impact.
The other part in term of your question about the indication, the best indication for me is when we deal with, as you know, very heavily with the customers, is their new technology, new development, and new product, and then when are they embarking on something that's really exciting, like machine learning, deep learning going to be a huge impact to our overall industry across all the different verticals, either in automotive or in the search engine or in term of the genomic and sequencing development. We are actively engaging with their customer in our R&D development and then the trend, they are working and they brainstorm with us, and then we make sure that our product and our tool providing the differentiating solutions that they are looking for in order to succeed 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. You participate in each of these categories to varying degrees, and 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 to those categories like AMS and RTL and so forth that have otherwise been kind of lagging for the last couple of years?
Very good question. Let me touch on some of the topics that you mentioned earlier about the category of products. As I mentioned earlier, we are very focused on the customer engagement in some of their new product development, and that's where our tool come in and our IP come in. 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 started to shine, and a lot of customers very interested in our Tensilica related area. In 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.
Also, they are worried about the power and signal integrity issue in terms of the end-to-end. Our IC packaging that I highlight become very critical. Then the PCB, in terms of security, in terms of power, signal integrity, become very compelling for them to engage with us. I think overall, I would say that across the board, all the products, looking forward, we are excited about the opportunity and the customer feedback, and then they really like the performance that we have. 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. That's why I think, across the portfolio that you look at, even the custom analog side, we see it continue to grow, especially in the mixed-signal side.
We are the de facto standard for the last decade, and a lot are moving into the advanced node. We are really aggressive, more on the 10 and 7, and also move proactively. More than 100 customers right now are using our Virtuoso in the most advanced FinFET. I think I see continual growth, because of mixed-signal requirement and especially in the automotive side. 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.
Hi. Thanks for taking my question. Actually, I have a few of them. Lip-Bu, just to follow up on the semi R&D impacting EDA 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%-10%. On a go-forward basis, what do you think is the right growth rate for the industry? I had a few other questions to follow up. Thank you.
Good question. I think you mentioned about the R&D impact and some of the retirement program that Geoff will be able to highlight to you. Clearly, we continue to drive the innovative part in term 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. 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 Rocketick acquisition, we can really drive some of this runtime and the build time requirement the customer need.
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, so that we can really drive the customer engagement, so that make sure that we cannot just continue pour a lot of AE and support, we drive some of the product quality performance. We have a big quality effort so that we can really drive efficiency across the organization. Geoff can highlight a little bit more about the retirement program.
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. I think it's a win-win solution.
Got you. All right. I had a couple of other quick questions. One is for Lip-Bu. 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 outsource. Would that be of interest for the emulation hardware platform, or is it too small a market? Along the same path for Geoff, you guys had done about $240 million a quarter share buyback pretty consistently. That's going to get done by Q4 this current quarter. 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.
Yeah, good question. Let me address the first question you have about the emulation and the prototyping. 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. We continue to drive some of the new use models that are very exciting for us. The other part is clearly, beside selling a lot to our clear leading semiconductor company and anything that below 40 nanometer process design, this is a must-have, and it's very scalable. The capacity is very strong, 9.2 billion gates over 2,000 concurrent user, and that is the scale that we have. Also, it's a very datacenter-class reliability that we have. I think customer just love it.
We continue to see more new customer, we mentioned about the Aerospace, Mobileye, and Fujitsu for the super computer. They are all using ours. Saying that, clearly we also double down on the prototyping side. We have the Protium and the series of product families, we are adding our FPGA prototyping scale and capacity and performance and stay tuned. We're going to continue to drive that and make sure that is a fully integrated verification, not just the Palladium prototyping Protium, then with our Incisive Rocketick, then also our very successful, the formal verification JasperGold. In fact, this quarter is the best quarter we have. So we continue to drive success. People think about verification, they think about Cadence verification suite of products, that drive the performance that they need.
Krish, on the buyback, we remain committed to the $1.2 billion repurchase program, which as you point out, ends in Q4. So far, we've repurchased over 45 million shares for $916 million. That's approximately 15% of the shares outstanding when the program began in July of 2015. As always, we look at how our program balances our need for investment in our business, the appropriate level of risk for our business model and operating environment, of course, opportunities to return cash to shareholders. We regularly review our capital structure along those same lines, 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? Is one portion of the business growing faster than the other?
Hi, Farhan. Welcome to the call. 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, is growing nicely. Also our semi business is growing, 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. One question on your IP. Lip-Bu noted in the prepared comments that Tensilica, the HoloLens, when it was pretty significant. I was wondering if you could provide some color on what's the long-term opportunity of DSP cores in high-performance computing or visual processing. If you guys have done any kind of market sizing related to that would be helpful.
Sure. Let me touch on that topic. I think clearly, Tensilica, as you know, is a DSP programmable processor engine, and very low power. This is really suitable for all the kind of vertical computing engine. Something that 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. I think this is going to really open up a lot of opportunity for us. 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. I think overall, we are excited about it. This Tensilica is an area that we are doubling down in that investment.
Meanwhile, with this 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. Overall, we are excited about this opportunity for Tensilica, opportunity for us.
Thank you. That's all I have.
Sure. Thank you.
The next question is from Mitch Steves from RBC Capital Markets.
Hey, guys. Thanks for taking my question. Just two quick ones. First, on the semiconductor IP segment, 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? I think clearly Yeah. Clearly, as I mentioned, with the refinement of our strategy and our more focus on the standard off-the-shelf IP and then some of the vertical markets strategically for us and also the most advanced process, then de-emphasize the customized IP. We believe that it's going to be returned to that moderate sequential growth for Q4. This outsourcing trend that is happening, that will grow the even further future growth. I mentioned earlier some of the highlights I make in the VR, AR, machine learning, deep learning, and then the most advanced node, the seven nanometer process, the design IP with our partners at TSMC and our IP partners.
Also in the automotive application side on the 16 nanometer FinFET, some of the audio standard and the VIP [audio distortion], the critical new standard protocols. I think those are the things that we're going to help driving the future growth.
Hey, Mitch, welcome to the call. This is Geoff. As we always do, we normally provide our 2017 outlook when we do our Q4 earnings, stay tuned for January, February timeframe.
Got it. Just one small one on 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 upticked for the full year and just maybe talk about the dynamics there.
Yeah. Stay tuned for our 2017 guidance in January, February. We'll let you know then.
The next question is from Monika Garg from Pacific Crest Securities.
Hi, thanks for taking my question. First on the R&D line, Geoff, if we look, R&D's percentage of revenue is like 38.4% this quarter. Year-over-year, definitely, it used to be 33%-34% of revenue. Do you see it normalizing from here, or is it a new normal? Kind of factors leading to such high revenue, especially in 2016?
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, where we're investing in our innovative solutions. I think you're seeing that show up in R&D expense. We'll comment on the future in the future.
Got it. If I look at acquisitions, what Cadence has historically made is more tuck-in, 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?
Yeah, Monika, let me address that issue. I think clearly, if you follow our last eight years, we are very disciplined in terms of approach to M&A. Clearly, the acquisition had to meet some of the key criteria. One is the fit and further our strategy, the SDE strategy that we've embarked on. Secondly, clearly, we want to look for products that are differentiating technology. A lot of time, our leading customer will indicate to us what are the new technology we need to integrate into ours. Clearly, the top talent, either managerial and technical talents. If you look at executive, we all spot for the good talents for the managerial or technical leadership that we are looking for. Of course, we hold ourselves accountable to our team, and also to our board.
In terms of the ROI, the return on investment, the synergy that we're looking for, and we hold ourselves accountable for that. With that in mind, whether it's a big or small acquisition, we apply the same strategy, same criteria, we work very close with our board, and our executive works as one team. We debate and decide 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. Just as a follow-up on the IP question. If you look year-to-date, IP revenue year-over-year is down high single digits, 7%-8%. First of all, is it in line with your expectations? 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?
Yeah. I think as I mentioned in my remarks, this is very important business IP to us. Clearly there's a lot of growth opportunity because of outsourcing trend. Many of my top customers, they would love to outsource some of them to us, especially if the industry standard, off-the-shelf IP and also the most advanced node process. Just to meet and to fulfill the various protocols that keep changing, they will prefer to outsource. It's a very heavy investment. I think we are very good in terms of trying to do that and meet our customer requirements. What we did is that the refinement is to de-emphasize some of the kind of one-off customized IP and really focus on some of the standard, and the market that we are pursuing. We mentioned quite a few of that.
Also in the most advanced nodes. 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. Those I think will have the foundation for us to grow in some of the verticals that we are pursuing and the advanced nodes 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. I understand this is sort of part of your focus on system customers, 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?
Yeah. Very good question, Rich. A couple of point I just want to highlight, it's not just the marketing campaign work. As you know us for last eight years, we have been very focused on executions. The system design enablement, what it really mean is to provide the solution that system company can optimize for their differentiations with the end product in mind. 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.
Because a lot of this system company and service provider, they're looking for that software, hardware, co-design, co-verification, also the packaging, become end-to-end solution that providing the power, signal integrity, the interference, all within the envelope of the system company that they have that requirement they need to meet. Of course, the time to market is critical, they need to have that scalability they're looking for. That's why you see Palladium has that kind of scalability and performance checking that they need in term of compact system. Like I mentioned earlier, this one major aerospace company see the benefit of using our Palladium, they can really testing the system level solution that meet their requirement of their design.
Same thing, this Fujitsu on their supercomputer design, they starting to see the benefit of we not only providing the tool, the hardware, the IP portfolio. Those are the things that we're going to continue to highlight. Previously, last quarter we mentioned about Northrop Grumman, this time we mentioned about BAE Systems. On not only using our digital flow also using our IC packaging that are uniquely qualified for their spec, the requirement they need.
Got it. Thank you for that, Lip-Bu. Geoff, 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?
Yeah, we've had a lot of strength in our hardware business, as you know, this year. It's been a very good year. Z1 has been a very successful product. I think the point is our DSO will go up. Our long-term receivables go up as we sell more hardware and as we lease more hardware. I think that's the key point that I want to make.
Got it. Okay. Thank you. That's it for me, gentlemen.
Okay, thank you.
The next question is from Sterling Auty from JP Morgan.
Thanks, guys. Had a couple 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.
We're sorry. We understand that we've had audio problems today. We wanted to remind you that our prepared remarks will be posted on our website after the call. Thanks for mentioning it.
Great. Thank you. We appreciate it. 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? Just can you give us some more color as to what's driving that significant deceleration?
As you would expect, as I think we said in our Q2 call, we expected Q3 to actually have lower revenue than Q2. Certainly, functional verification and emulation was a large piece of that.
What goes into that? Is that lease versus sales? Is it lead times on emulators?
Yeah. 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. We want to take it when our customers want the product. By the way, that came after two record quarters in both Q1 and Q2. I think we expect a little bit of a downturn, and that's what happened in Q3.
On the lease idea, can you give us a sense of what portion of that emulation business is leased? I think Rich started to allude to it, is that recognized ratably when you're leasing the equipment? Maybe just start with those two.
Yeah. Leasing is recognized, the revenue is recognized upfront because it's a lease, but we collect the cash over a period of time. I think that's key for us.
Okay, what % of that emulation business is leased?
It remains a small portion. We don't break out the details, it remains a small portion of it. We do want to point out that we've had a very good year, right? We expect that to continue in Q4. The guidance at this point for Q4 includes everything we know. Product mix has certainly been a factor this year, as hardware's 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, in Q4, we'll see some of the cost of the end of the life of Palladium XP.
Got it. Last question, since it is a public forum, I know you can't answer too directly around Mentor Graphics and some of the comments and thoughts around possible acquisition, et cetera. I wouldn't expect you to say, yes, you're interested in buying the whole company, 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 Calibre line from the other vendors in EDA, your product portfolio has changed over time. Is Calibre as a technology as interesting and as complementary to Cadence today as it was, say, in 2007?
Yeah, I think, Sterling, first of all, we have a lot of respect for our friend, Mentor, the management team, they are very important industry player. Clearly, as you know, we don't comment on some of these topics. We have a lot of respect for them. Their product, Calibre, is well-known in the industry. I think we just stop there, we're not going to comment on any of the specific.
Okay. Thank you, guys.
Sure. Thank you.
As a reminder, if you would like to ask a question, press star one on your telephone keypad. The next question is from Tom Diffely from D.A. Davidson.
Yes. Good afternoon. One more IP question. Could you quantify how your change in focus affects the served available market that you're going after in IP directly?
I think, as you know, IP is a new business a few years ago, and we embark on that, and we grow nicely to 10%-12% of the revenue for our company. This is very strategic for us in our whole key component to our SDE strategy. We reviewed recently IP business strategy, as I mentioned earlier, we're going to be focused on standard off-the-shelf IP, pursuing the vertical market that we want to pursue, and then the most advanced process nodes. We de-emphasizing the customized IP that kind of more once-off and it's not many of IP reuse, and that's where you're going to make money. I think long term, we like this.
This outsourcing trend continue because a lot of company, a customer we talk to just to catch up and then follow these various protocol that keep coming up. If they have a silicon-proven IP, and then they would love to outsource that. We see that opportunity, but we're going to be really disciplined, just like when we do the M&A. Again, this refined strategy, we are focused on scalability, sustainable, and more focused on the profits and more focused on the quality of the customer, the more focused effort into this whole vertical market we're going to go after and the most advanced nodes, and then de-emphasizing some of this customized IP.
From a strategic point of view, that makes a lot of sense. What percentage of your IP business historically has been in the customized part that you're moving away from?
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 were expecting another leg down in that business and then growth from that point on.
All we can say is, clearly, this is a refocus. As you know, when you grow to 10%, 12%, then you are starting to look at, okay, now you grow to 10%, 12%, how is it? Is it scalable? Is it sustainable? Is it profitable? Then we kind of refine the strategy then for the next phase of growth, that are more focused and more IP reuse and more repeatable, scalable business model going forward.
Again, we expect modest sequential growth from Q3 to Q4.
Okay. All right. I guess moving over then on a 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?
Yeah. 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.
Just to add on to it, this is Lip-Bu here. The China semiconductor sector, actually this year growing at 26% compared to the overall global market is kind of not growing. Government have put a lot of effort into it, and Cadence is very well-positioned for the tool design and IP. We are excited about the opportunity. You see that over time, the region is growing.
Okay. I guess just finally here, 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. I'm curious, what are you seeing in the growth in the key areas for you, like in the logic area? What are you seeing just for overall design activity with your customers?
Yeah. Very good question. In term 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. The IoT and all this data are going to be in the cloud. The cloud infrastructure are going to be a very great opportunity for us. 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 whole neuroscience is intriguing to me.
I think those are going to be driving some of this growth opportunity going forward. Of course, the security related to across all this vertical will be very interesting to me. Our tool is try to optimize to address some of these design challenges and all the different application have different challenges. Also our IP and that the refinement that we make going to be focused on some of this vertical market, also some of this application opportunity for Tensilica to explore. With their DSP programmability and low power, it will be really shine just like a Microsoft HoloLens as an example.
Okay. 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 new design engagement we have, and our hardworking, capable employees, they are working really hard. I haven't seen any time in the last eight years they work harder than today. 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.
Yeah. Hi. Thanks for taking my follow-up. I have two of them. One is, Geoff, 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 there any update on this whole ratable 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.
Yeah. We don't break out auto. We just stay with system companies as about 40%, but we do believe it's growing as a portion of our business. On the 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, Geoff.
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 second consecutive quarter and also down slightly year-over-year. Was that largely a function of variability in hardware? 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. Lastly, Geoff, 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 the five or so million in total corporate, in emulation.
You also seem to have had a pretty significant increase, in the gross margin year-over-year. You had a decline of cost of revenue for the first time in over a year, but revenues had to have grown in emulation. It looks like you had a pretty substantial increase year-over-year on the gross margin there, even with a sequential decline of revenues.
Yeah. 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 the part of our revenue that's upfront. 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 old generation product, to the Z1, and we've said the Z1 will have higher margins, right, than the XP. 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.
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.
This concludes today's conference call.