Good afternoon. Welcome to this session. Really delighted to have the team from Synopsys join us. Trey Campbell, Head of Investor Relations. I'll, you know, typical fireside format, I'll go through my questions, but please feel free to raise your hand. Before we get into the fireside, just a quick statement from Synopsys. Today's discussion may contain forward-looking statements related to their current outlook, expectations, and beliefs subject to certain risks and uncertainties that could cause actual results to differ. Please refer to Synopsys' most recent SEC filings for a discussion of risk factors that may materially affect these statements. With that exciting thing out of the way, Trey, welcome.
Yeah, great to be here.
Yeah, really appreciate you being here. I know a lot of, you know, macro cross-currents, and I really wanted to, you know, spend the bulk of the call on kind of the longer-term drivers for, you know, what's a very high-quality industry and business. Just at the start, let's get some of the recent headlines, right, out of the way. Synopsys, like, you know, all of your peers received some notification from BIS. Maybe, you know, give us a sense for, you know, what that letter says, right, to the extent you can, and then what it means for Synopsys.
Yeah, so thanks, everybody, for joining. Great to be here. We had our Q2 quarterly earnings last Wednesday. It was the first time I've gotten to do earnings and then update the guidance the next day. We had heard some rumblings in the industry. We had not received a letter from Commerce, but we heard that there were, and we saw some of the chatter in X and those kinds of things. We delivered our quarter, and then the next morning, I guess maybe they were listening to our call. We had not received a letter. We got one. If you read 8-K, basically the paraphrased kind of comments of that letter. If you look at the Cadence letter, it is pretty much straightforward. The letter is pretty, you know, as written in their 8-K.
It was something where there were, it's a too informed letter, which typically is to stop doing something. There were a couple of broad codes, and, you know, through the period of regulatory restrictions in China, there are a number of, there's classification for software and hardware and chips and all manner of things put into different codes to check, you know, the effectiveness of those. We were informed to stop selling along this. We basically worked through that day and have kind of stopped shipping to China. You know, one of the things, it was a surprise in seeing that letter. Typically, when we get, we'd worked through quite a few restrictions, you know, in the Biden administration and even previous to that.
Typically, there's a, you know, anywhere from a four-week to a 12-week comment period, which is valuable because you can imagine, you know, these are complicated technologies with a lot of interconnections, you know, things like, you know, software versus firmware versus, you know, all of these things that matter when we're selling. We stopped shipping, but we've been having conversations, and I assume peers have been doing the same thing to kind of after the fact try to create that comment period to understand, you know, what was the intent of the regulation? How do we follow that intent? Are there elements of our business that can still be sold, you know, that are not a part of the strategic intent of the regulation?
We've been working through that, and we pulled our guidance, which we thought was appropriate, given this is, you know, could be a material impact. We will, you know, we'll put new guidance up there as we work through this with the government and understand, you know, what is off limits and what could be sold. That's kind of what we're working through right now.
Got it. Is there a timeline, Trey, to when we should, you know, we might hear of an update?
You know, there's nothing I can give you as a point. I mean, we're working vigorously on it.
Is it a weeks thing? Is it a month?
Yeah, I don't think, I mean, I don't think it's a long-term thing, but, you know, it's going to take, it takes a little bit of time. I mean, we have, you'd think, oh, we only have a few products that we sell, but these are broken up into thousands of subpart numbers, even in software, of how things move together. So we have to be, you know, we want to be really solid in looking through that and making sure that we've really checked through it with, you know, our legal teams, worked through with the government. You know, interestingly, we compete vigorously with, you know, with our peers in this industry. This is one space where we, you know, we do work together as legal teams and as, you know, government relations teams because, you know, we don't have the scale of Apple and NVIDIA.
We want to be a combined force. And so, you know, I know that the rest of the industry is also working through this.
Got it. Why would they single out the EDA, you know, industry versus the equipment industry, right, which has almost like 30% exposure? What is the difference between the enablement that, as an industry, EDA is giving to China versus what the equipment companies are doing?
You know, I'd be speculating, I mean, in terms of the intent. But, you know, I mean, usually there are a couple of things that come up with administrations in terms of when you think about restricting. There are two significant choke points. One is always EDA, one is cap equipment, as you mentioned. You know, it certainly can impact the ability to go get things done in, you know, in China. There are also, you know, one of the reasons you have to look at how you do these, these are high collateral damage areas too in terms of, you know, the restrictions that we've gotten historically have been targeted at AI. This all kind of started in 2019 when Huawei was banned, and then you had a number of other players in the space that were banned.
You kind of went on to a technology restriction kind of schema where initially it was Gate All-Around. You basically were taking away the most advanced process nodes, which were, you know, highly used by AI and HPC chips. There was a restriction on the performance per square millimeter that you can drive. Hey, if you could manage to cobble it together without two nanometer or three nanometer, you could go do, you'd still have this restriction. The final leg of this was in November when High Bandwidth Memory was restricted. The combination of all of those technology restrictions have had an impact. I just, I mean, I point to, you know, pre-restrictions. China geography was growing kind of 20%-25% for Synopsys.
In the most recent quarter, you know, we were down 28% year over year, and that was about the same thing for the first half. A lot of the impact is those technology restrictions have meant that a lot of the AI and HPC chips that were getting developed may die on the vine before, you know, just say, hey, I can't have a performance solution relative to what AMD or NVIDIA can offer from a merchant. That means, hey, the IP doesn't get used. I don't need the hardware to verify it, even if we're continuing to sell EDAs on recurring contracts. Less kind of flexibility in that. You know, that's what we saw. We have been working through all those. As a company, we 100% are going to comply with everything that the government comes in with this.
Same thing with our peers. This one, it was atypical because, you know, there was not really a comment period, and now we are working that comment period after the fact.
Got it. Historically, what's sort of been the exposure across, you know, applications in China? Is it like half as high performance computing, quote unquote, the other half as, you know, mature node, you know, washing machines, trailing edge type stuff? Is it like half and half? Is it, you know, tilted more one way or another?
Yeah. I don't, I mean, I don't have that kind of rough proxy, but I can tell you there are a lot of chips on lagging edge, but probably, I mean, we get paid a lot more at advanced node, right? Because these are the chips that are going to have, you know, the high-end EDA use more IP and newer IP. You know, those designs are the ones that require hardware verification where you may be able to kind of do it without on lagging edge. Our kind of business was skewed definitely toward the advanced node in that space. What's happened with the technology restrictions is we've, as the AI and HPC TAM has compressed with the restrictions, we've moved more into automotive and IoT and industrial, and those have been really good markets.
The challenge is that they just weren't as big from a revenue TAM perspective as the AI market.
If we were to just do a very, very high level, you know, breakout, is it like one-third high-end, two-thirds trailing edge? Is it as?
You know, I mean, it really is whether you're looking at design starts or the revenue TAM out there. I mean, there's still a lot of design starts at lagging edge because, you know, like 25%-30% of lagging edge is in China. And so there's a significant amount of kind of 16, 14 nanometer and above chips that are made. However, our, you know, EDA IP intensity is much higher at advanced nodes.
Right. The reason, obviously, you know, we are focused on that is because, you know, the investment community is trying to get some rough sizing of, you know, if there were to be, right, some kind of additional scrutiny, right, would it apply to a quarter or a half? Like, what is the right way to kind of?
Yeah, this is the one where right now we're just, you know, really trying to work through a little bit of the clarity and to put more fine-grain understanding on what we can and can't sell. The other piece is it really gets down to duration. So, you know, this is how long will these restrictions be in place? Will they be narrowed? What's the intent? How does this play? In that, it really, a lot of the questions for us, we don't want to make dramatic changes to our business if something is very fluid. I'm sure we'll get to the answer to this question. You know, I mean, there's lots of knock-on implications of this.
If this is a short-term thing, you know, a lot of the question I've gotten today in one-on-ones and after the call, oh, well, maybe there's a glass half full. Maybe you guys can close Ansys this week, right? And that it gets back to a duration question of, would you do something like that if this is a short duration thing where we don't want to lose out on a market we really want to participate in in China? I mean, back to this was a 20%-25% growth market before you had the restrictions. If you reach a trade negotiation or something that, you know, that has the right controls but restores our ability to sell, we certainly don't want to walk out of a growth market like that.
Of course. Makes sense. What's also interesting is that, you know, we are seeing all these headlines in the midst of just U.S. and China trade negotiations. It's hard to know because, you know, you also mentioned that historically the industry has always been given notice. There's been a comment period, right, of several weeks, but this has just sort of come out of the blue right in the midst of these trade, you know, negotiations. Is there a chance that it is perhaps part of that bigger negotiation? It's not like singling out?
Yeah, I mean, I think there's a lot of conjecture, you know, on one way what it is. I certainly hope that it's a short duration kind of thing and that we can work our way through it. I am not on the right side of the government to answer that.
Understood. And then finally, in terms of, you know, the spending that is associated with this revenue, you know, if we were to say hypothetically X% of this revenue goes away, then is there some, you know, OpEx profile associated with it that can also go away? Or you think that OpEx is fairly fixed?
Yeah, I mean, there are certainly some variable elements of OpEx. I mean, if you were in a situation and you said, hey, this is written in stone and it's permanent, well, you know, you'd look at the revenue driving kind of sales force and those things. But, you know, if you look at our business and, you know, just software in general, it takes a certain amount of resources to go put out Fusion Compiler and our key EDA tool or, you know, to develop IP blocks and these kinds of things. So regardless of how many geographies I can scale my revenue, it's a great thing for my P&L to be able to do that, but I still have to invest the right OpEx to go get these done.
You know, that's why, no, I mean, we'll certainly look at all opportunities to be more efficient in OpEx and all those things, but it does take a certain amount of resources to go put this tool set out there.
Right. Got it. And then finally, you mentioned that, oh, sorry, yes, please.
Yeah. When you say you stop selling to China, is that when you stop sending them software updates? Or can they continue to operate on the existing software they have? If they are operating on the existing software, how long can they operate through?
Yeah, I'll give you kind of the schema, and the short answer is it depends a little bit. I mean, the way we go to market, and this is, I'll just do kind of a broad genericized, because I mean, it's different for customer to customer, but typically we have two and a half to three and a half year EDA contracts. We basically chunk those contracts, let's say it's a three-year contract, we basically chunk that up into yearly increments and we provide a key for that year. If you continued using us, you'd get the next year of keys around your renewal date.
On an EDA side, you know, customers are anywhere from, you know, the time last week that we got this note for the next 355 days, assuming this was written in stone, they'll go dark at some point during that period, right? It just depends on what their renewal dates were. We can no longer, you know, we're not maintaining or fixing bugs or, you know, doing updates in that. They could continue to use the tool, which they'd have to kind of keep updated themselves. On IP, you know, if that was, you know, something, we would, if they've downloaded the IP from our databases before that date, they could use it, but there won't be new downloads until we create resolution here. With hardware, they could keep using that, but it would be the same thing.
There wouldn't be updates or software bug fixes, those kinds of things. Yep.
Please.
Yeah, no, thank you so much. I was just wondering, like in conversations with the government, is the intent really like a restriction on the final owner or on the geography of sale, especially since like software design services can be moved around? Like how strict is the BIS oversight in sales, in the language sounds like sales direct to China outside of that military end user list where it's anywhere versus just Chinese subsidiaries that would open into Singapore, Middle East, and moving around some of those designs? What is the intent behind that? How do you see, like, you know, reactions in talking to customers in China on how they are trying to, like, maintain that access?
Yeah, no, yeah, it's a great question. And it's, these are some of the questions we're going back to Commerce on, you know, to really get clarification on some of these things because it's a fairly generic and vague, you know, kind of, and you naturally will ask a lot of questions of, would this apply to a U.S. multinational company with Chinese national employees? Is it an export if they look at it? These are the kinds of things that we would refine and we are refining as we go through it. But we need a little more time to kind of go through some of these things. These are exactly the kind of questions that we want to get fine-grained answers on so we can basically follow the intent. Right now, as I said, we've stopped everything while we're working through this.
Those are the kinds of questions we have to kind of get answers to so that we can make sure, hey, these are sales that we can make and these are allowable and supported and these are things that we must keep off limits. Yeah, it's a good question, but some of the things we're refining right now.
Any other questions? Is there a way to ring-fence, you know, your product just by the kind of applications? Because the way I understand it, it's the same kind of basic tool, but it's the libraries, right, that go along with it that somewhat, you know, determine what range of applications it can get into.
We have done this. I mean, a good example is the Gate All-Around, right? You know, we can sell Fusion Compiler, which is kind of a core design, you know, digital implementation tool, place and route tool that we have. In China, it just does not work on Gate All-Around. You can do some, you know, you can manage what is okayed by the tool when it calls back to us. We can do those kinds of things. There was not, at least in the initial note, that kind of clarification.
Just a blanket. Okay. Understood. Let's get to kind of the core, you know, business. You know, the AI exposure for the company, so the industry was involved, I think, right from the get-go, right? So the growth was, you know, above trend for a few years. Now it has kind of come back to the trend line. Where are you seeing the benefits of AI in your business? First in terms of the features in the product itself, and then secondly, the ability to upsell, you know, versions of the product that have AI copilot-like enablement.
Yeah. No, it's a great question. I mean, there's a, we kind of started, it was really Sassine, who's our CEO, who started this journey when he ran our EDA group, kind of, you know, 2018, that kind of timeframe. We brought out the first optimization engine in 2020. Samsung, you know, this was around Hot Chips. Samsung wrote an article about it. And we started to see, you know, this was, we added it to a variety of our tools to have traditional reinforcement learning optimization engines, hugely valuable, you know, to our customers. Also, then we, you know, this has kind of been a journey we've developed along with a lot of people in the industry, knowledge assistants or copilots that kind of get the first blushes of generative AI and get engineers into a prompting space. And we've seen huge benefit.
I mean, we've run kind of sample cohorts at some of our big customers. The nice thing is they broke it up into the maturity level of the engineers. It's not probably unexpected that really senior engineers don't get a ton of bang from a copilot because they've done it so much. Junior engineers, mid-level engineers get a ton of efficiency, like 30%-40%, because you instantly find things that may be in a 1,200-page manual, right? Huge learning curve benefit. Those things have been beneficial and are adding to the P&L, but they aren't that kind of, you know, inflection in terms of the P&L and the cash flow. Where we see that really coming is with Agentic.
For, you know, as you kind of look through AI, a lot of these early stages are, you know, are table stakes to really get to Agentic. Because as we get into, you know, actually having agents that we sell to customers that can actually do design engineering workloads, they're going to pull on those optimization engines. They're going to use the copilots, all those things. And we see a ton of interest from our customers. We're already doing some beta work inside. We want to get it out there as fast, but this is probably a few years away. The challenge in our space relative to maybe, you know, someone in a lower risk environment, you know, in a call center, things like that, the impacts of making an error are so huge, right?
If it's a billion-dollar tape out, you know, that's not the place you want to make the mistake. We need to operate in that kind of five to six, nine space. Where we'll bring this in is we'll start to do things that are more risk tolerant, things like checking test benches, checking the work of engineers. This is going to progress. I encourage you, if you didn't get to go to our CR user group in March, Sassine spent a lot of time on this. He had a pretty good parallel, an analogy of the autonomous driving kind of level one through level five and how that would look in Agentic.
It starts with, you know, early kind of work in the background, but it will progress to where you have agents working with other agents, an orchestration level that's Agentic, and then it gets to kind of more autonomous mode. There is a huge amount of promise in this. It comes into a market where we have a significant resource scarcity issue. The industry overall, our customers and ourselves, is about 20% short the number of design engineers we need to go make all the products on the roadmap that people have for the next five years. This is one of those where you can say, hey, this is an, you know, an excellent way to kind of be a scale multiplier in terms of how our engineers work. We have a lot, you know, there is a lot of work to do technically.
There's also a lot of work to do on business model because this is a pretty big change. We've been selling three-year subscriptions. As you get into this, you certainly would have something, you know, more metered or consumption-driven, kind of usage-driven. There is a lot of business model update. At a high level, kind of cocktail napkin math, this hunts. I mean, our customers pay us about 15% of the R&D money for our IP and EDA. The other really goes to their headcount. It is one of those arguments where you can say, hey, would you pay 50% more on 15% to get a 30% reduction on 80%? Very ServiceNow-like argument, but a lot of work to go do to get there, but it's compelling.
A few quick things. So Ansys, from what has been said, I think, let's set the BIS, right, implications aside. I think you guys have kept this June closing date. Are you getting enough kind of warm and fuzzy from, you know, the final jurisdiction that matters to maintain that level of confidence?
Yeah, I mean, you know, I started when I was talking to everybody today, I was like, you know, I'm not sure I could construct an argument with all of the things that are, you know, that you see in Bloomberg and New York Times and everything to get everybody here to give me a high five on, you know, the conviction level. What I can tell you is we're having really good dialogues. And so.
Is there any sticky points still, you think?
They're the same kind of good dialogues that happened. We've gotten through the right, we, you know, last week we got the final consent decree from the FTC. We've cleared all the other geographies regulatory. The discussions have been really good. You know, there is significant interest in keeping Synopsys and Ansys technologies in country, you know, and having those capabilities. Ansys only has 5% of their revenue there, but it's important revenue that touches a lot of important infrastructure and other capabilities, you know, we're used prolifically in the country. The one thing I would say too, as we had in other geographies, we're getting a ton of customer support. These are Chinese customers who want to see the combination and be able to use simulation and EDA together. Yeah, there's tons of noise and issues at a top level working through trade issues.
There is also a realization that, you know, there is a long term, right? These are capabilities that the country and companies want. So good dialogues. We still are very optimistic and we want to get this through the typical approval.
All right. Next important topic is, you know, your largest customer, right? And you know, they have a new CEO, right, who comes from Cadence. So talk to us about, you know, what that means from a competitive landscape, your market share, you know, is there, you know, an opportunity that maybe just the spend there, you know, expands and we are just worried about a fixed pie, whereas maybe the pie there can expand, right? How do you think about market share and their spending levels?
Yeah, I, you know, Intel has been a great customer. You know, we exist there with others, you know, and certainly, you know, Lip-Bu has ties, deep ties to Cadence from his past. But, you know, we've worked with Lip-Bu also and Sassine has a great relationship with him. You know, in fact, you know, there are a number of companies in the Walden portfolio that just use Synopsys, right? So before you even got to Intel, I mean, there's a lot of companies that were exposed through his investment portfolios. You know, our goal is to make them as successful as possible. I mean, you know, it's a critical company for the world and we want to do everything we can to make them successful.
I would say EDA is pretty sticky, you know, in terms of, you know, you have users that have used it for a long time. Certainly, people move back and forth and they may use both tools. You know, that's not one of our major concerns. We have a lot of other things that we're working on. The main one is just to make them super successful.
Got it. You think there is a possibility that maybe just their spending, you know, because they have, I mean, you have direct experience there that, you know, their spending has not been at par with the percent of R&D, as you mentioned, that that's the industry norm. You think there is a chance that maybe there is a larger addressable market?
I mean, a part of this gets back to, and I know, you know, I was at Intel for 22, 23 years. You know, the most important thing for any company is leadership products, right? I mean, and EDA is a piece of that, but all the other aspects that come into that. I mean, and I think if Lip-Bu was here, he'd probably say, hey, we're focused on building leadership products, however you get that done. Yeah, I hope that is the opportunity that they, you know, they operate in a great way and it creates more time for everybody.
You have not seen any slippage of share or anything along?
No, I mean, you know, so we have long-term EDA contracts with them. We have another contract. We're, you know, recently, over the last couple of years, they used us. They had done a lot of internal IP and chose us as we kind of get into 18A and some of the more advanced nodes. Then they've been a great hardware customer too. Yeah, all three of those are separate. No, we've continued to see, you know, good support.
Got it. And finally, just, you know, from your experience now at all these organizations, you know, one question that always comes up, people will rightly or wrongly, you know, contrast Synopsys, right, and trading multiples with like Cadence and trading multiples and say, well, how come there is, you know, such a wide gap, right, in the multiples? Historically, I think that existed because of the difference in profit margins. But I think Synopsys has done a good job, right, since Shelagh has come there, right, to kind of help close some of that gap. Why do you think there is still this really large delta?
Yeah, I mean, I'm sitting with a group of experienced investment professionals and I'm going to tell them why I think the stock is trading. So take this with a grain of salt. So yeah, I used to.
Rumors of our greatness are greatly exaggerated.
You know, it's a quick aside, but when I was at Intel in IR and Stacy Smith was the CFO, you know, and every IR professional has this experience where it's like, you know, what happened to the stock today, right? I'm sure you all get this and, you know, after talking to multiple trading desks and hearing seven different stories of why the, you know, why the stock moved, you know, Stacy and I were going, looks like more sellers than buyers. Yeah, that's what I'm just hearing. Yeah, no, I think, I think it's a couple of things. One, I think was what you hit. When I came in about two years ago, you know, Shelagh's had a tremendous focus on scaling the company at an improved operating margin.
We've been doing about 150-200 basis points a year of operating margin accretion, which is fantastic. It's not over. We're going to keep doing that. We're still at a delta relative to Cadence. As we did and we gave pro forma when we did the Ansys acquisition, we expect the combined company to be mid-40s, which would be, you know, market-leading kind of operating margin. We need to continue to work on that front. I do think, you know, and you know, we can all compare notes at the watering hole afterward, but I mean, certainly the deal overhang, you know, has meant that, you know, when I came in, I looked at the stock, a lot of investors own us and Cadence, right?
I mean, you're kind of playing the entire market for the sector, which is, you know, very rich, a lot of high growth. But, you know, Cadence is a pure play that isn't wrapped up in a $35 billion acquisition where a lot of ours is how's the deal closing, how are these things? I think that's created a little bit of a disconnect. But the margin one is real and we intend to close it.
Terrific. Thank you so much, Trey. Really appreciate your help on this.
Thanks for joining.
All the best.