Ladies and gentlemen, thank you for standing by, and welcome to the Synopsys earnings conference call for the second quarter of fiscal year 2017. At this time, all participants are in a listen-only mode. Later, we'll conduct a question and answer session, and instructions will be given at that time. If you should require assistance during the call, please press star followed by zero. Today's call will last one hour. Five minutes prior to the end of the call, we will announce the amount of time remaining in the conference. As a reminder, today's call is being recorded. At this time, I would like to turn the conference over to Lisa Ewbank, Vice President of Investor Relations. Please go ahead.
Thank you, Ryan. Good afternoon, everyone. With us today are Aart de Geus, Chairman and co-CEO of Synopsys, and Trac Pham, Chief Financial Officer. Before we begin, I'd like to remind everyone that during the course of this conference call, Synopsys will discuss forecasts, targets, and other forward-looking statements regarding the company and its financial results. While these statements represent our best current judgment about future results and performance as of today, our actual results and performance are subject to many risks and uncertainties that could cause actual results to differ materially from what we expect. In addition to any risks that we highlight during the call, important factors that may affect our future results are described in our most recent SEC reports and today's earnings press release. We will also refer to non-GAAP financial measures.
Reconciliations to their most directly comparable GAAP financial measures and supplemental financial information can be found in the 8-K, earnings press release, and financial supplement that we released earlier today. All of these items, plus the most recent investor presentation, are available on our website at synopsys.com. The prepared remarks will be posted on the site at the conclusion of the call. With that, I'll turn the call over to Aart de Geus.
Good afternoon. I am happy to report that our second quarter results were strong. We delivered revenue of $680 million and non-GAAP earnings per share of $0.88, both at the top of our target ranges. We executed a $100 million share buyback, for a total of $200 million so far this year, and we are raising our revenue, non-GAAP earnings per share, and operating cash flow guidance for the year. Trac will discuss the financials in more detail. The landscape around us is solid, with what feels like a continuing stable outlook for 2017. Our three customer groups, semiconductors, systems companies, and software developers, continue to invest significantly. This is driven by the dawning age of digital intelligence, which is both exciting and evolving quickly. Everything around us is becoming smart, connected, but also complex.
Mounting software content, whether integrated on a chip or as an app, creates huge functionality, development, and security challenges. This, in turn, drives growth opportunities around machine learning, automotive, augmented and virtual reality, networking infrastructure, and the soaring need for more cloud-based computation and storage. With a unique portfolio reaching from the roots of silicon all the way up to software, combined with best-in-class global support, Synopsys continues to demonstrate that our vision, strategy, investments, and execution are right on the money. This is evident in all three product groups. Core EDA revenue growth has outpaced competitors over the past years. IP continues its double-digit growth, and our software quality and security group is scaling to critical mass with excellent revenue expansion. Let me provide some highlights from the quarter, beginning with core EDA. Synopsys is a mission-critical partner for the most advanced designs.
Our EDA and IP collaboration with TSMC illustrates this. During Q2, we announced full flow certification for TSMC's 12 and seven-nanometer processes, as well as broad IP cooperation for 12-nanometer FinFET. Customers today rely on Synopsys for more than 95% of their FinFET designs. Meanwhile, we're already partnering on early R&D of five nanometer and below. Our design platform is generating solid results and notable customer successes. IC Compiler II, our place and route solution, is used on highly complex chips, some as advanced as seven nanometer, by companies such as Xilinx, Nvidia, ST, and Broadcom. IC Validator, our physical verification product, has already performed final sign-off of more than 100 FinFET production tape-outs, a significant accomplishment given the historical reliance on competitors. Meanwhile, intensive R&D across our digital platform is delivering new high-impact capabilities at a very rapid pace.
In custom, our longtime leadership in simulation and our new Custom Compiler design solution are generating high interest. Custom Compiler's FinFET optimization and our close collaboration with UMC, for example, enabled customers to use Custom Compiler in their new 14-nanometer process. At our March user group conference, ST, MediaTek, and Renesas shared their production successes with engineers from more than 40 companies. In verification, we continue to see excellent results and a strong outlook for the year. Our verification continuum platform is in high demand for two reasons. First, we have leading-edge verification technologies ranging from simulation, to emulation, to prototyping, to static techniques, to powerful, well-integrated debugging. Second, our coherent platform is solidly centered at the intersection of hardware and software. The very intersection enabling smart everything and addressing the time to market urgency of this dynamic market.
We continue to see great progress, ranging from excellent customer interest in our new super-fast VCS simulator to platform-wide adoption and proliferation. Over the last several quarters, leading mobile, graphics, and processor companies have aligned with us through expanded multi-year strategic agreements, including simulation, verification IP, debug, formal emulation, and prototyping technologies. In Q2, broad demand for ZeBu emulation continued, with six new logos and expansion in top accounts. For example, Spreadtrum standardized on ZeBu for its advanced mobile SoCs, and Wave Computing adopted ZeBu for its machine learning products. While lumpy from quarter to quarter, we expect 2017 to be another record year for hardware revenue, driven by industry demand and the robustness of our solution. On top of this, virtual prototyping, which enables early software development and architectural assessments, resonated particularly well in the automotive market.
During the quarter, we announced support for chips from Silicon Mobility Inc, a leading semiconductor provider for hybrid and electric vehicle control systems. Let me pause for a moment on automotive, where over the past several years, we've deployed a wide range of targeted solutions. With touchpoints ranging from functional safety to autonomous driving to the next generation of entertainment, all the way to lighting simulation, Synopsys is growing into a crucial participant in the automotive ecosystem. Elements throughout our EDA, IP, and software integrity portfolio are now certified for the most stringent level of automotive safety defined by the ISO 26262 standard. In IP, for example, over the last eight quarters, we've significantly extended our portfolio of certified IP. More broadly, in Q2, we saw strong demand in IP with particular momentum in advanced technology and security.
We announced an expansive portfolio of IP for TSMC's 12 FFC process and taped out multiple 10 and seven-nanometer IP test chips with advanced foundries. We're systematically building out our portfolio of security IP for mobile, automotive, IoT, and cloud computing markets. In Q2, for example, we delivered a high-performance, hardware-secure module that protects sensitive information and data processing within SoCs. The need for security is, of course, much broader than IP. Which brings me to our third customer base, software developers across many industries. The focus in our growing software integrity group is to provide products and services that help developers write high-quality code that can withstand security vulnerabilities. This is a key differentiator and new TAM for Synopsys, and I'm happy to report that it's scaling well, both organically and via acquisitions.
Our software sign-off platform is making good progress, and we've expanded our roadmap to reflect the acquisition of Cigital. We're strong in the embedded space with growing transaction sizes and are gaining good traction in the automotive industry with our security solutions and well-respected expertise. With the acquisition of Cigital in Q1, we're accelerating penetration in other key verticals, such as the financial services industry. Our objective is to drive demand creation at early stages of security strategy development. The Cigital integration is already delivering examples of our first combined services and product agreements and cross-selling opportunities. Finally, Synopsys was named a leader in Gartner's Magic Quadrant for application security testing. The Magic Quadrant is an important indicator for customers who often use it to narrow their list of potential vendors. We've already seen increased customer interest as a result.
In closing, as we look to the second half of the year and beyond, our priorities remain centered on generating long-term shareholder value. We do this by investing organically and through M&A and EDA, IP, and software integrity to realize our silicon-to-software vision. We do this by executing with a clear intent to sustain technology leadership while simultaneously growing revenue and profitability throughout our business. We do this with a clear bottom-line objective and many-year track record of driving ongoing high single-digit EPS growth and returning cash to shareholders. Let me now turn the call over to Trac.
Thanks, Aart. Good afternoon, everyone. In Q2, we closed another outstanding quarter and continued to execute very well. We met or exceeded all key financial targets, delivered strong revenue and non-GAAP earnings growth, completed a $100 million share buyback, and generated significant cash flow. Our first half was very strong, and as a result, we are raising our 2017 outlook for revenue, non-GAAP earnings, and operating cash flow. Now to the numbers. As I talk through the results and targets, all comparisons will be year-over-year unless I specify otherwise. Total revenue increased 12% to $680 million at the high end of our target range, with particular strength in hardware and IP. About 90% of revenue came from beginning of quarter backlog, and one customer accounted for more than 10% of revenue.
The weighted average license duration was approximately 2.7 years, and we expect the 2017 average to be slightly less than three years. Total GAAP costs and expenses were $626 million, which included a $38 million accrual related to the ongoing EVE Mentor litigation. Total non-GAAP costs and expenses were $513 million within our target range. Non-GAAP operating margin was 24.6% for the quarter. For the year, we expect solid organic margin expansion over 2016, moderated by the impact of the Cigital and Codiscope acquisitions. GAAP earnings per share were $0.34, and non-GAAP earnings per share were $0.88, at the high end of our target range. Operating cash flow was $123 million, driven by strong collections and business levels. We are again raising our 2017 cash flow target to a range of $580 million-$600 million.
We ended the quarter with cash equivalents, and short-term investments of $1.1 billion, with 11% onshore and total debt of $418 million. In Q2, we returned $100 million to shareholders through our stock buyback program, and we have $235 million remaining on our current authorization. Before moving on to guidance, let me briefly update you on ASC 606, the new revenue recognition rules that we'll implement in fiscal 2019. We are preparing for the rule change and are confident that our predictable model will remain substantially intact. Now to third quarter and fiscal 2017 guidance. For Q3, the targets are revenue between $685 million and $700 million, which reflects both strength and timing of hardware sales. Total GAAP costs and expenses between $574 million and $593 million. Total non-GAAP costs and expenses between $517 million and $527 million. Other income between -$1 million and $1 million.
A non-GAAP normalized tax rate of 19%. Outstanding shares between 153 million and 156 million. GAAP earnings of $0.69-$0.78 per share, and non-GAAP earnings of $0.91-$0.94 per share. For 2017, we're raising our revenue target to $2.65 billion-$2.67 billion, a growth rate of 9%-10%, which reflects underlying strength in our business, including record hardware sales. Other income between $2 million and $6 million. A non-GAAP normalized tax rate of 19%. Outstanding shares between 153 million and 156 million. GAAP earnings of $1.84-$1.97 per share. We're raising the midpoint of our non-GAAP earnings target range by $0.03 to $3.24-$3.29 per share, a growth rate of 7%-9%. Capital expenditures of approximately $90 million, and cash flow from operations of $580 million-$600 million.
As we look to the remainder of 2017, we expect Q4 to be the lowest revenue and EPS quarter due to the timing of hardware shipments and seasonally higher operating expenses. Investors should expect continued variability in revenue due to the growth of our hardware products and their upfront revenue recognition. Excluding hardware, our 90/10 time-based revenue model remains in effect. We're in the early stages of planning for next year and would encourage investors to wait until we've provided guidance before updating estimates. We believe the current 2018 consensus non-GAAP EPS estimates look reasonable. This is consistent with our long-term objective of driving high single-digit non-GAAP EPS growth. Q2 was a great quarter. We delivered strong growth across the board. We're raising our 2017 outlook for revenue, non-GAAP earnings, and cash flow.
We continue to drive long-term shareholder value by investing in the business, both organically and through acquisitions, and by returning capital through share buybacks. I'll turn it over to the operator for questions.
Ladies and gentlemen, if you do wish to ask a question, please press star then one at this time. Once again, if you have a question, please press star one. Our first question will come from the line of Rich Valera, Needham & Company. Please go ahead.
Hi. I wanted to ask about the strength you're seeing in the core EDA business. You've been on record on numerous occasions saying you thought that was kind of a low single-digit growth business, yet it looks like you're growing that close to double digits last couple of quarters. Just wanted to get your sense of what's driving that, with any more color than you gave in your prepared remarks, and how sustainable this well above industry growth rate might be.
Well, in general, I think we're in a phase of the industry around us and ourselves that tends to be strong. When we give you directions on growth rates of the different areas, we always look at it from the perspective of a multi-year outlook, because that's sort of the only fair way to do it, all the more given that we have multi-year agreements.
Having said that, there's no question that the push towards more advanced chips is actually continuing strong. I think the reason for that is relatively straightforward, which is that the new opportunities in technologies and products are using any of the existing computation and mobility techniques, but now amended by increased digital intelligence requirements, will continue to be very strong. You add to that enormous amounts of data generated by a rapidly growing set of sensors, and you can see that the entire field is really poised to demand more computation. It is natural, therefore, for people to come to our products. While there's some up and down from quarter to quarter, they are driving the leading edge, and they need the tools to support that. I think we've been fortunate to do well.
Got it. Then just more specifically for the quarter, the service maintenance line was very strong. I'm not sure if you could give any commentary on what that was and how we should think about that line for the balance of the year.
Hi, Rich. You're referring to the P&L with the split?
Correct.
On the services and product line, that includes the Cigital acquisition, as well as strength in underlying IP, right? That's where the POC revenues flow through as well.
Got it. That was an unusually strong quarter. Should we think about that as above?
No, IP tends to be pretty lumpy. If you look at the results from our product mix, we are doing well in IP.
Right.
It does tend to be lumpy, and then you add that to the Cigital acquisition, where we've got a full quarter of that now. That's driving a quarter-over-quarter change.
Got it. Higher than historical levels, but maybe not quite that high going forward. That makes sense.
Yeah, we keep it in, as we said publicly, we expect IP to grow in the double-digit rate, and it could be lumpy from quarter-to-quarter, but our goal is to drive that growth sustainably in the double digits.
Got it. Just with respect to hardware, you've obviously had a great run of demand here in hardware, and it looks like Q3 probably not expecting any different, but you're currently modeling it sounds like for Q4 to maybe take a breather in hardware. Is that something you really have visibility to, or is that just out of an abundance of caution? Just trying to get a sense of how much visibility you actually have to that Q4 tailwind in hardware.
It feels like repetitive in the last three or four earnings releases, we must have used the word hardware is lumpy every time, that is an indication that the visibility is not complete, meaning that some of these things come in and then the customer wants immediate fulfillment or delayed fulfillment, the timing can be somewhat arbitrary. There's no question that we have done well in the hardware area. I think that correlates directly to what we said earlier, which is growth in complexity of chips, but also more and more chips, and the affiliated software needing to be verified together, and that is only a center of strength for Synopsys.
Rich, you bring up a good point in terms of Q4. The profile of Q4 is impacted by the variability of hardware. As you've seen in the results across geos, across product mixes, we're doing well, and going forward, you'll see more variability quarter and quarter. I think focus on the full year and just as you've brought up, the Q4 profile is down, but that's just mostly on hardware.
Fair enough. Appreciate the color. Good execution, gentlemen. Thank you.
Thank you.
Thanks, Rich.
Next question comes from the line of Tom Diffley with D. A. Davidson. Please go ahead.
Yeah, good afternoon. First I was curious, what are the specific drivers of the hardware IPs? Is it the core semi business, the system players, or perhaps new customers in Asia?
Actually, the first two groups, because in order for emulation and other hardware acceleration methods to be useful, it is really in the proximity of the intersection of hardware and software, which means it's the high-end chips that invariably drive a lot of software, or it is the systems companies that integrate multiple chips around building apps or building entire products. The distinction between semiconductor vendors and system vendors sometimes is a little blurred because they tend to increasingly do stuff for each other, or demand from each other that sits at this intersection. Both of those, I think sort of go hand in hand.
Okay, on the IP side, do you have to join the new customers that are looking to fast track some designs then?
Yeah, actually, sorry, I forgot that part of your question. IP is directly related to efficiency and productivity, and with continued complexity of chips, and by the way, continued complexity of the IP blocks, the Lego collection of these blocks continues to grow, and the efficiency with which people can put together large chips is directly a function of which blocks are available, how easy is it to integrate them, and how much do you trust the vendor? Because obviously, you're highly relying on who provides you those blocks. As companies design large chips or larger systems, increasingly they put their engineers on those aspects that they can't purchase, but where they can provide additional differentiation while outsourcing increasingly blocks that in the past they would have done themselves. I think that bodes very well for us.
Okay. For both of those groups too, have you begun to see any kind of a seasonality pattern with them, or is it purely just project-based and could be fairly random through the year?
I have not seen any seasonality. I think it is very much project-based, and it has always a little bit the characteristic that the minute they figure out what's going to be in the project, they would like to have the IP the next day, which of course, not possible because a lot of this gets developed as part of agreements and service development sets. The projects come and go. The companies have no aligned timeline for these projects. I don't see any seasonality, but one could have the configuration that for some reason or other, some quarter, there are more project finishing than others or deliveries that we do. It could be somewhat lumpy, but it's not because of seasonality.
Okay. Moving over to the core EDA market. Are the software tools now completely ready for the seven and five-nanometer nodes, or are there still challenges to be overcome?
They are completely ready for the 7 nanometer. 5 nanometer is not on the market, 5 nanometer is still in deep development. That will take a little while. Even when I say for the 7 nanometer, 7 nanometer is really leading edge. What that means is that the foundries that provide the technology and that manufacture these chips will keep refining their technology on an ongoing basis because they constantly are trying to tune the yields that they get. If you have a little higher yields, meaning a higher percentage of chips that work on a wafer, that has enormous economic impact. We are in constant interaction with foundries. Every time that they tune it a little bit, we tune our tools, and in some cases, we also tune our IP a little further.
Okay. In your answer there, did you include the IP and the 7 nanometers being ready as well?
Yeah. We have a number of efforts in these advanced nodes, the word ready is not a black and white.
Yeah
meaning that there are certain things that are ready earlier, there are certain things that are ready when 7 nanometers, not quite there for test chips, for example. There's a very complex multi-year process to bring something to market. From my commentary, you should read that we are well-exercised in trying to align as much as possible with the foundry train so that we arrive at the station at the same time.
Okay. Does your answer there either include or not include EUV? Does it matter to you?
It doesn't matter that much. There are some very fundamental IP that's impacted by EUV, as you may know, EUV is sort of now just slowly seeping into potentially some production manufacturing in the coming years, that is only for a few layers of the chip. There are many layers, so EUV will be for the very refined ones initially. So we're well on top of that, but it's not been a big effort nor a big issue.
Okay, finally, Trac, you said that the accounting rule changes should have just not much impact on your model. If you were to see an impact, where would it be?
There's some portions of it in the IP business that could be affected, fortunately, we've got time to work through how to structure those contracts. There's a small portion on some elements of FSAs related to the software contracts. The FSAs being the equivalent, the gift cards that you buy a certain amount and then draw down over time. Those things will be challenging as we work through the rules, but fortunately, we know what they are, and they're a relatively small portion, and we've got some time to address them.
Great. All right. Thanks for your time today.
You're welcome.
Our next question comes from the line of Krish Sankar with Bank of America Merrill Lynch. One moment, please. Okay. Sorry about that. Krish, your line is open. Please go ahead.
Yeah. Hi, can you hear me?
Yes, we can hear you. Was the easiest question so far.
I had a few more easy questions for you, Aart. Number 1, on your IP business, can you guys say how much of it is actually ratable versus upfront?
Roughly 60% is ratable.
Yeah, just to clarify, when we do IP, people buy existing functionality, but very often want it to be delivered in a very specific form, maybe with some alterations or with some tuning for their versions of technology. This is why the IP is accompanied by a statement of work which can be viewed essentially as a service business, but it is service business around an existing product. The reason you saw us hesitate is because we rarely think about it in those two categories, but it is a good question. It is sort of a balance between the two.
Got it. That's very helpful. A couple of other ones. Obviously, there's been a lot of chatter about activity in China on their own semiconductor investment front. Have you guys started seeing any purchases for EDA tools from the indigenous Chinese companies?
Yeah, we have seen those since the middle 1990s. We've been in China for a long time and there have been for now many years, many design companies. Many have not been successful. I would say we're at least already on the third or fourth generation of companies where a bunch have disappeared, reconfigured, and so on. There is a significant segment of strong Chinese companies that have year after year become closer and closer to be at the state-of-the-art. We would certainly say that there are a few companies that are designing with absolutely state-of-the-art silicon technology. They have been broad users of our tools. China has been a growing market for us, and we continue to see expansion of that market.
Let me add that we're actually doing well across our entire portfolio. We've been selling EDA in China for a long time, as Aart described it. IP is a very good opportunity, and we've seen growth there. Even with the software integrity business, that's been emerging over the last few years as well.
Okay. All right. I'm going to try to ask the question a different way. If I look at historically for Synopsys, memory has been about 15%-20% of your business, and China has this huge plan to get into memory with new 3D NAND factories. From those customers, are you guys having any conversation with these new 3D NAND investment in China, or have you guys started seeing any early POs or anything of that nature?
Definitely, yes. Memory development is a development that requires pretty deep understanding of semiconductor physics and device construction. With a number of companies we have now been working for a while on the development of those. You're absolutely right that in the last recent period, I would say maybe last two years, there have been an increase in attention and effort, that is a direct response to the fact that most economies are seeing an enormous amount of data coming about, that the big data will be analyzed, and therefore be it in the cloud or be it the devices around it, are all going to use massively more memory and that there's strong desire to make that memory a lot faster so that you can do more processing.
In that sense, while China may be new to this game, the push in new memory technologies is quite interesting and it fits well the overall picture of a semiconductor business that is going to be an enabler to many other high-tech capabilities.
Got you. The final question I had is, if I look at your fiscal first half or the last two quarters, your R&D as a percentage of sales, it's kind of been running at the low end of your historical range. I'm curious to know, is that a new fundamental shift in how you're going to be more effective with your R&D or two quarters is not too big a data point to extrapolate?
I wouldn't extrapolate off of two quarters. I think what you're seeing in the first half is mostly the acceleration of revenues. We expect to maintain R&D investments in the 30% range, and depending on what you're seeing this year is just the lumpiness of revenues and the quality profile will skew that. Overall, we expect to maintain the model in that 30% range.
Got you. Thanks, Trac. Thanks, Aart.
You're welcome.
Our next question will come from the line of Sterling Auty, JPMorgan. Please go ahead.
Yeah, thanks. Hi guys. I'm wondering with the acquisition of Cigital on top of all the other elements that you've pieced together in some of the software assurance, et cetera, how much of your sales and marketing headcount is now focused outside the core kind of systems and semiconductor industries?
Good question. I don't know the exact answer, but I can venture that it is probably half to a little bit more is outside. The reason for that is that the marketing needed in our core semiconductor space is not that high because we have many very good connections, and we can relatively easily access people that need security and quality tools for their software. Whereas in the rest of the space, there are many different market segments. You mentioned Cigital, which is a really interesting acquisition because it's not only that it brings to us a service business that allows us to engage at a higher level with customers that are looking at the strategy of how to deal with quality and security. It is that they also are very strong in the financial market.
The way you communicate with financial market is very different than, let's say, the health market or the embedded software market. That is why some marketing effort has to be specialized on that. From a sales point of view, there is this much more question of global access and how quickly can we grow this and be in a situation where we have high-quality salespeople. That is an ongoing effort and going well, we're growing well, but there's no end to that one yet.
On the IP business, you mentioned the strength that you're seeing there. We look at the gross margins. Obviously, the gross margins relative to expectations was probably heavily influenced on the mix, but specifically to the IP, how would you characterize the gross margin contribution at this point and the thoughts of where that could trend?
Sure. This is Trac. The margins on that are pretty healthy, but directionally, they're slightly below the corporate average. That's about where we expect to drive that.
Okay. Last question, you mentioned 606 on a couple areas, I didn't hear one of the attributes of 606 is the backlog disclosure. Any thoughts around the structure of how you're going to disclose the backlog? Specifically, I know it has to be done quarterly, there's the commentary that goes with it describing how you go from backlog into revenue. Is there any conclusions at this point in terms of how that would be, how those disclosures will come?
No, we're still assessing that. I would say that we've done a pretty good job disclosing backlog in the past, the metrics that we provided, I think, gives investors a pretty good sense of the health of the business. Going into any particular year, we do aim for about 80% visibility of backlog, scheduled revenue in backlog at the end of the year. Secondly, we try to enter each quarter with about 90% of backlog in hand. I think those two metrics, combined with anything else we provide, should give pretty good color on the health of the business.
Thank you.
You're welcome.
Next question comes from the line of Jay Vleeschhouwer with Griffin Securities. Please go ahead.
Thanks. Good evening. Trac, let me start with you. You raised the midpoint of your cash flow expectation for the year by $80 million. Is that pretty broadly based in terms of numbers of customers driving that, or is it fairly narrowly based in terms of perhaps just a small number of customers with a large amount of collections driving that number? Secondly, for you, before I turn to Aart, given the scaling that you're seeing now in hardware, could you comment on the margin or mixed trends vis-à-vis hardware profitability?
Okay. Let me start with the first one. The cash flow, whether it was broad-based, it was, yes, definitely broad-based, and that would be consistent with the health of the business that we're seeing in the first half. As I mentioned, when you look across, the growth was pretty broad-based across geographies and product mixes. The cash flow is consistent with that. From a hardware perspective, we are definitely doing well with hardware revenues and the profitability on that certainly is improving and is.
Well-
profits
Is it improving as a percentage of the hardware revenue?
Yes.
For Aart, a couple of things for you. We often hear over the years from the EDA companies when new hardware is introduced, particularly emulation, of course, detailed descriptions about the hardware specifications and most particularly about the design capacity that the hardware systems are capable of. We don't typically hear that sort of discussion around the software tool capacity. This issue has come up for you and others over the years in terms of design size capacity that you could put through DC, for example, and issues of that kind. As you move now to 10 nanometer and below, could you talk about whether or not there are any capacity issues that you need to resolve for any or all of your tools to adequately handle the design sizes that you're likely to see? You mentioned new version of VCS, so perhaps that's one example.
Anything you can address with regard to the capacity on the software side would be helpful. Lastly for you on the technology front, are you beginning to see any kind of conjoined usage of your prototyping hardware with software integrity? In other words, is the software bring up capability of hardware being used somehow with the software integrity business? Similarly, is the prototyping business being used increasingly along with emulation as part of your verification continuum?
Well, for being at Synopsys for 30 years, I would say our capacity has always been less than the customer wanted and more than they thought they would get. Meaning that the state-of-the-art is limited typically by a few things, which is one is how fast can you run, and two, how much can you run at the same time. It has been actually quite remarkable how over all this time period, these numbers have continued to increase. I'm certainly on record of having argued many times that we are the other half of Moore's Law, which is if they can manufacture it, we will find a way to simulate it, to design it, and so on, and that goes hand in hand. For the most state-of-the-art situations, one is always at the limit of what one can do.
The second comment I would have for that, it is quite remarkable how over all these years, over and over, there have been redesigns of architecture, of utilization of compute environments, of utilization of multiple computers, multiple cores, multiple threads that have managed to keep your question in check. We're always chasing the horizon, in other words, and this is true on the hardware side in emulation or prototyping. It is certainly true for software for a long time, and expect that to absolutely continue, and we will stay at the leading edge with that. Secondly, regarding the intersection of prototyping and software integrity I expect that we're going to start seeing some of that in the not too distant future. Far, there's not been a lot of evidence of that, we have not really pushed on that front yet either.
The intersection between prototyping of emulation, we have already seen quite a bit of that. By the way, it's the intersection of prototyping, emulation, and simulation, and in some cases even virtual prototyping. That is because the system people would like to simulate software on larger systems that have many components that may be defined at different levels of abstraction. All of this is being done. I don't want to give the impression that this is routinely easy. This is sophisticated stuff, but we're in a very strong position with this, and the most advanced customers are very literate about these type of problems.
Thanks very much.
You're welcome.
Okay, our next question will come from the line of Monika Garg with Pacific Crest. Please go ahead.
Hi. Thanks for taking my question. If I look at your guidance, even if you model at the high end of revenue guidance, seems Q4 you are guiding almost $15 million down Q-over-Q. Historically, your Q4 is at least flattish to modestly up. What is leading to such high kind of revenue down Q-over-Q, or is it just you being conservative?
No, Monika, it's really the hardware business. As we mentioned, it will vary from quarter to quarter. Outside of hardware, all the other businesses are doing well, so it's not offsetting anything, but hardware is driving the quarter-on-quarter comparison.
$50 million?
I'm sorry?
The delta is about $50 million, five-zero, if the others are up.
We have a very strong hardware business.
Okay. A similar point, your operating margins, if I have to model for the guidance, is going to be like 17%. Again, down like almost 700, 800 basis points year-over-year and Q-over-Q.
For the-
If hardware is down, operating margin should be better, right?
Again, as we mentioned in the earlier comments, expenses are seasonally up in Q4. You've got the offset of revenues coming down because of a hardware trend and expenses going up in Q4.
Got it. Can you just remind us how big is software security business now, and when do you expect it to be breakeven?
As we mentioned in previous calls, we were guiding to about $100 million last year, which we met, and the overall growth in that business is about 20%, which is tracking too. Then Cigital, when we acquired them, was roughly half of the existing business.
Okay.
The underlying business, we mentioned that the acquisitions would be dilutive to earnings this year and would affect margins. On the classic software integrity business, we are on track to break even in the second half of the year.
All right. Going forward, what is the growth rate you expect in the software security business, including the Cigital acquisition?
We're looking in the 20% range.
Okay. Aart, we saw over the weekend a big security breach. Could you maybe talk about how this could impact the software security test business?
Well, for starters.
Are you seeing any Yeah.
Yeah, for starters, we're fortunate that our own processes around upgrading our firewalls, making sure that all of the patches have been applied to software have been effective. We have not had any issues with this. Very clearly, every time there is a big story of, in this case, massive number of stories, the attention level around the notion of security goes up. We are sitting in the space where the idea is to design security in the first place, not to just fix all the things that went wrong in the past, but make it essentially correct by construction. From that perspective, I think we are in a very healthy situation.
If you amend that by the fact that Gartner, which tracks many security-related companies such as ourselves, are now putting us in the leading quadrant for the activities that we do, obviously the attention that this is getting is positive for our business, even if it's a negative for the world. We are seeing that with the acquisition of Cigital, with the commentary that Trac just gave you on the existing business. I feel that we can now state that this business has, for lack of a better term, reached critical mass. What I mean with that is that a number of years ago, we made a decision to move up from the silicon to the software.
We made a decision to bank beyond the hardware and software intersection. Moreover, this new TAM that touches many companies that in the past we had no business with, looks very promising. There were many execution challenges in getting there. I think we've navigated well through those. I'm very encouraged with where we are in the middle of 2017 because we see this vision materializing. Hopefully it's not on the back of catastrophes around us, but more on the premise that building correctly for the future is really where the software industry should go. That is where our contribution will be.
Got it. The new administration has talked about making it easier for cash repatriation. If that happens, how could we think about the usage of cash?
Monika, we are staying on top of what's developing as far as tax reform in the U.S. If it does occur, obviously I think we'll use cash the same way we've been using over the last several years. Over the last trailing four quarters, we've bought back close to $400 million in stock. We've acquired companies in the software integrity space. We'll continue to use the cash to drive growth in terms of acquisitions. Then return cash when it's appropriate via buybacks.
Last one from me on IP. You're growing double digit. Is double digit the right way to look at going forward? You've been building ADAS IP for autos for some time, are you seeing inflection in that? Thank you.
Well, for the first part of your question, yeah, we think that it is in the low double digits. So far the team has been executing particularly well, and if you look at it from the complex chips, our expectations are that we will continue to see good growth and healthy business there. I'm sorry, I couldn't acoustically hear your second part of the question.
You've been building the ADAS IP for autos for some time. Maybe, are you seeing inflection in that?
Oh, yes. Sure. Sorry. Yeah, automotive has been an interesting area because it's getting so much attention, frankly, by a whole number of people that may create a bit of a bubble there. At the same time, there's a good reason it's getting so much attention, which is, it is the showcase for what modern hardware software will be able to do to fundamentally transform a field that has been relatively slow in evolving and is now evolving very rapidly. So we have invested quite a bit over the last few years, not only to make sure that the tools are capable of dealing with these type of designs, but our IP portfolio has grown significantly in the realm of having certified IP.
Certification of IP is for one key reason, which is automotive demands a certain set of checks to make sure that what you're doing is actually safe. In the past, safety has been actually developed quite well in automotive. With this very rapid increase of both hardware and software, the complexity that comes with that is going to be a challenge for safety. The fact that we have a portfolio that is now massively certified, I think bodes very well for our position there.
Thank you so much.
You're welcome.
Our last question comes from the line of Mitch Steves with RBC Capital Markets. Please go ahead.
Hey, guys. Two questions for me, if I could. First for Aart. Just in terms of the core EDA business, that's continuing to grow at double digits now. I know you guys have talked to low to mid-single growth, but what exactly has changed there? I know the CAD business or the CAD industry is growing faster. Can you maybe highlight some changes that have happened over the past year or so?
Well, one of the key pieces is that the intersection of hardware and software has been driving verification extremely hard, a subcategory to that is really emulation and prototyping. We refer to that as hardware. That growth has just been exemplary because so many people would like to run software on hardware they don't have. Instead they use an emulator to sort of fake the hardware, if you like. I expect that to continue because, if you want to go to market, you want to start the software development as soon as you possibly can and make sure that it's going to work with the hardware that takes a long time to manufacture. That has been really one of the key variables in this game.
Got it. Secondly, for Trac, on the financial side, I'm having a hard time getting to the kind of Q4 EPS, because if I look historically, typically from Q3 to Q4, your total expenses go up by $20 million or so.
In order to get to the new midpoint that the full-year guide implies, it's going to be $30 million-plus or a 50% increase. I guess what's kind of in the financial model for Q4 that's abnormal from the past?
Well, normally, as you highlighted, the expenses do ramp up from Q3 to Q4. What we would normally see this year is an increase in hiring that's per our plan.
Right.
You would see a ramp up in variable comp as we accrue for where we think we're going to end up the year. Historically, the numbers, we can model with you offline, but your historical numbers in terms of growth might be a little aggressive. The offset to that is how you model the Q3 revenue to Q4 profile, but we can work with you afterwards.
Got it. Thank you.
Yes.
Okay, we have no further questions in queue, and we do have five minutes remaining. I'll turn it back to the Executive Board.
Well, thank you very much for attending this earnings release. Hopefully you took away that we had a very strong quarter, that the outlook for the coming quarter is strong, the overall year is looking extremely solid. Most importantly, I think the alignment around our Silicon-to-Software Strategy appears to be working quite well, and all the individual businesses have contributed strongly to our present success. With the intent to continue on that trajectory, we thank you for your support and attention.
Ladies and gentlemen, that does conclude today's conference. Thank you for your participation and for using AT&T. You may now disconnect.