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Edited Transcript of CDNS earnings conference call or presentation 21-Oct-19 9:00pm GMT

Q3 2019 Cadence Design Systems Inc Earnings Call

SAN JOSE Oct 24, 2019 (Thomson StreetEvents) -- Edited Transcript of Cadence Design Systems Inc earnings conference call or presentation Monday, October 21, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alan H. Lindstrom

Cadence Design Systems, Inc. - Senior Group Director of IR

* John M. Wall

Cadence Design Systems, Inc. - Senior VP & CFO

* Lip-Bu Tan

Cadence Design Systems, Inc. - CEO & Director

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Conference Call Participants

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* Adam Gonzalez

BofA Merrill Lynch, Research Division - Research Analyst

* Gary Wade Mobley

Wells Fargo Securities, LLC, Research Division - Senior Analyst

* Jackson Edmund Ader

JP Morgan Chase & Co, Research Division - Analyst

* Jason Vincent Celino

KeyBanc Capital Markets Inc., Research Division - Associate

* Jay Vleeschhouwer

Griffin Securities, Inc., Research Division - MD of Software Research

* John William Pitzer

Crédit Suisse AG, Research Division - MD, Global Technology Strategist and Global Technology Sector Head

* Joshua Alexander Tilton

Joh. Berenberg, Gossler & Co. KG, Research Division - Associate Analyst

* Krish Sankar

Cowen and Company, LLC, Research Division - MD & Senior Research Analyst

* Mitchell Toshiro Steves

RBC Capital Markets, LLC, Research Division - Analyst

* Richard Frank Valera

Needham & Company, LLC, Research Division - Senior Analyst

* Thomas Robert Diffely

D.A. Davidson & Co., Research Division - MD & Senior Research Analyst

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Presentation

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Operator [1]

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Good afternoon. My name is Josh, and I will be your conference operator today. At this time, I would like to welcome everyone to Cadence Third Quarter 2019 Earnings Conference Call. (Operator Instructions) Thank you.

I will now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence. Please go ahead.

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Alan H. Lindstrom, Cadence Design Systems, Inc. - Senior Group Director of IR [2]

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Thank you, Josh, and I would like to welcome everyone to our third quarter 2019 earnings conference call. I am joined today by Lip-Bu Tan, CEO; and John Wall, Senior Vice President and CFO. The webcast of this call is available through our website, cadence.com and will be archived through the 13th of December 2019. A copy of today's prepared remarks will also be available on our website at the conclusion of the call today.

Please note that the discussion today will contain forward-looking statements and that 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 we issued today.

In addition to financial results prepared in accordance with Generally Accepted Accounting Principles, or GAAP, we will also present certain non-GAAP financial measures today. Cadence management believes that in addition to using GAAP results in evaluating our business, it can also be useful to review 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. The reconciliations are available at the Investor Relations section of cadence.com. Copies of today's press release dated October 21, 2019, for the quarter ended September 28, 2019, related financial tables and the CFO commentary are also available on our website.

And now I will turn the call over to Lip-Bu.

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [3]

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Good afternoon, everyone, and thank you for joining us today. I'm pleased to report that Cadence achieved excellent operating results for the third quarter of 2019, delivering 9% year-over-year revenue growth.

Based on our strong execution and strength of our technology and business, we are, again, raising our outlook for the year. Given the uncertainty of the ongoing trade situations with China, our outlook assume current export limitations remain in place for the rest of the year. John will provide more detail on our outlook shortly.

While global economy and geopolitical uncertainty continues, long-term trends such as AI, 5G, cloud and IoT continues to drive strong design activity. The move to domain-specific computing and system companies building custom silicon as well as a host of innovative silicon startups are all pushing the technology envelope and driving the need for high-performance, low-power computing, high-bandwidth connectivity and high-density storage.

Our Intelligent System Design strategy focus position us well to maximize the resulting opportunities through building out our portfolio and providing more capabilities and value to our customers. The foundation of our strategy is the design excellence segment, which comprise of our core EDA and IP business. I will now provide some of the key quarterly highlights in this area.

A key element of our approach has been to closely collaborate with our ecosystem partners and focus on market-shaping customers. In Q3, we deepened our partnership with Samsung through a comprehensive agreement across our digital, custom and verification product portfolio.

Early this year, we had reported a breakthrough wide-ranging win with a marquee U.S. semiconductor company. I am particularly pleased that we augmented that partnership with our largest-ever IP order that included our Tensilica processor family and our design IP portfolio, including ultra-high-speed SerDes.

At its recent open innovation platform event, TSMC recognized Cadence with 4 Partners of the Year Awards, including an award for joint development of 6-nanometer design infrastructure, and 1 for joint delivery of cloud-based productivity solution.

Our Cadence Cloud portfolio has great momentum with over 50 customers using our solution in the cloud. Cadence Cloud-ready products in close collaboration with our cloud infrastructure and foundry partners are enabling our customers to realize meaningful scalability, performance and flexibility benefits from using the cloud.

Our CloudBurst model is used for hybrid cloud infrastructures where customers want to augment their on-premise infrastructure with vast capacity from the public cloud to address peak load.

Continuing strong proliferation of our digital and sign-up solutions, especially with market-shaping customers at the most-advanced nodes have driven share gains and double-digit year-to-date revenue growth. In addition to numerous 7-nanometer tapeouts, there are more than 15 customer engagements at 5- and 3-nanometer using our digital flow. MediaTek has deployed our digital full flow in production for their 7-nanometer design.

At Mellanox, leading in -- the leader in technology -- in data, connectivity solutions, Innovus replaced the incumbent solution for all of their production 7-nanometer design. We also had a digital full-flow competitive win for 7-nanometer design with a leading Japanese imaging company. Uhnder used Cadence's digital full flow, which is based on common engines and includes Genus, Innovus, Tempus and Pegasus to achieve the best quality of results and the fastest convergent of their highly innovative and completely integrated first digital automotive radar on-chip.

Next, I will discuss highlights of our system design and verification solutions. Our Palladium Z1 emulator and the recently introduced Protium X1 FPGA-based prototyping platform now provide a comprehensive solution across IP and SoC verification, hardware, software regressions and earlier software development. Growing system design complexity and the high cost of failure continues to drive strong demand for our Palladium Z1. In Q3, the Z1 added 8 new customers and had key -- and have 8 key expansions.

Rounding off our hardware family is the Protium X1, which is a perfect complement to our Palladium Z1. I'm excited by the strong customer interest in Protium X1. A global marquee customer significantly expanded their existing hardware footprint with additional Z1 capacity and Protium X1 as well, making it one of the largest hardware orders ever for Cadence.

We had several full verification suite wins in Q3, including a major customer in Asia and an automotive semiconductor company in EMEA. In IP, our focused strategy and strong portfolio have enabled us to benefit from the continuing IP outsourcing trend. In Q3, we had our best-ever quarter for IP with year-over-year revenue growth exceeding 20%. It was an especially strong quarter for our Tensilica products with additional wins in audio, imaging, computer vision and machine learning.

In system innovation segments of our Intelligent System Design strategy, we introduced the Celsius Thermal Solver, which joins the Clarity 3D EM Solver in the growing suite of our system analysis products. Celsius is a industry-first complete electrothermal co-simulation solution for the electronic system from ICs to system or to physical enclosures. Based on the proven, massively parallel architecture that delivers up to 10x faster performance with full accuracy, Celsius enables design teams to mitigate thermal issues at an earlier stage, thereby reducing system development iterations. Bosch and ARM have both endorsed these exciting new products, and we're in the midst of earlier discussion with several other customers.

Clarity, which was announced earlier this year continue its strong momentum with 4 competitive wins during the quarter and more than 30 active customer engagements underway.

With that, I will now turn the call over to John to review the financial results and provide our updated outlook.

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [4]

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Thanks, Lip-Bu, and good afternoon, everyone. I'm pleased to report we met or exceeded all of our key operating metrics in Q3. As a result of continuing robust demand for our solutions and strong execution across our business, we are increasing our outlook for fiscal 2019.

Before we get into the Q3 results, I would like to take a moment and talk about the ongoing trade uncertainties. With more companies recently added to the entity list, the situation remains fluid, and we will continue to closely monitor it. For the purpose of providing guidance for 2019, we've assumed that the current export limitations remain in effect and the entity list remains unchanged for the remainder of the year.

Now let's go through the key results for the third quarter, starting with the P&L. Total revenue was $580 million, up 9% year-over-year. Non-GAAP operating margin was 31.7%. GAAP EPS was $0.36 and non-GAAP EPS was $0.54.

Next turning to the balance sheet and cash flow. At the end of the quarter, cash totaled $655 million, while the principal value of debt outstanding was $350 million. Operating cash flow for Q3 was $139 million. DSOs were 43 days, and during Q3, we repurchased $75 million of Cadence shares.

Now I will provide our updated guidance. For Q4, we expect the following results: Revenue in the range of $590 million to $600 million; non-GAAP operating margin of approximately 30%; GAAP EPS in the range of $0.33 to $0.35; non-GAAP EPS in the range of $0.52 to $0.54; and we expect to repurchase $75 million of Cadence shares.

As a result, our updated guidance for fiscal 2019 is now as follows: Revenue in the range of $2.327 billion to $2.337 billion; non-GAAP operating margin of 31.5% to 32%; GAAP EPS in the range of $1.50 to $1.52; non-GAAP EPS in the range of $2.18 to $2.20; and operating cash flow in the range of $700 million to $740 million. You will find guidance for additional items as well as further analysis in the CFO commentary available on our website.

In summary, I'm pleased with our execution in an uncertain environment. Our strong dependable results reflect the broad diversity of our global customer base. We remain focused on driving growth in our core business highlighted by the proliferation of our digital full flow, and we continue to invest in growth opportunities with market-shaping customers and new product areas.

In closing, I would like to thank our customers, partners and, of course, our employees for their continued support.

And with that operator, we'll now take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And your first question comes from Adam Gonzalez with Bank of America.

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Adam Gonzalez, BofA Merrill Lynch, Research Division - Research Analyst [2]

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Congrats on the strong results. For the first one, I'd like to focus on the IP business. I know IP can be a little bit volatile from a rev-rec standpoint, but can you help us understand how sustainable this large boost you saw in Q3 is? Should we expect a little bit of a reversion in Q4? Does Q3 kind of represent an inflection? And if the latter, can you walk us through what the sustainable drivers are?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [3]

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So Adam, yes, as Lip-Bu mentioned in his prepared remarks, the Q3 was our best-ever quarter for IP business with impressive revenue growth exceeding 20% year-over-year. I mean, if I look back over the last 4 quarters, the trailing 4 quarters were also up 20% year-over-year on IP. But we always say that revenue for IP can be lumpy in any single quarter, half or even year. But we do believe that it's relatively sustainable over the long term.

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Adam Gonzalez, BofA Merrill Lynch, Research Division - Research Analyst [4]

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Got it. And for my follow-up, I guess, can you just give us an early view on 2020 growth based on the bookings momentum that you're seeing today?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [5]

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Sorry, can you repeat the question?

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Adam Gonzalez, BofA Merrill Lynch, Research Division - Research Analyst [6]

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Just, if you have an early view on what 2020 growth could be directionally if not in absolute value, just based on the momentum that you're seeing today for the overall business?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [7]

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We're not giving any guidance on 2020 right now. Like we say, it can be lumpy in any 1 quarter, half or even year. We'll provide that guidance in -- at the end of our year.

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Operator [8]

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Your next question comes from Gary Mobley with Wells Fargo Securities.

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Gary Wade Mobley, Wells Fargo Securities, LLC, Research Division - Senior Analyst [9]

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Congrats on another strong quarter. I realize that you're probably going to be filing your 10-Q in about 3 hours or so. But can you give us a preview into what the remaining performance obligations were at the conclusion of the quarter?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [10]

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Yes. I think it's filed already. The contracted but unsatisfied performance obligations were approximately $3 billion at the end of Q3, including approximately $200 million of our IP access arrangements. Those IP access arrangements are noncancelable commitments from customers, where product selection and quantities are determined by customers each quarter.

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Gary Wade Mobley, Wells Fargo Securities, LLC, Research Division - Senior Analyst [11]

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Okay. So that's up about $200 million sequentially, if I'm not mistaken. All right. I've multiple question on your systems analysis business. Lip-Bu, you mentioned 4 wins for Clarity in your prepared remarks. In relation to those 4 wins, in the early activity in the 30 engagements that you have, how successful are you in your ability to separate these licensing deals from existing EDA customers, in other words, monetize them above and beyond your existing revenue run rate for existing customers?

And can you share with us what your typical deal size may be for these types of wins and as well, perhaps when you can start to recognize some revenue from these 4 early Clarity wins?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [12]

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Yes. Thank you for your question, Gary. I think couple of things. First of all, I think that we have our approach of the system analysis space and that's something that's really our core competence of computational software and that we can apply into this complex system analysis space. And then we have this 2 new product, initially we announced at Clarity. That is the 3D EM solver. We are delighted. We have 4 competitive wins and this is a very new product for us. And we have more than 30 active customer engagements going forward. And so we're excited about that.

And then meanwhile, we just announced our Celsius Thermal Solver. And again, back to that computational software strength that we have and we clearly demonstrate that up to 10x performance and customers are delighted to see our performance, specifically they are Bosch and ARM, they both endorse our new products and we're in middle of earlier discussion.

So it's still in a very early stage of our emerging into the system analysis, and more and more, our customer love that because beside the EDA, beside the IP, they want to look at the total system solution, simulation, whether it fit the whole system, power, thermal envelopes. And something that we can really demonstrate and provide the best solution for the customer. So it's still very early.

And in terms of our pricing, again, it's not part of our EDA, and so we do it differently and basically, close to the market competitive pricing, and -- but in a very early stage of winning and then, stay tune, over time, we will unfold and give you a progress update.

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Operator [13]

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Your next question comes from Jackson Ader with JPMorgan.

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Jackson Edmund Ader, JP Morgan Chase & Co, Research Division - Analyst [14]

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Can we just start with hardware? So it looks like verification was the segment that probably struggled the most year-over-year. And we've seen inventory balances tick up the last couple of quarters. So I'm just curious if this maybe a building of some hardware ahead of pipeline? Or are we seeing any kind of struggling close rates in that hardware business?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [15]

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Yes. Let me start first, Jackson, and then John will give you more detail about the inventory. So I think first of all, I think Functional Verification remained the fastest-growing challenge for our customer. And I mentioned, in Q3 we are delighted to deepen our partnership with Samsung through comprehensive agreement across not just digital custom and also verification products. And then the Palladium Z1 had been doing great and the customer love it on the hardware emulation, but now we add the Protium X1 FPGA-based prototyping that we can provide a comprehensive solution across IP and SoC verification, especially for hardware, software regression and earlier software development. That combination using the same front-end software make it easier for the customer. And so I think we clearly see that in new customers and in key expansions, and so I think we are just delighted and very pleased Protium is giving a lot of opportunity for us. And we also highlight a global marquee customer significantly expanded their existing hardware footprint with additional Z1 capacity and add on the Protium X1 as well make us -- make that one as a larger -- one of the largest hardware orders for Cadence. So I think all in all, we see strength. And then I think John can highlight the reason of building up the inventory.

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [16]

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Yes, yes. Jackson, as Lip-Bu says, I mean our hardware solutions are proving to be very robust in the marketplace and cost demand is good. Q3 results were slightly up on Q3 '18, but we were building inventories heading into Q4 because we have a strong pipeline going into Q4.

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Jackson Edmund Ader, JP Morgan Chase & Co, Research Division - Analyst [17]

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Okay. That makes sense. And then, 1 quick question, a follow-up on the 30 customers, the Clarity engagement. Can you give us any kind of industry sense for those? Is it significantly different from the Cadence customer base in EDA?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [18]

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Yes, I think both and not just on semiconductor, many other system companies and -- because you really see the value of the -- up to 10x performance and also tie in very well with the -- from the systems simulation down to the silicon emulation that fully integrated, it's a complete that customer love.

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Operator [19]

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Your next question comes from Rich Valera with Needham & Company.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [20]

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First, just a clarification. Congratulations on the large IP order that you mentioned was from the marquee customer you had referenced previously. I just wanted to clarify, is the significant hardware order as well from the same marquee customer or was that a different one?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [21]

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Yes. So I think what we mentioned earlier is that IP deal is with a global semi -- U.S. semiconductor company -- marquee U.S. semiconductor company. And then the hardware clearly is a marquee -- global marquee company. And they're already our customer, but they are increasing their hardware capacity plus the Protium that they like a lot, and so that they're fully integrated and make it one of the largest hardware orders.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [22]

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Got it. So they are different customers though is it, just to be perfectly clear?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [23]

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Yes. Yes, yes.

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [24]

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Yes.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [25]

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Okay. And then moving on to the system products. First, just wanted to understand, you mentioned that Bosch and ARM had endorsed, and I think you said both of these products, I just wanted to clarify that that was in fact an endorsement of both Celsius and Clarity. And then if that's the case, have either of them actually purchased Clarity? Are they among those 4 competitive wins you have for Clarity?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [26]

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Yes. I think we mentioned Bosch and ARM endorse the Celsius product. And the Clarity, we mentioned about 4 competitive wins and then plus another 30 active customers. So there's a differentiation here.

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Richard Frank Valera, Needham & Company, LLC, Research Division - Senior Analyst [27]

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Got it. Understood. And then, I know this is a tough subject, but just wanted to see if you're willing to say sort of anything about China as we look into next year. This year, you've had a number of customers put on the entity list. And you had the benefit of getting revenue from them for, in some cases, 3 quarters of the year, in some cases, maybe a couple of quarters. And as we head into next year, if the entity list sort of stays the same, you'd have kind of a full year, in essence, headwind from those customers. But I guess recently, there's also been some policy put in place in China whereby they're actually providing incentives for companies to purchase both EDA tools and IP, which could conceivably be a tailwind for you in the country. So just wondering if there's anything you can say about sort of China as we look into next year. There's a lot of sort of factors at play. I know you don't want to give numbers, but just any thoughts there, that would be helpful.

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [28]

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Sure. So let me just touch on. First of all, I think clearly Cadence has and will continue to comply with the United States Department of Commerce export control. And as I mentioned, that situation is fluid and we're monitoring carefully and even with this uncertainty, but we assume current export limitations remain in place for the rest of the year. So we -- our guidance is already provide everything we know in this and we are not -- and so I think this is kind of where we are. John?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [29]

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Yes. And clearly, we're not going to speculate on -- in terms of how that plays out for next year. But you're correct in your assessment that in some cases, for some customers, we had revenue in the first half of the year and the second half of the year is quite different now. We do have some headwinds. If there is no change, those headwinds will persist into next year.

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Operator [30]

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Your next question comes from Tom Diffely with D.A. Davidson.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [31]

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Another question on the IP. Just curious, is the sequential growth solely due to the one large customer or did you see a broad base increase in IP demand as well?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [32]

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Yes. Let me start first. Clearly, the -- our focus strategy and strong portfolio in IP and in fact, we keep on adding more IP portfolio beside the Tensilica, the memory, connectivity and we are excited about high-speed SerDes that we bought from nusemi and that 112-gig SerDes is a must-have from a lot of data center infrastructure build up and hyperscale guys really like it. And so I think we have a very -- we're pleased with our portfolio, and we are laser-focused on our strategy, focused on the leading customer and then focused on the advanced nodes and then focused on something that we can scale.

And then so far, I think we have a very broad portfolio, but meanwhile, we are very delighted. And I mentioned earlier, this marquee semiconductor company beside we have wide-ranging win and now we add on this largest IP not just include Tensilica family, also include the design IP portfolio. We are excited about it just add on top of it, and we are really pleased with the progress. And IP is like the building block of the system. You really need the -- I call it the star IP that they must have, and we are really focused on the star IP.

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [33]

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Yes. We're very pleased with the consistent execution there in IP and they had a very strong finish to last year. They had a very strong Q1. Q2 was kind of flat on Q2 last year and then we had a strong Q3. But as with all these things, of course, it creates a tough compare going forward.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [34]

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Do you see any natural seasonality in that business or is it purely project-based?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [35]

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It's purely project-based and there's -- it's kind of random from a seasonality standpoint.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [36]

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Okay. And then finally, John, in the press release, you mentioned kind of a reorganization of some international offices that you had.

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [37]

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Yes.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [38]

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And the impact on taxes going forward? Wondering if there is something you can say anything on that?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [39]

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Yes. I mean, that's a GAAP-only thing. I mean, in October 2019, we initiated a series of transactions involving an internal realignment of our international operating structure and that realignment may significantly increase our foreign deferred tax assets. As you know, deferred tax assets are recognized when the depreciation of the asset is expected to offset future profit. So there's a lot of calculations that go in to try and estimate the value.

We've not completed our analysis and cannot yet estimate the impact, but we expect to complete the analysis and record the income tax impact in the fourth quarter of 2019. We wanted to highlight that in our CFO commentary because our current GAAP guidance in the -- basically doesn't account for this change. So we just wanted to highlight that that piece is open.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [40]

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Okay. But no non-GAAP impact going forward?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [41]

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That's right.

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Operator [42]

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Your next question comes from Mitch Steves with RBC Capital Markets.

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Mitchell Toshiro Steves, RBC Capital Markets, LLC, Research Division - Analyst [43]

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Just 2 for me. Just regarding China in terms of historical. Last quarter, you guys kind of had a blowout quarter, with it being up 68% and then now it's up about 21%. Is there any way to confirm there's potentially some hardware pull and just given the Huawei dynamics last quarter and that's the reason why it's down sequentially or am I reading too much into it?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [44]

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Overall, China was, what, 10% of revenue in Q3. Now that's down from 12% in Q2, but flat from kind of Q1. It was -- I think it was 10% in Q1 as well. But we've seen variability in our China revenue mix over the last 6 quarters. It's ranged from a low of, I think, 8% back in Q2 '18 to a high of about 13% in Q4 '18. Back in Q4 '18, we did experience a hardware pull-in, and we did see the first half was quite strong for hardware. Q3 has been a little bit lighter for hardware and that's shown up in gross margin. But like I say, we -- the hardware pipeline is strong for Q4 and hardware can be lumpy in any one quarter.

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Mitchell Toshiro Steves, RBC Capital Markets, LLC, Research Division - Analyst [45]

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Okay. That makes a lot of sense. And then, secondly, I mean, EDA is probably one of the better way it's placed maybe over the next say, 5 to 10 years. But one thing that I'm noticing here is like your employee count is actually increasing pretty significantly, going from like 4% growth to 8%. I just want to be clear here if I look out over the next, like, let's call 3 to 5 years, that your OpEx is still going to undergrow the revenue line. Is that a fair assumption? Because it looks like it's actually pretty close now at this point.

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [46]

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Yes. We're not guiding anything on 2020 right now. But you're right to point out that, yes, head count has grown because we're investing in opportunities for proliferation and market-shaping customers and new products.

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [47]

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And in some way, we are very excited about the environment because, as I mentioned, the couple of big drivers, AI, 5G, cloud and IoT, and then the whole data infrastructure is because of AI and all these driver, there's a very big changes requirement are needed. And so we have a suite of startup and system company. They're all try to meet the new requirement. So there's a lot of innovation happening, and so we see the design activities increase. And that's why I think also we have a proliferation of our digital flow and also some of the key market-shaping customer that we are being adopted. And so we're building up the engineering and also the FAE support to win some of these account and then proliferating. And that's why John and I, we only increase the head count when we see the deployment and also the commitment from the customers.

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Operator [48]

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Your next question comes from John Pitzer with Crédit Suisse.

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John William Pitzer, Crédit Suisse AG, Research Division - MD, Global Technology Strategist and Global Technology Sector Head [49]

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Listen, I guess, my first question is just on the relatively new North American customer, clearly, additive to the September quarter. I'm wondering if you could just help me understand how we should be thinking about sizing that business over multiple years; and how that business scales for you as that customer continues to move down nodes.

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [50]

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Yes. So I think clearly, we don't guide any 2020 outlook. But we're excited about -- I don't know quite sure, new North America, but we only mentioned about marquee, the semi -- U.S. semiconductor company. We are excited about the partnership, and we're expanding -- beside the 2, expanding the IP proliferation and that part will continue. We're excited about it.

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John William Pitzer, Crédit Suisse AG, Research Division - MD, Global Technology Strategist and Global Technology Sector Head [51]

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That's helpful. And then as my follow-up, Lip-Bu. Just going back to your comments about AI, I'd be kind of curious if you could size how big that business is, either as a percent of overall revenue or maybe of the growth. And I guess specifically, the semiconductor industry went 10 or 15 years without a lot of venture capitalist money and that's clearly changed around AI and there's somewhere between 40 to 60 potential AI startups that are getting funded. I'm just trying to get a sense of how important that is to your growth in the near term. And kind of do you think that all of these companies are going to be viable or is it more likely that this consolidates? And if it's the latter, how do I think about kind of the AI revenue stream unfolding from here?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [52]

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Yes. I think in that AI implication to the whole industry can be quite significant. If you look at the university like MIT, there's a group called the school of -- new school of computing, they just raised $1 billion for that. Same thing with CMU, Carnegie Mellon, and I'm on the trustee, and now they are just offering the AI degree for undergrad. And then you can see the SoftBank, the Vision Fund 2 is focused on AI. So you can see the AI implication.

And in fact, you are correct. If you look at the semiconductor growth recently and in terms of funding, a lot is driven by AI. AI is not just semiconductor; it's applied into all the different vertical industries. So the impact can be quite huge. And we're excited about this opportunity. The design activities increase a lot. And so I think all in all, I think clearly, we have a very good position. We have the AI, machine learning application to our tool. So we see significant improvement in terms of our various tool, in terms of PPA run time and verification. So we are embarking on improving our tool so that we can get the best product to meet the customer requirement.

And the AI development is not just a startup. All the big hyperscale guy and all the big system company, they all have various degree of investment into AI. And then we also, our Tensilica that's a very clear good engine for some of the AI application like the audio, video and various others and we are trying to build the software stack on top of the AI platform, so that we can provide a solution to our customer for the various vertical market they try to address.

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John William Pitzer, Crédit Suisse AG, Research Division - MD, Global Technology Strategist and Global Technology Sector Head [53]

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That's helpful. And then if I could just get a quick financial one in for John. John, just given what you guys did in the September quarter and in the year-ago quarter, I'm just kind of curious, your op margins sort of guidance for the December quarter. Can you help me understand why it would be down sequentially year-over-year rather than just an abundance of conservatism on your part?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [54]

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Yes. And so we haven't changed how we guide. I mean, we guide the same way all the time. But essentially, it's the same as where we were this time last quarter. Last quarter, we guided Q3 at 30% for op margin and Q4 for 30%. In Q3, the beat was mainly on the gross margin side. I mean, we assume gross margin comes out at about 90% in our estimates and we did better in Q3. It came out at, I think, it was at 91.6% and we landed at 31.7% for op margins. So most of the beat on the op margin side in Q3 was a result of gross margins.

My expectation for Q4 is that we have a significant hardware pipeline heading into Q4. It was kind of similar. It reminds me of where we were this time last year. And last year, our gross margin ticked down, I think, 200 basis points from Q3 to Q4. So we're expecting about 30%. And that's because you've got a combination of things happening, right? You've got Q3 and Q4, we're assuming that there's no change in export limitations right now. We're also investing in proliferation opportunities, market-shaping customers and in new product areas. So that's what's driving the numbers.

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Operator [55]

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Your next question comes from Jay Vleeschhouwer with Griffin Securities.

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Jay Vleeschhouwer, Griffin Securities, Inc., Research Division - MD of Software Research [56]

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Question for you, John, first. You noted in your prepared remarks the $200 million or $212 million to be precise, in IPAA commitments. This is not a metric that I think you've disclosed before until tonight's Q. Was that amount due mostly, if not solely due to a single customer? Or is it fairly broadly based in terms of numbers of IT customers comprising that? And then secondly, just a longer-term EDA market question for -- to Lip-Bu.

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [57]

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Yes, Jay. Thanks for pointing that out. Yes, the -- that was an issue we had with how remaining performance obligations were calculated. In the past, we reported backlog under the old rules. And we would have included our IP access arrangements. And then, under the new rules, the remaining performance obligations didn't include IP access arrangements and it didn't seem to be consistent with how we reported in the past. So we worked with our auditors just to say that we wanted to disclose it because, as you say, now, as of Q3, it's $212 million the exact number. But the $3 billion that we have in contracted but unsatisfied performance obligations is more comparable to the backlog that we had at the end of last year.

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Jay Vleeschhouwer, Griffin Securities, Inc., Research Division - MD of Software Research [58]

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Okay. So Lip-Bu, maybe a 2-part technology or market question. First, you often use the term market-shaping customer. And it's frankly a somewhat odd expression. How do you define customers that fall into that category? And more specifically, how do you dedicate resources to those customers in terms of commitments and so forth?

And then, a growth question. We've seen a number of categories in EDA have extended periods of consecutive growth. For example, the industry data, and of course, your numbers, the custom category has had more than 30 consecutive trailing 12-month periods of growth, IC implementation more than 16, PCB 12. So that's all very good, of course, but historically, EDA growth cycles for particular categories don't last for more than 3 to 4 years, 3 to 4 years each. But we've now seen multiple categories that are meeting or beating historical periods of consistent growth. So what's your thinking in terms of sustainability or what's different now vis-à-vis the different categories?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [59]

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Yes. So Jay, thank you for these questions. And let me address 1 each time. So first of all, about market-shaping customer. The definition is that they're clearly the leaders in their sector. And so they're the most demanding customer, but because they are leader, they are driving the innovation, they're driving the performance. And we want to be the partners for them, the trusted partner to enable their innovation, to continue their leadership in the marketplace in the various different vertical market or the platform that they create. We want them -- we want to be the partner for them. And that is how we define the market-shaping customer.

In terms of growth, as I mentioned, you can see in my passion. Clearly, in a way, we are not creating the changes, we arrive with the wave. And the beauty part in this particular junction of the industry, there's a 5 different wave driving the growth and they're changing the landscape of the requirement. As I just mentioned, one example, is AI and now we're moving into, I call it, the data-centric economy. It's all about data. And then today, it's only 2% of the data being analyzed and being utilized. So there's a humongous opportunity.

And then this is applying to across all the different vertical and it's really driving the change to the memory, driving the change of the storage, driving the domain-specific processor. So in a way, it's workload-specific, depending on different workload, different market require different -- rather than just CPU/GPU or FPGA, there's a new class of workload that require different type of processor. And then we're also driving the memory, the storage, the infrastructure in terms of able to cope with the data, massive, massive explosion of data. And then so, all this is going to require new innovation in order to support that. Like, for example, the programmability, the scale out the storage and network and then scale out the top of the rack all the way to top on the spine in terms of the infrastructure, 12.8 terabyte per second to 51.2 terabytes per second switch. And all the high-speed interconnecting and that's why the SerDes is so important for high speed. And that's why Cadence bought it and then we're going to triple down on it to really drive the requirement that the hyperscale and the big infrastructure player need that.

So I think it's going to be driving a lot of new innovation in semiconductor side, and we are learning and we're trying to be the trusted partner to fulfill some of these requirements. And that's why I mentioned earlier, the design activity increased a lot. And we're excited about it and it's just the beginning of it.

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Operator [60]

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Your next question comes from Jason Celino with KeyBanc Capital Markets.

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Jason Vincent Celino, KeyBanc Capital Markets Inc., Research Division - Associate [61]

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Just 2 for me today. The first one, with your Q4 pipeline for your hardware business, you talked about more modest growth this year following a tough comp from last year, but if the pipeline holds, could we see some upside to that modest growth commentary that you provided previously?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [62]

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Yes. Jason, the -- it's kind of hard to move the needle in 1 quarter. I mean, if you look over the total year, we're expecting kind of low to mid-single digits growth for Functional Verification for the year. Although, if you do look over like the trailing 4 quarters to the end of Q3, I think Functional Verification is up kind of high single digits. But the challenge this year has been tough comps, and like I say, we enter into Q2 optimistic with a strong pipeline.

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Jason Vincent Celino, KeyBanc Capital Markets Inc., Research Division - Associate [63]

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Okay. Great. And my next question has to do with your system analysis business. So you announced the electromagnetic solver in April time frame and then you came out with your second solver, the thermal solver in September. I'm not necessarily looking for specific timing, but can you just remind us what other solvers we could expect?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [64]

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Yes. So I think this is just our initial entry to the system analysis using our core computant on computation software. And stay tuned. I mean, we are just beginning. We have -- first product came out in April as you correctly point out, with good tractions. And now the second product came out. People love the performance. They're excited about it.

We are continuing to investing and it tie-in also very well with our PCB business and that the whole system modeling, system simulation will be really exciting area for us. So stay tuned. And we will update you when we announce any new products.

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Operator [65]

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Your next question comes from Joshua Tilton with Berenberg.

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Joshua Alexander Tilton, Joh. Berenberg, Gossler & Co. KG, Research Division - Associate Analyst [66]

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It appears as if the drivers of design starts today address a broader set of companies relative to previous drivers such as maybe mobile. So I'm just curious how does having a broader set of addressable companies benefit Cadence?

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [67]

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So yes, having a broader set of companies benefits us because Cadence revenue and growth generally tracks design starts, right? The more design starts are, the better it is for Cadence business.

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [68]

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Yes. So I think we like to broaden the customer and applications so that we can really find new opportunity and new solution to support them, either in the automotive or 5G or AI or cloud or huge opportunity in industrial IoT and providing the solution for the system infrastructure player, and so that we can broaden the customer requirement. And that greater diversity to our customer is always good.

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Joshua Alexander Tilton, Joh. Berenberg, Gossler & Co. KG, Research Division - Associate Analyst [69]

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Okay. That make sense. And then just as a follow-up. In the prepared remarks, you mentioned customers were adopting a full digital flow. It was my understanding that companies tend to build their flow using products from both you and other competitors. So are we just starting to see customers standardizing their flow from 1 vendor?

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [70]

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Yes. So I think when you move down the geometry to 7 to 5 to 3, try to integrate different product, different tool from different customer, that means that you have to build internal team to do all the integration. And also you have a lot of opportunity to fail because the different tool have different methodology. And so the customers starting to really focus on getting a full flow, the best -- I think it's very important. Our focus first of all is to have the best of breed for each product line, like the Innovus we mentioned earlier for place and route. Right now, it's a majority, over 70% of the customer are adopting it in the most advanced nodes. And then now we have the Genus come out, very strong, and then Tempus come out and Pegasus. The customers are starting to see that not only the best of breed of product and also how to integrate them, how to optimize them and correlations among all the different flow that we've been talking about last few years. And so right now, we can not only have the best of breed for each product, now we can integrate, and that's why you're starting to hear that we mentioned a lot about digital full flow that our customers depend completely on us on the most advanced node in the 7 and 5 and 3 and that's the way we're going to continue to support the customer.

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Operator [71]

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Our last question comes from Krish Sankar with Cowen and Company.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [72]

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Lip-Bu, I had 2 of them. One is, you guys are definitely getting a good traction with your hyperscale customers. I'm kind of curious, I've seen hyperscale customers build their own silicon. How are their requirements for EDA different than your traditional semiconductor customers? Do they see one way towards IP blocks or whatever it is? Any color on that would be helpful. And then I have a follow-up.

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [73]

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Okay. Clearly, we are excited about the hyperscale players. They are going to be very important for our industry because they are quietly building up. As I mentioned earlier, their workload requirement have changed and it's more about data. And then, so that domain-specific processing development and also in the server, into the data storage network, scale out going to be even more and more important for them. And great partners for us and great customer, and we love them. And first of all, they are a bit different on our semiconductor players. Time to market is more important to them and also performance, scalability is most important to them. And that part, I think we worked very -- from the early days, we are already working and partner with them, and we are also very excited about the cloud infrastructure that we also support the cloud infrastructure using some of our tool to do that. We continue the leadership on that.

So I think in multiple expects, we are working with our partners in the cloud and we are excited about the opportunity.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [74]

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That's very helpful, Lip-Bu. And then a follow-up for either you or John. Is there a way you can size the hardware market this year? How big is it? And within that, the different subsegments like FPGA, HAPS, how big are they? Any color that would be helpful.

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John M. Wall, Cadence Design Systems, Inc. - Senior VP & CFO [75]

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Yes. I don't have any breakdown in terms of the market data that I can share with you today. But we are very, very happy with how our year is going and with the strong pipeline that we have leading into Q4.

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Operator [76]

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There are no further questions at this time. I'll turn the call back to Lip-Bu for closing remarks.

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Lip-Bu Tan, Cadence Design Systems, Inc. - CEO & Director [77]

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Thank you all for joining us this afternoon. Next phase of our strategy, Intelligent System Design, brings new opportunities in design excellence, system innovation and pervasive intelligence in an expanded total addressable market. We are capitalizing on multiple technology trends and further proliferating our solutions with a broader base of customers.

And in closing, I would like to thank all our shareholders, customers and partners, the Board of Directors and our hard-working employees for their continued support.

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Operator [78]

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Thank you for participating in today's Cadence Third Quarter 2019 Earnings Conference Call. This concludes today's call. And you may now disconnect.