Synopsys - Q2 2023

Transcript

Operator (participant)

Ladies and gentlemen, welcome to the Synopsys Earnings Conference Call for the Second Quarter of Fiscal Year 2023. At this time, all participants are in a listen-only mode. After the speaker's remarks, we will conduct a question-and-answer session. If you would like to ask a question during this time, press star followed by the one on your telephone keypad. If you would like to withdraw your question, again, press the star one. If you should require assistance during the call, please press star followed by zero. Today's call will last one hour. As a reminder, today's call is being recorded. At this time, I would like to turn the conference over to Trey Campbell, Senior Vice President in Investor Relations. Please go ahead.

Trey Campbell (SVP of Investor Relations)

Thank you. Good afternoon, everyone. With us today are Aart de Geus, Chair and CEO of Synopsys, and Shelagh Glaser, 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 are subject to many risks and uncertainties that could cause actual results to differ materially from what we expect. Important factors that may affect our future results are described in our most recent SEC reports and today's earnings press release.

We will refer to certain non-GAAP financial measures during the discussion. Reconciliations to their most directly comparable GAAP financial measures and supplemental financial information can be found in the earnings press release, financial supplement, and 8-K that we released earlier today. All of these items, plus the most recent investor presentation, are available on our website at synopsys.com. In addition, the prepared remarks will be posted on our website at the conclusion of the call. With that, I'll turn the call over to Aart de Geus.

Aart de Geus (Chair and CEO)

Good afternoon. We delivered excellent results in the second quarter, exceeding all our guidance targets while reaching another quarterly revenue record. Revenue of $1.395 billion was above the high end of our guidance range, with non-GAAP operating margin at 33.3%. GAAP earnings per share was $1.76, while non-GAAP earnings per share was above the high end of our target range at $2.54. We generated $703 million of operating cash flow and increased our backlog to $7.3 billion. The market is playing out much as we expected when we planned the year. Demand is weaker for semiconductors overall, with consumer markets most impacted. Despite choppy macroeconomic conditions, customers continue to prioritize R&D for new chip designs so that they emerge stronger when demand accelerates.

The transition to smart everything is well underway and will drive significant long-term growth for semiconductors and outsized contribution for us. Against this backdrop, we planned and are executing accordingly. Based on continued strong design activity and high confidence in our business, we are raising our full year revenue guidance range to between $5.579 billion and $5.83 billion. We're increasing our year-over-year non-GAAP operating margin improvement expectation to 150 basis points, up approximately half a point versus prior guidance. We are raising our full year non-GAAP EPS range to between $10.77 and $10.84. Sheila will discuss the financials in more detail. Let me give some color for the quarter. In March, we held SNUG, our yearly Synopsys Users Group conference in Silicon Valley.

Including its follow-on roadshows, we bring together over 12,000 passionate design engineers around our common focus of driving innovation in chip and system design. Live after three years of COVID, the conference was fantastically engaging. Our audience fully recognized how design parameters and product requirements have become exponentially more complex and interwoven, accelerated by the breakthroughs of multi-die designs. Simultaneously, the end market hunger for smart everything puts huge pressure on increasing performance per watt to the limit. On top of that, security and safety are now becoming mandatory everywhere. Synopsys' vision and mission of smart, secure, and safe thus sets both a high bar and foreshadows great opportunities for our customers and our company. Users told me, though, that while system complexities are growing exponentially, design resources are not. Design productivity thus requires a catalytic step function change in our approach.

To us, this inflection comes from AI. We are embedding AI in everything we do. We have made world-class advances in design flow automation. Our customers are now adopting Synopsys AI on production designs at a remarkable rate. This is not by accident. 12 years ago, we called out a vision of smart everything, unleashed by the intersection of big data and machine learning. Since then, we applied ML everywhere on our product offering. In 2017, we decided to harness AI for entire design subflows and began investing in DSO.ai, where DSO stands for Design Space Optimization. We rapidly progressed from prototype to customer validation of AI-driven results in 2019.

Recognized by the AspenCore World Electronics Achievement Award for Innovative Product of the Year in 2020. The following year, at the 2021 Hot Chips conference, we unveiled our pioneering AI journey and roadmap, showcased by a slew of remarkable results. DSO.ai delivered not only better speed and power on large and complex design blocks, but it did so in a fraction of the time, meaning months down to weeks, while requiring fewer, less specialized designers. This did not go unnoticed, as it had been validated weeks earlier by Samsung, an early partner, announcing the world's first AI-driven commercial tape-out with DSO.ai. By the end of 2022, adoption, including nine of the top 10 semiconductor vendors, had moved forward at great speed with 100 AI-driven commercial tape-outs.

Today, the tally is well over 200 and continues to increase at a very fast clip as the industry broadly adopts AI for design from Synopsys. We have not sat still. At SNUG, we unveiled the industry's first full-stack AI-driven EDA suite, Synopsys.ai. Specifically, in parallel to second-generation advances in DSO.ai, we announced VSO.ai, which stands for Verification Space Optimization, and TSO.ai, Test Space Optimization. In addition, we are extending AI across the design stack to include analog design and manufacturing. Partners in the announcement included NVIDIA, TSMC, MediaTek, Renesas, and IBM Research, all providing stunning use cases of the rapid progress and criticality of Synopsys.ai to deliver their breakthrough results. As an example, Renesas achieved up to 10x improvement in reducing functional coverage holes and up to 30% increase in verification productivity.

This is substantial progress, yet it's still only the beginning of our AI journey. The roadmap of optimizing, automating, and generative AI use cases is wide open to deliver productivity breakthroughs for years to come. Turning now to our segment results, let me start with design automation, which accounts for roughly 65% of Synopsys revenue. Design automation had a very strong quarter with robust order and revenue growth. Let me lead off by recognizing the one year anniversary of Synopsys Cloud, the industry's first and only SaaS solution that provides customers with a completely browser-based experience, optimized compute, and pre-configured EDA flows. We're seeing excellent momentum as customers gain significant time to market advantages with the industry's only cloud-optimized, pay-per-use business model, providing on-demand tool access with cloud-scale elasticity.

In the past year, we have doubled our customer base every quarter this year with the SaaS model accounting for 70% of users. Market adoption of our Fusion Compiler continues to grow across vertical segments and manufacturing nodes. This quarter, we won many major designs, including wins at two top Asian semiconductor companies and a leading high-performance computing company. Fusion Compiler is leading advanced three nanometer node tape-outs with roughly two-thirds of designs exclusively using Synopsys flows. We continue to drive our design automation leadership. In Q2, we announced a collaboration with TSMC to deliver digital and custom design EDA flows on their most advanced two nanometer process node. Our full EDA stack, complemented with the timeliness of IP offering, allows designers to jump-start their two nanometer designs, differentiate their SOCs, and accelerate their time to market.

Expanding from digital, we continue to grow and displace competition in the custom design market. We earned 8 new design wins in Q2, giving us 23 wins year-to-date. We also benefit from a growing pipeline of top customers using Synopsys for advanced node retargeting. Transitioning to multi-die chip design, we're leading the industry's transformation from monolithic SOCs to multi-die systems with a comprehensive and scalable solution for fast heterogeneous integration. In Q2, we deployed our multi-die VCS functional verification at a leading U.S. high-performance computing customer, delivering more than 2x faster turnaround time. We also announced our collaboration with TSMC and Ansys for multi-die system design and manufacturing, providing the industry's most comprehensive EDA and IP solutions on TSMC's advanced process technologies. We've often talked about the unbounded demands for verification. The need for verification acceleration is unrelenting.

Our customers want more, more throughput, more capacity, and more energy efficiency, all with lower total cost of ownership. This quarter, we announced ZeBu Server 5, the industry's first emulation system with unmatched capacity to enable electronics digital twins of advanced SoCs. ZeBu Server 5 delivers this with 2x higher throughput and 2x lower energy usage compared to our previous generation. We are seeing pull from a broad range of semiconductor system and hyperscaler companies with exceptional adoption results. One large semiconductor company saw ZeBu Server 5 deliver a 40% reduction in compile times on multiple large designs. Finally, I want to highlight a breakthrough on the manufacturing front that NVIDIA announced at its March GTC conference. Current lithography is nearing the limits of what physics makes possible.

Our collaboration with NVIDIA remedies this, by running Synopsys OPC optical proximity correction software on NVIDIA's computational lithography platform named cuLitho. Our collaboration massively reduces compute time from literally weeks to days. Let's move to design IP, which is roughly 25% of our revenue. This quarter, we're celebrating 25 years of being in the IP business. Starting with simple building blocks and interfaces then, we now provide entire IP subsystems. Today, we have over 7,500 IP components supporting 340 process technologies, all driven by the same smart, secure, and safe innovation imperative. Momentum in the business is very strong, with demand fueled by high-performance computing, automotive, and mobile applications, where smart everything devices need high speed and secure connectivity, increasingly architected for multi-die systems.

These systems drive the need for state-of-the-art high-speed die-to-die interfaces led by UCIe, or Universal Chiplet Interconnect Express, which is rapidly becoming the industry standard. We continue to build technical leadership in advanced nodes. In Q2, we received outstanding silicon results on our 224G PHY IP, already demonstrated at multiple conferences. We're also achieving excellent silicon results and customer engagement on the advanced 3 nanometer process across multiple IP products, including our high-speed interfaces and Foundation IP. Third, the Software Integrity segment, which represents around 10% of our revenue. Another milestone here as well, as we just passed the $500 million mark in trailing 12 months revenue. The imperative for security and quality in software is vital. Today, every meaningful business is a software business.

Our solutions help companies improve and manage security and quality vectors across a broad set of vertical end markets. While this part of our business is the most affected by the challenging macro environment, we delivered solid growth with notable wins across vertical segments, including technology, financials, healthcare, and telecommunications. We also continued to see most of this segment's revenue driven by customers adopting two or more of our solutions as they consolidate providers for efficiency and economics. One last closing point. This week we released our 2022 ESG report. Throughout this call, I have highlighted the privilege of delivering world-changing technology. For Synopsys, this starts with a commitment to maximize our positive impact and to use our influence to drive broad-based change. I encourage you to read our full report at synopsys.com.

In summary, we had excellent Q2 financial results and operational execution, growing confidence in the second half of the year. We're raising our guidance for full year revenue to between $5.79 billion and $5.83 billion. Sorry, the cents was mistaken here. We now expect to improve full-year non-GAAP ops margin by 150 basis points versus last year. We are raising our year-over-year non-GAAP earnings per share growth expectation to 21%-22%. We have a resilient business model, uncommon in most software companies.

Despite expected macroeconomic headwinds throughout the year, our customers continue to prioritize investments in the chips, systems, and security that will position them for future growth. As you heard, we continue to invest in advanced technologies, multi-die design solutions, state-of-the-art IP, and the leading-edge EDA AI-driven suite to make this decade of smart, secure, and safe products happen. I would like to thank our employees and our partners for their dedication and passion that makes this possible. With that, I'll turn it over to Shelagh.

Shelagh Glaser (CFO)

Thank you, Aart. Q2 was a record revenue quarter, and we delivered revenue and EPS above the high end of our guidance range. Our strong results are driven by our execution and leadership position across our segments, robust chip and system design activity despite macro choppiness, and a resilient, stable, time-based business model with $7.3 billion in non-cancellable backlog. We remain confident in our business and, as a result, we are raising our full year targets for revenue, non-GAAP operating margin improvement, and EPS. I'll now review our second quarter results. All comparisons are year-over-year unless otherwise stated. We generated total revenue of $1.395 billion. Total GAAP costs and expenses were $1.108 billion. Total non-GAAP costs and expenses were $930 million, resulting in non-GAAP operating margin of 33.3%.

GAAP earnings per share were $1.76, and non-GAAP earnings per share were $2.54. On to our segments. Design automation segment revenue was $928 million, up 13%, driven by continued strength in both EDA software and hardware. Design automation adjusted operating margin was 38.8%. Design IP segment revenue was $335 million, down 4% due to a tough compare to Q2 2022, which was an exceptionally strong IP quarter. Adjusted operating margin was 25.8%. Software Integrity revenue was $132 million, up 17%, and adjusted operating margin was 13.9%. Despite some macro impact on this segment, we continue to expect Software Integrity revenue growth of 15%-20% with expanding adjusted operating margin for 2023. Turning to cash.

We generated $703 million in operating cash flow. We used $300 million of our cash for stock buybacks. We ended the quarter with cash and short-term investments of $1.7 billion and total debt of $20 million. Now to guidance. For fiscal year 2023, the full year targets are revenue of $5.79 billion-$5.83 billion. Total GAAP costs and expenses between $4.520 billion and $4.565 billion. Total non-GAAP costs and expenses between $3.79 billion and $3.82 billion, resulting in non-GAAP margin improvement of 150 basis points. Non-GAAP tax rate of 16%. GAAP earnings of $7.44-$7.60 per share.

Non-GAAP earnings of $10.77-$10.84 per share. Cash flow from operations of approximately $1.65 billion. To targets for the third quarter. Revenue between $1.465 billion and $1.495 billion. Total GAAP costs and expenses between $1.143 billion and $1.163 billion. Total non-GAAP costs and expenses between $970 million and $980 million. GAAP earnings of $1.88-$1.99 per share. Non-GAAP earnings of $2.70-$2.75 per share.

In conclusion, we are confident in achieving revenue growth of 14%-15%, 150 basis points of non-GAAP operating margin improvement, and 21%-22% non-GAAP earnings growth in 2023. Our strong execution reflects our leadership position across our segments, robust design activity by our customers who continue to invest through semiconductor cycles, and the stability and resiliency of our time-based business model. With that, I'll turn it over to the operator for questions.

Operator (participant)

As a reminder, if you would like to ask a question, press star followed by the number one. Before we begin the Q&A session, I would like to ask everyone to please limit yourself to one question and one brief follow-up to allow us to accommodate all participants. If you have additional questions, please re-enter the queue and we'll take as many as time permits. Your first question comes from the line of Harlan Sur with JPMorgan. Your line is open.

Harlan Sur (Managing Director and Senior Equity Research Analyst)

Hi, good afternoon, and congratulations on a well-executed quarter.

Aart de Geus (Chair and CEO)

Thank you.

Harlan Sur (Managing Director and Senior Equity Research Analyst)

You know, we do our best to try and. Yeah thank you. We do our best to try and track chip design activity, primarily with the large ASIC semiconductor companies that are helping the large hyperscalers and systems companies sort of co-design their custom chips because they're sort of a good proxy for overall leading-edge chip design activity, right? From what we can tell, overall chip design starts have accelerated just over the past few months given this AI arms race, you know, among the cloud and hyperscalers. They all wanna bring their silicon solutions to the market sooner rather than later. You know, are you guys seeing this step up in acceleration in design activity as well? How is this acceleration manifesting itself in terms of upcoming renewals, and just your confidence on full-year outlook and continued strong growth into next year?

Aart de Geus (Chair and CEO)

Well, first, the answer is absolutely yes. It's not a surprise. In general, even when there are economic downturns, the semiconductor industry tends to invest strongly in chip design so that when the downturn fades away, they have differentiation because the worst is to miss an upturn because that's where most of the money is made. In this case, there's an additional substantial driver. You've seen it with all the excitement, I would say, 5% hype and 95% absolutely great understanding of the impact of what this will have on the world, where every vertical market is now committed to smart everything. Now the question is how quickly can they become smart?

They quickly discover that while the software is fantastic, the computational requirements of that software are fantastic too. The race is on for more chips, faster chips, and most importantly, chips where you can get high compute at low power. This plays into the core competencies that Synopsys has. Because simultaneously there is a shortage of top designers, the productivity enhancements that we can bring about with our own AI have a material impact on that.

Harlan Sur (Managing Director and Senior Equity Research Analyst)

Well, thank you for that. As the team had anticipated on the last earnings call, you're demonstrating it with your guide on this call, right? You've seen a strong step up in the second half. I think it's roughly about 11% half-on-half growth. On a year-over-year basis, I think second half is gonna be up like 20% plus. I know the team talked about second half waiting on renewal activity and also more IP consumption, given the timing of some of your customers' design programs. IP was down slightly year-over-year in the first half. Is the team still anticipating half to half in year-over-year step up in IP for the second half?

Aart de Geus (Chair and CEO)

Yeah. You know, I think in hindsight, I think we had mapped out the year pretty well. You know, you have to always map it out by also looking at the previous year, which was exceptional in its other directivity. It had very big growth early on and then less growth in the second half. Now we're back to essentially a normal year, which where you move left to right and bottom to up on an ongoing basis.

One of the reasons that we were able to map it pretty well is because we have a reasonable understanding of what designs are coming, what renewals, but also what IP will be pulled during the year from the needs of the different projects. you know, you can never quite forecast the future exactly, we may have been careful. I think we had it actually mapped pretty well and we have a high degree of confidence on the numbers that we're guiding you to.

Gerd Ascheid (Director)

Yeah. I would just add, Harlan, I mean, our teams are deeply embedded in the design team, so we have a really good understanding of where they are in terms of their needs from us, specifically, on the IP side, which is, you know, a strong second half, which is traditional like Aart said.

Harlan Sur (Managing Director and Senior Equity Research Analyst)

Yeah. Perfect. Thank you very much.

Aart de Geus (Chair and CEO)

Thank you.

Operator (participant)

Your next question comes from the line of Joe Vruwink with Baird. Your line is open.

Joe Vruwink (Senior Research Analyst)

Great. Hi, everyone. I guess I'll start. At this point, two of your peers have mentioned the expectation for some larger software renewals coming through in the second half of the year. I'm just wondering if maybe that commentary is representative of what might just be a stronger new business environment for the industry in the second half of the year, and if you're seeing that. Kind of related to the renewal conversation, you know, given the backlog increase sequentially, I would imagine you're seeing some good renewals come through. Is the nature of what your customers are looking for changing at all? I guess embedded in the question is whether the AI products are increasingly being incorporated in the bigger renewals.

Aart de Geus (Chair and CEO)

Well, let me work backwards on that one. Yeah, AI is absolutely prominent in many transactions, because either people have already very good experience and just racing to implement it in many more chips or use it on many more chips, or they have heard from others and are racing to now look at how they can use it. At the same time, I would say that there's no alignment in big renewals across the industry. They happen whenever they happen for each one of the individual companies.

I would say that there are evolutions in industry, and the evolutions are that, companies that in the past were sort of, investing in chip design because they felt it was going to be important in the future now are suddenly realizing it has big impact on their future because they have to make architectural decisions, because they're suddenly discovering that they do have a lot of data to do things with.

I'm talking about hyperscalers or big system design companies, or then the semiconductor design companies that have this nonstop pressure from their customers, "Give me way more compute for less power and maybe roughly the same cost." Those are pressures that are challenging but also exciting. I would think that the industry is overall, notwithstanding ups and downs of volumes, is actually quite healthy and looking at the coming decade of great opportunities given the state-of-the-art of the software demand.

Joe Vruwink (Senior Research Analyst)

Okay. That's great. And then a question on your verification hardware business. You know, as I think about your non-recurring revenues and the growth there over time, I mean, you've sustained just a very high CAGR in that business. And yet when I think about, you know, the demand for verification, sometimes it's, you know, been in geos that are building out a semiconductor supply chain. Sometimes it's, you know, new companies. You know, I think about like China being down year-on-year, and yet it looked like your hardware business grew. Is the nature of growth in your verification business maybe coming from different sources than might have been the case in years past?

Aart de Geus (Chair and CEO)

Well, I would say that it has broadened. You know, a number of years ago, only very few companies would use hardware assistance in verification. They would use it quite massively. Now many companies are doing that, and actually there are two very different reasons. One is to use the verification assistance or the hardware to essentially accelerate tasks that you used to do, which is verify the functionality of chips. We have long entered a different space with Synopsys by being at the heart of the intersection between software and hardware. There, the objective is essentially to mimic the hardware on a machine or partially on a machine so that people can run the software to not only check if the hardware works, but just as importantly, how good is the software.

Even more interestingly is can you optimize the software so that you use less energy in the computation? In other words, there's an interaction between hardware and software that is a great place to optimize the actual computational cost. As you can imagine, running real software on machines that mimic the very chips you don't have yet is very complex, and we're doing very well with that. The ZeBu Server 5 that we just announced is yet another example of a big piece all around the space of what we would call, electronic digital twinning, which is create an artificial world on a computer and be able to exercise the real world on it to see what the results will look like.

Shelagh Glaser (CFO)

Yeah. I would just share, we had shared that 2022 was a record hardware year. We expect 2023 to be another record hardware year. As Aart said, the demand is very strong across our customer base.

Joe Vruwink (Senior Research Analyst)

That's great. Thank you very much.

Aart de Geus (Chair and CEO)

Thank you, Joe.

Operator (participant)

Your next question comes from the line of Jason Celino with Keybanc. Your line is open.

Jason Celino (Managing Director and Equity Research Analyst)

Great. Thanks for taking my questions. You know, Art, you know, I appreciate all your comments about mapping the year appropriately and seeing, you know, fitting, you know, the pattern that you had planned. When I look at the quarter, the beat was still nice and, you know, suggests that something must have come in better than expected. You know, can you just elaborate where you exactly saw the strength and the upside? Thanks.

Aart de Geus (Chair and CEO)

Well, it's always hard to say if it's better than expected or if we just worked harder at it. The fact is, I think we executed well. We have a number of key people in our management team that have been new to the company in the last year, and we are making really excellent progress of scaling Synopsys for the ability to work at this level. Simultaneously, I think the trust build up with the customers and the breakthroughs in technologies that we've had in the last few years, really bode well going forward.

I've plenty highlighted, I think the AI in the preamble. I'd like to also mention the fact that multi-die is really in many ways the technology answer for a few additional decades of what I like to call SysMoore. Systemic complexity, Moore's Law, still an exponential ambition, but much more complex with multiple chips. We are very well engaged with that. It is quite complex to do, these are good things for us to deliver.

Jason Celino (Managing Director and Equity Research Analyst)

Okay, perfect. I did have an AI question, but it's actually for your security business. You know, we've seen, you know, some examples of AI being used to, you know, write code and even test and debug it. You know, how do you think this may augment or evolve processes for developers going forward?

Aart de Geus (Chair and CEO)

You know, I think what we're seeing with AI, that it will augment everything. Everything. Now, not all the everythings are created equal, right? You need to have understanding of any of the fields or the disciplines to use AI well. The ability to look at data from many different perspectives and many different interconnections opens the door to all kinds of advances. It shouldn't be surprising that Synopsys is well invested in many different explorations.

That includes the SIG area, that includes every aspect of the company. It's also exciting to see that with the approaches that we have taken that require a very high degree of accuracy, we've been successful. Just to make a distinction, generative AI can do wonders with enormous amount of data, but it is not necessarily always correct. We cannot afford that. A single transistor doesn't work, the whole system doesn't work. We're in a class of AI that requires actually very rigorous computation. All of this is wide open, so it's an exciting time.

Jason Celino (Managing Director and Equity Research Analyst)

Perfect. Great. Thank you.

Aart de Geus (Chair and CEO)

Thank you.

Operator (participant)

Your next question comes from the line of Gary Mobley with Wells Fargo. Your line is open.

Gary Mobley (Executive Director)

Hi, everyone. Thanks for taking my question. Wanted to ask about how transformational AI can be for the core EDA market. The angle I'm taking here is that clearly the core EDA market has grown faster than chip designers, that really is driven by efficiency. That's what the A in EDA stands for, right? My question is, you know, how does AI further enhance the automation in chip design? How do you share with your customer savings on that? Could you just give us a sense of, you know, sort of the magnitude of the inflationary tailwind on a per seat license basis, or maybe from a different perspective, how it transforms the growth rate of the core EDA market?

Aart de Geus (Chair and CEO)

Well, it's only to say how it transforms the market because we're at, I think at the beginning of a decade of impact. It is not early to clarify the impact it already has. For the very few of you that, actually remember the beginning of Synopsys, we started in an era where automation was just beginning. The, the synthesis at that time was suddenly out of nowhere, able in a matter of hours to do something that designers took many, many weeks to do.

In many ways, the AI that we have right now on entire subflows does exactly the same. The reaction at that time by, I wanna say 5% of the designers, "Oh, you're taking my job away." The other 95 said, "Oh, give it to me faster because now I can do so many new things. By the way, the demand for gates will not stop. It will double." That was enormous. You could use exactly the same words today.

Many companies and designers see that this impactHow they will be able to design very complex things where their own ingenuity greatly matters, but at the same time gets multiplied with this capability to see many dimensions and many, an enormous amount of data all at the same time. I think it is profoundly transformational, and we're seeing the benefit of that and the benefit manifests itself through much of our tool chain because people tend to want to have a complete solution from Synopsys for precisely these capabilities.

Gary Mobley (Executive Director)

Thanks for that, Aart. This may be a question more for Shelagh, but I appreciate the fact that your first half IP business is facing a tough year go comp and thus the minor increase or, excuse me, decrease in the revenue. What's driving the profitability headwind? If I'm not mistaken, there's a 10-12 percentage point degradation in the op margin. Is that mix related or are there some other factors factoring in there? Thank you.

Shelagh Glaser (CFO)

Thanks for the question, Gary. Our IP business is super lumpy, and the way I kind of think about the IP business is we're always building new IPs. Art talked about us having greater than 7,500 IPs on 340 process nodes. We're constantly building and innovating new IPs, but then the customer pull-down is based on when their design schedules are. You're going to tend to see a lumpy operating margin. Over time, that operating margin is slightly below the corporate average. That's really the way we're managing it. We'll see some variations quarter-on-quarter because we're not changing our resourcing because we've got to continue on that race to deliver those IP blocks. The customer pull-downs are really based on when their design need is.

Gary Mobley (Executive Director)

Thank you.

Operator (participant)

Your next question comes from the line of Vivek Arya with Bank of America. Your line is open.

Vivek Arya (Managing Director and Senior Equity Research Analyst)

Thanks for taking my question. Aart, you mentioned the adoption of multi-die designs, and I'm curious what percentage of chip design starts do you think are in this multi-die architecture, and where do you see that going? Is there a way to quantify the benefit to Synopsys in that transition?

Aart de Geus (Chair and CEO)

We're just at the beginning because just at the beginning at the same time, you know, we track over 100 designs and multi-die is not simple design. These are sophisticated investments. What is very clear is that the adoption is accelerating, but more importantly is the notion that this is where the future is going. As with any of these changes, some of the most invested parties move first and move aggressively, and then others follow when the risk declines, the cost equation becomes better. The movement is moving fast forward.

you know, from a understanding of the needs, we understand very well that a lot of the things that people want to do in specifically AI-related computation is only possible if they have more capabilities, i.e., way more chips working very closely together. A great example for that is actually automotive, where a number of companies are looking at what is the architecture that they need in order to supply, let's say, level four autonomous driving by roughly the end of this decade. It's substantial, and it also takes a substantial amount of power to do all that computation. That is one of the reasons that many are looking at doing their own solutions or teaming up with a few companies to do dedicated solutions for their car brand.

Vivek Arya (Managing Director and Senior Equity Research Analyst)

Good. For my follow-up, maybe one for Shelagh on operating margin expansion. You mentioned you're raising the target 250, you know, basis points. When I look over the last few years, I know your former target is to expand it by 100 basis points, but I think on an average it's been over 250 basis points for the last several years, if my model is right. First part of the question is, what is helping the expansion this year? Is it, you know, sales are doing better, costs are under control? What's the driver? What keeps them from expanding the way you have been able to expand over the last few years?

Gerd Ascheid (Director)

Well, I would start with we're very committed to both short-term and long-term margin expansion. Short term, what's driving it is, we're putting in some more rigorous financial controls. As we work through these great opportunities that Art painted for us, how do we make sure that we properly scale ourselves? That's really the improvement that we're putting forward, the greater than 150 basis points. We're committed to continuing to long-term improve margin.

Vivek Arya (Managing Director and Senior Equity Research Analyst)

Thank you.

Operator (participant)

Your next question comes from the line of Charles Shi with Needham. Your line is open.

Charles Shi (Principal and Senior Analyst)

Hey, thank you for letting me ask a couple questions. So Art, maybe first off, I want to ask a long-term question related to generative AI, not to your products, but to your customers' products. It looks like with all the news flows over the last quarter, the accelerator hardware right now seems to be converging to NVIDIA GPUs. I remember over the past few years, I mean, at least for EDA industry, system companies designing their own AI accelerators and AI startups innovating in AI hardware has been big driver for EDA. My question is, and maybe I'm just picking one very specific hardware AI accelerator here, but is the trend towards customer accelerators reversing or is it not quite reversing but will likely continue? How do we think about what's going on in the trend there?

Aart de Geus (Chair and CEO)

It's a race of all of the above. Kudos to NVIDIA to have positioned themselves so well and be so unbelievably technically competent. At the same time, the very fact that there is such an interest and such an ambition on many parties to do well, some that have the ability themselves to develop acceleration for AI will absolutely do so. Others will team up, and yet others will really work well with NVIDIA. In general, when you have a new field that gets a lot of attention, you also get a lot of new innovation and new investments. I foresee that we will continue to see that moving forward at a pretty rapid clip because the demand is so high. Now, underneath all of this, there are some very challenging problems.

While the results that we've seen are truly exciting, you know, figuring out some of the software solutions to make sure that your results are actually truthful, that you can actually protect the intellectual property, what was used, what's open, what's available, what's illegal. I mean, there's a lot of technical questions that will demand even more compute simultaneously, because these systems are very powerful, the security and the safety will also be paramount. I like to highlight that because we touch this at multiple places.

We touch it obviously top-down through the software via our SIG side of the company, the Software Integrity group. We also touch it bottom up by virtue of putting mechanism in chips that help encrypt the data, provide root of trust, a unique identification, et cetera. That's built into the IP and the design flows. There's a lot of opportunity. Whenever the world changes, there's opportunity, and it changes at a very rapid pace. That's why, you know, SysMoore, this exponential part of Moore's Law is very much alive and well.

Charles Shi (Principal and Senior Analyst)

Thank you, Aart. Maybe the next follow-up on the second half acceleration, can you kind of provide a little bit more color on what are the drivers? I think you mentioned about the better visibility into the IP drawdowns in the second half, but is that the majority of the drivers? Shall we expect that the EDA revenue run rate to go higher into second half? I kinda noted that in fiscal second quarter, your EDA revenue actually broke the $900 million mark. Which by the way, congratulations on that. Shall we expect-

Aart de Geus (Chair and CEO)

Thank you.

Charles Shi (Principal and Senior Analyst)

That to trend higher into the second half? Thank you.

Aart de Geus (Chair and CEO)

Well, you know, in order to deliver the results that we're guiding you to, you need to really see growth everywhere. I think Sheila already stated that IP is truly very lumpy, and, you know, I forget the exact comparison versus a year ago, but IP definitely has to contribute and will contribute in the second half to get the numbers. EDA is, of course, more ratable. There we have a good assessment of the situation. Fundamentally, I think all cylinders will do well in the second half.

Gerd Ascheid (Director)

Yeah. I mean, obviously, you know, the trend of first half, second half is more traditionally what we see. Last year was a little bit unusual and then a very balanced first half and second half. We do expect growth across the businesses, and we do expect particular growth in our IP business.

Charles Shi (Principal and Senior Analyst)

Thank you.

Aart de Geus (Chair and CEO)

You're welcome.

Operator (participant)

Your next question comes from the line of Jay Vleeschhouwer with Griffin's Securities. Your line is open.

Jay Vleeschhouwer (Managing Director)

Thank you. Thank you. Aart, for you first, it was interesting to hear you speak about the extent of production deployments of AI so far in terms of your software, as compared to what might have been perhaps more ad hoc or piloting or conservative implementation to this point, since historically, EDA customers are somewhat conservative in terms of how quickly they adopt new technology. The question for you is, as that is occurring, what effect are you seeing or what effect do you expect in terms of your services revenue? You had an unusually flat sequential comp in terms of services, you have been, on the other hand, investing substantially in the AE capacity. Maybe talk about the that relationship and then my follow-up.

Aart de Geus (Chair and CEO)

Well, you know, the adoption rate, I think is the result of a great opportunity space for our customers to come out with new products, the need to have faster products. Secondly, the fact that very early on in our development, and I gave you sort of the five-year timeline for that, we're able to get good results. Good results was equivalent to what the traditional, more human-driven design flow would do. That's sort of an imperative. If you don't do that, people like automation, but they don't like to be not competitive. After that, we were able to accelerate this substantially. Then the very productivity angle came in. I would argue that probably the productivity angle has been the singular most impressive in terms of the ability to move this forward.

Now, from a service point of view, our own teams have the ability to use all of these tools. Obviously, they have in-house teaching, so to speak. We don't disclose specifically our service business, but what is clear is that customers count on us to, what I like to call make it all work, which is the complexity of so many dimensions of multiple chips, of multiple challenges between hardware and software, between energy and thermal impact. Between the utilization of certain technologies versus others. These are all things where, you know, we are a team with the customer. We have so many people of Synopsys, be it in service or in support, that are integral to the design teams of our customers. It's a privilege to be sort of in the kitchen.

In the kitchen, hopefully they're doing a good job, including using our most advanced oven, so to speak, the AI oven here, right? The, the teamwork component in the industry has grown. That we predicted that quite a while ago, and many of you have heard me say that, in English, we so often use the term, you know, success is the sum of our efforts. It's not. It's the product. Single zero, everybody gets zero. This applies to individual teams, but it also applies to the relationship between companies. That's why it's exciting to be part of this wave of companies plotting entirely new horizons for themselves and be privileged to be part of it.

Jay Vleeschhouwer (Managing Director)

As follow-up, there's been a number of questions about the second half. When we look at your inventories, which of course is related to your hardware business, there was a substantial sequential increase to a record level to just over a quarter billion. How quickly do you think you'll be able to convert that into shipment? I assume you've got a pretty substantial pipeline now for emulation and prototyping behind that inventory number. Are you expecting to convert that in the second half and thereby drive hardware revenue?

Shelagh Glaser (CFO)

We do expect this to be another record revenue year, and we're actually grateful to be able to build some inventory because we hadn't been able to build considerable inventory with some of the supply line disruption. We're gonna be able to service our customers, and we're really excited about that. Yeah, you did see a big, big build, about 14% build, and that's really so we can satisfy our customers' demand.

Jay Vleeschhouwer (Managing Director)

Good. Thank you both.

Aart de Geus (Chair and CEO)

Thank you.

Operator (participant)

Thank you. Your next question comes from the line of Joshua Tilton with Wolfe Research. Your line is open.

Joshua Tilton (SVP)

Hey, guys. Thanks for taking my questions.

Aart de Geus (Chair and CEO)

You're welcome.

Joshua Tilton (SVP)

My first one, Aart, you might have alluded to it a little bit, but I kinda just wanna ask it more clearly. Outside of all the productivity benefits that you're talking to from AI, do you expect these new AI tools or capabilities to make it more likely for a customer to want to choose a full flow from Synopsys versus maybe in the past where they might have, you know, put that flow together from numerous products from numerous vendors?

Aart de Geus (Chair and CEO)

Absolutely. There's a very good reason for that, which is that the tools have been optimized now to work in concert with each other. You know, this is not some individual musician, right? This is a choir that has to sing together in tune. I alluded to the fact earlier that in contrast to many other AI applications where, you know, the outcome can be in the ballpark and be very useful, we cannot be in the ballpark. We have to be meticulously correct. Many of our tools are actually specialized and best in class in verifying timing, power, layout ability correctness. So these are absolute a necessity to make this work.

I think as we move to more and more designs, this is gonna be true in a broader set of tasks and at different levels of abstraction. This is, by the way, why we have created Synopsys.ai, which is essentially a suite of tools working in different areas. The suite that we've highlighted is design. In simple terms, design is, you know, create it and make it as small as possible, as fast as possible, and as low power as possible. Just as important, some would say even more important, is verification, which is, does it actually do the function that it's supposed to do? Does it multiply two and three and not get five, but get six, right? You have to be absolutely correct. Then test is yet another aspect.

That is the whole, does it still work and does it work well after you manufacture it? Because a number of things can go wrong there as well. So broadening these capabilities on top of a set of tools that continually optimize individually, but also as a, as a team, if I can call it that, is one of the key reasons why I think we're doing so well.

Joshua Tilton (SVP)

Super helpful. Just for my follow-up, it has been kind of a tough go, for some of the pure play security names this quarter so far. SIG revenue growth is obviously pretty fantastic in the quarter, but it's kind of a lagging indicator. Can you just maybe, you know, talk to how the SIG bookings have been trending and maybe just, you know, what gives you confidence that you continue to sustain that growth in SIG that you're seeing today throughout the rest of the year?

Aart de Geus (Chair and CEO)

Well, we don't disclose bookings, but we did say that there is a headwind that we have seen in that business, mostly viewed by virtue of people delaying some purchases or having more levels of signature that are needed. That should not be a surprise because things like security, you can always argue are super important, but they're rarely urgent until the next day. Over time, we expect that to rectify itself because the sum total of the entire product base is highly dependent on actually the security of every layer.

While SIG for us is still, I would say fairly high in the level of abstraction compared to the rest of our business. Recently, we've seen some very interesting areas such as automotive, where, you know, OEMs are buying from us the security for the software sort of coming down and the security from the hardware moving up. In that sense, it becomes an area that we will continue to invest in, and I think is crucial for the future. It is clear that the EDA and IP areas have been particularly strong at this point in time.

Gerd Ascheid (Director)

Yeah. I would add that, our long-term view of that business is 15%-20%. Due to some of the headwinds that, Art mentioned, we think we're probably closer to the lower end of that, closer to the 15% this year.

Joshua Tilton (SVP)

Thanks, guys. Very helpful.

Gerd Ascheid (Director)

Thanks.

Aart de Geus (Chair and CEO)

You're welcome.

Operator (participant)

Your next question comes from the line of Ruben Roy with Stifel. Your line is open.

Ruben Roy (Managing Director and Equity Research Analyst)

Thank you. Aart, I had a couple of AI questions. I'll ask them both, the question and the follow-up. As the AI product family starts to take shape, 200 tape outs or production tape outs, I guess you said, are you seeing kind of a sweet spot in kind of where AI is being implemented in terms of either, I don't know, type of design, gate count or is it a kind of a broad-based usage of AI?

The follow-up to that, I guess, longer term, I was wondering if you think that, you know, as the AI tools develop, if you think that, either semiconductor companies or non-traditional semiconductor companies that historically might have been reluctant to design custom semiconductors, right, because of the expense and maybe went to merchant chips that weren't best fit or FPGAs or what have you, do you think that your productivity improvement from AI may push, you know, those customers towards custom semi designs in the future? Thank you.

Aart de Geus (Chair and CEO)

Well, those are great questions, because as you were asking them, I was feverishly thinking, okay, what have we indeed done? You know, you may know that many, many years ago, we coined the term techonomics as really this notion of at any point in time, judging the advances of technology through the economic feedback loop or the opposite, looking at the economics that are possible and then figuring out which technology would have the shortest term impact. It's not by accident that we focused first on DSO, and by the way, it was DSO for really advanced designs because these are really, really hard and actually you can sort of almost feel that the human ability to see all dimensions, while extraordinary from an architecture point of view, gradually diminishes for the details.

When you're suddenly dealing with literally trillions of decisions in a design, many are very small decisions, but a small decision can corrupt a design in weird ways, automation can really handle that better. That is where we started. We then started to broaden to other areas that have high economic impact. Verification, it falls in that category because since the beginning of at least electronic time, you know, you were never done verifying. It was all a question, how much can you afford? If you could, for the same price, get twice as much, you would absolutely go for it. So the benefit was a very positive feedback. In many ways, the same for test, where every test that you do on a tester machine costs money for the manufacturing people.

If instead of, you know, 50,000 tests, you can do 25,000 tests and get the same quality of results, that is economically viable. Your question has an interesting second ramification, which is this whole question of, are there certain things in custom design that could be impacted? Here we have not really formally announced anything, but we have absolutely great results in a number of customers already retargeting from one technology node to another. These are good examples that will become very relevant for much of the custom design and a number of other things as well. You know, we race forward on the hottest vector, so to speak, but we have also substantially broadened, and that's the reason that we put the investment in to have a suite, so many common mechanisms in Synopsys.ai.

Ruben Roy (Managing Director and Equity Research Analyst)

I appreciate that detail, Art. That's all I had. Thank you.

Aart de Geus (Chair and CEO)

Thank you, Ruben.

Operator (participant)

Our last question will come from Gianmarco Conti with Deutsche Bank. Your line is open.

Gianmarco Conti (Equity Research Analyst)

Yeah. Hi there. Thanks for taking my questions. Aart, I appreciate your comments on hardware, sorry to touch again on this. I was wondering if you could maybe share a little bit more detail about the demand environment here, both on emulation and prototyping. You know, given we're sitting in H1, do you have full visibility into 2023 fiscal year on the hardware deliveries? Are the emulation trends still ultimately how should we think about hardware development beyond the 2023, given 2022 was indeed a record year, and 2023 is expected also to be a record year from a hardware perspective? I'm just trying to think here, you know, will there be a point in time where near-term companies would have caught up on computational power for a year or two until, you know, the next big challenge comes? Then I'll ask a follow-up after. Thank you.

Aart de Geus (Chair and CEO)

Okay. Well, you know, they're record years and yet record years, right? If you're a growing company, hopefully on a linear scale or trailing 12 months or so, you're a little bit record every quarter. The last few years have been particularly lumpy for a variety of reasons, some to do directly with hardware, some to do with supply chains, and some to do with COVID changing the world. In aggregate, though, if you buy into my premise that there will be more and more need for fast verification, hardware accelerated verification is absolutely worthwhile because of the speed that you can get.

On top of that, the intersection with software is a little bit more complex than that because we have not only hardware verification, but also virtual verification and combination of the two, and that's why Synopsys is so well positioned at that intersection. Be it as it may, all of those things are gonna continue to increase in importance, and our job is to just keep up, A, from the technologies that are available to us. Now we're on the spot of delivering something that has to be state-of-the-art. Secondly, to make that in such a fashion that it's economically, i.e. techonomics for our customers, viable and so on. We have to deliver the fact that they will need more. That's, that is, a self-regulating, business opportunity, but there's no doubt whatsoever that this will continue for quite a while.

Operator (participant)

This concludes our Q&A session for today. I now would like to turn the call back to Synopsys CEO, Aart de Geus.

Aart de Geus (Chair and CEO)

Well, thank you again for participating. I hope that you got the sense that we had a very strong quarter and that we're enthusiastic about the future, be it technology-wise and business-wise, and in all cases, we're always thankful for your participation in this event. Have a good rest of the day.

Operator (participant)

This concludes today's conference call. Thank you for attending. You may now disconnect.