SYNOPSYS INC quarterly report, Q3 FY2018

Synopsys, Inc. — Q3 FY2018 Form 10-Q

Reporting period: Fiscal quarter ended July 31, 2018; year-to-date figures cover the first nine months of fiscal 2018. Synopsys provides electronic design automation software, semiconductor IP, hardware, and software security and quality products and services. Fiscal 2018 is a 53-week year; the first nine months included one extra week versus the prior-year period, adding approximately $46 million of revenue and $34 million of expenses.

Financial performance

Metric	Q3 FY2018	Q3 FY2017	First 9 months FY2018	First 9 months FY2017
Revenue	$779.7 million	$695.4 million	$2,326.0 million	$2,028.2 million
Gross margin	$594.3 million; 76.2%	$525.8 million; 75.6%	$1,780.7 million; 76.5%	$1,540.9 million; 76.0%
Operating income / margin	$64.0 million; 8.2%	$105.4 million; 15.2%	$298.7 million; 12.8%	$255.9 million; 12.6%
Net income	$79.4 million	$116.8 million	$178.2 million	$256.6 million
Diluted EPS	$0.52	$0.75	$1.16	$1.66

• Quarterly revenue grew 12%, primarily from higher time-based subscription license revenue. Time-based products represented 73% of revenue. Maintenance and service revenue rose 20%; upfront products revenue was essentially flat.
• Quarterly cost of revenue and operating expenses increased 21% to $715.7 million. R&D rose 21% to $277.4 million, sales and marketing rose 20% to $158.0 million, and G&A rose 82% to $84.3 million, including $26 million of additional Mentor settlement expense.
• Quarterly operating income fell 39% and net income fell 32% year over year. The filing attributes expense growth to headcount, including acquisitions, and the litigation settlement. The quarterly tax benefit was $7.5 million, compared with a $4.0 million benefit a year earlier.
• For the first nine months, operating income increased 17%, but net income declined 31%, principally reflecting the Tax Act-related tax charge. The nine-month effective tax rate was 42.8%, versus 9.4% in 2017.
• Cash and cash equivalents were $741.2 million at July 31, 2018, down from $1,048.4 million at October 31, 2017. Nine-month operating cash flow was $293.3 million, versus $449.7 million; investing cash outflow was $705.9 million, versus $245.0 million; financing cash inflow was $109.3 million, versus a $25.9 million outflow.
• Investing outflow included $646.7 million for acquisitions and intangible assets and $70.5 million for property and equipment. Financing included $367.0 million of treasury-stock purchases and net borrowing activity.
• Total debt was approximately $621.6 million: $497.8 million short-term and $123.8 million long-term. This compares with approximately $144.0 million of debt at October 31, 2017. Revolver borrowings were $485.0 million of a $650 million facility; the company reported compliance with financial covenants.
• Working capital was negative $617.8 million, compared with positive $68.5 million at October 31, 2017, mainly due to lower cash and higher short-term debt. Deferred revenue was $1,243.5 million in total, including current and long-term balances.

Material changes and notable items

• Acquisitions: The company spent $631.1 million net of acquired cash and investments on acquisitions during the nine months. Black Duck Software was acquired for approximately $565.1 million; its preliminary allocation included $396.3 million of goodwill and $178.0 million of identifiable intangible assets.
• Mentor litigation settlement: Synopsys paid $65 million in June 2018 to settle all outstanding patent litigation with Siemens/Mentor. The company had previously accrued $39 million and recorded the remaining $26 million as Q3 expense. The settlement vacated an injunction and included mutual seven-year patent cross-licenses. An additional $0–$25 million termination charge may be payable under certain conditions.
• Tax Act: The company recorded a provisional $119 million increase in income tax expense in Q1 FY2018, consisting principally of a $46 million deferred-tax remeasurement charge and a $71 million transition-tax expense, plus $2 million of provisional state tax. The transition-tax payable estimate was subsequently reduced from $78 million to $18 million; Synopsys intends to pay over eight years. Tax accounting remained provisional, with finalization expected no later than Q1 FY2019.
• Restructuring: FY2018 realignment charges were approximately $1.9 million through Q3; total FY2018 charges were expected to be $8–$10 million. Prior-year restructuring actions had no outstanding balance at July 31, 2018.
• Share repurchases: The company repurchased $387 million of stock during the first nine months and had $325 million remaining under its $500 million program. The May 2018 accelerated repurchase included a $165 million prepayment; $33 million remained to be settled by November 1, 2018.

Outlook, risks and contingencies

• Management described the business outlook as solid, citing technology leadership, customer relationships, the time-based revenue model, expense management, and acquisitions. The filing provides no specific quarterly or full-year revenue or earnings guidance.
• Management expects cash, operating cash generation, and available revolver capacity to meet routine business requirements for at least the next 12 months. It noted that cash flows can vary with billings, collections, operating results, and tax payments.
• Most revenue is recognized over contract terms averaging approximately three years. Management expects the FY2019 adoption of ASC 606 to have no material effect on the nature and timing of TSL revenue, but anticipates some backlog adjustment to retained earnings and potential timing changes for certain term and IP licenses.
• Key disclosed risks include semiconductor-industry cyclicality and customer consolidation; dependence on a relatively small number of large customers (one customer exceeded 10% of revenue); competition and product innovation; acquisition integration; cybersecurity and product defects; hardware supply and margin variability; foreign-exchange exposure; and changes in tax rules.
• The Hungarian tax assessment remains under appeal. Synopsys paid approximately $65 million, including tax, interest and penalties, and recorded the payment as a long-term prepaid tax. The filing states that the court process was ongoing; the company believes the assessment lacks merit.
• The company has foreign-currency hedges and variable-rate debt. It disclosed no material change in market-risk exposure since October 31, 2017. Fiscal 2018’s extra week affects period comparisons.

Investor verification priorities

1. Confirm the drivers and sustainability of revenue growth, especially TSL renewals, backlog conversion, and the contribution from acquisitions and the extra fiscal week.
2. Assess whether operating margins recover after Q3 expense growth, including acquisition-related headcount, R&D investment, and litigation costs.
3. Review cash conversion and liquidity in light of reduced operating cash flow, negative working capital, increased short-term borrowings, and ongoing repurchases.
4. Track final Tax Act accounting, transition-tax payments, future international tax provisions, and the outcome of the Hungarian tax appeal.
5. Check whether the conditional Mentor agreement termination charge is triggered and whether the settlement changes customer or competitive dynamics.