CADENCE DESIGN SYSTEMS INC annual report, FY2010

Business context and reporting period

Cadence Design Systems, Inc. develops electronic design automation software and hardware, silicon intellectual property, and related maintenance and engineering services. This Form 10-K covers fiscal 2010, the 52-week year ended January 1, 2011; comparisons are to fiscal 2009, ended January 2, 2010.

Financial performance and condition

• Revenue increased 9.8%. Approximate gross margin was 83.3%; operating margin was negative 3.1%. Net income included significant tax benefits and should not be read as a measure of recurring operating profitability.
• FY2010 tax benefit was $189.3 million, including $147.9 million from effective settlement of IRS tax positions for 2000–2002 and $66.7 million from release of deferred-tax valuation allowance related primarily to Denali acquisition accounting. Effective tax rate was reported as 302%.
• Cash provided by operations was $199.1 million; investing activities used $285.1 million, including the Denali acquisition; financing activities provided $59.9 million. Cash and cash equivalents declined $11.7 million during the year.
• Cash, cash equivalents and short-term investments totaled $570.1 million at year-end. Net working capital was $181.9 million, down $270.9 million, largely reflecting the 2011 notes becoming current and changes in deferred revenue and accrued liabilities.
• Outstanding debt principal was approximately $644.7 million: $350 million of 2015 notes, $150 million of 2011 notes, $144.5 million of 2013 notes and $0.2 million of 2023 notes. The $150 million 2011 notes mature in December 2011.
• R&D expense was $376.4 million. The filing does not provide a consolidated gross-margin line; the gross margin above is calculated from reported revenue and cost of revenue.

Material changes versus the prior comparable period

• Revenue recovered from fiscal 2009, with product and maintenance revenue higher; services revenue declined. Management attributed the increase mainly to customer renewals and revenue recognized from prior-period contracts under the shift toward ratable licensing.
• Operating loss narrowed by $94.6 million, but remained a loss. Lower bad-debt expense—including a $16.5 million reserve release after collections—helped results; higher employee costs and Denali-related expense partly offset the improvement.
• Operating cash flow rose by $173.5 million, reflecting improved earnings before noncash items and working-capital movements.
• Cadence acquired Denali in June 2010 for an initial $296.8 million in cash. The acquisition added verification IP, memory models and design IP, and increased operating expenses more than revenue in fiscal 2010.
• Cadence issued $350 million of 2.625% cash-convertible notes due 2015, repurchased $100 million principal of 2011 notes and $105.5 million of 2013 notes, and repurchased approximately 6.5 million common shares for $40 million.

Outlook, commentary, risks and unusual items

• Management expected modest semiconductor-industry growth and potentially modest EDA spending growth in 2011. It expected fiscal 2011 revenue to increase from fiscal 2010, and approximately 80% of fiscal 2011 revenue to come from year-end backlog of about $1.7 billion.
• Management expected fiscal 2011 income to be near break-even, operating expenses to increase, and interest expense to rise with a full year of 2015-note costs. Fiscal 2011 tax expense was anticipated, with the effective rate especially sensitive to estimates because of near-break-even earnings.
• About 90% of fiscal 2010 executed-order value and revenue was ratable. A ratable mix makes revenue less dependent on immediate bookings but can limit near-term reported growth. New accounting rules adopted at the start of fiscal 2011 may permit earlier revenue recognition for certain hardware and nonsoftware deliverables.
• A restructuring plan announced in February 2011 eliminated about 95 positions. Fiscal 2010 included $13.2 million of restructuring charges; expected annual savings of $14.5 million were expected to be largely offset by increased product-development spending. Additional facility-related charges of $1 million to $2 million were anticipated.
• After year-end, Cadence agreed to settle securities and derivative litigation, subject to court approval. Fiscal 2010 includes a $15.8 million net litigation charge against total settlement costs of $40 million, with $24.2 million expected from insurers.
• Key risks include cyclical and cautious customer spending, long sales cycles and revenue-recognition timing, intense competition and rapid technology change, customer collection risk and receivables concentration, foreign exchange exposure, sole-source hardware components, acquisition integration, and substantial convertible debt.
• The IRS proposed a $60.7 million deficiency for tax years 2003–2005, which Cadence is contesting; IRS examinations for 2006–2008 were ongoing. The ultimate tax exposure and payment timing are uncertain. One customer represented 19% of net receivables and installment receivables at year-end.
• Management reported effective disclosure controls and internal control over financial reporting; KPMG issued unqualified opinions on the financial statements and internal control.

Important facts for investors to verify

• How much of reported net income reflects recurring operations versus the $147.9 million IRS settlement benefit and $66.7 million valuation-allowance release.
• The cash repayment plan for the $150 million 2011 notes and the effects of convertible-note conversion, hedges and warrants on liquidity and dilution.
• Whether revenue growth, backlog conversion and customer renewals support management’s fiscal 2011 outlook, given the predominantly ratable license mix.
• Collection of concentrated customer receivables, including the $6.9 million allowance tied to one customer, and resolution of the 2003–2005 IRS dispute.
• Final court approval and insurer contribution for the litigation settlements, plus execution of restructuring savings and Denali integration benefits.