Cadence Design Systems, Inc. — 2010 Q3 Form 10-Q
Business and period: Cadence develops electronic design automation software, hardware and silicon intellectual property, and provides maintenance and engineering services. This unaudited report covers the quarter ended October 2, 2010 and the nine months then ended; comparisons are with the periods ended October 3, 2009. Amounts below are in millions except per-share data.
Financial results and liquidity
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Revenue | $237.9 | $216.1 | $686.9 | $632.4 |
| Operating income (loss) | $(3.1) | $(10.1) | $(3.2) | $(112.3) |
| Net income (loss) | $126.8 | $(14.0) | $163.6 | $(151.7) |
| Diluted EPS | $0.48 | $(0.05) | $0.62 | $(0.59) |
- Revenue grew 10.1% in Q3 and 8.6% for the nine-month period. Product revenue rose to $118.2 million in Q3 and $338.1 million year to date; services revenue declined in both comparisons.
- Gross margin, calculated from reported revenue and cost of revenue, was approximately 83.3% in Q3 2010 versus 82.1% a year earlier, and 82.9% for nine months versus 79.6%.
- Despite positive net income, Cadence reported operating and pretax losses. Net income chiefly reflects income-tax benefits: $143.2 million in Q3 and $192.7 million for nine months, including the effective settlement of IRS examinations for 2000–2002 and, year to date, a $66.7 million valuation-allowance release associated primarily with Denali acquisition accounting. These are not equivalent to recurring operating earnings.
- Operating cash flow was $142.1 million for nine months, versus $24.7 million in 2009. Investing cash outflow was $279.6 million, including $256.1 million for acquisitions; financing cash inflow was $67.8 million. Cash and equivalents declined $60.1 million to $509.0 million; short-term investments were $2.6 million.
- At October 2, current assets were $822.3 million and current liabilities $461.0 million; reported net working capital was $361.3 million. Working capital declined $91.5 million from year-end, principally due to lower cash and increased current deferred revenue.
- Outstanding debt principal was approximately $650.2 million: $350 million of 2015 notes, $150 million each of 2011 and 2013 notes, and $0.2 million of 2023 notes. The balance-sheet carrying value of convertible notes is lower because of debt discounts. The 2015 notes carry a 2.625% coupon and mature in 2015; no note conversion conditions had been met at quarter-end.
Material changes and notable items
- Cadence acquired Denali Software in June 2010 for $296.8 million cash, adding verification and semiconductor IP offerings. It recorded $152.2 million of goodwill and substantial acquired intangibles. Management expected Denali-related costs to exceed incremental revenue during the remainder of 2010. Deferred employee-retention payments were also expensed; the filing expected approximately $9.5 million of such payments in Q4 2010.
- In June, Cadence issued $350 million of 2015 cash-convertible notes, repurchased $200 million principal of older notes for $187.2 million, bought back approximately 6.5 million shares for $40.0 million and entered into note hedge and warrant transactions. The debt repurchase produced a $5.3 million early-extinguishment loss.
- Revenue growth was attributed primarily to higher business levels, timing of existing-customer renewals, contracts previously executed under the shift toward ratable revenue recognition, and Denali. Approximately 90% of executed-order value was ratable in both current and comparative periods.
- Nine-month operating expenses were lower by $23.4 million, mainly reflecting a $35.2 million reduction in bad-debt expense versus the prior-year period, partly offset by higher marketing and R&D spending. Q3 operating expenses increased $13.5 million, including employee and Denali-related costs.
- Restructuring credits were $1.7 million in Q3 and $3.1 million for nine months. Restructuring accruals totaled $6.1 million at quarter-end; estimated lease losses could reach $9.3 million.
Outlook, risks and contingencies
- Management said available cash and expected operating cash flows should cover working-capital, capital and liquidity needs for at least the next 12 months. It expected a fiscal 2010 pretax loss but an income-tax benefit for the year. The filing does not provide clear numerical revenue or earnings guidance.
- Cadence cited ongoing uncertainty in semiconductor and electronics markets, potentially slower EDA spending growth than semiconductor industry growth, customer delays or defaults, renewal timing, and the effect of its ratable-license mix on revenue recognition. It also expected marketing and sales expense to increase in the remainder of 2010.
- Tax exposures remain significant despite the 2000–2002 settlement. The IRS proposed approximately $60.7 million of deficiencies for 2003–2005, including disputes over transfer pricing and foreign-trade-income deductions; those matters were being contested. The IRS was examining 2006–2008 returns. Unrecognized tax benefits were $126.8 million at quarter-end, and management could not estimate a range of possible outcomes for certain examinations.
- Securities class-action and shareholder derivative cases were stayed while mediation proceeded. Management said it could not predict outcomes but did not believe current matters would have a material adverse effect on financial position, liquidity or results.
- Other risks include substantial indebtedness, possible cash repurchase obligations upon specified fundamental changes, dilution and share-price effects from convertible-note hedge and warrant arrangements, acquisition integration and valuation risks, foreign-exchange exposure, and the cyclical and competitive nature of the business. Management reported disclosure controls were effective and no material change in internal control over financial reporting during the quarter.
Investor verification priorities
- Separate recurring operating performance and operating cash generation from the large, largely tax-related benefits driving reported net income.
- Track Denali’s contribution to revenue, costs, integration progress, acquired-intangible amortization and any contingent or retention payments.
- Review the status and cash consequences of remaining IRS examinations, unrecognized tax benefits and the 2003–2005 transfer-pricing dispute.
- Assess debt service, maturity and conversion terms, and the actual effectiveness and counterparty exposure of the note hedges and warrants.
- Monitor customer collections, receivable concentration, deferred revenue and the sustainability of operating cash flow as renewals and ratable contracts develop.