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Cadence Design Systems, Inc. (CDNS) Q4 2021 Earnings Call Transcript

CDNS Earnings Call - Final Transcript

Cadence Design Systems, Inc. (NASDAQ: CDNS) Q4 2021 earnings call dated Feb. 22, 2022

Corporate Participants:

Alan Lindstrom — Senior Group Director, Investor Relations

Anirudh Devgan — President and Chief Executive Officer

John Wall — Senior Vice President and Chief Financial Officer

Analysts:

Joe Vruwink — Baird — Analyst

Charles Shi — Needham and Company — Analyst

Jackson Ader — JPMorgan — Analyst

Jay Vleeschhouwer — Griffin Securities — Analyst

Pradeep Ramani — UBS — Analyst

Gary Mobley — Wells Fargo Securities — Analyst

John Pitzer — Credit Suisse — Analyst

Gal Munda — Berenberg — Analyst

Vivek Arya — Bank of America — Analyst

Presentation:

Operator

Good afternoon. My name is Jumyria, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Fourth Quarter 2021 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [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.

Alan Lindstrom — Senior Group Director, Investor Relations

Thank you, Jumyria. I would like to welcome everyone to our fourth quarter and fiscal year 2021 earnings conference call. I am joined today by Anirudh Devgan, President and Chief Executive Officer; and John Wall, Senior Vice President and Chief Financial Officer.

The webcast of this call is available through our website, cadence.com, and will be archived through March 18, 2022. 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. Forward-looking statements include, but are not limited to, statements about our business outlook, product development, business strategy and plans, industry and regulatory trends, market size opportunities and positioning, due to known and unknown risks and uncertainties, actual results may differ materially from those projected or implied in today’s discussion.

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 and the cautionary comments regarding forward-looking statements in today’s earnings press release. And please note that our 2021 Form 10-K was filed about 1:30 today, Pacific Time.

You should not rely on our forward-looking statements as predictions of future events. All such statements are based on estimates and information available to us at this time, and Cadence disclaims any obligation to update any forward-looking statements, except as required by law.

In addition to the 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. These non-GAAP financial measures should not be considered in isolation from or as a substitute or GAAP results.

These non-GAAP financial measures are not based on any standardized methodology prescribed by GAAP and may not be comparable to similarly titled measures from other companies. Investors and potential investors are encouraged to review the reconciliation of non-GAAP financial measures with their most direct comparable GAAP financial results in today’s earnings press release.

Copies of today’s press release dated February 22, 2022 for the quarter and fiscal year ended January 1, 2022, related financial tables and the CFO commentary are also available on our website. [Operator Instructions] You may re-queue, if you would like to ask additional questions and time permits.

Now, I will turn the call over to Anirudh.

Anirudh Devgan — President and Chief Executive Officer

Good afternoon, everyone, and thank you for joining us today. I’m pleased to report that Cadence delivered outstanding financial results for 2021. As we exceeded our original growth target, achieving 11% revenue growth, 37% non-GAAP operating margin and operating cash flow of over $1 billion. Generational trends such as 5G, hyperscale computing, and AI ML are propelling the digital transformation of multiple end markets and fueling a golden era for semiconductors and electronic systems.

With robust design activity providing a strong tailwind, we expect our innovative solutions to continue driving broad-based business momentum in 2021 and 2022, accelerating revenue growth and profitability. John will provide more details in a moment. Our Intelligent System Design strategy triples our total available market. And our compelling portfolio of chip, package, board and system design solutions, leveraging our computational software expertise uniquely positions us to capture a wide range of exciting opportunities.

During the year, we significantly expanded our core EDA and IP solutions footprint with market-shaping customers, as new customers accelerated their adoption of our expanding systems portfolio. We deepened our partnerships with leading foundry, IP and cloud service providers and launched key strategic initiatives.

Earlier today, we announced an exciting strategic partnership with Dassault Systemes that brings together Cadence Allegro and Dassault’s 3D experience platform to provide virtual twin experiences for optimizing the entire value chain for electromechanical system modeling, design, simulation and product life cycle management. Central to our strategy is the relentless commitment to innovation. And in 2021, we introduced 13 significant differentiated products across our business groups that will be key to our future growth.

Now let’s talk about some of the product highlights for both Q4 and 2021. Our Digital and Signoff business had another strong year with 10% revenue growth. Deployment of our digital full flow, delivering industry-leading quality of results at the most advanced nodes continue to accelerate as more than 45 additional customers adopted it during the year.

In 2021, we strengthened our relationship with Oppo, a leading mobile phone manufacturer in China with our digital full flow and an expansion of our system design and analysis products. We expanded our relationship with Socionext, who used our digital full flow, delivering the best quality of results to successfully tape out several advanced node automotive and hyperscaler design.

Our transformative Cadence Cerebrus solution incorporates sophisticated ML technologies to explore the entire design space and intelligently optimize the digital full flow in an automated manner.

Several leading customers are increasingly deploying Cadence series in production designs and gaining exceptional power, performance, area and productivity benefits, including a market-shaping U.S. automotive company that reduced the power consumption of critical five-nanometer SoC AI blocks by nearly 10% in just two weeks.

Additionally, a premier Asia Pacific system company reduced power of their four-nanometer design by 10% with one-tenth the effort of manual optimization and then applied the Cadence Cerebrus-trained ML model to other designs, further improving their power and productivity.

And Cadence Cerebrus enabled a marquee U.S. semiconductor company to tape out their next-generation SoC with a 5 times productivity improvement on several critical blocks. Rapidly escalating system verification and software bring up challenges continue to drive heavy demand for our verification full flow solutions, delivering the industry’s leading verification throughput.

Our verification business grew 20% year-over-year, fueled by a record year for hardware. Our next-generation Palladium Z2 and Protium X2 platforms provide best-in-class solutions to address system verification and software bring-up challenges of complex multibillion gate design.

Demand for these platforms that were launched earlier last year has greatly exceeded our expectations, as customers quickly embrace their superior performance, capacity and debug capabilities. The compelling value offered by the common front-end compiler led to more than half of our customers purchasing both Palladium as well as Protium platforms during the year.

Our hardware family added over 30 new customers and over 100 repeat orders during the year, with particular strength seen in hyperscaler, mobile and networking vertical. Our verification software product, which includes the Xcelium Logic Simulator and Jasper Formal Verification Platform continue to proliferate, with Jasper having an exceptional year, adding 40 new customers with particular strength in compute and hyperscale.

Today’s complex memory and mixed-signal high-frequency design underscore the need for high-performance and very accurate circuit simulation. Our Spectre platform has been a long-standing leader in simulation tech solutions for analog and RF design.

And now with the recent addition of Spectre FX, our next-generation FastSPICE simulator for memory and large SoC design, we provide the industry’s most advanced comprehensive cross-domain circuit simulation platform.

Several leading customers have already deployed Spectre FX on their production designs. Such as SK Hynix has successfully evaluated and deployed the Spectre FX simulation solution to improve their design methodology and productivity in DRAM verification.

And Micron adopted Spectre FX simulators, as it gave very compelling phosphide simulation performance for accurate verification of the DRAM and flash design.

In 2021, our IP business grew in multiple vertical markets, including mobile, 5G, hyperscaler and automotive. Our leadership DDR and PCI IP portfolio continue to proliferate at the five-nanometer and lower process nodes, and our design IP portfolio had several wins at top customers, including a significant expansion at a marquee US semiconductor company.

Our Tensilica DSP portfolio continued expanding its footprint in audio, imaging, computer vision and ML applications. And during the year, we introduced the Tensilica AI platform, delivering scalable and energy-efficient on device to edge AI processes. Pricing system complexity for advanced 5G, automotive, and HPC application is driving the need for a seamless platform solution across design, simulation and analysis.

Our System Design and Analysis business that is driving our expansion beyond EDA continued its strong momentum, delivering 18% year-over-year growth. There is rapidly growing demand for sophisticated multi-die integration packaging solutions and our revolutionary integrity 3D-IC solution, providing tightly integrated system planning, implementation and analysis technology has been gaining strong customer traction.

Our Integrity 3D-IC platform was recognized at TSMC’s OIP ecosystem forum by winning Partner of the Year Award for joint development of 3D Fabric design solutions as well as winning a customer choice award for 3D-IC design. Last year, we furthered our system analysis strategy on building out a disruptive, comprehensive multiphysics platform by expanding into CFT domain through the acquisitions of NUMECA and Pointwise.

The integration has gone well and we have added nearly 100 new logos, including competitive wins across multiple end markets, notably in aerospace and defense. We expanded our collaboration with Schneider Electric, a leader in digital transformation of energy management and industrial automation. As they standardize on Allegro X platform for PCB design, as well as adopting our Clarity Solution for system analysis.

In Q4, we significantly strengthened our partnership with EDI, with a wide-ranging expansion of our EDA product, along with deployment of our System Design and Analysis solutions, which will enable them to develop more complete end-to-end solutions for their customers. And Butterfly Networks leverage our Clarity 3D solver for advanced mobile ultrasound design.

Lastly, usage of our Cadence Cloud portfolio continued to scale with over 250 customers using our solutions in the cloud. Cadence Cloud-ready products are enabling our customers to realize meaningful scalability, performance and productivity benefits through the availability of several flexible use models.

Now, I will turn it over to John to provide more details on the Q4 results and our 2022 outlook.

John Wall — Senior Vice President and Chief Financial Officer

Thanks, Anirudh, and good afternoon, everyone. I’m pleased to report we exceeded all of our key operating metrics for the fourth quarter and fiscal year 2021. The underlying strength in demand for our essential technology and solutions continues to drive consistent growth across the business.

A strong finish to 2021, combined with our relentless focus on innovation, customer success and inclusive employee culture and continued execution, helped Cadence to achieve revenue growth of 11% and the fifth consecutive year of non-GAAP incremental margin of greater than 50%, which contributed to an increase in our operating cash flow to $1.1 billion for the year.

Here are some highlights from the fourth quarter and the year, starting with the P&L. Total revenue was $773 million for the quarter and $2.988 billion for the year. Non-GAAP operating margin was approximately 36% for the quarter and 37% for the year. GAAP EPS was $0.63 for the quarter and $2.50 for the year. And non-GAAP EPS was $0.82 for the quarter and $3.29 for the year.

Next, turning to the balance sheet and cash flow. Our cash balance was $1.09 billion at year-end, while the principal value of debt outstanding was $350 million. Operating cash flow in the fourth quarter was $216 million and $1.10 billion for the full year. DSOs were 40 days and we repurchased $61 million of Cadence shares during the year.

Before I provide commentary for Q1 and fiscal 2022, I’d like to take a moment to share the assumptions embedded in our outlook. Our outlook assumes a non-GAAP tax rate of 17.5%. At the midpoint of our 2022 outlook, we are assuming our annual upfront revenue percentage will increase slightly from 2021 to 2022.

This is primarily due to higher upfront revenue in Q1, resulting from a very strong hardware bookings finish to 2021. And finally, our outlook assumes that the export limitations that exist today will remain in place for all of 2022.

Embedding these assumptions into our outlook for fiscal 2022, we expect revenue in the range of $3.32 billion to $3.38 billion, non-GAAP operating margin of 37.5% to 39%, GAAP EPS in the range of $2.46 to $2.56, non-GAAP EPS in the range of $3.70 to $3.80, operating cash flow in the range of $1.15 billion to $1.25 billion. And we expect to use at least 50% of our free cash flow to repurchase Cadence shares in 2022.

For Q1 2022, we expect revenue in the range of $850 million to $870 million. Non-GAAP operating margin of 40% to 41%, GAAP EPS in the range of $0.70 to $0.74, non-GAAP EPS in the range of $1 to $1.04. And we expect to repurchase approximately $250 million of Cadence shares in Q1. Our CFO commentary, which is available on our website, includes our outlook for additional items, as well as further analysis and GAAP to non-GAAP reconciliations.

In conclusion, I would like to take a moment to acknowledge the entire Cadence team for continuously improving our three-year revenue growth CAGR and delivering over 50% incremental margin for five years in a row. As a result of the compounding impact of all their efforts, I am pleased that at the midpoint of our outlook, we expect revenue growth of 12% and over 38% non-GAAP operating margin for 2022. As always, I’d like to close by thanking our customers, partners and our employees for their continued support.

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

Questions and Answers:

Operator

[Operator Instructions] Your first question will come from the line of Joe Vruwink with Baird. Please proceed with your question.

Joe Vruwink — Baird — Analyst

Great. I wanted to start in the past, Cadence has alluded to certain product segments maybe having a faster growth opportunity over the course of an upcoming year. I’m curious if maybe you could give an updated rank ordering. And I guess two questions. One, on maybe the growth a bit more towards verification in 2022, given the ongoing new product cycle you alluded to? And then maybe 1b to this question. Is there any region that might contribute outsized growth for Cadence over the coming year?

Anirudh Devgan — President and Chief Executive Officer

Yes, Joe, this is a great question and let me start and John can comment more. I think what I would like say is that, we feel that all business groups in all product areas and all regions are performing well at this time. So we feel pretty good where we are in the design activity we see. So we are expecting good growth across our portfolio. And I think we feel good how we are positioned.

John Wall — Senior Vice President and Chief Financial Officer

Yes, Joe, I would add to that, that if you look at the CFO commentary on Page five, we’ve outlined the three-year revenue CAGR by product category. I find that the most interesting view for me because it’s typically one contract cycle with customers. And if you look at how we finish 2021, you have kind of strong double-digit growth across all lines of business with the exception of Custom IC, which is high single-digit growth.

Looking at the guide that we have for 2022. I’m expecting slight improvement on all of those, for 2022 over 2021. The one I’ve hedged back a little bit with IP. I’ve got low teens growth in the guide for IP for 2022. There may be upside to that, but right now, I feel comfortable with low teens.

Joe Vruwink — Baird — Analyst

Okay. That’s great. And then — just on the outlook and maybe more of a midterm focus question, but if I leave 1Q aside, given the elevated upfront product contribution, it seems like the rates of growth for the remainder of the year are not too far from these three-year CAGRs. We’re talking about 11%, 12%.

As you kind of think mid-term, and we’ve gotten some midterm frameworks from some of your peers in the space. Would you expect Cadence to deviate that much from kind of these 11%, 12%, 13% rate of growth — as you say, you seem to have quite a good degree of visibility? So it seems like it may be sustainable, but curious on your thoughts there.

John Wall — Senior Vice President and Chief Financial Officer

Yes, I can take that Anirudh. So on that, Joe, the — yes, I think you’re right to assume that. So we’re expecting a very strong Q1. And we have a lot of visibility into core EDA. We continue to expect like double-digit growth there. I called out IP. IP, we typically aim for low teens.

If you look at the three-year CAGR, we’ve achieved mid-teens in that, but we typically aim for low teens, because we’re looking for the highest level of sustainable, profitable revenue growth there. I don’t want to give the team the opportunity to walk away from some business if it’s not the profitable nature we want.

And then on system analysis, we’ve typically driven to kind of high teens there. Yes, I kind of expect that. The challenge is probably on — in terms of visibility, it’s on the upfront business. On the functional verification side, on the hardware side, it’s tough to have visibility into the second half of the year until we get to the summer.

Joe Vruwink — Baird — Analyst

Okay. Very helpful. Thank you.

Operator

Your next question will come from Charles Shi with Needham & Company. Please proceed with your question.

Charles Shi — Needham and Company — Analyst

Good afternoon and thank you for taking my question. Maybe as we exit 2021, could the management team kind of provide us an update on how much of your revenue coming from system companies versus semiconductor companies. So how does that number stack up with the previous years?

Anirudh Devgan — President and Chief Executive Officer

Richard, I think what we say is that about 45% of our revenue is coming from system companies versus semi companies. And over the years, that has increased — it used to be 40% now trending towards 45%.

And as you know, there is more and more system companies doing silicon and semi companies are becoming more system companies and system companies are becoming more semi companies. So that is a good trend for us and for the industry.

And the other thing is our product portfolio is also adding, as you know, more system design and analysis products, that makes us work more with the system company. So that’s a trend that is positive, and I expect to be extra positive for Cadence for the future.

Charles Shi — Needham and Company — Analyst

Got it, got it. So maybe the next question is really to John Wall. I think, your first quarter guidance operating margin is well north of 40%. I know you have this metric that called out 50% flow through for the flow-through rate.

As your operating margin kind of get to the 40% plus, at one point, your margin expansion, if you don’t change that target, 50% flow through, it’s going to moderate at some point. I just wonder, any thoughts, updated thinking here, when do you think you want to raise that flow-through rate? Thank you.

John Wall — Senior Vice President and Chief Financial Officer

Yes, Charles, good observation there. Yes. I mean, we’re very pleased with the fact that operating — our incremental margins have come through at over 50% for five years running now. It’s actually averaged 55% over those five years. And I’m delighted that the start for this year, I think the incremental margin that we’ve included or embedded in our outlook on the initial guide is the highest of the record incremental margin for Cadence on our outlook. So we’re certainly targeting to try and drive that up to 50% and higher again for this year. But naturally, that as long as we’re driving incremental margins that are higher than the underlying margin, we’ll continue to see operating margin expand.

Charles Shi — Needham and Company — Analyst

Got it. Thank you.

Operator

Your Next question will come from the line of Jackson Ader with JPMorgan. Please proceed with your question.

Jackson Ader — JPMorgan — Analyst

Good evening, guys. Thanks for taking my questions. The — on the system interconnect and analysis side, the growth rate in that product segment came down pretty steadily and precipitously through the year. So I’m just curious what gives you the confidence to kind of go from this fourth quarter growth rate in the low single digits back to that low double digits that might be embedded in the outlook?

Alan Lindstrom — Senior Group Director, Investor Relations

Jackson, this is John. That’s one of the easier ones to forecast given that we’re mostly recurring revenue in that segment. And like you said, we’ve embedded high-teen growth into the guide there. Like I say, most of this coming from recurring revenue.

Jackson Ader — JPMorgan — Analyst

Okay. Great. Easy enough. And then I guess on the partnership with Dassault, just curious what the commercial relationship will actually look like? And then also, I mean — I guess I would have thought that maybe Cadence was already trying to kind of go from your PCB Allegro business to 3D electromagnetics. And so how does — with your own organic solvers that you’ve developed. So I’m just like curious how this all fits together and what your organic electromagnetics business fits into the puzzle.

Anirudh Devgan — President and Chief Executive Officer

Yes, that’s a great question. And what I would like to say is, I’m really excited about this partnership with Dassault because this is like two leaders in their respective spaces coming together to address the problem that I think is becoming more and more important, and that’s where the industry is going. So as you know, the market is moving towards a megatronics, combination of mechanical and electronic with software and data and talk and then silicon driving all these engines.

And we — and then when you come from the mechanical side, right, whether it’s a car or a washing machine or an airplane, the first electronics you see is the PCB. And then the chip, I mean on the package and the chip. So with Allegro with our position in Allegro, it gives us a great platform and then, of course, there’s a chip and a package solution and then with Dassault, they are the leader in 3D mechanical design and with product life cycle management.

So this is a natural combination of doing a seamless integration of the data and also the application that span now from — all the way from concept to design to manufacture. So it’s truly a broad-ranging partnership and it’s a multiyear partnership, and we are in the beginning of it. And to your specific question on electromagnetics, that’s the one specific application that we have and we are developing, but there are a lot of things that Dassault does, which are completely orthogonal to what Cadence is and our plans are, things like 3D mechanical design, things like their leadership in product life cycle management. So I think, there’s a good synergy between the two leaders coming together to address this whole space of mechanical plus electronic systems.

Jackson Ader — JPMorgan — Analyst

All right. Thank you.

Operator

Your next question will come from the line of Jay Vleeschhouwer with Griffin Securities. Please proceed with your question.

Jay Vleeschhouwer — Griffin Securities — Analyst

Thanks. Good evening. Anirudh, we’ve seen over the last six to 12 months, a quite material increase in semiconductor R&D spending for a number of the large semiconductor companies. We call it the great inflection in R&D.

When we look at numbers from AMD, Intel, NVIDIA, Qualcomm and so forth, to the extent that EDA perhaps as a percentage of semi R&D has held steady or even increased in recent years.

Would it be fair to say that a good part of this inflection in R&D has already been reflected in your business, hence, your $500 million increase in backlog over the past year? And this is what it accounts for at least part of your accelerated growth expectation for 2022.

The second question, you’ve had a recurring theme in your technology development for the last number of years of commonality and integrations across the product line. Could you mention perhaps which of the integrations, whether organic or organic and acquisition might have been the most meaningful for you in terms of incremental business? For example, AWR and Allegro or anything else you might care to mention.

Anirudh Devgan — President and Chief Executive Officer

Yes, Jay, I mean, as you know, I think, we are — like you said, the R&D spending is including semi and the other thing just to point out is, all the system companies doing semi design, okay? That is also adding to this — and also, our portfolio is increasing beyond traditional semi to system design and analysis like we discussed.

So I think all these factors are contributing to the strength. And I don’t see any — we see a lot of design activity continuing to be very, very strong across multiple regions, across multiple verticals. So we feel pretty good as to where we are and where the market is growing.

On the second part of your question in terms of integration. So we always believe that we have to provide a complete solution. I mean, our industry has to move beyond point tools that used to happen five, 10 years ago to more of these comprehensive solutions.

And we have driven that across all segments, whether it’s digital implementation starting from 2015 to verification for now system design and analysis. And also, at the same time, partner with the right leaders as it makes sense, like we did with MATLAB a few years ago and now with Dassault.

Now in terms of return, I think there are a lot of areas which are growing. The whole 3D-IC and chiplet-based design, I think that’s growing nicely and the whole notion of integrity and the overall solution together with analysis and implementation can provide a good factor. There’s a whole hardware platform, Palladium and Protium with a common compiler and then integration with the rest of the verification suite, I think this still has a lot of legs to go a lot of growth can happen there.

And then the third area I would highlight is truly excited is the Cadence Cerebrus and this integration of AI driving chip design. I think we are still in the early innings and results are phenomenal. And I think that can provide a lot of growth going forward. So just to pick like these three top things, Jay, to highlight with 3D-IC design being one of them, the whole verification and software bring up being another one and an AI-based design and Cerebrus being the third one.

Jay Vleeschhouwer — Griffin Securities — Analyst

Okay. A clarification on the Dassault relationship. Would it be fair to say that it pertains to both your direct and indirect channels and perhaps both their direct and indirect channels?

Anirudh Devgan — President and Chief Executive Officer

Yes. So Jay, this is a wide-ranging arrangement like you said, and it will start with enterprise and then go to the other parts of the market.

Jay Vleeschhouwer — Griffin Securities — Analyst

Thanks Anirudh. Thanks John.

Operator

Your next question will come from the line of Pradeep Ramani with UBS. Please proceed with your question.

Pradeep Ramani — UBS — Analyst

Hey thanks for taking the question. Congratulations on the strong results. I had a question about the trajectory of margins through the year. It feels like very strong guidance in Q1, despite what you could argue is a very big hardware quarter. And yes, the full year margin guide at the midpoint is roughly 38.5%. So if — is there something going on with the mix? Maybe it’s a big IP back half? Or is the guidance just way too conservative. I mean, can you help us sort of understand that trajectory? And I have a follow-up.

John Wall — Senior Vice President and Chief Financial Officer

Yes. Sure, Pradeep. This is John. I mean, effectively, what I’ve got in the first half versus second half is probably 50% revenue first half versus second half. But on the expense side, it’s probably 49 and 51 because we’ve got — we typically do our pay increases and our promotion cycle effective July 1. So you probably see something similar to last year where margins are probably higher in the first half compared to the second half, and then we continue to improve efficiency through the year so that we start the next year higher than we started the previous year.

And then on the hardware side, on the upfront piece, I mean, that’s certainly benefiting Q1. And it’s just — it’s a pipeline business. So it’s tough to see into the second half of the year. So the second half of the year may be conservative right now. I don’t know.

Pradeep Ramani — UBS — Analyst

And for my follow-up on hardware, can you speak to maybe where you are with respect to penetration? I mean, I get it that maybe visibility into the second half is not clear. But just in terms of penetration with respect to the installed base and maybe even your growing customer base, where do you think we are as of, call it, Q1?

Anirudh Devgan — President and Chief Executive Officer

Yes, let me take that on the hardware business. I mean, I think there are two big trends, I would say, that are helping us. One is the market is growing. I more hardware-based verification and software bring up is increasing. And this is true for multiple verticals because as we said, like more semi companies become system companies, then more system companies become semi-company, of course, the reason there are system companies is they have a software stack, right? So you have to develop the chip and also bring up software. So I think one thing is that the overall market is increasing.

The second thing, I think our competitive position is improving tremendously on top of that. So in the old days, we wouldn’t participate that much in the prototyping side, and we are more on the Palladium side, but now with the combination of Palladium and Protium and these brand-new systems and we feel pretty strongly in terms of how well we are positioned in the market.

So I think the market is growing and our position with Palladium and Protium together with the new system is pretty good. So I think that, it’s difficult to predict in terms of — like your exact question of how far into it, but it still appears to me that both of these are net positive. The market will continue to expand over the next few years, and we feel pretty good about our market position there.

Pradeep Ramani — UBS — Analyst

Thank you.

Operator

Your next question will come from the line of Gary Mobley with Wells Fargo Securities. Please proceed with your questions.

Gary Mobley — Wells Fargo Securities — Analyst

Hey, guys. Hope, all is well. Thanks for taking my question and congrats on a strong finish to the year and a strong start to the fiscal year 2022. I wanted to give a little bit of a pushback on your fiscal year 2022 guide. This is a first-class pushback, so don’t take it the wrong way.

If I look at your next 12-month backlog as disclosed in your 10-K, it’s up about 18.5%. If you back out the extra week from fiscal year 2022, you just grew 13.3%. And so, how do the assumption that the backlog didn’t increase as a result of the hardware sales you’re expecting in the first quarter, why the conservative view on fiscal year 2022 revenue growth?

John Wall — Senior Vice President and Chief Financial Officer

So, Gary, okay, great question. But I’m not sure I followed the logic on the backlog growth, but there’s nothing unusual about the structure of backlog. I think we have about 75% of the guide for next year’s guide coming out of backlog.

Now I know our backlog includes RPO plus the IP access arrangements. I’m not sure if you’re looking at the RPO piece only or if you’re looking at the full backlog number. But essentially, in round numbers, about $2.5 billion of the $3 billion, $3.50 billion is coming out of backlog. Is that what you’re getting at?

Gary Mobley — Wells Fargo Securities — Analyst

Yes. I mean, that’s helpful. And we can talk more about it offline. But on a related note, going way back to the end of 2019, I think it was you and Lip-Bu sat down for whatever reason you’re projecting a recession and you could be right for the wrong reasons perhaps.

And you pulled in some license renewals in that late 2019 time frame. And now we’re about two-and-a-half years past that mark. And so should we — are we seeing now or should we expect to see some higher level of renewal activity, given that we’re kind of at the two-and-a-half-year mark?

John Wall — Senior Vice President and Chief Financial Officer

Yes. Good question, Gary. I mean — so generally, in terms of duration, it was typically within our normal range. We typically have — most of our customers are predominantly on a three-year baseline contract. And then they’ll do add-ons throughout the contract that co-terminate and that generally results in roughly two-and-a-half-year kind of average duration. And if you look over contracts, I think, we’re always in and around the two-and-a-half years on a weighted average over kind of a three-year booking time frame.

Yes, RPO was up, I mean, very, very strong finish to the year. We ended up at the $4.4 billion. And the only thing that was unusual, I called out in my prepared remarks because I wanted to make sure that you understood that there was a slightly higher kind of upfront revenue percentage in the guide than in the prior year. Typically, I mean we say, what, 85% to 90% of our revenue is recurring generally, which means that’s, what, 10% to 15% is upfront. Last year, it was 88% was recurring, 12% was upfront in the 350, it’s actually 87% recurring and 13% upfront, 1% higher in upfront revenue, but a lot of that’s falling into Q1, and that’s why we have a strong Q1.

Gary Mobley — Wells Fargo Securities — Analyst

Got it. That’s helpful. Thank you.

John Wall — Senior Vice President and Chief Financial Officer

Thanks.

Operator

Your next question will come from John Pitzer with Credit Suisse. Please proceed with your question.

John Pitzer — Credit Suisse — Analyst

Yes, guys thanks for let me ask question. Congratulation results. John, maybe just to follow up on Gary’s question and maybe to ask it a little bit differently. But if Q1 and the full year plays out as guided today, Q1 will be about 25.6% of full year guide, which is I go back in history would be the highest ever. And I know the linearity of some of the hardware stuff is falling in Q1. But is the SKU really such that this could be a historic year? And I guess as you think about visibility into the back half of the year, especially around some of the hardware sales, when would that start to materialize one way or the other?

John Wall — Senior Vice President and Chief Financial Officer

Yes, I definitely think it’s going to be a historic year. I mean you can see from the guide in the in the CFO commentary that the three-year CAGR continues to accelerate. I think we’re — with the 12% revenue growth embedded in the guide for 2022, our three -year CAGR is naturally rounding up to 13%, when we achieved 12% this year.

Now it’s off of the back of a strong Q1. The second half of the year is tougher to predict for hardware. So that’s why I kind of modeled it out at 50% of our revenue falling in the first half versus second half. If we see the demand continue to flow through into the second half, then that will take the guide up. But it’s — but it’s tough to see that right now because typically our visibility in hardware and the pipeline is about six months. So I mean, that’s basically how we constructed the outlook.

John Pitzer — Credit Suisse — Analyst

That’s I’m wondering if you could help me better understand the impact of AI in the design process. Couple of questions. What percent of the designs out there are intended impact of having more AI functionality embedded in design? Is it higher velocity, higher variety? Is it bringing down the entry cost for new customers? What would be the longer-term impact you see on the design business and the growth rate there?

Anirudh Devgan — President and Chief Executive Officer

Yes, that’s a good question, and you already have several key observations there in the question. So I think AI, we are still in the early innings, but the demand for Cadence Cerebrus and the AI solutions is phenomenal. Actually, at this point, we are engaged with almost all of our major customers. So I think if you look forward like 12 to 24 months, it’s not a question — it will not be a question of who is using AI-driven design is like who’s not using. So I think most of our top customers are moving towards that. And we are seeing phenomenal results.

I mean, some of the numbers we mentioned like 10% power savings; 20%, timing. I mean these are numbers that you typically get when you move from one process node to another process node. And we are able to get these kind of improvement purely on results of better algorithms and AI and mathematics.

So I think the value proposition is very well understood and recognized by all our customers. The engagements are there across all regions and across all verticals. And I think it’s just like to give analogy to driving a car. Once you get used to more automated cars, people are not going back to driving cars the old way. So I think the new way will be AI and Cerebrus being the primary driver of how people will design chips.

And the benefits are significant. And mostly in productivity to the customers, can do more things with the same number of engineers in PPA and also geographically, sometimes we have different skill level in different geographies and all that can be kind of made better with these Cerebrus kind of solutions.

So I’m very optimistic. I think the demand is through the roof and the solutions are providing real meaningful results. So, actually, I expect almost all customers will move towards this as the way to run our digital full flow.

And the other thing I would like to add is that, even though we started Cerebrus with digital, the similar technologies can be applied to other parts of the design flow. So overall, I think this can provide a pretty big benefit to the industry.

John Pitzer — Credit Suisse — Analyst

Anirudh, not at the risk of getting you too far over your skis against a three-year CAGR that’s been accelerating, does the addition of AI allow you to maintain the gains you’ve made? Or does it actually open the promise of even a faster growth rate ahead?

Anirudh Devgan — President and Chief Executive Officer

I think the promise is there. We just have to see how much of the design process is taken over by AI. And, I mean, the other thing is that, the other good thing with Cerebrus is that, when we run these things, when a human is running, they run like one — like, one experiment at a time typically.

But when Cerebrus done it mathematically, we typically run 10, 20 machines in parallel and each of them may have like 16 CPUs or 32. So we’re running hundreds of CPUs or thousands of CPUs and multiple design iterations in parallel. So it’s not like driving one car automatically. It’s like driving 10 cars automatically in parallel and finding what is the best way to get from point A to point B. So that naturally consumes more licenses, and I think its good value that our customers are getting.

Now in terms of the CAGR and all, we just have to see. I mean, I think it’s promising. We just have to see, and we don’t want to project too much until we actually see what it’s doing to the license counts and utilization?

And what percentage of design teams are moving to a purely AI-driven flow. So I think we will update you more over the next 12 to 24 months. But the process is there, but we have to see the uptick, yes.

John Pitzer — Credit Suisse — Analyst

Perfect. Thanks, guys.

Operator

Your next question will come from the line of Gal Munda with Berenberg. Please proceed with your questions.

Gal Munda — Berenberg — Analyst

Yes. Good afternoon. Thanks for taking my questions. And the first one, just let me piggyback on the Cerebrus stuff. Obviously, like you said, it’s early innings, but just to try to understand how you capitalize on it in terms of contract size, does it increase your just contract size and negotiations, so basically further pricing? Or do you actually include it as a new SKU that goes in and it’s a direct uplift to existing contracts or it helps in the contract renewal? So, like, when do you usually engage customers on it?

Anirudh Devgan — President and Chief Executive Officer

Yes. So that Cerebrus is a new product. So of course, we have to make sure that the base products are good and best-in-class, right? So the Innovus platform in gene is the whole digital flow. And then Cerebrus is additional capability and products that we provide to our customers and so its add on sale top of that. But I think it’s important to make sure not just the AI part is good, but the base tool is also good. And typically, the customers will — when they would run Cerebrus, they run multiple copies like I mentioned, of Innovus or our digital full flow.

Gal Munda — Berenberg — Analyst

Yes, that’s my question. Would it increase the usage of the core products actually because there could be more — because in the past, you were limited by the number of engineers that companies have. so if it expands that does it widen the bottleneck and potentially they need more of the basic products as well? That’s why I was thinking kind of does it get along together?

Anirudh Devgan — President and Chief Executive Officer

Yes, absolutely. That’s a great observation. So because when you run Cerberus mathematically, it is running like 10 or 20 experiments in parallel. And when you’re running it manually, you are running one or two experiments. So naturally, it is increasing the use of the base product, like you mentioned.

Gal Munda — Berenberg — Analyst

Awesome. And then just as a follow-up, obviously, you’ve been talking and seeing the systems segment growing — outgrowing the other segments and continue to post a great performance there. What kind of — if you think about the verticals there, you made a little comment around the auto and the hyperscalers. And like what is the growth you see on the auto, for example, in that area? And like how — maybe if you can give us an idea of how important Ulta is for you today versus other verticals?

Anirudh Devgan — President and Chief Executive Officer

Yes, that’s a good question. Now in general, Ulta has multiple aspects to it, right? There’s the semiconductor design of it. And I think Cadence historically, because we have both, we have analog mixed-signal and digital verification. We have traditionally done well with the auto companies like the semiconductor ecosystem of the auto company, okay? Because we always had the broadest portfolio and auto chips are naturally mixed signal.

Now I think as we have more of these new products like CFD or system analysis, auto is a very important segment for that, too, which is beyond just a semiconductor component. This is actual physical car and the electromagnetics and the thermal dynamics of that. And last quarter, we talked about, for example, Tesla being one of our key customers.

So I think auto for overall system analysis market is a very important market. I mean, I think the three big markets there are our auto and aero and defense and then high-tech electronics, which includes, of course, the semiconductor and the hyperscalers. So I think all these three markets are important. And as we expand our system portfolio, we want to make sure we do well in all three of them, like, for example, pointwise, acquisition we made is particularly strong in aero and defense.

So I think the — to answer your question, we have been traditionally strong in the semi part of the auto and now with the expanded product, we have opportunity to engage on the overall auto including the mechanical and the system design. And also this partnership with Dassault amplifies that connection beyond semi to more system and software connection.

Gal Munda — Berenberg — Analyst

Perfect. That’s very helpful. Thank you so much.

Operator

Your next question will come from Vivek Arya with Bank of America. Please proceed with your questions.

Vivek Arya — Bank of America — Analyst

Thanks for taking my question. Anirudh, I’m curious, if this increase that a lot of the foundries are putting at the leading edge, is it pricing some EDA customers, perhaps out of the market or maybe making some customers stay at the N-1 node or be more judicious about the use of the most leading edge, because given the expense of going to it, just what is the correlation, if any, between the cost inflation, right, from the foundry side and the customers’ willingness to engage with designs at the leading edge?

Anirudh Devgan — President and Chief Executive Officer

Yes. So I think the way I would says that, I think, we always want to make sure we address the whole range of process technology. So we always are working at the most advanced nodes. And I think that’s going very well and there is more and more investment in demand for that. And we are working at three-nanometer and most of the R&D like two-nanometer.

We always were more than more, right, with traditional legacy nodes and then now with RF and 3D-IC. In 3D-IC and chiplet-based design, one of the key things is that, as you know, the customers and mix — can mix process node, not everything has to be a three-nanometer, maybe some chips are at three-nanometer, some are at seven-nanometer.

So I think the key thing from Cadence standpoint is to have a very broad solution that addresses the chiplet and 3D-IC part, the most advanced digital part and the mainstream legacy nodes. And as the customers make different choices, which is best for their end markets and economics, we are in a position to support them fully.

So what I would like to say is that, I mean, there is more and more divergence of how the customers put the systems together with advanced node and legacy nodes and chiplet. And I think we are in the best position to provide the solutions for the entire set and that the customers choose how they want to use it and we’ll be there to support them in whatever choices they make in terms of process node and foundries and design with the dollar.

Vivek Arya — Bank of America — Analyst

That’s very helpful. And maybe a follow-up, if I may, for John, kind of two related questions. So, John, the earnings growth you’re guiding to this year is 14%, but free cash flow growth, very modest, only 4%, I guess, capex is doubling, but very modest free cash flow growth. And kind of related to that, if you’re essentially spending on half of the buyback allocation in Q1, does it mean buyback activity is kind of modest under the rest of the year?

John Wall — Senior Vice President and Chief Financial Officer

So on — can you hear me? Yes. So on the buyback side, our first priority for cash is invest in organic R&D. And then to a lesser extent, it’s kind of smaller tuck-in M&A that gives us an opportunity to accelerate our road map. But when we — after that, we look at repurchasing shares and we look to use our free cash flow.

Traditionally, we’ve been using over 50% or around 50% of free cash flow to repurchase shares every year. I expect that we’ll do at least 50% this year. As I said in the prepared remarks, we’re planning to repurchase $250 million worth of shares in Q1, and that’s a lot more than 50%. And that’s just we’re taking the opportunity to repurchase shares at the prices that we see today.

In relation to your observation on free cash flow, I mean, some of that’s the timing of cash. We received a lot of cash in the last week of last year, but also in 2022, we’re picking up some additional or extra cash taxes. There was — as a result of — there was a provision of the Tax Cuts and Jobs Act of 2017 that went into effect on January 1, 2022, that required companies to capitalize and amortize or decost rather than expense those costs has occurred as incurred. That creates a bit of an extra cash or tax burden for us in 2022, and we’ve embedded that into the guidance.

Vivek Arya — Bank of America — Analyst

Thank you.

Operator

We have reached the end of the allotted time for questions and answers. I would now like to turn the call back over to Anirudh Devgan for closing remarks.

Anirudh Devgan — President and Chief Executive Officer

Thank you all for joining us this afternoon. It’s an exciting time for Cadence as we enter 2022, with strong business momentum and a thriving semiconductor and system industry, offering tremendous market opportunity. Our intelligent system design strategy, relentless execution and customer-first mindset is driving accelerating growth as we continue expanding our portfolio with new innovative solutions. We are proud of the innovative and inclusive culture we have built at Cadence and are grateful for the recognition we have received over the years. And on behalf of our employees and our Board of Directors, for their continued trust and confidence in Cadence. Thank you.

Operator

[Operator Closing Remarks]

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