A new hand on the helm at Cadence

Some time ago we speculated about problems at Cadence involving early recognition of revenue and its impact on future revenues from major accounts. At that time, Cadence’s president and CEO Michael Fister had resigned, and there appeared to be turmoil in the upper ranks of the company. Since then the board has asserted itself, working with the interim executive team and then confirming Lip-Bu Tan as president and CEO. Now that Tan has been in command on the bridge for just shy of a month, we had an opportunity to tap into his thinking about his new charge.

The first question that comes up, I suppose, is Cadence’s own finding that some revenue had been improperly recognized and had to be restated. This move appeared to resolve any legal question about improper statement of revenues and earnings. But in what state did it leave Cadence’s major accounts? Will future revenue from these companies be impaired because of the aggressive license terms they received?

Tan said that there had been differences in the past from the 90/10 licensing model Cadence now employs, and that restatements had been necessary. He also said that the company was going to exercise discipline about these matters in the future. And he added that indeed, there will be some accounts in which Cadence will just have to manage the situation until the licenses come up for renewal.

Given that there is not likely to be a lot of new license business in this dire year, one speculates that there may in fact be some lean months for license revenue in the near-term. Whether that impacts only licenses or also support and maintenance contracts is not clear, but the latter appear to be separate issues.

Just as things were getting quiet after the shock of the revenue restatement and executive changes, Cadence dropped another explosive device on the financial wires this week: an enormous–$1.36 billion, or nearly an entire year’s revenue—write-down of the value of goodwill, intangible assets, and fixed assets. This move, technically a non-cash impairment, is similar to what happened when investment banks were required to mark the value of their mortgage-backed securities down to market value. Essentially, Cadence simply changed the numbers on their balance sheet for the value of companies they had bought, intellectual property they had acquired, and equipment, buildings, real property or other physical stuff they owned.

This is neither unusual nor a sign of trouble, necessarily. From an accounting point of view, Tan explained, it is entirely appropriate that when a market changes, you adjust the value you place on assets that have become less valuable. Some of what you thought was wonderful about a company you bought—represented on your balance sheet as goodwill, the difference between asset value and the price you paid—may have turned out in the teeth of a vicious recession to be not so great. Some of the equipment or facilities you own—office buildings and real estate, for example, though I don’t know if these specific items were involved in Cadence’s case—may have substantially lower market value than they did last year. It’s a good idea to make those adjustments.

But the act of adjusting them requires you, under Generally Accepted Accounting Principles (GAAP,) to state the change as a net income or loss. That makes CEOs very reluctant to do this maintenance work in a quarter when investors are expecting good news. A quarter everyone expects to be tough anyway makes a good time. After the initial shock from the sheer size of the number, most investors will swallow, shake their heads about the heady days of deal-making, and move on. Such impairments—even huge ones—have happened before to companies that went on to be quite successful: Broadcom, for one. And even with its staggering size, this number at Cadence may not be the largest one we see in the next few months. Keep an eye on any public company that has been aggressive in the mergers and acquisitions market in the recent bubble days. Watch the public ones, and speculate about what is going on within private equity companies who don’t have to report such things except to their investors.

There is another point to the timing, Tan said. In some ways, without explicitly criticizing previous administrations, the accumulated intangibles on the balance sheet represent baggage from the past. "This is a good time to get rid of old baggage," Tan said.

The impairment has nothing directly to do with cash flow or operations. Indirectly, by reducing the net worth of the company and the shareholders’ equity, it might impact the company’s market capitalization and its access to credit. So it’s reasonable to ask, in the current environment where almost nobody can get a line of credit, just how Cadence’s ability to finance operations stands. Here, Tan can be assertive.

"We have $568 million in cash and cash-equivalents," Tan said. "That is a very solid position to be in right now." Tan did say that some of its customers would experience difficult times as the recession progresses, and that this risk would require very careful watching. But he appeared confident about Cadence’s ability to operate through the recession with its reserves. Given that if you take out the impact of the impairment, Cadence lost about $11 million in the fourth quarter, its war chest looks pretty reasonable for anything short of a Japanese-style lost decade. That assumes, of course, that the problems among customers remain the exception and do not become epidemic.

With the financial situation discussed, it seemed appropriate to ask about strategy. Tan agreed that differentiation is critical to a leading EDA company, and said that it has to start in engineering. To nurture his engineering resources, Tan seems to be bringing his experience as a venture capitalist (founder and chairman of VC elder Walden International) to his new gig. "We are doing weekly engineering review meetings," Tan said. "I’m giving our engineers a simple challenge: out-design your competitors."

Tan expects to extend Cadence’s established strengths in analog/mixed-signal tools and verification—both bastions under increasing siege from competitors who feel Cadence is actually losing momentum in these areas. To do this, he is once again turning to his VC personna. "We will engage with customers early, and make sure we are designing tools that get the customer to market more quickly," he said. Tan also described a VC-like process of continuously evaluating projects against progress milestones, impact on the customer’s design process, and competitive advantage. A project that falls behind in this evaluation may find its plug pulled.

The formula is simple, Tan maintained. "If you use your engineering investment to support your customers, and if you exercise financial discipline, you will increase shareholder value." It is a tough company situation and a very tough time, but independent analysts say Cadence still has magnificent technical minds and development skills. With start-up honed discipline, Tan might just turn those assets into real value, not impaired intangibles.