LIVINGSTON, Scotland -- Amid pressure from analysts and shareholders to unleash value from the fastest-growing portion of its business, Cadence Design Systems Inc. appears poised to spin out its lucrative design-services operation with a public offering. The only question is when.
Chief executive Ray Bingham and design services senior vice president Bob Wiederhold both declined this past week to say whether a public offering is in the works. But sources close to Cadence said the company has begun laying the groundwork for such an offering by talking with financial underwriters and sending headhunters scurrying for key executive candidates. If it does happen, the move would come on the heels of Cadence's spin-outs of SpinCircuit and Alchemy.
"We hear all the rumors," Bingham said Thursday at a press briefing held at the company's design-services center here, 30 minutes outside Edinburgh. "The analysts are always asking us about the services business."
Industry sources said Cadence has secured an investment banker -- possibly Goldman Sachs or Morgan Stanley -- for the spin-off. One source familiar with the situation said that the die is cast but that bankers are awaiting favorable market conditions for an offering.
In addition, a top Mentor Graphics Corp. executive who asked not to be identified said he was approached by a Korn/Ferry headhunter to join a Cadence Design Services spin-off.
At first glance, such a move seems counterintuitive, Mentor executive said. Whereas top EDA companies have valuations of four or five times their yearly revenue, services companies typically have valuations that run at half of yearly revenue. But he added that a design services spin-off might have a higher valuation, and said the move might be financially justifiable for Cadence.
Bingham flashed a Cheshire Cat smile when asked about the spin-out this past week, and Wiederhold, while declining to confirm the move, acknowledged it would make sense.
"Analysts demand a lot when it comes to valuations," Wiederhold said. "You can ask Ray when we're going to break it out. There is increasing pressure to do so."
Much of that pressure is pure math. Cadence's stock price has struggled since last summer, when departing executives publicly criticized the company's management, particularly in design services. Cadence's stock traded at about $10 a share last summer. It rose to $25 by the end of the year and has since fallen back, closing Thursday at $20.
Cadence's 1999 revenue totaled $804 million for products and a whopping $295 million for services. Former Cadence chief executive Joseph Costello initiated the full-on services push in 1995 amid an EDA-sector slump, insisting that systems and IC houses needed design assistance as well as tools in a tighter time-to-market world. The business has grown prominently, with one or two high-level contracts. Wiederhold said that the design half of the services operation (the other half is methodology services) accounts for half the services revenue and is growing at 50% a year.
The growth could be even faster but for the constraints of engineering resources, he said, noting that Cadence Design Services plans to add 600 employees this year, although attrition will probably lead to a net staff gain of 450.
Wiederhold reckons that design services -- in the broadest sense of what companies are spending, in one form or another, to start and complete a design project -- is a $50 billion business, part of which isclearly low-hanging fruit for Cadence. The company claims to be the largest design-services vendor in the world, at three times the size of its nearest competitor.
It is that market potential, and the growth rates of the services business -- which includes everything from a complete design to design verification or other partial aspects of design -- that has analysts intrigued. The largest portion of Cadence's business, $804 million in its strong, traditional EDA tools market, is expected to grow with the industry, at some 10-to-12% a year. But if services grow at 50% a year, that portion of Cadence's business will overtake the tools portion in size in the near future. That, analysts said, would make for attractive stock-valuation prospects.
"I think valuations would certainly be higher for a design-services company than an EDA company, at least in today's market," said Jay Vleeschhouwer, a financial analyst with Merrill Lynch.
Vleeschhouwer pointed out that Intrinsix Corp. is the only design-services company to have announced plans for a spin-off and that the company has not completed the move. Intrinsix is currently in a quiet period and had no comment for this story.
Margins dogged the early years of the Cadence design model. Largely because there was no direct precedent, Cadence had to reference the services margins of such businesses as Ernst and Young, not a direct correlation, whose margins are well above 50%. Cadence's early operating revenue for services was in the 30-to-40% range, and executives at the time acknowledged they had some work to do.
That work has been done, Wiederhold said. Although he would only say that margins have grown "significantly," he outlined the steps his company has taken to slash costs.
While keeping an eye on head count (1,000 people generating nearly $300,000 per head), he pushed the group to lean on certain physical implementation tools to cut design time. In addition, he discovered that customers were comparing the costs of using Cadence services with the costs of adding to their own staffs. Cadence found quickly that for small projects, many tiny design consultancies were competing on price. To get in the door of many companies early on, Cadence had to play the price game, which ate into margins.
But the market above that level was one in which Cadence could leverage its technical and business credibility to obtain bigger contracts and firmer pricing. At the top of the three-tiered Cadence cosmology are business and technical relationships that are long-term and deeply entrenched -- and lucrative. Among them are major deals with Nokia and Ingersoll-Rand that include not only design-services fees and tools revenue but also, because the design work was broad and intimate, downstream revenue from the sales of Cadence's customers' products.
"Our business is moving toward longer-term, multiple-project relationships," Wiederhold said, adding the company has completed 35 projects and delivered 107 million transistors to customers worldwide.
But does a spin-out of Cadence Design Services effectively signal the rebirth of Cadence as a systems company? Forms of that question have been posed since the outset of the business model, when critics chimed in that Cadence was either going to steal engineering jobs or compete with its customers by building products.
"If we were going to become a product company, we would have done it a long time ago," Wiederhold said.
In many respects, a spin-out would create an even more flexible unit than exists now. It would let the independent company license tools freely from such Cadence competitors as Synopsys Inc., Mentor Graphics and, especially, archrival Avanti Corp. That could allow the services company to adapt more easily to a company's in-house tool flow and methodology.
But there are lingering questions. Should Wall Street embrace the services model in an IPO? What would happen to the valuation of the "old" Cadence, half bogged down in EDA R&D and trying to grow faster than an industry that traditionally grows 10% a year?
"Services will always be a part of the Cadence story," Bingham said. Wiederhold's design-services operation "is just one part of it."