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Cadence Design Systems Inc (NASDAQ:CDNS)
Q2 2019 Earnings Call
Jul 22, 2019, 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good afternoon. My name is Erica, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cadence Second Quarter 2019 Earnings Conference Call. [Operator Instructions] Thank you.

I'll now turn the call over to Alan Lindstrom, Senior Group Director of Investor Relations for Cadence. Please go ahead.

Alan Lindstrom -- Senior Group Director of Investor Relations

Thank you, Erica. And I would like to welcome everyone to our second quarter 2019 earnings conference call. I am joined today by Lip-Bu Tan, CEO; and John Wall, Senior Vice President and CFO.

The webcast of this call is available through our website cadence.com, and will be archived through September 13, 2019. A copy of today's prepared remarks will also be available on our website at the conclusion of today's call. Please note that the discussion today will contain forward-looking statements and that actual results may differ materially from those expectations. 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, including the Company's future filings and the cautionary comments regarding forward-looking statements in the earnings press release that we issued today.

In addition to 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. Investors and potential investors are encouraged to review the reconciliation of non-GAAP financial measures with their most direct comparable GAAP financial results. The reconciliations are available at the Investor Relations section of cadence.com. Copies of today's press release dated July 22, 2019, for the quarter ended July 29, -- excuse me, June 29, 2019, related financial tables and the CFO commentary are all available on our website.

Now, I will turn the call over to Lip-Bu.

Lip-Bu Tan -- Chief Executive Officer

Good afternoon, everyone. Thank you for joining us today. Cadence achieved strong operating results for the second quarter of 2019, delivering 12% year-over-year revenue growth on broad base strength across our product lines. Based on the strength of our business, we are raising our outlook for the year. John will provide more details shortly.

While there's a ongoing global economic and geopolitical uncertainty, we remain confident about the multiple long-term trends that continue to drive strong design activity. Driven by strength and driven by trends such as artificial intelligence or AI, 5G, autonomous driving and IoT, design activity is being fueled by workload specific computing, system companies building custom silicon, new silicon start ups, and digital transformation of industries, such as automotive, aerospace, medical and other industrial applications.

Our intelligent system design strategy will enable us to provide more capabilities and value to our customers, while also expanding our current total addressable market from about $10 billion to estimate $30 billion over the next five years. The foundation of the strategy is design excellence, which is comprised of our core EDA and IP business. In addition, we are building upon our core competency in computational software to expand into two new areas.

The first one is system innovation, where we are expanding into new system domains with products like Clarity, our new 3D EM solver that was launched last quarter. Clarity has received considerable customer interest with numerous evaluations under way. And second new area is pervasive intelligence, where we are beginning to apply AI and our algorithmic knowledge to our core business and specific verticals.

Now, let us turn to our quarterly highlights for our core business. Our innovation engine continued to deliver as we introduced four significant new products in the quarter. We grew revenue in digital and signoff by double-digit year-over-year through both ongoing proliferation with market shaping customers and adoption by new customers at advanced notes. Samsung Austin R&D Center, a leader in high-performance design has selected Cadence digital implementation solution for a next generation high-end mobile CPU core design. Cadence state-of-the-art Innovus base flow delivered the best quality of results for that design, enabled Samsung Austin R&D Center to meet its advance process note objectives.

Innovium, a leading provider of innovative data center switching solutions adopted Innovus for its highly scalable Teledyne TERALYNX Ethernet switch design. There were more than 40 tape-outs at 7-nanometer and below using our full digital flow in the first half of 2019. And Innovus, our digital implementation solutions has over 18 active customers for 7-nanometer and below designs, including 10 at 5-nanometer.

Next, I want to discuss highlights of our system design and verification solutions. For this [Phonetic] revenue grew 7% year-over-year. Our hardware assisted verification products, which are an integrated part of our verification suite had another good quarter. With the addition of Protium X1, we also provide a comprehensive solutions across IP and SoC verification, hardware, software regression runs, system validation, and earlier software development.

Palladium Z1, our flagship emulation platform added six new customers, and had nine repeat orders. Habana Lab, a leading AI processor start-up say that Palladium was instrumental for the development of Gaudi, the industry first AI training processor that natively integrate Ethernet and RDMA, and for their Goya inferencing chip. [Indecipherable] a pioneer in data centric computing use a combination of Palladium Z1 and Protium S1 systems in the development of their DPU family of products. The DPU is a new type of microprocessor that will revolutionize the performance, reliability and economics of data center at all skills.

We introduced the Protium X1 enterprise prototyping platform, which is the first data center optimize FPGA-based prototyping system, and provide multi megahertz speed for billion-gate designs, accelerating earlier software development and hardware, software convergence. Customer reception of Protium X1 has been very positive with early adoption from some market shaping customers, including Nvidia. Protium S1 and X1 also added three new customers and receive -- received seven repeat orders.

We also delivered the smart JasperGold formal verification platform that delivers an average of 2 times faster proofs out of the box, and 5 times faster regression runs by leveraging new machine learning-enabled Smart Proof Technology. STMicro has been able to significantly boost its verification productivity with smart JasperGold. Custom analog grew a strong 11% year-over-year.

In the quarter, we introduced an important new product, Spectre X Simulator, which is next generation massively parallel circuit simulator designs to provide up to 10 times performance gain, while solving 5 times larger designs, and while maintaining the golden accuracy customer expect from 25 years or Spectre industry leadership in analog, mixed-signal, and RF applications. Spectre X was endorsed by MediaTek, Mellanox, Renesas, and Silicon Works.

Now, let me make a few comments on the geopolitical situation. We have and will continue to comply with the United States Department of Commerce export control regulations. The situation is fluid and we will continue to closely monitoring it. While there is a ongoing uncertainty, thanks to our strategy, continue innovation, and operation -- operational execution, we are well positioned to capture growth opportunities arise from the longer-term trends, driving strong design activity. While we do not provide details about any specific customer, I do want to emphasize that we have a very broad diversified and global customer base.

With that I will now turn the call over to John to review the financial results and provide our updated outlook.

John Wall -- Senior Vice President and Chief Financial Officer

Thanks, Lip-Bu, and good afternoon, everyone. I'm pleased with our results for Q2 and our updated outlook for fiscal 2019. Q2 was a little unusual due to the export limitations that were imposed during the quarter. The export limitations that took effect on May 16, and June 24, in respect to certain customers remain in place today. We're aware that this is a very fluid situation, so for the purpose of providing guidance for the second half of 2019, we've assumed that these current export limitations remain in effect for the remainder of the year.

Now, let me walk you through the key results for Q2, beginning with the P&L. Total revenue was $580 million, non-GAAP operating margin was 33.6%, GAAP EPS was $0.38, and non-GAAP EPS was $0.57.

Next, turning to the balance sheet and cash flow. At the end of the quarter, cash totaled $633 million, while the principal value of debt outstanding was $350 million. Operating cash flow for Q2 was $246 million, DSOs were 38 days, and during Q2, we repurchased $75 million of Cadence shares.

Now, I will provide our updated guidance. For Q3, we expect the following results. Revenue in the range of $570 million to $580 million, non-GAAP operating margin of approximately 30%, GAAP EPS in the range of $0.32 to $0.34, and non-GAAP EPS in the range of $0.50 to $0.52.

Our updated guidance for fiscal 2019 is now as follows. Revenue in the range of $2.315 billion to $2.335 billion. Non-GAAP operating margin in the range of 31% to 32%. GAAP EPS in the range of $1.44 to $1.50. Non-GAAP EPS in the range of $2.11 to $2.17. Operating cash flow in the range of $680 million to $720 million. And for the year, we continued to expect to use approximately 50% of free cash flow to repurchase Cadence stock. You will find guidance for additional items as well as further analysis in the CFO commentary available on our website.

In summary, I'm pleased with our execution so far this year. We are living in uncertain times and I am proud of how we are adapting to a fluid environment. Our improved outlook speaks to the diversification of our customer base, the underlying strength of demand for our technology and solutions, and the continued focus of our employees throughout the Company, on achieving our key financial metrics. I would like to thank our customers, partners and of course our employees. We look forward to updating you on our progress throughout the second half of 2019.

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

Questions and Answers:

Operator

[Operator Instructions] Your first question comes from Tom Diffely with D.A. Davidson.

Tom Diffely -- D.A. Davidson & Co. -- Analyst

Yes. Good afternoon. I was wondering, if there is any way you could do more of a quantification of the impact from the different export controls in China right now; kind of the relative size of that or the impact to earnings, or anything what you can give it would be great.

John Wall -- Senior Vice President and Chief Financial Officer

So Tom, we wanted to provide clarity in relation to second half guidance and expectations without speculating on what may or may not happen with regard to current export limitations. While we don't provide details on what that speculation might be, we don't -- we do want to emphasize that we have a very broad diversified and global customer base.

Tom Diffely -- D.A. Davidson & Co. -- Analyst

Okay. But no way to size in case it does come back to give us a sense of what the upside potentially could be to your guidance?

John Wall -- Senior Vice President and Chief Financial Officer

It's very hard to say. We don't want to speculate.

Tom Diffely -- D.A. Davidson & Co. -- Analyst

Okay. And then moving on, maybe you could talk about the margins in the quarter versus the guided margins about 10% lower. Is it just mix or is it more going on there?

John Wall -- Senior Vice President and Chief Financial Officer

Yes, certainly, Q2 was a -- there was a more profitable mix in revenue. We were happy with the performance in functional verification. We continue to expect modest growth for 2019, even considering the impact of those export limitations. The -- we expect gross margins, of course, like Q2 was a little unusual to see export limitations, we'd expect the gross margins for the second half to return to more typical levels. We're investing in opportunities to expand our business with market shaping customers and investing in TAM expansion opportunities. So we'd -- that's why the op margin is -- for the second half is forecasted approximately 30%.

Tom Diffely -- D.A. Davidson & Co. -- Analyst

Okay. And then finally, when you look at the growth in intelligent system design over the next several years, is that meaningfully change the model for either a margin or cost structure point of view versus traditional EDA?

John Wall -- Senior Vice President and Chief Financial Officer

Well, we're not guiding out beyond 2019. Everything we know is included in our guidance for 2019. We take a longer-term view over things and again wouldn't focus on any one quarter. I tend to like compare current results against our current midpoint of guidance against 2016. And I think I would expect the model to be pretty consistent.

Tom Diffely -- D.A. Davidson & Co. -- Analyst

Okay, thank you.

Operator

Your next question comes from John Pitzer with Credit Suisse.

John Pitzer -- Credit Suisse -- Analyst

Yes. Good afternoon, guys. Thanks for taking my [Phonetic] question. John, just a follow up on the gross margin, I want to make sure I understand. What was unusual about the June quarter.I thought I heard you say from the last question, it had to do with the export tariffs. But then you're saying that the gross margins to return back to normal in the back half of the year, despite the fact that it looks like you're still excluding some business related to the tariff issues.

John Wall -- Senior Vice President and Chief Financial Officer

Well, Q2 was a little unusual in that -- the export limitations took effect on May 16, and again on June 24, in respect to certain customers, and like you say, those remain in place today. The -- and then, I mean we had a few things in terms of hardware results. Hardware results is a little bit more profitable than we expected. Services revenue was a little bit more profitable than we expected. And just generally, like I say, I wouldn't -- it was great. It was a profitable quarter for Q2, but I wouldn't extrapolate that into any kind of future guidance that we expect non-GAAP gross margin to return to more typical levels in the second half of the year.

John Pitzer -- Credit Suisse -- Analyst

That's helpful. And then maybe as kind of a follow-up for Lip-Bu. Well, clearly, China is going to continue to be a long-term strategic customer for you. I'm just kind of curious, given the heightened tension U.S.-China trade, is there any concern that we should have that China might try to do EDA on their own? Or the very attention [Phonetic] to that business just so high, it will be difficult for them to kind of generate domestic sources for what you provide. Any sort of longer term color on that would be very helpful.

Lip-Bu Tan -- Chief Executive Officer

Sure. So I think now clearly they have a number of Chinese -- China-based EDA companies offering 0.2 solutions. And clearly, we are not going to speculate in the broader hypothesis. But clearly, we focus on the -- to be the best partner for our customer in globally, include China.

John Pitzer -- Credit Suisse -- Analyst

Thank you.

Operator

Your next question comes from Gary Mobley with Wells Fargo Securities.

Gary Mobley -- Wells Fargo Securities -- Analyst

Hey, guys, thanks for taking my question. Can you hear me all right?

Lip-Bu Tan -- Chief Executive Officer

Yes.

John Wall -- Senior Vice President and Chief Financial Officer

Yes.

Gary Mobley -- Wells Fargo Securities -- Analyst

All right, good. John, I wanted to ask you a question about your fiscal year '20 outlook. I know you're not going to say anything with respect to revenue growth or margins or anything at all relating to 2020. But as you enter your budget meeting, whatever that is, are you still going to use the guiding principle of the Rule of 40 is in terms of looking at the revenue growth, the some of the revenue growth in operating margin?

John Wall -- Senior Vice President and Chief Financial Officer

Yes, Gary, certainly. I mean the model we have, we expect to apply consistently. And Rule of 40 has been something we've looked at across the different business groups. So with that we're guiding for 2019; no, we're [Phonetic] not guiding beyond.

Gary Mobley -- Wells Fargo Securities -- Analyst

Understood. And with respect to your market shaping customer, I presume that you're still in the investment mode with this customer. Is it fair to assume that you haven't been able to recognize any revenue from the relationship at this point? And if that's the case, when would you expect you to bring the product to full fruition and be able to recognize revenue ?

John Wall -- Senior Vice President and Chief Financial Officer

Yes. So I think, Gary, now we mentioned quite a few market shaping customers, that's a quite a few important one. They are the leader in the industry. And I think I assume that you refer to this marquee U.S. semiconductor company; clearly, we have a breakthrough and wide-ranging win with this U.S. based semiconductor company, where we have a breakthrough and wide-ranging win. We are in the early stage of partnership. We're not very heavily engaging with them across the product line, the breadth of our engagement. So we're excited about it, but we continue to stay on cost and focus.

Gary Mobley -- Wells Fargo Securities -- Analyst

Got you. Okay. Thank you for taking the questions.

John Wall -- Senior Vice President and Chief Financial Officer

Sure.

Operator

Your next question comes from Jay Vleeschhouwer with Griffin Securities.

Jay Vleeschhouwer -- Griffin Securities -- Analyst

Thanks. Good evening. Lip-Bu, let me ask you a competitive question regarding Mentor. That is -- it's becoming recently apparent to that -- since the acquisition 2.5 years ago, they've been doing quite well with renews well when [Phonetic] they last reported in 2016, and particularly in the areas for which they were always the market leader, including physical verification and PCB, and it looks more recently also in hardware. The question is, have you encountered that or -- and have you had to make competitive adjustment, let's say, to the fact that Mentor is in fact doing somewhat better than they were pre-acquisition? And then a couple of follow-ups.

Lip-Bu Tan -- Chief Executive Officer

Yes, Jay, first of all, we respect Mentor tremendously, and run -- part of the Siemens is a very big $100 billion company. So we don't take them lightly and meanwhile we respect them a lot. And then clearly, there are some products are competing with us, I think you mentioned earlier at the hardware verification in Malaysian site, and of course they are callable products. So I think clearly we continue to respect them, but we effectively competing with them and so we treat then a business as usual.

Jay Vleeschhouwer -- Griffin Securities -- Analyst

All right. And you've grown your headcount pretty substantially year-to-date and also for Q1. Could you talk specifically about how well you've been able to bring on applications engineers? We've talked about this that for I believe the last half year, going back to last fall, that you've had a significant increase open reqs for your AEs, particularly domestically. Where you're now looking for AEs well beyond the number of that I think Synopsys or Mentor are looking for. So I imagine you've been able to onboard some, but can you talk about how you're doing in terms of bringing those kind of people on?

And then lastly for John, you've talked for the last number of years about deep quality, price optimization and so forth. When you think about your base of customer contracts in cohort terms or aging of the cohort of the contracts, how do you think you've done so far in terms of optimizing the base of contracts or how much is left to be done in terms of add any [Phonetic] contracts that at renewals you can optimize?

Lip-Bu Tan -- Chief Executive Officer

Yes. So Jay, let me answer the first question, and then John will answer the second question. So on the headcount and we pretty much -- that is pretty much on plan in terms of [Indecipherable] to bring on board. In terms of the talent and also the FAE, and engineering talent, we continue to bring in. And then John and I, we have very thoughtfully tried to bring in the talent with our executive team to really drive and our focus on customer success.

And so clearly, we have a lot of multiple market shaping customer we are proliferating. And we need the FAE to support the customer success and that's something that we're very focused on that. In terms of the AE resources increase, clearly not just domestically, also internationally to support our customer. So I think all-in-all, I think it's pretty much on plan and we continue to drive that. And then the -- as we always say, only when we see the green life on the customer in term of commitment, in term of proliferation with us, then we add AE and engineering talent to support that.

John Wall -- Senior Vice President and Chief Financial Officer

Yes. And Jay, in respect to your questions about deal quality and optimizing pricing, I mean we're very disciplined and value-driven. And we believe the best way to drive value for our products is to collaborate deeply with customers and deliver innovative and clearly differentiated solutions. And as Lip-Bu highlighted, we're investing in opportunities to expand our business with market shaping customers, and we're investing in TAM expansion opportunities that results from our intelligent system design strategy. I mean, in the end, it's all about innovation, which means attracting, retaining and incentivizing top talent.

Jay Vleeschhouwer -- Griffin Securities -- Analyst

Thank you.

Operator

Your next question comes from Sterling Auty with J.P. Morgan.

Sterling Auty -- J.P. Morgan -- Analyst

Yes. Thanks. Hi, guys. I want to start off by circling back to the export control the quantification. I understand you don't want to speculate on what might come back in. But is there a way to look backwards and just give us some quantification of how much contribution we've gotten from these customers in the past?

John Wall -- Senior Vice President and Chief Financial Officer

Okay. It's -- Sterling, I mean.

Lip-Bu Tan -- Chief Executive Officer

So let me start first, I think, John?

John Wall -- Senior Vice President and Chief Financial Officer

Yes.

Lip-Bu Tan -- Chief Executive Officer

First of all, I think, Sterling, we're clearly complying the regulation and limit some of relationship with some of the -- any customer that may be on that entity list. And clearly we review all the products portfolio to determine which are the products and related support subject to the limitations. So I think this is something that we really focus on what are the maintenance and support we can provide, and we want to the best customer and we want to do the best we can. But meanwhile, very important is to comply with the regulation.

John Wall -- Senior Vice President and Chief Financial Officer

Yes. We're not going to speculate on if and when either the regulations may change our ability to service those customers under the existing regulations may change. But our updated guidance for fiscal 2019 assumes no change, either positive or negative to current export limitations. But we would want to highlight that and emphasize that we have a very broad diversified and global customer base.

Sterling Auty -- J.P. Morgan -- Analyst

Okay. And then on the margin guidance for the back half of the year, you talked about the gross margins. But is there anything else that would kind of dictate why the operating margin would be? I mean the sort of an operating margins has been kind of down for the third quarter or even in the second half since the beginning. And usually that's kind of counterintuitive when we think about when your FICA rolls off, and some other timing of investments we've usually thought about you guys like most enterprise software is being more profitable in the back half than in the front half. So just looking at the margin guide for next quarter, other than gross margins, is there anything else that we can look to describe why the operating margins will be down sequentially?

John Wall -- Senior Vice President and Chief Financial Officer

Of course, Sterling, yes. And like you said -- like you pointed out, most of the expectation of a reversion to mean kind of for the gross margins. But on the op margin side, we're investing in opportunities with market shaping customers, and in our time expansion opportunities. We also have the annual pay increases for employees are effective in July here at Cadence, so that kicks in for the second half of the year. And that's what's taken us to an expectation of 30% for the second half.

Sterling Auty -- J.P. Morgan -- Analyst

All right. Perfect. Thank you.

Operator

Your next question comes from Rich Valera with Needham & Company.

Rich Valera -- Needham & Company -- Analyst

Thank you. Lip-Bu, you referenced geopolitical tension in your prepared remarks, which I think most would agree has increased probably over the last quarter or so. And notwithstanding the fact that your business remains obviously very healthy. Have you seen any change in any customer buying patterns or demand due to this increased tension, or any products, [Phonetic] unexpected customer attrition?

Lip-Bu Tan -- Chief Executive Officer

Yes. So far, we -- no, we don't see that. But clearly, when the process prolong and then clearly we'll see some impact. But clearly right now, so far we don't see any impact. And then we have a very broad based customer, as John mentioned, and we are happy in serving those customers.

Rich Valera -- Needham & Company -- Analyst

Got it. And then the custom analog was particularly strong this quarter, I think 11% was the growth rate you provided. Is there anything you can point to sort of justify why that was I think sort of above trend? And should we think of this as somewhat anomalous, or do we think that this business might be growing at a faster rate than it has historically?

Lip-Bu Tan -- Chief Executive Officer

Yes. We are very delighted with that 11% growth with a big base we have. And then clearly, it reflect our the leading products that we have and the tools that we have, and the customer really counting on us to delivering the design. And then meanwhile, a lot of application that I mentioned earlier in the 5G and some of the IoT and autonomous driving, and they are all mixed signal. And so that is really a strong combination of our strength in the analog, and now very strong portfolio that we have in digital, and then make it very compelling to grow that -- the mixed signal RF area.

John Wall -- Senior Vice President and Chief Financial Officer

And as always, we'd encourage you not to focus on any one quarter that you kind of have to look at the results over a longer period. And certainly, I wouldn't focus on -- if you're picking one quarter, I wouldn't extrapolate Q2 given the unusual nature of the impact of export limitations imposed during the quarter.

Rich Valera -- Needham & Company -- Analyst

Got it. And then, just to follow up on the Q2 gross margin, just a little confused. It sounds like you're suggesting that the export limitations bumped up the gross margins and just trying to understand why that would be? Did you ship less hardware than you expected to and that helped your mix? Or just -- if there is any color you could provide on why the export restrictions would actually helped gross margin?

John Wall -- Senior Vice President and Chief Financial Officer

Certainly, it's not just the export restrictions. Essentially it's a combination of events in the quarter. Like we say, the quarter was a little bit unusual in that respect. But hardware is a little bit more profitable than we originally anticipated. Services revenue was a little bit more profitable than we originally anticipated. And then just Q2 was a unusual in itself given the export limitations imposed during the quarter. That's what I'm saying, I wouldn't focus on extrapolating Q2, but focus on any one quarter. But you look at the year, really.

Rich Valera -- Needham & Company -- Analyst

Got it. Okay. Thank you.

Operator

Your next question is from Mitch Steves with RBC Capital Markets.

Mitch Steves -- RBC Capital Markets -- Analyst

Hey, guys, thanks for taking my question. So if I look at your China revenue growth, you guys are up 20% -- 21% sequentially. And then in your prepared remarks, you don't really say that you couldn't ship. So when you say that there is a anomaly in Q2, was that a actual negative in the quarter, or did it actually not impact the revenue volume? [Phonetic]

John Wall -- Senior Vice President and Chief Financial Officer

So you see, China is up -- yes, of course, yes. Yes, China was up. It was up -- it was 12% of our revenue in Q2 in comparison to 10% in Q1. But of course that's down from 13% in Q4. The nature of hardware and IP is a bit lumpy in nature anyway. But like I said, we wouldn't lead into any one quarter. But -- yes, our forecast for the second half of the year assumes that the export limitations that are in place today remain in effect for the rest of the year.

Mitch Steves -- RBC Capital Markets -- Analyst

Sure, yes. So just to clarify that. So I realize that you're assuming a neutral environment as of today. But was a negative for Q2 results?

John Wall -- Senior Vice President and Chief Financial Officer

Yes. I think our results would have been higher if there were no limitations.

Mitch Steves -- RBC Capital Markets -- Analyst

Okay, perfect. Thank you.

Operator

Your next question is from Gal Munda with Berenberg Capital.

Gal Munda -- Berenberg Capital -- Analyst

Hey, guys, thanks for taking my question. Just to follow up on the China argument. So it's up to 12% of overall [Phonetic] revenue today versus a year ago 8%, and it was kind of trending between 8% to 10% except for the Q4, which probably was hardware heavy. And can you just talk a bit more about the overall growth there? Is it the big players that are driving it, or is it a lot of the smaller players that are basically trying to ramp up their semi space there? Where do you -- where are you seeing demand if we kind of ignore the trade restrictions for a particular customer for now?

John Wall -- Senior Vice President and Chief Financial Officer

Sure. Like you say, I mean our China revenue mix over the past five quarters has ranged from a low of 8% in Q2 '18 to a high of 13% in Q4 '18. So I'm not inclined to attribute motivation. Our China business has been strong over the past several quarters. But for now, our ability to deliver products and services to certain customers that are on the BIS entity list is limited. So we would expect the percentage of revenue in China to be lower for the second half of fiscal 2019 than the first half.

Gal Munda -- Berenberg Capital -- Analyst

Okay, that makes sense. Thank you. And then just as a follow-up, if I think about -- and without thinking about a particular number, but just for margin outlook in the future. Recently, we've had this bump in gross margin helping and the mix helping. But going forward, would you expect the gross margin to start contributing to the operating margin improvement as well? Or do you think it's mostly based on the continued operating leverage in the business as you think about it? [Phonetic]

John Wall -- Senior Vice President and Chief Financial Officer

Yes. I'd expect non-GAAP gross margin to return to more typical levels in the second half of the year. And then the reason we expect operating margin to be 30% is because we're investing in new employees for -- as we invest in opportunities to expand our business with market-shaping customers, and the TAM expansion opportunities we have, and also because the annual pay increases for employees were effective in July. That's impacting our Q3 and Q4 op margin. But I wouldn't -- I expect gross margin to return to more typical levels in the second half of the year.

Gal Munda -- Berenberg Capital -- Analyst

John, if you look maybe a year or two ahead and I'm not asking for the guidance, but just kind of trend-wise, is there a potential in gross margin for this [Phonetic] to contribute to operating margin improvement in the future, is it mostly going to be from operating leverage?

John Wall -- Senior Vice President and Chief Financial Officer

Again, everything we know is in our guidance for 2019 and we're not guiding beyond 2019.

Gal Munda -- Berenberg Capital -- Analyst

Thank you.

Operator

Your next question comes from Jason Celino with KeyBanc Capital Markets.

Jason Celino -- KeyBanc Capital Markets -- Analyst

Hey, guys, can you hear me OK?

Lip-Bu Tan -- Chief Executive Officer

Yes.

John Wall -- Senior Vice President and Chief Financial Officer

Loud and clear. Yes.

Jason Celino -- KeyBanc Capital Markets -- Analyst

Yes. Just a quick one from me. So I appreciate your comments around kind of the investing in your market-shaping customers and your TAM expansion opportunities. But as you think about these investments, over the next second half and longer term, is there a one area that you feel is going to be more investment near term, and then one area to be more investments long-term, or is it going to be kind of equal?

John Wall -- Senior Vice President and Chief Financial Officer

We assess that -- I mean we assess that regularly as part of our normal review of annual operating expenses. But -- and really back to Gary's comment earlier in terms of Rule of 40, our approach is to invest in the areas where we think we have the highest revenue growth. I'm not saying 40 is the right number because -- and actually, we're not guiding beyond 2019. But essentially the whole premise on the Rule of 40 is, you add your operating margin to revenue growth. So basically the -- where we have areas of more revenue growth, we'll invest a little bit heavier there. Where we have less revenue growth opportunities, we look for more profitability.

Jason Celino -- KeyBanc Capital Markets -- Analyst

Okay. Thank you.

Operator

Your final question comes from Krish Sankar with Cowen.

Krish Sankar -- Cowen & Co. -- Analyst

Yes. Hi. Thanks for taking my question. I had two of them for either Lip-Bu or John. Number one is on your IP business, especially with the hyperscale customers. Are you guys doing any more customized projects, or is that all mostly done behind those at this point? And then the second question is, on the PCB business, have you seen any incremental design activity in PCB over the last few months? And if so, do you think is that just a short-term blip, or do you think there something else interesting in the horizon longer term on PCB? Thank you.

Lip-Bu Tan -- Chief Executive Officer

So I would add. Krish, let me address these two topic and then John will add some color. First of all, IP is a very lumpy business. And clearly if you look at first half is a double-digit growth for us and we like that. And then secondly, we just announced our Tensilica Q7. We are excited about that whole double vision, and then AI performance for automotive, AR, VR, mobile, and civilian [Phonetic] applications. And so with just product release on that, and we have couple of design wins in the data center, mobile, and automotive application.

And then the other part we like a lot is this SerDes -- high-speed SerDes, 120-gig SerDes at 7-nanometer. And we have very strong customer demands and then we're working very intensively with them. So overall, we like the IP business and we continue to build that as part of our whole, we call it the design excellence in core EDA and IP, that is the -- our strategy.

In terms of the PCB, interconnect side, also a very good -- solid business. And clearly, the whole system interconnect and a system analysis side, and we have double-digit growth in that area. And so clearly the whole system analysis that will increase $4.5 billion TAM market. And then our Clarity 3D Solver very well received by customer. We have numerous evaluations and our strong customer engagement and interest. So all-in-all, I think we are pretty solid on that.

John Wall -- Senior Vice President and Chief Financial Officer

Yes. And I would just add that IP as Lip-Bu says, is can be lumpy in any single quarter. But looking at the first half for IP, we had double-digit growth there and we're happy with that. But -- and then with regard to system interconnect, it was a strong quarter for our PCB IC packaging and security analysis products. And again as Lip-Bu said, we had double-digit growth there, so we're very pleased with the results there.

Rich Valera -- Needham & Company -- Analyst

That's it. Thank you, Lip-Bu and John.

Lip-Bu Tan -- Chief Executive Officer

Thank you.

John Wall -- Senior Vice President and Chief Financial Officer

Thanks.

Operator

As there are no further questions at this time, Mr. Lip-Bu, your closing remarks, please.

Lip-Bu Tan -- Chief Executive Officer

Yes. Thank you all for joining us this afternoon. Next phase of our strategy intelligent system design brings new opportunities in the design, excellence, system innovation and pervasive intelligence, and then expanded the total addressable market. Of course, Cadence will complying with all export regulation and will continue to access and adapt to the situation.

In summary, we are capitalizing on the multi-port analogy ways and further proliferating our solutions with a broader base of our customers. In closing, I would like to thank, all our shareholders, customers and partners, Board of Directors, and our hardworking employees for their continued support.

Operator

[Operator Closing Remarks]

Duration: 44 minutes

Call participants:

Alan Lindstrom -- Senior Group Director of Investor Relations

Lip-Bu Tan -- Chief Executive Officer

John Wall -- Senior Vice President and Chief Financial Officer

Tom Diffely -- D.A. Davidson & Co. -- Analyst

John Pitzer -- Credit Suisse -- Analyst

Gary Mobley -- Wells Fargo Securities -- Analyst

Jay Vleeschhouwer -- Griffin Securities -- Analyst

Sterling Auty -- J.P. Morgan -- Analyst

Rich Valera -- Needham & Company -- Analyst

Mitch Steves -- RBC Capital Markets -- Analyst

Gal Munda -- Berenberg Capital -- Analyst

Jason Celino -- KeyBanc Capital Markets -- Analyst

Krish Sankar -- Cowen & Co. -- Analyst

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