Magma Design Automation (LAVA) 10-Q 2005 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to            .

Commission File No.: 0-33213

MAGMA DESIGN AUTOMATION, INC.

(Exact name of registrant as specified in its charter)

Delaware	77-0454924
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

5460 Bayfront Plaza

Santa Clara, California 95054

(Address of principal executive offices)

Telephone: (408) 565-7500

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (l) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days. Yesx No¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yesx No¨

On November 5, 2004, 34,332,428 shares of Registrant’s Common Stock, $.0001 par value were outstanding.

MAGMA DESIGN AUTOMATION, INC.

FORM 10-Q

QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

INDEX

		Page
Part I: Financial Information		3
Item 1:	Financial Statements (unaudited)	3
	Condensed Consolidated Balance Sheets at September 30, 2004 and March 31, 2004	3
	Condensed Consolidated Statements of Operations for the Three and Six Months Ended September 30, 2004 and 2003	4
	Condensed Consolidated Statements of Cash Flows for the Six Months Ended September 30, 2004 and 2003	5
	Notes to Unaudited Condensed Consolidated Financial Statements	6
Item 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3:	Quantitative and Qualitative Disclosures About Market Risk	51
Item 4:	Controls and Procedures	52
Part II: Other Information		53
Item 1:	Legal Proceedings	53
Item 2:	Unregistered Sales of Equity Securities and Use of Proceeds	53
Item 4:	Submission of Matters to a Vote of Security Holders	54
Item 5:	Other Information	54
Item 6:	Exhibits	55
Signatures		56
Exhibit Index		57

2

PART I: FINANCIAL INFORMATION

Item  1. Financial Statements.

MAGMA DESIGN AUTOMATION, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

	September 30, 2004			March 31, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	54,213		$	72,684
Restricted cash		2,678			2,662
Accounts receivable, net		30,653			34,237
Prepaid expenses and other current assets		8,576			9,588
Total current assets		96,120			119,171
Property and equipment, net		21,138			15,196
Intangibles, net		76,849			62,793
Goodwill		29,057			33,529
Long-term investments		81,952			78,158
Other assets		6,589			5,628
Total assets	$	311,705		$	314,475
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,484		$	1,658
Accrued expenses		19,093			19,132
Deferred revenue		20,046			19,947
Total current liabilities		41,623			40,737
Convertible subordinated notes		150,000			150,000
Deferred income taxes		—			5,102
Other long-term liabilities		2,010			897
Total liabilities		193,633			196,736
Contingencies (Note 9)
Stockholders’ equity:
Common stock		3			3
Additional paid-in capital		246,460			226,586
Deferred stock-based compensation		(1,083	)		(718	)
Accumulated deficit		(109,311	)		(107,063	)
Treasury stock at cost, 1,000,000 and 0 shares at September 30, 2004 and March 31, 2004, respectively		(16,606	)		—
Accumulated other comprehensive loss		(1,391	)		(1,069	)
Total stockholders’ equity		118,072			117,739
Total liabilities and stockholders’ equity	$	311,705		$	314,475

See accompanying notes to unaudited condensed consolidated financial statements.

3

MAGMA DESIGN AUTOMATION, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	For the Three Months Ended September 30,						For the Six Months Ended September 30,
	2004			2003			2004			2003
Revenue:
Licenses	$	31,275		$	22,837		$	62,167		$	43,354
Services		5,653			2,980			10,790			5,276
Total revenue		36,928			25,817			72,957			48,630
Cost of revenue*		5,510			3,892			10,552			7,138
Gross profit		31,418			21,925			62,405			41,492
Operating expenses:
Research and development		10,524			6,019			20,093			11,027
In-process research and development		—			—			4,009			—
Sales and marketing		11,679			8,314			22,946			15,403
General and administrative		3,455			2,399			7,080			4,837
Amortization of intangible assets		4,093			—			8,568			—
Amortization of stock-based compensation**		116			1,755			574			5,733
Restructuring charge		(63	)		—			439			—
Total operating expenses		29,804			18,487			63,709			37,000
Operating income (loss)		1,614			3,438			(1,304	)		4,492
Other income (expense):
Interest income		556			635			1,109			1,243
Interest expense		(251	)		(211	)		(497	)		(322	)
Other income, net		(642	)		419			(1,204	)		(334	)
Other income (expense), net		(337	)		843			(592	)		587
Net income (loss) before income taxes		1,277			4,281			(1,896	)		5,079
Income taxes		(990	)		(866	)		(352	)		(1,591	)
Net income (loss)	$	287		$	3,415		$	(2,248	)	$	3,488
Net income (loss) per common share
Basic	$	0.01		$	0.11		$	(0.07	)	$	0.12
Diluted	$	0.01		$	0.09		$	(0.07	)	$	0.09
Shares used in calculation:
Basic		33,734			30,255			33,702			30,264
Diluted		42,333			40,064			33,702			39,688
* Stock-based compensation included in cost of revenue	$	2		$	3		$	6		$	7
** Components of stock-based compensation included in operating expenses:
Research and development	$	(16	)	$	1,347		$	274		$	2,906
Sales and marketing		18			49			43			180
General and administrative		114			359			257			2,647
	$	116		$	1,755		$	574		$	5,733

See accompanying notes to unaudited condensed consolidated financial statements.

4

MAGMA DESIGN AUTOMATION, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Six Months Ended September 30,
	2004			2003
Cash flows from operating activities:
Net (loss) income	$	(2,248	)	$	3,488
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization		14,623			2,572
In-process research and development		4,009			—
Provision for doubtful accounts		165			171
Interest expense on convertible subordinated note		497			351
Equity investment loss		665			122
Impairment of private company investments		—			700
Accrued interest on notes receivable from stockholders		—			8
Amortization of stock-based compensation		580			5,740
Restructuring charge		439			—
Change in operating assets and liabilities:
Accounts receivable		2,456			(3,222	)
Prepaid expenses and other assets		1,245			(6,265	)
Accounts payable		826			(52	)
Accrued expenses		(4,902	)		2,483
Deferred revenue		99			3,238
Other long-term liabilities		446			(65	)
Net cash provided by operating activities		18,900			9,269
Cash flows from investing activities:
Asset purchases, net of cash acquired		(11,902	)		—
Purchase of property and equipment		(9,183	)		(4,012	)
Purchase of short-term investments		(196	)		—
Purchase of long-term investments		(32,263	)		(94,000	)
Proceeds from the sale of short-term investments		196			—
Proceeds from the sale of long-term investments		27,798			5,000
Purchase of strategic equity investments		(1,100	)		—
Restricted cash		(16	)		—
Other assets		—			355
Net cash used in investing activities		(26,666	)		(92,657	)
Cash flows from financing activities:
Net proceeds from issuance of convertible subordinated notes		—			145,187
Proceeds from issuance of common stock		5,463			11,008
Repurchase of common stock		(16,606	)		(19,980	)
Purchase of hedge instrument		—			(56,154	)
Proceeds from issuance of common stock warrant		—			35,904
Proceeds from repayment of notes receivable from stockholder		—			214
Net cash (used in) provided by financing activities		(11,143	)		116,179
Effect of foreign currency translation on cash and cash equivalents		438			(317	)
Net increase (decrease) in cash and cash equivalents		(18,471	)		32,474
Cash and cash equivalents at beginning of period		72,684			64,756
Cash and cash equivalents at end of period	$	54,213		$	97,230
Supplemental disclosure:
Non-cash investing and financing activities:
Deferred stock-based compensation	$	(458	)	$	(5,509	)
Settlement of note receivable from shareholder in connection with purchase of common stock	$	—		$	(3,566	)
Stock issuance pursuant to acquisitions or milestone earnout payments	$	12,007		$	7,882

See accompanying notes to unaudited condensed consolidated financial statements.

5

MAGMA DESIGN AUTOMATION, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Basis of Presentation

The interim unaudited condensed consolidated financial statements included herein have been prepared by Magma Design Automation, Inc. (“Magma” or “Company”), pursuant to the rules and regulations of the United States Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted, pursuant to these rules and regulations. However, management believes that the disclosures are adequate to ensure that the information presented is not misleading. The interim unaudited condensed consolidated financial statements reflect, in the opinion of management, all adjustments necessary (consisting only of normal recurring adjustments) to present a fair statement of results for the interim periods presented. The operating results for any interim period are not necessarily indicative of the results that may be expected for the entire fiscal year ending March 31, 2005. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company’s Form 10-K for the year ended March 31, 2004, as filed with the SEC on June 8, 2004. The accompanying unaudited condensed consolidated balance sheet at March 31, 2004 is derived from audited consolidated financial statements at that date.

Preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

6

Note 2. Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principals Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” as interpreted by Financial Accounting Standards Board (“FASB”) Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25” and Emerging Issues Task Force No. 00-23 (“EITF 00-23”), “Issues related to the Accounting for Stock Compensation under APB 25 and FIN 44,” and FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans,” and complies with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of SFAS 123.” Under APB Opinion No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price. SFAS No. 123 as amended by SFAS No. 148 requires a “fair value” based method of accounting for an employee stock option or similar equity instrument. Had compensation cost for the Company’s stock-based compensation plan been determined using the Black-Scholes option pricing model at the grant date for awards granted in accordance with the provisions of SFAS No. 123, the Company’s net income (loss) would have been the amounts indicated below (in thousands):

	Three Months Ended September 30,						Six Months Ended September 30,
	2004			2003			2004			2003
	in thousands
Net income (loss):
As reported	$	287		$	3,415		$	(2,248	)	$	3,488
Add: Stock-based employee compensation expense included in reported net income (loss)		118			1,758			580			5,740
Deduct: Stock-based employee compensation expense determined under fair value method for all awards		(5,133	)		(5,187	)		(10,876	)		(11,372	)
Pro forma	$	(4,728	)	$	(14	)	$	(12,544	)	$	(2,144	)
Net income (loss) per share, basic:
As reported	$	0.01		$	0.11		$	(0.07	)	$	0.12
Pro forma	$	(0.14	)	$	0.00		$	(0.37	)	$	(0.07	)
Net income (loss) per share, diluted:
As reported	$	0.01		$	0.09		$	(0.07	)	$	0.09
Pro forma	$	(0.14	)	$	0.00		$	(0.37	)	$	(0.07	)

Such pro forma disclosures may not be representative of future compensation cost because options vest over several years and additional grants are made each year.

The weighted average fair value per option at the date of grant for options granted to employees during the three months and six months ended September 30, 2004 was $5.26 and $5.85, respectively. The weighted average fair value per option at the date of grant for options granted to employees during the three and six months ended September 30, 2003 was $9.06 and $8.72, respectively. The fair value of options at the date of grant was estimated using the Black-Scholes option pricing model using the following assumptions:

	Three Months Ended September 30,				Six months ended September 30,
	2004		2003		2004		2003
Stock options:
Risk-free interest	3.29	%	2.41	%	3.10	%	2.31	%
Expected life	3.14 years		4.75 years		2.91 years		4.75 years
Expected dividend yield	0	%	0	%	0	%	0	%
Volatility	43	%	77	%	44	%	76	%

7

	Three Months Ended September 30,				Six Months Ended September 30,
	2004		2003		2004		2003
Employee stock purchase plans:
Risk-free interest	2.37	%	1.38	%	2.03	%	1.32	%
Expected life	1.19 years		0.59 years		1.17 years		0.49 years
Expected dividend yield	0	%	0	%	0	%	0	%
Volatility	43	%	68	%	44	%	69	%

Note 3. Basic and Diluted Net Income (Loss) Per Share

The Company computes net income per share in accordance with SFAS 128, “Earnings per Share”. Basic net income (loss) per share is computed by dividing net income attributable to common stockholders (numerator) by the weighted average number of common shares outstanding (denominator) during the period. Diluted net income per share gives effect to all dilutive potential common shares outstanding during the period including stock options and redeemable convertible subordinated notes using the as-if-converted method.

The following is a reconciliation of the weighted average common shares used to calculate basic net income per share to the weighted average common and potential common shares used to calculate diluted net income per share for the three months ended September 30, 2004 and 2003 (in thousands):

	Three Months Ended September 30,		Six Months Ended September 30,
	2004	2003	2004	2003
Weighted average common shares used to calculate basic net income (loss) per share	33,734	30,255	33,702	30,264
Options outstanding using the treasury method	1,515	3,033	—	2,725
Redeemable convertible subordinated notes using the as-if-converted method	6,562	6,562	—	6,562
Warrants outstanding using the treasury stock method	—	25	—	24
Common stock subject to repurchase	522	189	—	113
Weighted average common and potential common shares used to calculate diluted net income per share	42,333	40,064	33,702	39,688

For the six months ended September 30, 2004, all potential common shares outstanding during the period were excluded from the computation of diluted net loss per share as their effect would be anti-dilutive. This includes 6,562,000 shares for redeemable convertible notes and 8,387,969 shares of common stock issuable under stock option plans outstanding as of September 30, 2004. For the three months ended September 30, 2004, 4,686,962 shares of stock options at the average exercise price of $20.14 was excluded from the computation of diluted income per share, as the result would be anti-dilutive under the treasury method. For the three and six months ended September 30, 2003, 346,770 and 541,520 shares, respectively, of common stock issuable under the stock option plans were excluded from the computation of diluted income per share. The average exercise price of such shares was $24.31 and $24.05 for the three and six months ended September 30, 2003.

8

Note 4. Cash equivalents and investments

Cash equivalents, short-term investments, and long-term investments are detailed as follows:

	Cost		Unrealized Gains		Unrealized Loss			Estimated Fair Value
	(In Thousands)
September 30, 2004
Classified as current assets (less than 12 months):
Cash	$	16,367	$	—	$	—		$	16,367
Money market funds		6,396		—		—			6,396
Municipal obligations		31,450		—		—			31,450
		54,213		—		—			54,213
Classified as non-current assets (more than 12 months):
Corporate bonds		31,853		—		(174	)		31,679
Government / Municipal debt securities		50,587		—		(314	)		50,273
Total	$	136,653	$	—	$	(488	)	$	136,165

	Cost		Unrealized Gains		Unrealized Loss			Estimated Fair Value
	(In Thousands)
March 31, 2004
Classified as current assets (less than 12 months):
Cash	$	15,888	$	—	$	—		$	15,888
Money market funds		1,746		—		—			1,746
Municipal obligations		55,050		—		—			55,050
		72,684		—		—			72,684
Classified as non-current assets (more than 12 months):
Corporate bonds		38,580		118		(10	)		38,688
Debt securities		39,394		88		(12	)		39,470
Total	$	150,658	$	206	$	(22	)	$	150,842

The Company’s investment portfolio consists of both corporate and government securities that have a maximum maturity of two years. The longer the duration of these securities, the more susceptible they are to changes in market interest rates and bond yields. As yields in the marketplace increase, those securities purchased with lower yields at the time of purchase will show a marked-to-market unrealized loss. All unrealized losses are due to changes in interest rates and bond yields. We expect to realize the full value of all these investments upon maturity or sale. The average duration of the losses on these securities has been less than 12 months.

Note 5. Asset Purchases

Mojave, Inc.

On April 29, 2004, the Company completed its acquisition of Mojave, Inc. (“Mojave”), a privately held developer of advanced technology for integrated circuit manufacturability and verification. The acquisition of Mojave will allow Magma to more comprehensively address its customers’ needs of designing and verifying semiconductors that are manufacturable with desirable yield and performance. Manufacturability is a key design parameter as semiconductor process technology moves to sub-90nm geometries. The total initial purchase price of the Mojave acquisition was approximately $25.1 million and the transaction was accounted for as an asset purchase transaction. The Company acquired all of the outstanding common stock of Mojave in exchange for

9

initial consideration of $24.2 million, which consisted of 607,554 shares of Magma common stock valued at $11.8 million and $12.4 million in cash. In addition to the initial merger consideration, the Company agreed to pay contingent consideration of up to $115 million, half in stock and half in cash, based on product orders over a period ending March 31, 2009, but such payments are contingent on the achievement of certain technology milestones. The Company did not assume any stock options or warrants. No contingent consideration yet has been paid under the agreement as of September 30, 2004 because none of the milestones have been achieved.

Magma allocated the initial purchase price of $25.1 million to the fair values of the assets acquired and liabilities assumed. The fair value of the existing technology and assembled workforce intangible assets and in-process research and development were determined by management with the use of a third party valuation report. A summary of the purchase price allocation and the amortization periods of the intangible assets acquired is as follows (in thousands):

	Amount Allocated
Allocation of the preliminary purchase price:
Net tangible assets acquired	$	611
Intangible assets acquired:
Developed technology		16,964
Assembled workforce		966
In-process research and development		4,009
Deferred compensation		1,320
Deferred stock-based compensation		1,254
Total purchase price	$	25,124
Amortization period of existing technology		5 years
Amortization period of assembled workforce		4 years

The value assigned to developed technology was based upon future discounted cash flows related to the developed technology’s projected income streams using discount rate of 16%. The Company believes this rate was appropriate given the business risks inherent in marketing and selling this technology. Factors considered in estimating the discounted cash flows to be derived from the developed technology included risks related to the characteristics and applications of the technology, existing and future markets and an assessment of the age of the technology within its life span.

The valuation method used to value in-process research and development (“IPR&D”) is a form of discounted cash flow method. This approach is a widely recognized appraisal method and is commonly used to value technology assets. The value of the in-process technology is the sum of the discounted expected future cash flows attributable to the in-process technology, taking into consideration the percentage of completion of products utilizing this technology, utilization of pre-existing technology, the risks related to the characteristics and applications of the technology, existing and future markets and the technological risk associated with completing the development of the technology. The cash flows derived from the in-process technology project were discounted at a rate of 30%. The Company believes the rate used was appropriate given the risks associated with the technologies for which commercial feasibility had not been established. The percentage of completion for the in-process project was determined by identifying the elapsed time and costs invested in the project as a ratio of the total time and costs required to bring the project to technical and commercial feasibility, as well as consideration of engineering milestones required to complete the project. The percentage of completion for the in-process project acquired was 12.4%. Schedules were based on management’s estimate of tasks completed and the tasks to be completed to bring the project to technical and commercial feasibility. There has been no change to the IPR&D project schedule as of September 30, 2004. Revenue resulting from the IPR&D project is expected to commence in calendar year 2005.

Development of in-process technology remains a substantial risk to the Company due to a variety of factors including the remaining effort needed to achieve technical feasibility, rapidly changing customer requirements and competitive threats from other companies and technologies. Additionally, the value of other intangible assets

10

acquired may become impaired. The in-process research and development valuation, as well as the valuation of other intangible assets was prepared and determined by management with the assistance of an independent appraisal firm, based on input from the Company and the acquired company’s management, using valuation methods that are recognized by the United States Securities and Exchange Commission staff.

As part of the initial consideration for the Mojave acquisition, the Company paid cash of $1.3 million which was recorded as deferred cash compensation and issued Magma common stock with a value of $1.3 million which was recorded as deferred stock-based compensation. Both the cash and the shares were unearned on the acquisition date and will be earned based on continued provision of employment services by the former Mojave employees in accordance with pre-defined vesting schedules which range from 20 to 41 months. Accordingly, both the deferred cash compensation and the deferred stock-based compensation are treated as compensation, and are charged to operating expense as services are performed. During the three and six months ended September 30, 2004, the Company amortized $0.1 million and $0.3 million of deferred cash compensation, respectively. During the three and six months ended September 30, 2003, the Company amortized $0.1 million and $0.2 million of deferred stock-based compensation, respectively.

Lemmatis, Inc.

On April 16, 2004, the Company acquired Lemmatis, Inc. (“Lemmatis”), a privately-held developer of formal verification technology. Pursuant to a merger agreement signed on April 14, 2004, the Company paid the stockholders of Lemmatis initial consideration of approximately $600,000 in cash, less $60,000 which the Company withheld to secure the indemnification obligations of the Lemmatis stockholders. In addition to the initial merger consideration, the Company may pay up to an additional $1.4 million upon the achievement of certain technology milestones set forth in the merger agreement. No contingent consideration yet has been paid under the agreement as of September 30, 2004 because the milestones have not been achieved. The acquisition of Lemmatis has been accounted for as an asset purchase transaction.

Based on management’s estimates and appraisal, the initial consideration of $600,000 and $76,000 of legal and other professional expenses directly associated with the acquisition of Lemmatis were entirely allocated to a developed technology intangible asset and were included in the intangible asset balance on the Company’s condensed consolidated balance sheet as of September 30, 2004. This developed technology intangible asset is being amortized to cost of revenue over the estimated economic life of three years.

Note 6. Goodwill and Other Intangible Assets

The following table summarizes the components of goodwill, other intangible assets and related accumulated amortization balances as of September 30, 2004 and March 31, 2004 (in thousands):

		September 30, 2004							March 31, 2004
	Weighted Average Life (months)	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Goodwill		$	29,057	$	—		$	29,057	$	33,529	$	—		$	33,529
Other intangible assets:
Developed technology	49	$	53,595	$	(9,042	)	$	44,553	$	29,507	$	(3,316	)	$	26,191
Licensed technology	36		22,996		(3,832	)		19,164		22,988		—			22,988
Customer relationship or base	61		2,200		(418	)		1,782		2,200		(200	)		2,000
Patents	60		11,582		(2,191	)		9,391		11,282		(1,032	)		10,250
Acquired customer contracts	36		900		(288	)		612		900		(137	)		763
Assembled workforce	46		1,166		(168	)		998		200		(31	)		169
No shop right	24		100		(48	)		52		100		(23	)		77
Trademark	45		400		(103	)		297		400		(45	)		355
Total		$	92,939	$	(16,090	)	$	76,849	$	67,577	$	(4,784	)	$	62,793

11

During the quarter ended September 30, 2004, the Company accrued or paid $4.4 million in accordance with certain milestone achievement earnout provisions contained in prior acquisition agreements. These are recorded as developed technology as of September 30, 2004. During the quarter ended September 30, 2004, the Company reduced its net intangible assets by $10.9 million, goodwill by $5.0 million, and deferred tax liabilities by $15.9 million to reflect purchase price adjustments on the Company’s acquisitions.

For the three months ended September 30, 2004, the amortization expense related to other intangible assets was $5.5 million, of which $1.4 million was included in cost of revenue because it related to the products sold, while the remaining $4.1 million is shown as a separate line item in the Company’s unaudited condensed consolidated statement of operations. For the six months ended September 30, 2004, amortization expense related to other intangible assets was $11.3 million, of which $2.7 million was included in cost of revenue and remaining $8.6 million is shown as a separate line item. There was no intangible amortization expense for the three and six months ended September 30, 2003.

Note 7. Restructuring charge

During the six months ended September 30, 2004, the Company recorded a net restructuring charge of $0.4 million related to employee termination costs for 7 employees resulting from the Company’s realignment to current business conditions. The Company has paid these termination costs as of September 30, 2004.

Note 8. Convertible Subordinated Notes

On May 22, 2003, the Company completed an offering of $150.0 million principal amount of Zero Coupon Convertible Subordinated Notes due May 15, 2008 (the “Notes”) to qualified buyers pursuant to Rule 144A under the Securities Act of 1933, resulting in net proceeds to the Company of approximately $145.1 million. The Notes do not bear coupon interest and are convertible into shares of the Company’s common stock at a conversion price of $22.86 per share, for an aggregate of 6,561,680 shares. The Notes are subordinated to the Company’s existing and future senior indebtedness and effectively subordinated to all indebtedness and other liabilities of the Company’s subsidiaries. The Company may not redeem the Notes prior to their maturity date. The Company paid approximately $4.5 million in transaction fees to the underwriters of the offering and approximately $0.3 million in other debt issuance costs. The Company is amortizing the transaction fees and issuance costs over the life of the Notes using the effective interest method. As of September 30, 2004, approximately $1.5 million of transaction fees and debt issuance costs had been amortized. The shares issuable on the conversion of the Notes are included in diluted shares outstanding for the three months ended September 30, 2004 and September 30, 2003, and the six months ended September 30, 2003 under the as-if-converted method of accounting for purposes of calculating diluted earnings per share. Such shares are excluded from diluted shares outstanding for the six months ended September 30, 2004 as their effect would be anti-dilutive.

In order to minimize the dilutive effect from the issuance of the Notes, the Company undertook the following additional transactions concurrent with the issuance of the Notes:

• The Company repurchased approximately 1.1 million shares of its common stock at a price of $18.00 per share, or approximately $20.0 million, from one of the initial purchasers of the Notes, and those shares were retired as of May 30, 2003.

• The Company and Credit Suisse First Boston International (“CSFB International”) entered into convertible bond hedge and warrant transactions with respect to the Company’s common stock, the exposure for which is held by CSFB International. Under the convertible bond hedge arrangement, CSFB International agreed to sell to the Company, for $22.86 per share, up to 6,561,680 shares of Magma common stock to cover the Company’s obligation to issue shares upon conversion of the Notes. In addition, the Company issued CSFB International a warrant to purchase up to 6,561,680 shares of common stock for a purchase price of $31.50 per share. Purchases and sales under this arrangement may

12

be made only upon expiration of the Notes or their earlier conversion (to the extent thereof). Both transactions may be settled at the Company’s option either in cash or net shares, and will expire on the earlier of a conversion event or the maturity of the convertible debt on May 15, 2008. The transactions are expected to reduce the potential dilution from conversion of the Notes. The net cost incurred in connection with these arrangements was approximately $20.3 million, which is presented in stockholder’s equity as a reduction of additional paid-in-capital, in accordance with the guidance in Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” That net cost consisted of the $56.2 million cost of the convertible bond hedge, offset in part by the $35.9 million proceeds from the issuance of the warrant.

Note 9. Contingencies

On September 17, 2004, Synopsys, Inc. (“Synopsys”) filed a Complaint for Patent Infringement (“Complaint”) against the Company in the United States District Court for the Northern District of California, Case Number C04-03923. The Complaint alleges infringement of three patents: U.S. Patents Nos. 6,378,114 (“the ‘114 Patent”), 6,453,446 (“the ‘446 Patent”), and 6,725,438 (“the ‘438 Patent”). The ‘114 Patent was issued to Synopsys. The ‘446 and ‘438 Patents, however, were issued to Magma and claim inventions by Magma co-founder Dr. Lukas Van Ginneken. Synopsys alleges that it is the rightful owner of the ‘446 and ‘438 Patents and is entitled to assert them against Magma because the inventions claimed in the ‘446 and ‘438 Patents allegedly were made, conceived and developed by Dr. Van Ginneken while he was employed by Synopsys and were subject to an inventions assignment agreement. The Complaint alleges that by making, using, selling and distributing certain of its products, the Company is infringing the ‘114, ‘446, and ‘438 Patents. The Complaint seeks unspecified monetary damages, injunctive relief, trebling of damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other benefits allegedly obtained by the Company as a result of its alleged infringement of the asserted patents.

On October 21, 2004, the Company filed its answer with counterclaims (“Answer”) to the Complaint. In its Answer, the Company raised various defenses and allegations, including: (i) the Company owns all right, title and interest in and the ‘446 and ‘438 Patents, because the inventions disclosed in those patents were developed by Dr. Van Ginneken while at the Company, and without use of Synopsys’ confidential information; (ii) the Company does not infringe the ‘114 Patent because the Company’s technology is fundamentally different from the inventions claimed in the ‘114 Patent; (iii) the ‘114 Patent is invalid; (iv) Synopsys lacks standing to bring any infringement action under the ‘114 Patent because International Business Machines Corporation (“IBM”), which is not a party to the lawsuit, is a co-owner of the ‘114 Patent by operation of law and as a result of a joint development agreement between IBM and Synopsys; (v) if Synopsys could somehow show that the ‘446 and ‘438 Patents were invented at Synopsys, IBM would be a joint owner of those patents by operation of law and as a result of the joint development agreement, and Synopsys would lack standing to sue on those patents; (vi) the Company cannot be liable for infringing any patents co-owned by IBM because the Company is licensed under those patents pursuant to the Company’s patent license agreement with IBM; and (vii) if Synopsys could somehow show that the ‘446 and ‘438 Patents were invented at Synopsys, the ‘446 and ‘438 Patents are invalid and not infringed. In its Answer, the Company further alleges that Synopsys is engaging in efforts to spread false and misleading statements about the Company and its products to the public. The Answer seeks, among other things, dismissal with prejudice of the Complaint, reaffirmation of the Company’s ownership interest in ‘446 and ‘438 Patents, and an order enjoining Synopsys’ unfair business practices.

The Company intends to vigorously defend against the claims asserted by Synopsys and to fully enforce its rights against Synopsys. However, the results of any litigation are inherently uncertain and the Company can not assure that it will be able to successfully defend against the Complaint. As a result, no estimate can be made at this time of the loss or range of loss, if any, from this matter. A favorable outcome for Synopsys could have a material adverse effect on the Company’s financial position, results of operations or cash flows. A trial date has not been set and discovery has not yet commenced.

13

In addition to the above, from time to time, the Company is involved in disputes that arise in the ordinary course of business. The number and significance of these disputes is increasing as the Company’s business expands and it grows larger. Any claims against the Company, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. As a result, these disputes could harm the Company’s business, financial condition, results of operations or cash flows.

Indemnification Obligations

The Company enters into standard license agreements in the ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify its customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to the Company’s products. These indemnification obligations have perpetual terms. The Company’s normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification the Company may be required to make may exceed its normal business practices. The Company estimates the fair value of its indemnification obligations as insignificant, based upon its historical experience concerning product and patent infringement claims. Accordingly, the Company has no liabilities recorded for indemnification under these agreements as of September 30, 2004.

The Company has agreements whereby its officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a directors’ and officers’ liability insurance policy that reduces its exposure and enables the Company to recover a portion of future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of September 30, 2004.

In connection with certain of the Company’s recent business acquisitions, it has also agreed to assume, or cause Company subsidiaries to assume, the indemnification obligations of those acquired companies to their respective officers and directors.

Warranties

The Company offers its customers a warranty that its products will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, the Company has no liabilities recorded for these warranties as of September 30, 2004. The Company assesses the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the future.

Note 10. Promissory Note

In October 2001, the Company’s President, Mr. Roy Jewell, exercised an option to purchase 428,570 shares of common stock at the exercise price of $10.50 per share by executing a full recourse promissory note of approximately $4.5 million bearing interest of 5.5% per annum and due in March 2006. Terms of the note provided that if Mr. Jewell were still employed by the Company on any anniversary of his date of hire, up to $2.7 million note principal and $0.4 million related total interest to maturity would be forgiven. The forgivable portion of the note and related interest was recorded as a reduction of notes receivable from stockholders and a charge to deferred compensation, which would be amortized to compensation expense over the five-year term of the note. On May 14, 2003, the Company repurchased 209,753 shares of common stock from Mr. Jewell for an aggregate purchase price of $3.6 million, or $17.00 per share, which was the closing sale price of the common stock on that date, and he repaid the principal and related accrued interest outstanding under the promissory note in full.

14

On May 14, 2003, concurrently with the transaction described above, the Company granted Mr. Jewell an option to purchase 297,393 shares of its common stock at an exercise price of $7.00 per share, of which the first 209,753 shares vested immediately upon grant and the remaining 87,640 shares vest in equal monthly installments through March 5, 2005. In connection with this option grant, the Company recognized approximately $2.1 million of stock-based compensation immediately upon grant with respect to the vested shares and recorded $0.9 million of deferred stock-based compensation to be amortized over the vesting period of 22 months for the remaining shares. During the three and six months ended September 30, 2004, the Company amortized $45,000 and $0.1 million, respectively, of such deferred stock-based compensation. During the three and six months ended September 30, 2003, the Company amortized $0.2 million and $0.5 million, respectively, of such deferred stock-based compensation.

Note 11. Comprehensive Income (Loss)

Comprehensive income (loss) includes net income (loss), unrealized gain (loss) on investments and foreign currency translation adjustments as follows (in thousands):

	Three Months Ended September 30,					Six Months Ended September 30,
	2004		2003			2004			2003
Net income (loss)	$	287	$	3,415		$	(2,248	)	$	3,488
Unrealized gain (loss) on available-for-sale investments		284		71			(599	)		(156	)
Foreign currency translation adjustments		199		(323	)		276			346
Comprehensive income (loss)	$	770	$	3,163		$	(2,571	)	$	3,678

Components of accumulated other comprehensive loss, net of related tax effects, were as follows (in thousands):

	September 30, 2004			March 31, 2004
Unrealized gain (loss) on available-for-sale investments	$	(488	)	$	111
Foreign currency translation adjustments		(903	)		(1,180	)
Accumulated other comprehensive loss	$	(1,391	)	$	(1,069	)

Note 12. Segment Information

The Company adopted the provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, which requires the reporting of segment information using the “management approach.” Under this approach, operating segments are identified in substantially the same manner as they are reported internally and used by the Company’s President and Chief Operating Officer (“COO”) for purposes of evaluating performance and allocating resources. Based on this approach, the Company has one reportable segment as the COO reviews financial information on a basis consistent with that presented in the condensed consolidated financial statements.

Revenue from the United States, Europe, Japan and Asia-Pacific region, which includes, India, South Korea, Taiwan, Hong Kong and the People’s Republic of China, was as follows (in thousands):

	Three Months Ended September 30,				Six Months Ended September 30,
	2004		2003		2004		2003
North America	$	20,137	$	12,517	$	43,115	$	25,142
Europe		5,415		3,409		10,265		8,500
Japan		9,705		9,204		15,271		13,838
Asia Pacific (excluding Japan)		1,671		687		4,306		1,150
	$	36,928	$	25,817	$	72,957	$	48,630

15

	Three Months Ended September 30,				Six Months Ended September 30,
	2004		2003		2004		2003
North America	55	%	48	%	59	%	52	%
Europe	15		13		14		17
Japan	26		36		21		28
Asia Pacific (excluding Japan)	4		3		6		3
	100	%	100	%	100	%	100	%

Revenue attributable to significant customers, representing 10% or more of total revenue for at least one of the respective periods, is summarized as follows:

	Three Months Ended September 30,				Six Months Ended September 30,
	2004		2003		2004		2003
Customer A	15	%	6	%	7	%	3	%
Customer B	12		15		19		16
Customer C	4		14		5		14
Customer D	—		18		—		13

The Company has substantially all of its long-lived assets located in the United States.

Note 13. Shareholders’ Equity

The 2004 Employment Inducement Award Plan (“Inducement Plan”) was adopted by the Board of Directors on August 30, 2004. Under the Inducement Plan, the Company (with the approval of the Compensation Committee of the Board of Directors (the “Committee”)) may grant non-qualified stock options to “New Hire” employees who are not executive officers of the Company. These employees may also be awarded restricted common shares, stock appreciation rights (“SARs”) or stock unit awards (“Stock Units”). The maximum aggregate number of options, SARs, Stock Units and restricted shares that may be awarded under the Inducement Plan is 1,000,000 shares. The Committee determines whether an award may be granted, the number of shares/options awarded, the date an award may be exercised, vesting and the exercise price. Each award must be subject to an agreement between each applicable employee and the company. The term of the plan continues until May 4, 2011.

In July 2004, the board of directors authorized the Company to repurchase up to 1,000,000 shares of common stock. The repurchase program was completed during the quarter ended September 30, 2004, with repurchase prices ranging from $16.08 to $17.05 per share. Total cash used was $16.6 million for this program and the repurchased shares were recorded as treasury stock. The repurchased shares will be used to fund the Inducement Plan. As of September 30, 2004, the Committee had granted a total of 198,600 stock options under the Inducement Plan.

Note 14. Newly Adopted and Recently Issued Accounting Pronouncements

In March 2004, EITF reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The consensus clarifies the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method or the equity method. The EITF 03-01 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. The application of this consensus did not have a material effect on the Company’s consolidated results of operations.

16

In April 2004, the Emerging Issues Task Force issued Statement No. 03-06 “Participating Securities and the Two-Class Method Under FASB Statement No. 128,Earnings Per Share” (“EITF 03-06”). EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-06 did not have any effect on the Company’s calculation of EPS.

In July 2004, EITF reached a tentative consensus on EITF Issue No. 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share,” that the impact of contingently convertible debt, such as the Company’s zero-coupon convertible senior notes, should be included in diluted net income per share computations regardless of whether the market price trigger has been met. If the EITF’s tentative consensus is ratified by the FASB, the provisions are expected to be effective for reporting periods ending after December 15, 2004. The application of this consensus did not have any effect on the Company’s calculation of EPS.

On March 31, 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements No. 123 and 95,” that addresses the accounting for share-based payment transactions with employees and other third-parties. The proposed statement would eliminate the ability to account for share-based compensation transactions using the intrinsic value method as prescribed by Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees,” and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expenses in our consolidated statement of income. The proposed standard would require that the modified prospective method be used, which requires that the fair value of new awards granted from the beginning of the year of adoption (plus unvested awards at the date of adoption) be expensed over the vesting period. In addition, the proposed statement encourages the use of the “binomial” approach to value stock options, which differs from the Black-Scholes option pricing model that we currently use in the footnotes to our consolidated financial statements. The recommended effective date of the proposed standard for public companies is currently for interim and annual periods beginning after June 15, 2005.

Should this proposed statement be finalized in its current form, it will have a significant impact on our consolidated statement of operations as we will be required to expense the fair value of our stock option grants and stock purchases under our employee stock purchase plan rather than disclose the impact on our consolidated net income (loss) within our footnotes (see Note 2 above), as is our current practice. In addition, there are a number of implementation questions that are not fully resolved by the proposed statement. As a result, there may be additional changes reflected in our financial statements upon issuance of the final standard.

17

ITEM  2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion and Analysis of Financial Condition and Results of Operation section should be read in conjunction with our condensed consolidated financial statements and results appearing elsewhere in this report. Throughout this section, we make forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can often identify these and other forward looking statements by terms such as “becoming,” “may,” “will,” “should,” “predicts,” “potential,” “continue,” “anticipates,” “believes,” “estimates,” “seeks,” “expects,” “plans,” “intends,” or comparable terminology. These forward-looking statements include, but are not limited to, our expectations about revenue and various operating expenses. Although we believe that the expectations reflected in these forward-looking statements are reasonable, and we have based these expectations on our beliefs and assumptions, such expectations may prove to be incorrect. Our actual results of operations and financial performance could differ significantly from those expressed in or implied by our forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to: increasing competition in the EDA market; higher-than-anticipated costs in connection with recent patent litigation with Synopsys, Inc.; Magma’s ability to successfully integrate recently acquired businesses and technologies; the impact of economic slowdown in our customers’ markets; any delay of customer orders or failure of customers to renew licenses; weaker-than-anticipated sales of the company’s products and services; difficulties managing the company’s expanding operations; the ability to continue to deliver competitive products to customers to help them get their products to market; and changes in accounting rules.

Executive Summary

Magma Design Automation provides electronic design automation, or EDA, software products and related services. Our software enables chip designers to reduce the time it takes to design and produce complex integrated circuits used in the communications, computing, consumer electronics, networking and semiconductor industries. Our products are used in all major phases of the chip development cycle, from initial design through physical implementation. Our focus is on software used to design the most technologically advanced integrated circuits, specifically those with a measurement of 0.13 micron and smaller. See “Item 1, Business” in our Annual Report on Form 10-K for the year ended March 31, 2004 for a more complete description of our business.

As an EDA software provider, we generate substantially all our revenue from the semiconductor and electronics industries. Our customers typically fund purchases of our software and services out of their research and development budgets. As a result, our revenue is heavily influenced by our customers’ long-term business outlook and willingness to invest in new chip designs.

Beginning in late calendar 2000, the semiconductor industry entered its steepest and longest downturn of the past 20 years, with industry sales dropping significantly from late 2000 to early 2002. As a result, our customers have focused on controlling costs and reducing risk, reducing R&D expenditures, cutting back on design starts, purchasing from fewer suppliers, requiring more favorable pricing and payment terms from suppliers, and pursuing consolidation within their own industry. Further, during this downturn, many start-up semiconductor design companies failed or were acquired, and the pace of investment in new companies declined.

In response to these conditions, we have focused on providing the most technologically advanced products to address each step in the integrated circuit, or IC, design process, on integrating these products into broad platforms, and on expanding our product offerings. Our goal is to be the EDA technology supplier of choice for our customers as they pursue longer-term, broader and more flexible relationships with fewer suppliers.

While the semiconductor industry experienced a moderate recovery in 2003, our customers have remained cautious. It is therefore not yet clear when improved demand in our own customers’ electronics end markets will cause them to significantly increase their R&D spending or their design starts, and hence their spending on EDA.

18

Despite the condition of the semiconductor industry as described above, we were able to achieve the following during the second quarter of fiscal 2005:

• We achieved record quarterly revenue of $36.9 million during the second quarter of fiscal 2005, up 2 percent from the prior quarter and up 43% from the same quarter in fiscal 2004. License sales for the quarter ended September 30, 2004 accounted for approximately 85% of total revenue, compared to 86% in the prior quarter and 89% from the same quarter in the prior year. Revenue increased primarily from sales of additional licenses, services and contract extensions to existing customers in North America and Japan.

• We continued to penetrate our market, and during the second quarter of fiscal 2005 we passed the 165-customer threshold. To take advantage of opportunities to gain market share and support this growth, we accelerated hiring, primarily in the field support organization and R&D.

• Our technology continues to be a top choice among designers working on the most advanced designs. Magma customers are currently using our technology for 90 nanometer designs and several have started or are preparing for 65 nanometer designs.

• We successfully completed the integration of Mojave, Inc. personnel and systems into the Company during the quarter. With the acquisition of Mojave, we will be able to more comprehensively address our customers’ needs for designing and verifying semiconductors that are manufacturable with desirable yield and performance, which is a key design parameter as semiconductor process technology moves to sub-90 nanometer geometries.

Critical Accounting Policies and Estimates

In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our net revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. We consider the following accounting policies related to revenue recognition, allowance for doubtful accounts, investments, asset purchases and business combinations, deferred taxes and valuation of long-lived assets to be our most critical policies due to the estimation processes involved in each.

Revenue recognition

We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, as modified by SOP 98-9, which generally requires revenue earned on software arrangements involving multiple elements (such as software products, upgrades, enhancements, maintenance, installation and training) to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on evidence that is specific to us. If evidence of fair value does not exist for each element of a license arrangement and maintenance is the only undelivered element, then all revenue for the license arrangement is recognized over the term of the agreement. If evidence of fair value does exist for the elements that have not been delivered, but does not exist for one or more delivered elements, then revenue is recognized using the residual method, under which recognition of revenue for the undelivered elements is deferred and the residual license fee is recognized as revenue immediately.

Our revenue recognition policy is detailed in Note 1 of the Notes to Consolidated Financial Statements. Management has made significant judgments related to revenue recognition; specifically, in connection with each transaction involving our products (referred to as an “arrangement” in the accounting literature) we must evaluate whether our fee is “fixed or determinable” and we must assess whether “collectibility is probable”. These judgments are discussed below.

The fee is fixed or determinable. With respect to each arrangement, we must make a judgment as to whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, then revenue is recognized upon delivery of software (assuming other revenue recognition criteria are met). If the fee is not fixed or determinable,

19

then the revenue recognized in each period (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees were being recognized ratably.

Except in cases where we grant extended payment terms to a specific customer, we have determined that our fees are fixed or determinable at the inception of our arrangements based on the following:

• The fee our customers pay for our products is negotiated at the outset of an arrangement and is generally based on the specific volume of products to be delivered.

• Our license fees are not a function of variable-pricing mechanisms such as the number of units distributed or copied by the customer or the expected number of users of the product delivered.

In order for an arrangement to be considered fixed or determinable, 100% of the arrangement fee must be due within one year or less from the order date. We have a history of collecting fees on such arrangements according to contractual terms. Arrangements with payment terms extending beyond 12 months are considered not to be fixed or determinable.

Collectiblity is probable. In order to recognize revenue, we must make a judgment about the collectibility of the arrangement fee. Our judgment of the collectibility is applied on a customer-by-customer basis pursuant to our credit review policy. We typically sell to customers for which there is a history of successful collection. New customers are subjected to a credit review process, which evaluates the customers’ financial positions and ability to pay. If it is determined from the outset of an arrangement that collectibility is not probable based upon our credit review process, revenue is recognized on a cash receipts basis (as each payment is collected).

License revenue

We derive license revenue primarily from licenses of our design and implementation software and, to a much lesser extent, from licenses of our analysis and verification products. We license our products under time-based and perpetual licenses.

We recognize license revenue after the execution of a license agreement and the delivery of the product to the customer, provided that there are no uncertainties surrounding the product acceptance, fees are fixed or determinable, collection is probable and there are no remaining obligations other than maintenance. For licenses where we have vendor-specific objective evidence of fair value “VSOE”, for maintenance, we recognize license revenue using the residual method. For these licenses, license revenue is recognized in the period in which the license agreement is executed assuming all other revenue recognition criteria are met. For licenses where we have no VSOE for maintenance, we recognize license revenue ratably over the maintenance period, or if extended payment terms exist, based on the amounts due and payable.

For transactions in which we bundle maintenance for the entire license term into a time-based license agreement, no VSOE of fair value exists for each element of the arrangement. For these agreements, where the only undelivered element is maintenance, we recognize revenue ratably over the contract term. If an arrangement involves extended payment terms—that is, where payment for less than 100% of the license, services and initial post contract support is due within one year of the contract date—we recognize revenue to the extent of the lesser of the portion of the amount due and payable or the ratable portion of the entire fee.

For our perpetual licenses and some time-based license arrangements, we unbundle maintenance by including maintenance for up to first year of the license term, with maintenance thereafter renewable by the customer at the substantive rates stated in their agreements with us. In these unbundled licenses, the aggregate renewal period is greater than or equal to the initial maintenance period. The stated rate for maintenance renewal in these contracts is VSOE of the fair value of maintenance in both our unbundled time-based and perpetual licenses. Where the only undelivered element is maintenance, we recognize license revenue using the residual method. If an arrangement involves extended payment terms, revenue recognized using the residual method is limited to amounts due and payable.

20

If we were to change any of these assumptions or judgments, it could cause a material increase or decrease in the amount of revenue that we report in a particular period. Amounts invoiced relating to arrangements where revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized over time as the applicable revenue recognition criteria are satisfied.

Services revenue

We derive services revenue primarily from consulting and training for our software products and from maintenance fees for our products. Most of our license agreements include maintenance, generally for a one-year period, renewable annually. Services revenue from maintenance arrangements is recognized on a straight-line basis over the maintenance term. Because we have VSOE of fair value for consulting and training services, revenue is recognized as these services are performed or completed. Our consulting and training services are generally not essential to the functionality of the software. Our products are fully functional upon delivery of the product. Additional factors considered in determining whether the revenue should be accounted for separately include, but are not limited to: degree of risk, availability of services from other vendors, timing of payments and impact of milestones or acceptance criteria on our ability to recognize the software license fee.

Unbilled Accounts Receivable

Unbilled accounts receivable represent revenue that has been recognized in advance of being invoiced to the customer. In all cases, the revenue and unbilled receivables are for contracts which are non-cancelable, there are no contingencies and where the customer has taken delivery of both the software and the encryption key required to operate the software. We typically generate invoices 45 days in advance of contractual due dates, and we invoice the entire amount of the unbilled accounts receivable within one year from the contract inception. As of September 30, 2004 and March 31, 2004, unbilled accounts receivable were approximately $13.9 million and $14.9 million, respectively. These amounts were included in accounts receivable on our consolidated balance sheets for these periods. As of September 30, 2004, one customer accounted for approximately 17% of total receivables.

Allowance for doubtful accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We regularly review the adequacy of our accounts receivable allowance after considering the size of the accounts receivable balance, each customer’s expected ability to pay and our collection history with each customer. We review significant invoices that are past due to determine if an allowance is appropriate using the factors described above. We also monitor our accounts receivable for concentration in any one customer, industry or geographic region.

As of September 30, 2004, one customer accounted for approximately 17% of total receivables. The allowance for doubtful accounts represents our best estimate, but changes in circumstances relating to accounts receivable may result in a requirement for additional allowances in the future. If actual losses are significantly greater than the reserve we have established, that would increase our general and administrative expenses and reduce our reported net income. Conversely, if actual credit losses are significantly less than our reserve, this would decrease our general and administrative expenses and our reported net income would increase.

Accounting for asset purchases and business combinations

We are required to allocate the purchase price of acquired assets and business combinations to the tangible and intangible assets acquired, liabilities assumed, as well as in-process research and development based on their estimated fair values. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.

21

Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from license sales, maintenance agreements, consulting contracts, customer contracts, acquired workforce and acquired developed technologies and patents; expected costs to develop the in-process research and development into commercially viable products and estimated cash flows from the projects when completed; the acquired company’s brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined company’s product portfolio; and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.

Other estimates associated with the accounting for these acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed resulting in changes in the purchase price allocation.

Goodwill impairment

Our long-lived assets include goodwill and other intangible assets. Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests in certain circumstances. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting unit, and determining the fair value of the reporting unit. We have determined that we have one reporting unit (see Note 6 of the Notes to the Unaudited Condensed Consolidated Financial Statements under Item 1 of this report) Significant judgments required to estimate the fair value of a reporting unit include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for the reporting unit. Any impairment losses recorded in the future could have a material adverse impact on our financial condition and results of operations.

Valuation of long-lived intangible assets

Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” requires that we record an impairment charge on finite-lived intangibles or long-lived assets to be held and used when we determine that the carrying value of intangible assets and long-lived assets may not be recoverable. Based on the existence of one or more indicators of impairment, we measure any impairment of intangibles or long-lived assets based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our business model. Our estimates of cash flows require significant judgment based on our historical results and anticipated results and are subject to many factors.

Deferred tax asset valuation allowance

We account for income taxes in accordance with SFAS 109, “Accounting for Income Taxes.” We assess the likelihood that our net deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we establish a valuation allowance. We consider future taxable income and ongoing prudent and feasible tax planning strategies in assessing the amount of the valuation allowance. However, adjustments could be required in the future if we determine that the amount to be realized is greater or less than the amount we have recorded.

Strategic investments in privately held companies

During the second quarter of fiscal 2005, we entered into an agreement to purchase a $0.5 million convertible note that is convertible into preferred or common stock in a private company. At September 30, 2004, the carrying value of our portfolio of strategic equity investments in non-marketable equity securities (privately held companies) totaled $2.1 million. Our ability to recover our investments in private, non-marketable equity

22

securities and to earn a return on these investments is primarily dependent on how successfully these companies are able to execute to their business plans and how well their products are accepted, as well as their ability to obtain additional capital funding to continue operations and to grow. In the current equity market environment, their ability to obtain additional funding as well as to take advantage of liquidity events, such as initial public offerings, mergers and private sales, may be significantly constrained.

Under our accounting policy, the carrying value of a non-marketable investment is the amount paid for the investment unless it has been determined to be other than temporarily impaired, in which case we write the investment down to its impaired value. We review all of our investments periodically for impairment; however, for non-marketable equity securities, the impairment analysis requires significant judgment. This analysis includes assessment of each investee’s financial condition, the business outlook for its products and technology, its projected results and cash flows, the likelihood of obtaining subsequent rounds of financing and the impact of any relevant contractual equity preferences held by us or others. If an investee obtains additional funding at a valuation lower than our carrying amount, we presume that the investment is other than temporarily impaired, unless specific facts and circumstances indicate otherwise, such as when we hold contractual rights that give us a preference over the rights of other investors. As the equity markets have declined significantly over the past few years, we have experienced substantial impairments in our portfolio of non-marketable equity securities. If equity market conditions do not improve, as companies within our portfolio attempt to raise additional funds, the funds may not be available to them, or they may receive lower valuations, with more onerous investment terms than in previous financings, and the investments will likely become impaired. However, we are not able to determine at the present time which specific investments are likely to be impaired in the future, or the extent or timing of individual impairments. We recorded impairment charges related to these non-marketable equity investments of $0.3 million and $0.7 million during the three and six months ended September 30, 2004, respectively. Similarly, we recorded impairment charges related to these non-marketable equity investments of $0.8 million and $0.8 million during the three and six months ended September 30, 2003, respectively.

Results of Operations

Revenue

Revenue consists of licenses revenue and services revenue. License revenue consists of fees for time-based or perpetual licenses of our products. Services revenue consists of fees for services, such as post-contract customer support (“PCS”), customer training and consulting. We recognize revenue based on the specific terms and conditions of the license contracts with our customer for our products and services as described in detail above in our “Critical Accounting Policies and Estimates”. For management reporting and analysis purposes we classify our revenue into the following four categories:

• Ratable

• Due & Payable

• Cash Receipts

• “Turns or Up-front”/ Perpetual or Time-Based

We classify our license arrangements as either bundled or unbundled. Bundled license contracts include maintenance with the license fee and do not include optional maintenance periods. Unbundled license contracts have separate maintenance fees and include optional maintenance periods.

23

We use this classification of license revenue to provide greater insight into the reporting and monitoring of trends in the components of our revenue and to assist us in managing our business. It is important to note that the characterization of an individual contract may change over time. For example, a contract originally characterized as Ratable may be redefined as Cash Receipts should that customer have difficulty in making payments in a timely fashion. In cases where a contract has been re-characterized for management reporting purposes, prior periods are not restated to reflect that change. The following table shows the breakdown of license revenue by category as defined for management reporting and analysis purposes:

		Three months ended September 30,								Six months ended September 30,
		2004				2003				2004				2003
Revenue category:
License revenue
Ratable	Bundled and Unbundled	$	4,309	12	%	$	5,960	23	%	$	9,172	13	%	$	15,542	32	%
Due & Payable	Unbundled		12,933	35	%		13,568	52	%		28,284	39	%		17,338	36	%
Cash Receipts	Unbundled		2,848	8	%		162	1	%		5,425	7	%		497	1	%
Turns	Unbundled		11,185	30	%		3,147	12	%		19,286	26	%		9,977	20	%
Total license revenue			31,275	85	%		22,837	88	%		62,167	85	%		43,354	89	%
Maintenance & services			5,653	15	%		2,980	12	%		10,790	15	%		5,276	11	%
Total Revenue		$	36,928	100	%	$	25,817	100	%	$	72,957	100	%		48,630	100	%

Bundled and Unbundled Licenses: Ratable.For bundled time-based licenses, we recognize license revenue ratably over the contract term, or as customer payments become due and payable, if less. This revenue for bundled arrangements for both license and maintenance is classified as license revenue in our statement of operations. For unbundled time-based with a term of less than 15 months, we recognize license revenue ratably over the license term, or as customer payments become due and payable, if earlier. For management reporting and analysis purposes, we refer to these types of licenses generally as “Ratable” and we generally refer to all time-based licenses recognized on a ratable basis as “Long Term”, independent of the actual length of term of the license.

We classify unbundled perpetual or time-based licenses with a term of fifteen months or greater based on the payment term structure, as “Due and Payable”, “Cash Receipts” or “Perpetual”:

Unbundled Licenses: Due and Payable/Time-Based licenses with long term payments.For unbundled time-based licenses where the payment terms extend greater than one year from the arrangement effective date, we recognize license revenue on a due and payable basis and we recognize maintenance and services revenue ratably over the maintenance term. For management reporting and analysis purposes, we refer to this type of license generally as “Due and Payable/Long Term Time-Based Licenses”.

Unbundled Licenses: Cash Receipts.We recognize revenue from customers who have not met our predetermined credit criteria on a cash receipts basis to the extent that revenue has otherwise been earned. Such customers generally order short-term time based licenses or separate annual maintenance. We recognize license revenue as we receive cash payments from these customers. Maintenance is recognized ratably over the maintenance term after the customer has remitted payment. For management reporting and analysis purposes, we refer to this type of license revenue as “Cash Receipts”.

Unbundled Licenses: “Turns”/Perpetual License or Time-Based licenses with short-term payments.For unbundled time-based and perpetual licenses, we recognize license revenue upon shipment as long as the payment terms require the customer to pay 100% of the license fee and the initial period of PCS within one year from the agreement date and payments are generally linear. We recognize maintenance revenue ratably over the maintenance term. In all of these cases, the contracts are non-cancelable, and the customer has taken delivery of both the software and the encryption key required to operate the software. For management reporting and analysis purposes, we refer to this type of license generally as “Turns”, where the license is either perpetual or time-based.

24

Our license revenue in any given quarter depends upon the mix and volume of perpetual or short term licenses ordered during the quarter and the amount of long-term ratable or due and payable, and cash receipts license revenue recognized during the quarter. In general, we refer to license revenue recognized from perpetual or time based licenses during the quarter as “Up-front” or “turns” revenue, for management reporting and analysis purposes. All other types of revenue is generally referred to as revenue from backlog. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of short term licenses. The precise mix of orders fluctuates substantially from period to period and affects the revenue we recognize in the period. If we achieve our target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we have more-than-expected long term licenses) or may exceed them (if we have more-than-expected short term or perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets as described in the risk factors below.

Three Months Ended September 30, 2004 and 2003

Revenue, cost of revenue and gross profit

The table below sets forth the fluctuations in revenue, cost of revenue and gross profit data for the three months ended September 30, 2003 and the three months ended September 30, 2004 (in thousands, except percentage data):

	Three Months Ended September 30, 2004		Percentage of Revenue		Three Months Ended September 30, 2003		Percentage of Revenue		Year to Year Increase		Percentage Increase
Revenue:
Licenses	$	31,275	84.7	%	$	22,837	88.5	%	$	8,438	36.9	%
Services		5,653	15.3	%		2,980	11.5	%		2,673	89.7	%
Total revenue		36,928	100.0	%		25,817	100.0	%		11,111	43.0	%
Cost of revenue		5,510	14.9	%		3,892	15.1	%		1,618	41.6	%
Gross profit	$	31,418	85.1	%	$	21,925	84.9	%	$	9,493	43.3	%

We market our products and related services to customers in four geographic regions: the United States, Europe (Europe, the Middle East and Africa), Japan, and Asia Pacific. Internationally, we market our products and services primarily through our subsidiaries and various distributors. Revenue is attributed to geographic areas based on the country in which the customer is domiciled. The table below sets forth geographic distribution of revenue data for the three months ended September 30, 2003 and the three months ended September 30, 2004 (in thousands, except percentage data):

	Three Months Ended September 30, 2004		Percentage of Revenue		Three Months Ended September 30, 2003		Percentage of Revenue		Year to Year Increase		Percentage Increase
Domestic	$	20,137	54.5	%	$	12,517	48.5	%	$	7,620	60.9	%
International:
Europe		5,415	14.7	%		3,409	13.2	%		2,006	58.8	%
Japan		9,705	26.3	%		9,204	35.6	%		501	5.4	%
Asia-Pacific (excluding Japan)		1,671	4.5	%		687	2.7	%		984	143.2	%
Total International		16,791	45.5	%		13,300	51.5	%		3,491	26.2	%
Total revenue	$	36,928	100.0	%	$	25,817	100.0	%	$	11,111	43.0	%

25

Revenue

• Revenue for the second quarter of fiscal 2005 was $36.9 million, up 2 percent from the prior quarter and up 43% from the same quarter in the prior year.

• License revenue increased in the second quarter of fiscal 2005 as compared to the prior quarter and the second quarter in fiscal 2004 due to large orders executed during the quarter in North America and Japan. These orders came from existing customers who extended license periods and require additional license capacity due to the continued proliferation to their design group designers using Magma existing and new products, principally Blast Fusion APX. Two customers each accounted for greater than 10% of the quarterly revenue. License revenue for the quarter ended September 30, 2004 accounted for approximately 85% of total revenue, compared to 86% in the prior quarter and 89% from the second quarter of fiscal 2004.

• Service revenue increased in the second quarter of fiscal 2005 as compared to the prior quarter and the second quarter in fiscal 2004 primarily due to our large customers accelerating their deployment of our licenses and placing additional services orders. Service revenue for the quarter ended September 30, 2004 accounted for approximately 15% of total revenue, compared to 14% from the prior quarter and 11% from the second quarter of fiscal 2004.

• Domestic revenuedecreased in the second quarter of fiscal of 2005 as compared to the prior quarter due to significant increase in our revenue from international, primarily from Japan and Europe. Compared to the second quarter in fiscal 2004, domestic revenue increased due primarily to our existing customers in North America purchasing additional licenses and the new technology products. Domestic revenue for the quarter ended September 30, 2004 accounted for approximately 55% of total revenue, compared to 64% in the prior quarter and 49% in the second quarter in fiscal 2004.

• International revenue increased in the second quarter of fiscal 2005 compared to the second quarter of fiscal 2004 due primarily to our existing customers in Japan and Asia-Pacific purchasing additional licenses and the addition of new technology products. International revenue for the second quarter of fiscal 2005 accounted for approximately 45% of total revenue, compared to 36% in the prior quarter and 51% from the second quarter in fiscal 2004. The decline in international revenue as a percentage of revenue in the second quarter of fiscal 2005 was primarily due to the greater growth of our domestic revenue compared to that of international revenue during the period.

Gross profit

Cost of revenue primarily consists of personnel and related costs to provide product support, consulting services and training. Cost of revenue also includes software production costs, product packaging, documentation, amortization of acquired developed technology and other intangible assets, and amortization of deferred stock-based compensation. Management allocates these expenses to cost of upfront licenses, cost of time-based licenses and cost of services, based on orders booked within a given quarter. Accordingly, the costs allocated to upfront licenses, time-based licenses and services are heavily dependent on the mix of software orders received during any given period.

• Gross profit as a percentage of revenueremained relatively stable during the three months ended September 30, 2004 compared to the three months ended September 30, 2003 even though license revenue, which has a higher gross margin compared to service revenue, accounting for a lower percentage of total revenue for the period. This was due to the growth in total revenue for the three months ended September 30, 2004 and the fact that our cost of revenue consists primarily of payroll related costs for application engineers, which are fixed in nature.

26

Operating expenses

The table below sets forth operating expense data for the three months ended September 30, 2004 and the three months ended September 30, 2003 (in thousands, except percentage data):

	Three Months Ended September 30, 2004			Percentage of Revenue		Three Months Ended September 30, 2003		Percentage of Revenue		Year to Year Increase (Decrease)			Percentage Increase (Decrease)
Operating expenses:
Research and development	$	10,524		28.5	%	$	6,019	23.3	%	$	4,505		74.8	%
Sales and marketing		11,679		31.6	%		8,314	32.2	%		3,365		40.5	%
General and administrative		3,455		9.4	%		2,399	9.3	%		1,056		44.0	%
Restructuring costs		(63	)	(0.1	)%		—	0.0	%		(63	)	(100.0	)%
Amortization of intangible assets		4,093		11.1	%		—	0.0	%		4,093		100.0	%
Amortization of stock-based compensation		116		0.3	%		1,755	6.8	%		(1,639	)	(93.4	)%
Total operating expenses	$	29,804		80.7	%	$	18.487	71.6	%	$	11,317		61.2	%

• Research and development expense increased in the three months ended September 30, 2004 compared to the three months ended September 30, 2003 primarily due to an increase in payroll related expenses of $2.6 million as we increased our research and development headcount by approximately 75% through direct hiring and business acquisitions. The remainder of the increase was caused by increases in common expenses (e.g., facility related expenses) of $1.1 million and software maintenance costs of $0.9 million, both of which were caused by the headcount increase.

• Sales and marketing expense increased in the three months ended September 30, 2004 compared to the three months ended September 30, 2003 primarily due to an increase in payroll related expenses of $3.2 million as we increased our sales and marketing headcount by 54% (primarily application engineers) through direct hiring as well as business acquisitions. The remainder of the fluctuation in sales and marketing expenses was accounted for by other individually insignificant items.

• General and administrative expense increased in the three months ended September 30, 2004 compared to the three months ended September 30, 2003 primarily due to increases in professional service fees of $0.5 million and payroll related expenses of $0.9 million, offset by a reduction of $0.2 million bad debt expense. The increase in professional service fees in the three months ended September 30, 2004 was primarily due to the increase in our activity related to the Sarbanes-Oxley Act of 2002, as well as legal expenses related to patent applications. The increase in payroll related expenses was caused by a 64% increase in headcount related to general and administrative activities in the three months ended September 30, 2004, compared to the three months ended September 30, 2003. The remainder of the fluctuation in general and administrative expenses was accounted for by other individually insignificant items.

• Amortization of intangible assets of $4.0 million in the three months ended September 30, 2004 represents amortization of intangible assets recorded in connection with business combinations and asset purchases completed subsequent to September 30, 2003. The intangible assets being amortized include trademarks, customer contracts, customer relationships, no shop rights and assembled workforces that were identified in the purchase price allocation for each business combination and asset purchase transaction.

• Amortization of deferred stock-based compensation decreased in the three months ended September 30, 2004 compared to the three months ended September 30, 2003 primarily due to the decrease in amortization of deferred stock-based compensation (recorded in connection with our IPO in November 2001) of $1.6 million. These decreases in amortization of deferred stock-based compensation were partially offset by recording of stock-based compensation expense of $0.2 million related to our Mojave acquisition in the three months ended September 30, 2004.

27

Other items

The table below sets forth other data for the three months ended September 30, 2004 and the three months ended September 30, 2003 (in thousands, except percentage data):

	Three Months Ended September 30, 2004			Percentage of Revenue		Three Months Ended September 30, 2003			Percentage of Revenue		Year to Year change			Percentage Increase (Decrease)
Other income (expense), net:
Interest income	$	556		1.5	%	$	635		2.5	%	$	(79	)	(12.4	)%
Interest expense		(251	)	(0.7	)%		(211	)	(0.8	)%		(40	)	(18.9	)%
Other expense, net		(642	)	(1.7	)%		419		1.6	%		(1,061	)	(253.2	)%
Total other expense, net	$	(337	)	(0.9	)%	$	843		3.2	%	$	1,180		(140.0	)%
Benefit from (provision for) income taxes	$	(990	)	2.7	%	$	(866	)	(3.4	)%	$	(124	)	(14.3	)%

• Interest income decreased in the three months ended September 30, 2004 compared to the three months ended September 30, 2003 primarily due to our maintaining lower average cash and investments balance during the period. The average cash balance was higher during the three months ended September 30, 2003 because we had received $145 million of net proceeds in connection with our convertible subordinated debt offering, common stock warrant and bond hedge transactions, all of which were completed in May 2003.

• Interest expense primarily represents amortization of debt discount and issuance costs, which were recorded in connection with our convertible subordinated debt offering completed in May 2003. Quarterly interest expense is approximately $0.2 million for the amortization of debt discount and issuance costs.

• Other expense, net in the three months ended September 30, 2004 decreased compared to the three months ended September 30, 2003 primarily due to the charge associated with other than temporary impairment in our strategic investments by $0.3 million. Such charge was determined based on our periodic review of investee company financial performance. We also incurred an increase of foreign exchange loss of $0.3 million, which was caused by an unfavorable exchange rate fluctuation between the U.S. Dollar and the Japanese Yen during the three months ended September 30, 2004. For the three months ended September 30, 2003, we recorded a foreign exchange gain of $0.4 million.

• Benefit from (provision for) income taxes. We are in a net deferred tax asset position, for which a full valuation allowance has been recorded. We will continue to provide a valuation allowance for our net deferred tax assets until it becomes more likely than not that the deferred tax assets will be realizable. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis. As of September 30, 2004, the Company has released cumulative valuation allowance on its deferred tax assets of $18.8 million with the benefit allocated to goodwill and other intangibles. For the three months ended September 30, 2004 and September 30, 2003, we had a provision for income taxes of $1.0 million and $0.9 million, respectively. Our effective tax rate varies from the U.S. statutory rate primarily due to changes in our valuation allowance, state taxes, foreign income at other than U.S. rates, deferred compensation, in-process research and development (“R&D), research and development credits and foreign withholding taxes.

28

Six months Ended September 30, 2004 and 2003

Revenue, cost of revenue and gross profit

The table below sets forth the fluctuations in revenue, cost of revenue and gross profit data for the six months ended September 30, 2003 and the six months ended September 30, 2004 (in thousands, except percentage data):

	Six months Ended September 30, 2004		Percentage Of Revenue		Six months Ended September 30, 2003		Percentage of Revenue		Year to Year Increase		Increase Percentage
Revenue:
Licenses	$	62,167	85.2	%	$	43,354	89.2	%	$	18,813	43.4	%
Services		10,790	14.8	%		5,276	10.8	%		5,514	104.5	%
Total revenue		72,957	100.0	%		48,630	100.0	%		24,327	50.0	%
Cost of revenue		10,552	14.5	%		7,138	14.7	%		3,414	47.8	%
Gross profit	$	62,405	85.5	%	$	41,492	85.3	%	$	20,913	50.4	%

We market our products and related services to customers in four geographic regions: the United States, Europe (Europe, the Middle East and Africa), Japan, and Asia Pacific. Internationally, we market our products and services primarily through our subsidiaries and various distributors. Revenue is attributed to geographic areas based on the country in which the customer is domiciled. The table below sets forth geographic distribution of revenue data for the six months ended September 30, 2004 and the six months ended September 30, 2003 (in thousands, except percentage data):

	Six months Ended September 30, 2004		Percentage of Revenue		Six months Ended September 30, 2003		Percentage of Revenue		Year to Year Increase		Increase Percentage
Domestic	$	43,115	59.1	%	$	25,142	51.7	%	$	17,973	71.5	%
International:
Europe		10,265	14.1	%		8,500	17.5	%		1,765	20.8	%
Japan		15,271	20.9	%		13,838	28.5	%		1,433	10.4	%
Asia-Pacific (excluding Japan)		4,306	5.9	%		1,150	2.3	%		3,154	274.3	%
Total International		29,842	40.9	%		23,488	48.3	%		6,354	27.0	%
Total revenue	$	72,957	100.0	%	$	48,630	100.0	%	$	24,327	50.0	%

Revenue

• Revenue for the six months ended September 30, 2004 was $73.0 million, up 50% from the same period in the prior year.

• License revenue increased in the six months ended September 30, 2004 as compared to the same period in fiscal 2004 due to large orders executed during the period in North America and Asia-Pacific. These orders came from existing customers who require additional license capacity due to the continued proliferation of their design group designers using Magma existing and new products. One customer accounted for greater than 10% of the revenue generated for the six months ended September 30, 2004. License revenue for the six months ended September 30, 2004 accounted for approximately 85% of total revenue, compared to 89% in for the same period in fiscal 2004.

29

• Service revenue increased in the six months ended September 30, 2004 as compared to the same period in fiscal 2004 primarily due to our large customers accelerating their deployment of our licenses and placing additional services orders. Service revenue for the six months ended September 30, 2004 accounted for approximately 15% of total revenue, as compared to 11% from the same period in fiscal 2004.

• Domestic revenue increased in the six months ended September 30, 2004 as compared to the same period in fiscal 2004 due primarily to our existing customers in North America purchasing additional licenses and new technology products. Domestic revenue for the six months ended September 30, 2004 accounted for approximately 59% of total revenue, compared to 52% for the same period in fiscal 2004.

• International revenue increased in the six months ended September 30, 2004 compared to the same period in fiscal 2004 due primarily to our existing customers in Japan and Asia-Pacific purchasing additional licenses and the addition of new technology products. International revenue for the six months ended September 30, 2004 accounted for approximately 41% of total revenue, compared to 48% in the prior year same period in fiscal 2004. The decline in international revenue as a percentage of revenue in the first half of fiscal 2005 was primarily due to the greater growth of our domestic revenue compared to that of international revenue during the period.

Gross profit

Cost of revenue primarily consists of personnel and related costs to provide product support, consulting services and training. Cost of revenue also includes software production costs, product packaging, documentation, amortization of acquired developed technology and other intangible assets, and amortization of deferred stock-based compensation. Management allocates these expenses to cost of upfront licenses, cost of time-based licenses and cost of services, based on orders booked within a given quarter. Accordingly, the costs allocated to upfront licenses, time-based licenses and services are heavily dependent on the mix of software orders received during any given period.

• Gross profit as a percentage of revenueremained relatively stable during the six months ended September 30, 2004 compared to the six months ended September 30, 2003 even though license revenue, which has a higher gross margin compared to service revenue, accounting for a lower percentage of total revenue for the period. This was due to the growth in total revenue for the six months ended September 30, 2004 and the fact that our cost of revenue consists primarily of payroll related costs for application engineers, which are fixed in nature.

Operating expenses

The table below sets forth operating expense data for the six months ended September 30, 2004 and the six months ended September 30, 2003 (in thousands, except percentage data):

	Six months Ended September 30, 2004		Percentage of Revenue		Six months Ended September 30, 2003		Percentage of Revenue		Year to Year Increase (Decrease)			Increase (Decrease) Percentage
Operating expenses:
Research and development	$	20,093	27.5	%	$	11,027	22.6	%	$	9,066		82.2	%
In-process research and development		4,009	5.5	%		—	0.0	%		4,009		100.0	%
Sales and marketing		22,946	31.5	%		15,403	31.7	%		7,543		49.0	%
General and administrative		7,080	9.7	%		4,837	9.9	%		2,243		46.4	%
Restructuring costs		439	0.6	%		—	0.0	%		439		100.0	%
Amortization of intangible assets		8,568	11.7	%		—	0.0	%		8,568		100.0	%
Amortization of stock-based compensation		574	0.8	%		5,733	11.8	%		(5,159	)	(90.0	)%
Total operating expenses	$	63,709	87.3	%	$	37.000	76.1	%	$	26,709		72.2	%

30

• Research and development expense increased in the six months ended September 30, 2004 compared to the same period in fiscal 2004 primarily due to an increase in payroll related expenses of $5.5 million as we more than doubled our research and development headcount through direct hiring and business acquisitions. The remainder of the increase resulted from increases in common expenses (e.g., facility related expenses) of $2.1 million and software maintenance costs of $1.5 million, both of which were caused by the headcount increase.

• In-process research and development expense of $4.0 million for the six months ended September 30, 2004 represents the charge recorded in connection with our acquisition of Mojave, Inc. The charge was recorded based on management’s final purchase price allocation.

• Sales and marketing expense increased in the six months ended September 30, 2004 compared to the prior year same period in fiscal 2004 primarily due to an increase in payroll related expenses of $7.3 million as we increased our sales and marketing headcount by 56% (primarily application engineers) through direct hiring and business acquisitions. Total travel and entertainment expenses increased by $0.3 million due to an increased headcount.

• General and administrative expense increased in the six months ended September 30, 2004 compared to the prior year same period in fiscal 2004 primarily due to increases in professional service fees of $1.2 million and payroll related expenses of $1.2 million, offset by reduction of bad debt expense of $0.2 million. The increase in professional service fees in the six months ended September 30, 2004 was primarily due to the increase in our activity related to the Sarbanes-Oxley Act of 2002, as well as legal expenses related to patent applications. The increase in payroll related expenses was caused by the increase in headcount related to general and administrative activities, which increased by 64% in the six months ended September 30, 2004 compared to the six months ended September 30, 2003.

• Restructuring costs of $0.4 million in the six months ended September 30, 2004 represents a $0.4 million charge recorded in connection with employee terminations.

• Amortization of intangible assets of $8.6 million in the six months ended September 30, 2004 represents amortization of intangible assets recorded in connection with business combinations and asset purchases completed subsequent to September 30, 2003. The intangible assets being amortized include trademarks, customer contracts, customer relationships, no shop rights and assembled workforces that were identified in the purchase price allocation for each business combination and asset purchase transaction.

• Amortization of deferred stock-based compensation decreased in the six months ended September 30, 2004 compared to the six months ended September 30, 2003 primarily due to the decrease in amortization of deferred stock-based compensation (recorded in connection with our IPO in November 2001) of $3.4 million. Amortization of deferred stock-based compensation for the six months ended September 30, 2003 also included $2.1 million of stock-based compensation charge related to the stock option granted to the President of the Company in that period. No such charge was recorded for the six months ended September 30, 2004. These decreases in amortization of deferred stock-based compensation were offset by recording of stock-based compensation expense of $0.3 million related to our Mojave acquisition in the six months ended September 30, 2004.

31

Other items

The table below sets forth other data for the six months ended September 30, 2003 and the six months ended September 30, 2004 (in thousands, except percentage data):

	Six months Ended September 30, 2004			Percentage of Revenue		Six months Ended September 30, 2003			Percentage of Revenue		Year to Year change			Percentage Increase (Decrease)
Other income (expense), net:
Interest income	$	1,109		1.5	%	$	1,243		2.6	%	$	(134	)	(10.8	)%
Interest expense		(497	)	(0.7	)%		(322	)	(0.7	)%		(175	)	(54.3	)%
Other expense, net		(1,204	)	(1.7	)%		(334	)	(0.7	)%		(870	)	(260.5	)%
Total other (expense) income, net	$	(592	)	(0.8	)%	$	587		(1.2	)%	$	(1,179	)	(200.9	)%
Benefit from (provision for) income taxes	$	(352	)	0.5	%	$	(1,591	)	(3.3	)%	$	1,239		77.9	%

• Interest income decreased slightly in the six months ended September 30, 2004 compared to the six months ended September 30, 2003 primarily due to our maintaining lower average cash and investments balance. The average cash balance was higher during the six months ended September 30, 2003 because we had received $145 million of net proceeds in connection with our convertible subordinated debt offering, common stock warrant and bond hedge transactions, all of which were completed in May 2003.

• Interest expense represents amortization of debt discount and issuance costs, which were recorded in connection with our convertible subordinated debt offering completed in May 2003. The increase in amortization of debt discount and issuance costs in the six months ended September 30, 2004 was primarily due to having a full six months’s worth of amortization during that period compared to having amortization only for a part of the quarter for the six months ended September 30, 2003.

• Other expense, net in the six months ended September 30, 2004 decreased compared to the six months ended September 30, 2003 primarily due to the charge associated with other than temporary impairment in our strategic investments by $0.6 million. Such charge was determined based on our periodic review of investee company financial performance. No such charge was recorded for the six months ended September 30, 2003. We also incurred a foreign exchange loss of $0.5 million during the six months ended September 30, 2004, which was caused by an unfavorable exchange rate fluctuation between the U.S. Dollar and the Japanese Yen. For the six months ended September 30, 2003, we recorded a foreign exchange gain of $0.5 million.

• Benefit from (provision for) income taxes. We are in a net deferred tax asset position, for which a full valuation allowance has been recorded. We will continue to provide a valuation allowance for our net deferred tax assets until it becomes more likely than not that the deferred tax assets will be realizable. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis. As of September 30, 2004, the Company has released cumulative valuation allowance on its deferred tax assets of $18.8 million with the benefit allocated to goodwill and other intangibles. For the six months ended September 30, 2004 and September 30, 2003, we had a provision for income taxes of $0.4 million and $1.6 million, respectively. Our effective tax rate varies from the U.S. statutory rate primarily due to changes in our valuation allowance, state taxes, foreign income at other than U.S. rates, deferred compensation, in-process R&D, research and development credits and foreign withholding taxes.

Liquidity and Capital Resources

At September 30, 2004, our principal source of liquidity was our cash and cash equivalents and investments. We had $54.2 million in unrestricted cash and cash equivalents, and $82.0 million in short and long-term investments. Our investment portfolio consists primarily of fixed-income securities, with maturities of two years or less, diversified among industries and individual issuers. Our investments are generally liquid, investment grade securities.

32

On July 28, 2004, we announced that our board of directors authorized Magma to repurchase up to 1,000,000 shares of common stock. The repurchase was completed prior to September 30, 2004 and we used approximately $16.6 million to repurchase 1,000,000 common stock. The repurchased shares will be used for Magma’s 2004 Employment Inducement Award Plan.

On April 29, 2004, we completed the acquisition of Mojave, Inc. (“Mojave”), a privately held developer of advanced technology for integrated circuit manufacturability and verification. The acquisition of Mojave will allow Magma to more comprehensively address its customers’ needs of designing and verifying semiconductors that are manufacturable with desirable yield and performance. Manufacturability is a key design parameter as semiconductor process technology moves to sub-90nm geometries. The total initial purchase price of the Mojave acquisition was approximately $25.1 million and the transaction has been accounted for as an asset purchase transaction. We acquired all of the outstanding common stock of Mojave in exchange for initial consideration of $24.2 million, which consisted of $12.4 million in cash and 607,554 shares of Magma common stock valued at $11.8 million. In addition to the initial merger consideration, we agreed to pay contingent consideration of up to $115 million, half in stock and half in cash, based on product orders over a period ending March 31, 2009, but such payments are contingent on the achievement of certain technology milestones. No contingent consideration yet has been paid under the agreement because the milestones have not yet been achieved.

On April 16, 2004, we acquired Lemmatis, Inc. (“Lemmatis”), a developer of formal verification technology, for cash consideration of approximately $600,000, less $60,000 withheld to secure indemnification obligations. In addition, we may pay up to an additional $1.4 million upon the achievement of technology milestones set forth in the acquisition agreement. No contingent consideration yet has been paid under the agreement because the milestones have not yet been achieved.

On May 22, 2003, we issued $150.0 million principal amount of our Zero Coupon Convertible Subordinated Notes due May 15, 2008 (the “Notes”) resulting in net proceeds to us of approximately $145.1 million. The Notes do not bear coupon interest and are convertible into shares of our common stock at an initial conversion price of $22.86 per share, for an aggregate of approximately 6.56 million shares. The Notes are subordinated to our existing and future senior indebtedness and effectively subordinated to all indebtedness and other liabilities of our subsidiaries. We may not redeem the Notes prior to their maturity date. In order to minimize the dilutive effect from the issuance of the Notes, we undertook the following additional transactions concurrent with the issuance of the Notes:

• We repurchased approximately 1.1 million shares of common stock at a price of $18.00 per share, or approximately $20.0 million, from one of the initial purchasers of the Notes, and those shares were retired as of May 30, 2003.

• We entered into convertible bond hedge and warrant transactions with Credit Suisse First Boston International (“CSFB International”) with respect to our common stock. Under the convertible bond hedge arrangement, CSFB International agreed to sell us, for $22.86 per share, up to 6.56 million shares of our common stock to cover our obligation to issue shares upon conversion of the Notes. In addition, we issued CSFB International a warrant to purchase up to 6.56 million shares of common stock for a purchase price of $31.50 per share. Purchases and sales under this arrangement may be made only upon expiration of the Notes or their earlier conversion (to the extent thereof). Both transactions may be settled at our option either in cash or net shares, and will expire on the earlier of a conversion event or the maturity of the convertible debt on May 15, 2008. The net cost incurred in connection with these arrangements, which consists of the $56.2 million cost of the convertible bond hedge, offset in part by the $35.9 million proceeds from the issuance of the warrant, was approximately $20.3 million.

33

The table below (in thousands) sets forth the key components of cash flow for the six months ended September 30, 2004 and 2003:

	Six Months Ended September 30,
	2004			2003
Net cash provided by operating activities	$	18,900		$	9,269
Net cash used in investing activities	$	(26,666	)	$	(92,657	)
Net cash provided by financing activities	$	(11,143	)	$	116,179

Six months ended September 30, 2004

During the six months ended September 30, 2004, our operating activities provided net cash of $18.9 million. Cash was provided by net loss adjusted for non-cash related items and changes in working capital including decreases in accounts receivable and prepaid expenses and an increase in other long-term liabilities and deferred revenue. The decrease in accounts receivable was primarily due to strong cash collection during the six months ended September 30, 2004. A detail of our accounts receivable balance as of September 30, 2004 is provided below (in millions, except for percentages):

Gross accounts receivable balance and their due dates

	Balance at September 30, 2004			Due Dates
				Q2 Fiscal 2005			Q3 Fiscal 2005			Q4 Fiscal 2005			Q1 & Q2 Fiscal 2006
Billed	$	17.1		$	17.1		$	—		$	—		$	—
Percentage due					100	%		—			—			—
Unbilled		13.9			—			4.9			3.5			5.5
Percentage due		100	%		0	%		35	%		25	%		40	%
Gross accounts receivable	$	31.0		$	17.1		$	4.9		$	3.5		$	5.5
Percentage due					55	%		16	%		11	%		18	%

Gross billed accounts receivable balance and their aging

	Balance at September 30, 2004			Aging as of September 30, 2004
				Current			> 30 days Past Due			> 60 days Past Due*			> 90 days Past Due*
Billed accounts receivable	$	17.1		$	13.8		$	0.8		$	0.1		$	2.4
Percentage of billed accounts receivable		100	%		80	%		5	%		1	%		14	%

* Of $2.5 million that is more than 60 days past due as of September 30, 2004, no revenue has been recognized on $2.2 million and $0.3 million is fully reserved in allowance for doubtful accounts.

The decrease in prepaid expenses was primarily caused by decreases in prepaid commission expense and prepaid software maintenance expense. Prepaid commission decreased during the first half fiscal 2005 primarily due to orders recorded in fiscal 2003 of approximately $100 million for which we paid advance commissions but the entire order value has not been recognized as revenue as of September 30, 2004. We expect advance commission to decrease in fiscal 2005 as these orders are recognized as revenue.

Cash provided by the changes in accounts receivable, prepaid and other assets and deferred revenue was partially offset by a decrease in accrued liabilities during the six months ended September 30, 2004, which was primarily caused by a payout of accrued bonuses during the period.

Our investing activities used net cash of $26.7 million during the six months ended September 30, 2004. We used cash to complete the Mojave and Lemmatis asset purchase transactions during the six months ended

34

September 30, 2004 in order to broaden our product offerings and to incorporate certain key technologies into our existing products and paid a total of $9.1 million in cash, net of cash acquired. We also made investments of $1.1 million in two privately held technology companies for business and strategic purposes. We may make additional strategic equity investments in the future by using our cash and cash equivalents and investments. In August 2004, we made a total of $2.8 million milestone payment relating to prior asset purchases. We had a net purchase of $4.5 million of short and long-term investments as we invested our excess cash resources. During the six months ended September 30, 2004, we acquired property and equipment totaling $9.2 million. The property and equipment expenditures were primarily for purchases of computer equipment and research and development tools to support our growing operations. We expect to make capital expenditures of approximately $5.4 million for the remainder of fiscal 2005. These capital expenditures will be used to support selling and marketing and product development activities. We will use our cash and cash equivalents and investments to fund these purchases.

Our financing activities used net cash of $11.1 million for the six months ended September 30, 2004. The sole source of cash was $5.5 million of cash received from the exercise of stock options and shares purchased under the employee stock purchase plan during the period. We used $16.6 million to repurchase 1,000,000 common stock on the open market, as authorized by the board of directors in July 2004.

Six months ended September 30, 2003

Net cash provided by operating activities was $9.3 million for the six months ended September 30, 2003. For the six months ended September 30, 2003, cash flow from operating activities included increases in deferred revenue of $3.2 million and in accrued expenses of $2.5 million. These increases were offset by decreases in accounts receivable of $3.2 million, in prepaid expenses of $3.5 million and in other assets of $1.7 million. In addition, significant non-cash related adjustments for the six months ended September 30, 2003 included depreciation and amortization of $2.6 million, amortization of stock-based compensation of $5.7 million and provisions for doubtful accounts of $0.2 million.

Net cash used by investing activities was $92.7 million for the six months ended September 30, 2003. Of the cash used by investing activities for the six months ended September 30, 2003, $94.0 million was used for the purchase of investments and $4.0 million was used for purchases of property and equipment, offset by cash provided by investing activities including $5.0 million in proceeds from sale of investments and $0.4 million provided from other assets.

Cash provided by financing activities was $116.2 million for the six months ended September 30, 2003. Cash provided by financing activities for the six months ended September 30, 2003 consisted of net proceeds from convertible subordinated notes of $145.2 million and cash received from exercises of stock options of $11.0 million. A repurchase of 1,110,000 shares at $18 per share for an aggregate amount of $20.0 million partially offset those amounts. We also used $56.2 million for the purchase of a hedge instrument and sold a warrant for $35.9 million related to our issuance of convertible subordinated notes.

Capital resources

We believe that our existing cash and cash equivalents and long-term investments will be sufficient to meet our anticipated operating and working capital expenditure requirements in the ordinary course of business for at least the next 12 months. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may use cash or need to sell additional equity or debt securities. The sale of additional equity or convertible debt securities may result in more dilution to our existing stockholders. Financing arrangements may not be available to us, or may not be available in amounts or on terms acceptable to us.

Our acquisition agreements related to certain business combination and asset purchase transactions obligate us to pay certain contingent cash compensation based on continued employment and meeting certain revenue or project milestones. As of September 30, 2004, total contingent cash compensation that could be paid under our acquisition agreements assuming all contingencies are met, amounted to $79 million.

35

Contractual obligations

As of September 30, 2004, our principal commitments consisted of operating leases, the future amount of which was $14.0 million through fiscal 2011 for office facilities, and repayment of the convertible subordinated notes of $150.0 million due in fiscal 2009. Although we have no material commitments for capital expenditures, we anticipate a substantial increase in our capital expenditures and lease commitments with our anticipated growth in operations, infrastructure, and personnel.

The following summarizes our contractual obligations at September 30, 2004, and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in millions):

	Payments due by period
Contractual Obligations	Total		Less than 1 year		1-3 Years		4-5 Years		After 5 Years
Operating lease obligations	$	14.0	$	3.2	$	4.8	$	4.4	$	1.6
Convertible subordinated note		150.0		—		—		150.0		—
Total	$	164.0	$	3.2	$	4.8	$	154.4	$	1.6

In addition to the enforceable and legally binding obligations quantified in the table above, we have other obligations for goods and services entered into in the normal course of business. These obligations, however, either are not enforceable or legally binding or are subject to change based on our business decisions.

Off-balance Sheet Arrangements

Our off-balance sheet arrangements consist solely of operating leases as described above.

Indemnification Obligations

We enter into standard license agreements in the ordinary course of business. Pursuant to these agreements, we agree to indemnify our customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to our products. These indemnification obligations have perpetual terms. Our normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification we may be required to make may exceed its normal business practices. We estimate the fair value of its indemnification obligations as insignificant, based on our historical experience concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of September 30, 2004.

We have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a directors and officers insurance policy that reduces our exposure and enables us to recover a portion of future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of September 30, 2004.

In connection with recent business acquisitions, we agreed to assume, or cause our subsidiaries to assume, indemnification obligations to the officers and directors of acquired companies.

Warranties

We offer our customers a warranty that our products will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, we have no liabilities recorded for these warranties as of September 30, 2004. We assess the need for a warranty reserve on a quarterly basis, and there can be no guarantee that a warranty reserve will not become necessary in the future.

36

Newly Adopted and Recently Issued Accounting Pronouncements

In March 2004, EITF reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The consensus clarifies the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method or the equity method. The EITF 03-01 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. The application of this consensus did not have a material effect on our consolidated results of operations.

In April 2004, the Emerging Issues Task Force issued Statement No. 03-06 “Participating Securities and the Two-Class Method Under FASB Statement No. 128,Earnings Per Share” (“EITF 03-06”). EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. The adoption of EITF 03-06 did not have any effect on the Company’s calculation of earnings per share (“EPS”).

In July 2004, EITF reached a tentative consensus on EITF Issue No. 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share,” that the impact of contingently convertible debt, such as the Company’s zero-coupon convertible senior notes, should be included in diluted net income per share computations regardless of whether the market price trigger has been met. If the EITF’s tentative consensus is ratified by the FASB, the provisions are expected to be effective for reporting periods ending after December 15, 2004. The application of this consensus did not have any effect on the Company’s calculation of EPS.

On March 31, 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements No. 123 and 95,” that addresses the accounting for share-based payment transactions with employees and other third-parties. The proposed statement would eliminate the ability to account for share-based compensation transactions using the intrinsic value method as prescribed by Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees,” and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expenses in our consolidated statement of income. The proposed standard would require that the modified prospective method be used, which requires that the fair value of new awards granted from the beginning of the year of adoption (plus unvested awards at the date of adoption) be expensed over the vesting period. In addition, the proposed statement encourages the use of the “binomial” approach to value stock options, which differs from the Black-Scholes option pricing model that we currently use in the footnotes to our consolidated financial statements. The recommended effective date of the proposed standard for public companies is currently for interim and annual periods beginning after June 15, 2005.

Should this proposed statement be finalized in its current form, it will have a significant impact on our consolidated statement of operations as we will be required to expense the fair value of our stock option grants and stock purchases under our employee stock purchase plan rather than disclose the impact on our consolidated net income within our footnotes (see Note 2 above), as is our current practice. In addition, there are a number of implementation questions that are not fully resolved by the proposed statement. As a result, there may be additional changes reflected in our financial statements upon issuance of the final standard.

37

FACTORS THAT MAY AFFECT OUR BUSINESS AND FUTURE RESULTS OF OPERATIONS AND FINANCIAL CONDITION

Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently think are immaterial may also impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could suffer, and the trading price of our common stock could decline.

Our limited operating history makes it difficult to evaluate our business and prospects.

We were incorporated in April 1997 and introduced our first principal software product, Blast Fusion, in April 1999. We have a limited history of generating revenue from our software products, and the revenue and income potential of our business and market is still unproven. As a result of our short operating history, we have limited financial data that can be used to evaluate our business. We have only been profitable for eight of the last ten fiscal quarters, and we were not profitable prior to fiscal 2003. Our software products represent a new approach to the challenges presented in the electronic design automation market, which to date has been dominated by established companies with longer operating histories. Key markets within the electronic design automation industry may fail to adopt our proprietary technologies and software products. Any evaluation of our business and our prospects must be considered in light of our limited operating history and the risks and uncertainties often encountered by relatively young companies.

We have a history of losses prior to fiscal 2003 and have an accumulated deficit of approximately $109.3 million as of September 30, 2004; if we do not increase profitability, the public trading price of our stock would be likely to decline.

We had an accumulated deficit of approximately $109.3 million as of September 30, 2004. Although we achieved profitability in fiscal 2003 and fiscal 2004, we incurred losses in prior years and for the six months ended September 30, 2004. If we incur new losses, or do not increase profitability at a level expected by securities analysts or investors, the market price of our common stock is likely to decline. If we incur net losses, we may not be able to maintain or increase our number of employees or our investment in capital equipment, sales, marketing, and research and development programs, and we may not be able to continue to operate.

Our quarterly results are difficult to predict, and if we miss quarterly financial expectations, our stock price could decline.

Our quarterly revenue and operating results are difficult to predict, and fluctuate from quarter to quarter. It is likely that our operating results in some periods will be below investor expectations. If this happens, the market price of our common stock is likely to decline. Fluctuations in our future quarterly operating results may be caused by many factors, including:

• size and timing of customer orders, which are received unevenly and unpredictably throughout a fiscal year;

• the mix of products licensed and types of license agreements;

• our ability to recognize revenue in a given quarter;

• higher than anticipated costs in connection with patent litigation with Synopsys Inc.;

• timing of customer license payments;

• the relative mix of time-based licenses bundled with maintenance, unbundled time-based license agreements and perpetual license agreements, each of which has different revenue recognition practices;

• size and timing of revenue recognized in advance of actual customer billings and customers with graduated payment schedules which may result in higher accounts receivable balances and DSO;

• the relative mix of our license and services revenue;

38

• our ability to win new customers and retain existing customers;

• changes in our pricing and discounting practices and licensing terms and those of our competitors;

• changes in the level of our operating expenses, including increases in incentive compensation payments that may be associated with future revenue growth;

• changes in the interpretation of the authoritative literature under which we recognize revenue;

• the timing of product releases or upgrades by us or our competitors; and

• the integration, by us or our competitors, of newly-developed or acquired products.

Customer payment defaults may cause us to be unable to recognize revenue from backlog, and changes in the type of orders comprising backlog could affect the proportion of revenue recognized from backlog each quarter, which could have a material adverse effect on our financial condition and results of operations and on investor expectations.

As of September 30, 2004, we had approximately $300 million in backlog, which we define as non-cancelable contractual commitments by our customers through purchase orders or contracts. A portion of this backlog is variable based on volume of usage of our products by the customers or includes specific future deliverables or is recognized in revenue on a cash receipts basis. Management has estimated variable usage based on customers’ forecasts, but there can be no assurance that these estimates will be realized. In addition, it is possible that customers from whom we expect to derive revenue from backlog will default and as a result we may not be able to recognize expected revenue from backlog. If a customer defaults and fails to pay amounts owed, or if the level of defaults increases, our bad debt expense is likely to increase. Any material payment default by our customers could have a material adverse effect on our financial condition and results of operations.

Our lengthy and unpredictable sales cycle, and the large size of some orders, makes it difficult for us to forecast revenue and increases the magnitude of quarterly fluctuations, which could harm our stock price.

Customers for our software products typically commit significant resources to evaluate available software. The complexity of our products requires us to spend substantial time and effort to assist potential customers in evaluating our software and in benchmarking it against our competition. As the complexity of the products we sell increases, we expect the sales cycle to lengthen. In addition, potential customers may be limited in their current spending by existing time-based licenses with their legacy vendors. In these cases, customers delay a significant new commitment to our software until the term of the existing license has expired. Also, because our products require a significant investment of time and cost by our customers, we must target those individuals within the customer’s organization who are able to make these decisions on behalf of their companies. These individuals tend to be senior management in an organization, typically at the vice president level. We may face difficulty identifying and establishing contact with such individuals. Even after initial acceptance, the negotiation and documentation processes can be lengthy. Our sales cycle typically ranges between three and nine months, but can be longer. Any delay in completing sales in a particular quarter could cause our operating results to fall below expectations.

We rely on a small number of customers for a significant portion of our revenue, and our revenue could decline due to delays of customer orders or the failure of existing customers to renew licenses or if we are unable to maintain or develop relationships with current or potential customers.

Our business depends on sales to a small number of customers. In the three months ended September 30, 2004, we had two customers that each accounted for more than 10% of our revenue, and that together accounted for approximately 27% of our revenue. One of our customers accounted for 19% of our revenue for the six months ended September 30, 2004. In the twelve months ended March 31, 2004, we had two customers that accounted for 10% or more of our revenue, and that together accounted for approximately 24% of our revenue. In the twelve months ended March 31, 2003, we had two customers that each accounted for more than 10% of our revenue and that together accounted for approximately 30% of our revenue.

39

We expect that we will continue to depend upon a relatively small number of customers for a substantial portion of our revenue for the foreseeable future. If we fail to sell sufficient quantities of our products and services to one or more customers in any particular period, or if a large customer reduces purchases of our products or services, defers orders, or fails to renew licenses, our business and operating results will be harmed.

Most of our customers license our software under time-based licensing agreements, with terms that typically vary from 15 months to 48 months. Most of our license agreements automatically expire at the end of the term unless the customer renews the license with us or purchases a perpetual license. If our customers do not renew their licenses, we may not be able to maintain our current revenue or may not generate additional revenue. Some of our license agreements allow customers to terminate an agreement prior to its expiration under limited circumstances—for example, if our products do not meet specified performance requirements or goals. If these agreements are terminated prior to expiration or we are unable to collect under these agreements, our revenue may decline.

Some contracts with extended payment terms provide for payments which are weighted toward the later part of the contract term. Accordingly, as the payment terms are extended, the revenue from these contracts is not recognized evenly over the contract term, but is recognized as the lesser of the cumulative amounts due and payable or ratably for bundled agreements, and as amounts become due and payable for unbundled agreements, at each period end. Revenue recognized under these arrangements will be higher in the later part of the contract term, which puts our revenue recognition in the future at greater risk of the customer’s continuing credit-worthiness. In addition, some of our customers have extended payment terms, which creates additional credit risk.

We compete against companies that hold a large share of the electronic design automation market and competition is increasing among EDA vendors as customers cut back their EDA spending and use fewer vendors to meet their needs. If we cannot compete successfully, we will not gain market share.

We currently compete with companies that hold dominant shares in the electronic design automation market, such as Cadence and Synopsys. Each of these companies has a longer operating history and significantly greater financial, technical and marketing resources than we do, as well as greater name recognition and larger installed customer bases. Our competitors are better able to offer aggressive discounts on their products, a practice they often employ. Our competitors offer a more comprehensive range of products than we do; for example, we do not offer logic simulation, layout verification, full-feature custom layout editing, analog or mixed signal products, which can sometimes be an impediment to our winning a particular customer order. In addition, our industry has traditionally viewed acquisitions as an effective strategy for growth in products and market share and our competitors’ greater cash resources and higher market capitalization may give them a relative advantage over us in buying companies with promising new chip design products or companies that may be too large for us to acquire without a strain on our resources.

Competition in the EDA Market has increased as customers rationalized their EDA spending by using products from fewer EDA vendors and continued consolidation in the electronic design automation market could intensify this trend. Competitive pressures may prevent us from gaining market share, require us to reduce the price of products and services or cause us to lose existing customers, which could harm our business. To execute our business strategy successfully, we must continue to increase our sales worldwide. If we fail to do so in a timely manner or at all, we may not be able to gain market share and our business and operating results could suffer.

Also, a variety of small companies continue to emerge, developing and introducing new products. Any of these companies could become a significant competitor in the future. We also compete with the internal chip design automation development groups of our existing and potential customers. Therefore, these customers may not require, or may be reluctant to purchase, products offered by independent vendors.

Our competitors may develop or acquire new products or technologies that have the potential to replace our existing or new product offerings. The introduction of these new or additional products by competitors may cause potential customers to defer purchases of our products. If we fail to compete successfully, we will not gain market share and our business will fail.

40

We may not be successful in integrating the operations of acquired companies and acquired technology.

We expect to continuously evaluate the possibility of accelerating our growth through acquisitions, as is customary in the electronic design automation industry. Achieving the anticipated benefits of past and possible future acquisitions will depend in part upon whether we can integrate the operations, products and technology of acquired companies with our operations, products and technology in a timely and cost-effective manner. The process of integrating with acquired companies and acquired technology is complex, expensive and time-consuming, and may cause an interruption of, or loss of momentum in, the product development and sales activities and operations of both companies. In addition, the earnout arrangements we use, and expect to continue to use, to consummate some of our acquisitions, pursuant to which we agreed to pay additional amounts of contingent consideration based on the achievement of certain revenue, bookings or product development milestones, can sometimes complicate integration efforts. We cannot be sure that any part or all of the integration will be accomplished on a timely basis, or at all. Assimilating previously acquired companies such as Silicon Metrics Corporation and Mojave, Inc. or any other companies we may seek to acquire in the future, involves a number of other risks, including, but not limited to:

• adverse effects on existing customer relationships, such as cancellation of orders or the loss of key customers;

• difficulties in integrating or an inability to retain key employees of the acquired company;

• the risk that earnouts based on revenue will prove difficult to administer due to the complexities of revenue recognition accounting;

• the risk that actions incentivized by earnout provisions will ultimately prove not to be in Magma’s best interest as its interests may change over time;

• difficulties in integrating the operations of the acquired company, such as information technology resources, manufacturing processes, and financial and operational data;

• difficulties in integrating the technologies of the acquired company into our products;

• diversion of management attention;

• potential incompatibility of business cultures;

• potential dilution to existing stockholders if we have to incur debt or issue equity securities to pay for any future acquisitions; and

• additional expenses associated with the amortization of intangible assets.

Our operating results may be harmed if our customers do not adopt, or are slow to adopt, 65-nanometer design geometries.

Many Magma customers are currently working on 90-nanometer designs. Magma continues to work toward developing and enhancing its product line in anticipation of increased customer demand for 65-nanometer (sub-90 nanometer) design geometries. Similarly, Magma has acquired Mojave personnel and technology to better address customers’ needs for designing and verifying semiconductors that are manufacturable with higher yield and performance, which is a key design parameter when moving to 65-nanometer geometries. Notwithstanding our efforts to support 65-nanometer geometries, customers may fail to adopt or may be slower to adopt 65-nanometer geometries and we may be unable to convince our customers to purchase our related software products. Accordingly, any revenues we receive from enhancements to our products or acquired technologies may be less than the development or acquisition costs. If customers fail to adopt 65-nanometer design geometries or are slow to adopt 65-nanometer design geometries, our operating results may be harmed.

We may not be able to hire the number of qualified engineering personnel required for our business, particularly field application engineering personnel, which would harm our ability to grow.

We continue to experience difficulty in hiring and retaining skilled engineers with appropriate qualifications to support our growth strategy. Our success depends on our ability to identify, hire, train and retain qualified

41

engineering personnel with experience in integrated circuit design. Specifically, we need to continue to attract and retain field application engineers to work with our direct sales force to technically qualify new sales opportunities and perform design work to demonstrate our products’ capabilities to customers during the benchmark evaluation process. Competition for qualified engineers is intense, particularly in Silicon Valley where our headquarters is located. If we lose the services of a significant number of our engineers or we cannot hire additional engineers, we will be unable to increase our sales or implement or maintain our growth strategy.

Because many of our current competitors have pre-existing relationships with our current and potential customers, we might not be able to gain market share, which could harm our operations.

Many of our competitors, including Cadence and Synopsys, have established relationships with our current and potential customers and can devote substantial resources aimed at preventing us from establishing or enhancing our customer relationships. These existing relationships can make it difficult for us to obtain additional customers due to the substantial investment that these potential customers have already made in their current design flows. If we are unable to gain market share due to these relationships with our potential customers, our operating results could be harmed.

Our operating results will be significantly harmed if chip designers do not adopt Blast Fusion and Blast Fusion APX.

Blast Fusion and Blast Fusion APX have accounted for a significant majority of our revenue since our inception and we believe that revenue from Blast Fusion and Blast Fusion APX and related products will account for most of our revenue for the foreseeable future. If integrated circuit designers do not continue to adopt Blast Fusion and Blast Fusion APX, our operating results will be significantly harmed. We must continue market penetration of Blast Fusion and Blast Fusion APX to achieve our growth strategy and financial success.

If the industries into which we sell our products experience recession or other cyclical effects affecting our customers’ research and development budgets, our revenue would be likely to decline.

Demand for our products is driven by new integrated circuit design projects. The demand from semiconductor and systems companies is uncertain and difficult to predict. Slower growth in the semiconductor and systems industries, a reduced number of design starts, reduction of electronic design automation budgets or continued consolidation among our customers would harm our business and financial condition. We have experienced slower growth in revenue than we anticipated as a result of the prolonged downturn and decreased spending by our customers in the semiconductor and systems industries.

The primary customers for our products are companies in the communications, computing, consumer electronics, networking and semiconductor industries. Any significant downturn in our customers’ markets or in general economic conditions that results in the cutback of research and development budgets or the delay of software purchases would be likely to result in lower demand for our products and services and could harm our business. For example, the United States economy, including the semiconductor industry, has recently experienced a slowdown, which has negatively impacted and may continue to impact our business and operating results. While the semiconductor industry experienced a moderate recovery in 2003, our customers have remained cautious, and it is not yet clear when increased R&D spending will occur. The November 2004 presidential election, terrorist attacks in the United States, the ongoing events in Iraq and other worldwide events including in the Middle East have increased uncertainty in the United States economy. If the economy continues to decline as a result of the economic, political and social turmoil, existing customers may delay their implementation of our software products and prospective customers may decide not to adopt our software products, either of which could negatively impact our business and operating results.

In addition, the markets for semiconductor products are cyclical. In recent years, some Asian countries have experienced significant economic difficulties, including devaluation and instability, business failures and a

42

depressed business environment. These difficulties triggered a significant downturn in the semiconductor market, resulting in reduced budgets for chip design tools, which, in turn, negatively impacted us. We have experienced delayed orders and slower deployment of our products under new orders as a result of reduced budgets for chip design tools. In addition, the electronics industry has historically been subject to seasonal and cyclical fluctuations in demand for its products, and this trend may continue in the future. These industry downturns have been, and may continue to be, characterized by diminished product demand, excess manufacturing capacity and subsequent erosion of average selling prices.

Difficulties in developing and achieving market acceptance of new products and delays in planned release dates of our software products and upgrades may harm our business.

To succeed, we will need to develop innovative new products. We may not have the financial resources necessary to fund all required future innovations. Expanding into new technologies or extending our product line into areas we have not previously addressed may be more costly or difficult than anticipated. Also, any revenue that we receive from enhancements or new generations of our proprietary software products may be less than the costs of development. If we fail to develop and market new products in a timely manner, our reputation and our business will suffer.

Our costs of customer engagement and support are high, so our gross margin may decrease if we incur higher-than-expected costs associated with providing support services in the future or if we reduce our prices.

Because of the complexity of our products, we typically incur high field application engineering support costs to engage new customers and assist them in their evaluations of our products. If we fail to manage our customer engagement and support costs, our operating results could suffer. In addition, our gross margin may decrease if we are unable to manage support costs associated with the mix of license and services revenue we generate or if we reduce prices in response to competitive pressure.

Product defects could cause us to lose customers and revenue, or to incur unexpected expenses.

Our products depend on complex software, both internally developed and licensed from third parties. Our customers may use our products with other companies’ products, which also contain complex software. If our software does not meet our customers’ performance requirements, our customer relationships may suffer. Also, a limited number of our contracts include specified ongoing performance criteria. If our products fail to meet these criteria, it may lead to termination of these agreements and loss of future revenue. Complex software often contains errors. Any failure or poor performance of our software or the third-party software with which it is integrated could result in:

• delayed market acceptance of our software products;

• delays in product shipments;

• unexpected expenses and diversion of resources to identify the source of errors or to correct errors;

• damage to our reputation;

• delayed or lost revenue; and

• product liability claims.

Our product functions are often critical to our customers, especially because of the resources our customers expend on the design and fabrication of integrated circuits. Many of our licensing agreements contain provisions to provide a limited warranty, which provides the customer with a right of refund for the license fees if we are unable to correct errors reported during the warranty period. If our contractual limitations are unenforceable in a particular jurisdiction or if we are exposed to product liability claims that are not covered by insurance, a successful claim could harm our business. We currently do not carry product liability insurance.

43

Much of our business is international, which exposes us to risks inherent to doing business internationally that could harm our business. We also intend to expand our international operations. If our revenue from this expansion does not exceed the expenses associated with this expansion, our business and operating results could suffer.

We generated 41% of our total revenue from sales outside North America for the six months ended September 30, 2004, compared to 48% in the six months ended September 30, 2003. While most of our international sales to date have been denominated in U.S. dollars, our international operating expenses have been denominated in foreign currencies. As a result, a decrease in the value of the U.S. dollar relative to the foreign currencies could increase the relative costs of our overseas operations, which could reduce our operating margins.

The expansion of our international operations includes the maintenance of sales offices in Europe, the Middle East, and the Asia Pacific region. If our revenue from international operations does not exceed the expense of establishing and maintaining our international operations, our business could suffer. Additional risks we face in conducting business internationally include:

• difficulties and costs of staffing and managing international operations across different geographic areas;

• changes in currency exchange rates and controls;

• uncertainty regarding tax and regulatory requirements in multiple jurisdictions;

• the possible lack of financial and political stability in foreign countries, preventing overseas sales growth;

• on-going events in Iraq; and

• the effects of terrorist attacks in the United States and any related conflicts or similar events worldwide.

Future changes in accounting standards, specifically changes affecting revenue recognition, could cause adverse unexpected revenue fluctuations.

Future changes in accounting standards for interpretations thereof, specifically those changes affecting software revenue recognition, could require us to change our methods of revenue recognition. These changes could result in deferral of revenue recognized in current periods to subsequent periods or in accelerated recognition of deferred revenue to current periods, each of which could cause shortfalls in meeting the expectations of investors and securities analysts. Our stock price could decline as a result of any shortfall. Implementation of internal controls reporting and attestation requirements will impose additional financial and administrative obligations on us and will cause us to incur substantial implementation costs from third party consultants, that could adversely affect our results.

Changes in laws and regulations that affect the governance of public companies has increased our operating expenses and will continue to do so.

Recently enacted changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and the listing requirements for The Nasdaq Stock Market have imposed new duties on us and on our executives, directors, attorneys and independent accountants. In order to comply with these new rules, we have hired and expect to hire additional personnel and use additional outside legal, accounting and advisory services, which have increased and are likely to continue increasing our operating expenses. In particular, we expect to incur additional administrative expenses as we implement Section 404 of the Sarbanes-Oxley Act, which requires management to report on, and our Independent Registered Public Accounting Firm to attest to, our internal controls. For example, we expect to incur significant expenses in connection with the implementation, documentation and testing of our existing and possibly newly implemented control systems. Management time associated with these compliance efforts necessarily reduces time available for other operating activities, which could adversely affect operating results. If we are unable to achieve full and timely compliance with these regulatory requirements, we could be required to incur additional costs, expend additional management time on remedial efforts and make related public disclosures that could adversely affect our stock price and result in securities litigation.

44

Forecasting the Company’s tax rates is complex and subject to uncertainty.

Management must make significant assumptions, judgments and estimates to determine our current provision for income taxes, deferred tax assets and liabilities, and any valuation allowance that may be recorded against our deferred tax assets. These assumptions, judgments and estimates are difficult to make due to their complexity and the relevant tax law is often changing. Our future effective tax rates could be adversely affected by the following:

• an increase in expenses not deductible for tax purposes, including deferred stock-based compensation and write-offs of acquired in-process research and development;

• changes in the valuation of our deferred tax assets and liabilities;

• future changes in ownership as defined by Internal Revenue Code Sections 382 and 383 which may limit realization of certain assets;

• changes in forecasts of pre-tax profits and losses by jurisdiction used to estimate tax expense by jurisdiction; or

• changes in tax laws or interpretations of such tax laws.

Our success will depend on our ability to keep pace with the rapidly evolving technology standards of the semiconductor industry. If we are unable to keep pace with rapidly changing technology standards, our products could be rendered obsolete, which would cause our operating results to decline.

The semiconductor industry has made significant technological advances. In particular, recent advances in deep sub-micron technology have required electronic design automation companies to continuously develop or acquire new products and enhance existing products. The evolving nature of our industry could render our existing products and services obsolete. Our success will depend, in part, on our ability to:

• enhance our existing products and services;

• develop and introduce new products and services on a timely and cost-effective basis that will keep pace with technological developments and evolving industry standards;

• address the increasingly sophisticated needs of our customers; and

• acquire other companies that have complementary or innovative products.

If we are unable, for technical, legal, financial or other reasons, to respond in a timely manner to changing market conditions or customer requirements, our business and operating results could be seriously harmed.

Because competition for qualified personnel is intense in our industry, we may not be able to recruit necessary personnel, which could impact the development or sales of our products.

Our success will also depend on our ability to attract and retain senior management, sales, marketing and other key personnel. Because of the intense competition for such personnel, it is possible that we will fail to retain key technical and managerial personnel. If we are unable to retain our existing personnel, or attract and train additional qualified personnel, our growth may be limited due to our lack of capacity to develop and market our products. This could harm the market’s perception of our business and our ability to achieve our business goals.

Our success is highly dependent on the technical, sales, marketing and managerial contributions of key individuals, and we may be unable to recruit and retain these personnel.

We depend on our senior executives, and our research and development, sales and marketing personnel, who are critical to our business. We do not have long-term employment agreements with our key employees, and we do not maintain any key person life insurance policies. If we lose the services of any of these key executives,

45

our product development processes and sales efforts could be slowed. We may also incur increased operating expenses and be required to divert the attention of other senior executives to search for their replacements. The integration of our new executives or any new personnel could disrupt our ongoing operations.

If we fail to maintain competitive stock option packages for our employees, or if our stock price declines materially for a protracted period of time, we might have difficulty retaining our employees and our business may be harmed.

In today’s competitive technology industry, employment decisions of highly skilled personnel are influenced by stock option packages, which offer incentives above traditional compensation only where there is a consistent, long-term upward trend over time of a company’s stock price. If our stock price declines due to market conditions, investors’ perceptions of the technology industry or managerial or performance problems we have, our stock option incentives may lose value to key employees, and we may lose these employees or be forced to grant additional options to retain them. This in turn could result in:

• immediate and substantial dilution to investors resulting from the grant of additional options necessary to retain employees; and

• potential compensation charges against the company, which could negatively impact our operating results.

In addition, if we were required to account for stock options as an operating expense, our net income would be reduced or net losses increased. Accordingly, our financial results would be adversely affected, particularly relative to companies that grant fewer stock options. If we reduce our level of stock option grants, our ability to recruit and retain employees may be adversely affected.

If the accounting treatment for employee stock options changes, our earnings will be adversely affected and we may be forced to change our employee compensation and benefits practices.

We currently account for the issuance of employee stock options under principles that do not require us to record compensation expense for options granted at fair market value. On March 31, 2004, the FASB issued a proposed Statement “Share Based Payment, an Amendment to FASB Statements No. 123 and 95”, which, if implemented, would change U.S. Generally Accepted Accounting Principles (“GAAP”) accounting for equity-based compensation. Under this proposed accounting standard, public companies would be required to report compensation expense related to stock options and other forms of stock-based compensation based on the estimated value of the awards at the date of grant. We expect the final standard to be issued in late 2004, and if implemented, it would apply to the interim and annual periods beginning after June 15, 2005. If that proposed standard is adopted in its current form, our expenses will be higher and our earnings will decline compared to our current accounting. As a result, we may consider changing our employee compensation practices, and those changes could make it harder for us to retain existing employees and attract qualified candidates.

If our sales force compensation arrangements are not designed effectively, we may lose sales personnel and resources.

Designing an effective incentive compensation structure for our sales force is critical to our success. We have experimented, and continue to experiment, with different systems of sales force compensation. If our incentives are not well designed, we may experience reduced revenue generation, and we may also lose the services of our more productive sales personnel, either of which would reduce our revenue or potential revenue.

Fluctuations in our growth place a strain on our management systems and resources, and if we fail to manage the pace of our growth our business could be harmed.

Periods of growth followed by efforts to realign costs when revenue growth is slower than anticipated have placed a strain on our management, administrative and financial resources. For example, in the first quarter of

46

fiscal year 2005 and the third quarter of fiscal year 2003, we decreased our workforce by 7 and 32 employees, respectively. Over time we have significantly expanded our operations in the United States and internationally, and we plan to continue to expand the geographic scope of our operations. To pace the growth of our operations with the growth in our revenue, we must continue to improve administrative, financial and operations systems, procedures and controls. Failure to improve our internal procedures and controls could result in a disruption of our operations and harm to our business. We expect to incur a significant amount of consulting and other fees and expenses to document and enhance our financial processes and accounting controls and capabilities in order to achieve certification under Section 404 of the Sarbanes-Oxley Act of 2002. If we are unable to manage our growth the execution of our business plan could be delayed.

If chip designers and manufacturers do not integrate our software into existing design flows, or if other software companies do not cooperate in working with us to interface our products with their design flows, demand for our products may decrease.

To implement our business strategy successfully, we must provide products that interface with the software of other electronic design automation software companies. Our competitors may not support our or our customers’ efforts to integrate our products into their existing design flows. We must develop cooperative relationships with competitors so that they will work with us to integrate our software into a customer’s design flow. Currently, our software is designed to interface with the existing software of Cadence, Synopsys and others. If we are unable to convince customers to adopt our software products instead of those of competitors offering a broader set of products, or if we are unable to convince other software companies to work with us to interface our software with theirs to meet the demands of chip designers and manufacturers, our business and operating results will suffer.

We may not obtain sufficient patent protection, which could harm our competitive position and increase our expenses.

Our success and ability to compete depends to a significant degree upon the protection of our software and other proprietary technology. We currently have a number of issued patents in the United States, but this number is relatively few in relation to our competitors.

These legal protections afford only limited protection for our technology. In addition, rights that may be granted under any patent application that may issue in the future may not provide competitive advantages to us. Further, patent protection in foreign jurisdictions where we may need this protection may be limited or unavailable. It is possible that:

• our pending U.S. and non-U.S. patents may not be issued;

• competitors may design around our present or future issued patents or may develop competing non-infringing technologies;

• present and future issued patents may not be sufficiently broad to protect our proprietary rights; and

• present and future issued patents could be successfully challenged for validity and enforceability.

We believe the patent portfolios of our competitors are far larger than ours, and this may increase the risk that they may sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses.

We rely on trademark, copyright and trade secret laws and contractual restrictions to protect our proprietary rights, and if these rights are not sufficiently protected, it could harm our ability to compete and generate income.

To establish and protect our proprietary rights, we rely on a combination of trademark, copyright and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses. Our ability to compete

47

and grow our business could suffer if these rights are not adequately protected. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to agreements, which impose certain restrictions on the licensee’s ability to utilize the software. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. Our proprietary rights may not be adequately protected because:

• laws and contractual restrictions in U.S. and foreign jurisdictions may not prevent misappropriation of our technologies or deter others from developing similar technologies;

• competitors may independently develop similar technologies and software code;

• for some of our trademarks, federal U.S. trademark protection may be unavailable to us;

• our trademarks may not be protected or protectable in some foreign jurisdictions;

• the validity and scope of our U.S. and foreign trademarks could be successfully challenged; and

• policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we may be unable to determine the extent of this unauthorized use.

The laws of some countries in which we market our products may offer little or no protection of our proprietary technologies. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technologies could enable third parties to benefit from our technologies without paying us for it, which would harm our competitive position and market share.

We currently face a patent infringement suit brought by Synopsys, Inc., and we may face additional intellectual property infringement claims or other claims against us or our customers that could be costly to defend and result in our loss of significant rights.

Many of our contracts contain provisions in which we agree to indemnify our customers from third-party intellectual property infringement claims. On September 17, 2004, Synopsys, Inc., filed suit against us for patent infringement, and, in the future, other parties may assert intellectual property infringement claims against us or our customers. We have also acquired or may hereafter acquire software as a result of our past or future acquisitions, and we may be subject to claims that such software infringes the intellectual property rights of third parties.

Our products may be found to infringe intellectual property rights of third parties, including third-party patents. Also, we may be unaware of filed patent applications that relate to our software products. We believe the patent portfolios of our competitors are far larger than ours, and this may increase the risk that they may sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses.

Due to intellectual property litigation, including the Synopsys, Inc. litigation, we could lose our proprietary rights and incur substantial unexpected operating costs. Intellectual property litigation is expensive and time-consuming and could divert management’s attention from our business. If there is a successful claim of infringement, we may be ordered to pay substantial monetary damages, we may be prevented from distributing all or some of our products, and we may be required to develop non-infringing technology or enter into royalty or license agreements, which may not be available on acceptable terms, if at all. Our failure to develop non-infringing technologies or license the proprietary rights on a timely basis would harm our business.

We may also become involved in other litigation unrelated to intellectual property infringement claims. For example, in August 2001, a complaint was filed against us alleging breach of contract, among other things. This litigation was settled in early 2003. In addition, we may acquire companies that are actively engaged in litigation. We may not be successful in defending some or all claims that may be brought against us. Regardless of the outcome, litigation can result in substantial expense and could divert the efforts of our management and technical personnel from our business.

48

Our directors, executive officers and principal stockholders own a substantial portion of our common stock and this concentration of ownership may allow them to elect most of our directors and could delay or prevent a change in control of Magma.

Our directors, executive officers and stockholders who currently own over 5% of our common stock beneficially own a substantial portion of our outstanding common stock. These stockholders, if they vote together, will be able to significantly influence all matters requiring stockholder approval. For example, they may be able to elect most of our directors, delay or prevent a transaction in which stockholders might receive a premium over the market price for their shares or prevent changes in control or management.

Our stock price may decline significantly because of stock market fluctuations that affect the prices of technology stocks. A decline in our stock price could result in securities class action litigation against us, which could divert management’s attention and harm our business.

The stock market has experienced significant price and volume fluctuations that have adversely affected the market prices of common stock of technology companies. These broad market fluctuations may reduce the market price of our common stock. In the past, securities class action litigation has often been brought against a company after periods of volatility in the market price of securities. We may in the future be a target of similar litigation. Securities litigation could result in substantial costs and divert management’s attention and resources, which could harm our ability to execute our business plan.

We may need additional capital in the future, but there is no assurance that funds would be available on acceptable terms.

In the future we may need to raise additional capital in order to achieve growth or other business objectives. This financing may not be available in sufficient amounts or on terms acceptable to us and may be dilutive to existing stockholders. If adequate funds are not available or are not available on acceptable terms, our ability to expand, develop or enhance services or products, or respond to competitive pressures would be limited.

Our certificate of incorporation, bylaws and Delaware corporate law contain anti-takeover provisions which could delay or prevent a change in control even if the change in control would be beneficial to our stockholders. We could also adopt a stockholder rights plan, which could also delay or prevent a change in control.

Delaware law, as well as our certificate of incorporation and bylaws, contain anti-takeover provisions that could delay or prevent a change in control of our company, even if the change of control would be beneficial to the stockholders. These provisions could lower the price that future investors might be willing to pay for shares of our common stock. These anti-takeover provisions:

• authorize the Board of Directors without prior stockholder approval to create and issue preferred stock that can be issued increasing the number of outstanding shares and deter or prevent a takeover attempt;

• prohibit stockholder action by written consent, thereby requiring all stockholder actions to be taken at a meeting of our stockholders;

• establish a classified Board of Directors requiring that not all members of the board be elected at one time;

• prohibit cumulative voting in the election of directors, which would otherwise allow less than a majority of stockholders to elect director candidates;

• limit the ability of stockholders to call special meetings of stockholders; and

• require advance notice requirements for nominations for election to the Board of Directors and proposals that can be acted upon by stockholders at stockholder meetings.

49

In addition, Section 203 of the Delaware General Corporation Law and the terms of our stock option plans may discourage, delay or prevent a change in control of our company. That section generally prohibits a Delaware corporation from engaging in a business combination with an interested stockholder for three years after the date the stockholder became an interested stockholder. Also, our stock option plans include change-in-control provisions that allow us to grant options or stock purchase rights that will become vested immediately upon a change in control of us.

The board of directors also has the power to adopt a stockholder rights plan, which could delay or prevent a change in control even if the change in control appeared to be beneficial to stockholders. These plans, sometimes called “poison pills,” are sometimes criticized by institutional investors or their advisors and could affect our rating by such investors or advisors. If the board were to adopt such a plan it might have the effect of reducing the price that new investors are willing to pay for shares of our common stock.

We are subject to risks associated with changes in foreign currency exchange rates.

We transact some portions of our business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to operating expenses in the United Kingdom, Europe and Japan, which are denominated in the respective local currencies. As of September 30, 2004, we had no hedging contracts outstanding. We do not currently use financial instruments to hedge operating expenses denominated in Euro, British Pounds and Japanese Yen. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.

The convertible notes we issued in May 2003 are debt obligations that must be repaid in cash in May 2008 if they are not converted into our common stock at an earlier date, which is unlikely to occur if the price of our common stock does not exceed the conversion price.

In May 2003, we issued $150 million principal amount of our zero coupon convertible notes due May 2008. We will be required to repay that principal amount in full in May 2008 unless the holders of those notes elect to convert them into our common stock before the repayment date. The conversion price of the notes is $22.86 per share. If the price of our common stock does not rise above that level, conversion of the notes is unlikely and we would be required to repay the principal amount of the notes in cash. There have been previous quarters in which we have experienced shortfalls in revenue and earnings from levels expected by securities analysts and investors, which have had an immediate and significant adverse effect on the trading price of our common stock. In addition, the stock market in recent years has experienced extreme price and trading volume fluctuations that often have been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations may adversely affect the price of our stock, regardless of our operating performance. Because the notes are convertible into shares of our common stock, volatility or depressed prices for our common stock could have a similar effect on the trading price of the notes.

Hedging transactions and other transactions may affect the value of our common stock and our convertible notes.

We entered into hedging arrangements with Credit Suisse First Boston International at the time we issued our convertible notes, with the objective of reducing the potential dilutive effect of issuing common stock upon conversion of the notes. These hedging arrangements are likely to have caused Credit Suisse First Boston International and others to take positions in our common stock in secondary market transactions or to enter into derivative transactions at or after the sale of the notes. Any market participants entering into hedging arrangements are likely to modify their hedge positions from time to time prior to conversion or maturity of the notes by purchasing and selling shares of our common stock or other securities, which may increase the volatility and reduce the market price of our common stock.

Our convertible notes are subordinated and there are no financial covenants in the indenture.

Our convertible notes are general unsecured obligations of Magma and are subordinated in right of payment to all of our existing and future senior indebtedness, which we may incur in the future. In the event of our

50

bankruptcy, liquidation or reorganization, or upon acceleration of the notes due to an event of default under the indenture and in certain other events, our assets will be available to pay obligations on the notes only after all senior indebtedness has been paid. As a result, there may not be sufficient assets remaining to pay amounts due on any or all of the outstanding notes. In addition, we will not make any payments on the notes in the event of payment defaults or other specified defaults on our designated senior indebtedness.

Neither we nor our subsidiaries are restricted under the indenture for the notes from incurring additional debt, including senior indebtedness. If we or our subsidiaries incur additional debt or other liabilities, our ability to pay our obligations on the notes could be adversely affected. We expect that we and our subsidiaries from time to time will incur additional indebtedness and other liabilities.

We may be unable to meet the requirements under the indenture to purchase our convertible notes upon a change in control.

Upon a change in control, which is defined in the indenture to include some cash acquisitions and private company mergers, note holders may require us to purchase all or a portion of the notes they hold. If a change in control were to occur, we might not have enough funds to pay the purchase price for all tendered notes. Future credit agreements or other agreements relating to our indebtedness might prohibit the redemption or repurchase of the notes and provide that a change in control constitutes an event of default. If a change in control occurs at a time when we are prohibited from purchasing the notes, we could seek the consent of our lenders to purchase the notes or could attempt to refinance this debt. If we do not obtain a consent, we could not purchase the notes. Our failure to purchase tendered notes would constitute an event of default under the indenture, which might constitute a default under the terms of our other debt. In such circumstances, or if a change in control would constitute an event of default under our senior indebtedness, the subordination provisions of the indenture would possibly limit or prohibit payments to note holders. Our obligation to offer to purchase the notes upon a change in control would not necessarily afford note holders protection in the event of a highly leveraged transaction, reorganization, merger or similar transaction involving us.

Our business operations may be adversely affected in the event of an earthquake or other natural disaster.

Our corporate headquarters and much of our research and development operations are located in Silicon Valley, California, which is an area known for its seismic activity. An earthquake, fire or other significant natural disaster could have a material adverse impact on our business, financial condition and operating results.

ITEM  3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in widely diversified short-term and long-term investments, consisting primarily of investment grade securities, substantially all of which mature within the next twenty-four months. A hypothetical 100 basis point increase in interest rates would result in approximately a $1.1 million decline in the fair value of our available-for-sale securities.

Market Risk

The fair value of our fixed rate long-term debt is sensitive to interest rate changes. Interest rate changes would result in increases or decreases in the fair value of our debt, due to differences between market interest rates and rates in effect at the inception of our debt obligation. Changes in the fair value of our fixed rate debt have no impact on our cash flows or consolidated financial statements.

51

Credit Risk

We completed an offering on May 22, 2003 of $150 million principal amount of convertible subordinated notes due May 15, 2008. Concurrent with the issuance of the convertible notes, we entered into convertible bond hedge and warrant transactions with respect to our common stock, the exposure for which is held by Credit Suisse First Boston International. Both the bond hedge and warrant transactions may be settled at our option either in cash or net shares and expire on May 15, 2008. The transactions are expected to reduce the potential dilution from conversion of the notes. Subject to the movement in the share price of our common stock, we could be exposed to credit risk in the settlement of these options in our favor. Based on a review of the possible net settlements and the credit strength of Credit Suisse First Boston International and its affiliates, we believe that we do not have a material exposure to credit risk arising from these option transactions.

Foreign Currency Exchange Risk

We transact some portions of our business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to operating expenses in the United Kingdom and Japan, which are denominated in the respective local currency. As of September 30, 2004, we had no currency hedging contracts outstanding. We do not currently use financial instruments to hedge operating expenses denominated in Euro, British Pounds and Japanese Yen. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.

ITEM  4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. However, our disclosure controls and procedures have been designed to meet, and management believes that they meet, reasonable assurance standards.

Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared. Although our principal executive officer and principal accounting officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report, we continue to enhance our controls by hiring qualified personnel in key functional areas, implementing a new computerized system to automate a number of procedures related to quarterly and year-end close processes, and creating procedures to address the impact of acquisitions on a timely basis.

Changes in internal controls. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation described above that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

52

PART II. OTHER INFORMATION

ITEM  1. LEGAL PROCEEDINGS

On September 17, 2004, Synopsys, Inc. (“Synopsys”) filed a Complaint for Patent Infringement (“Complaint”) against the Company in the United States District Court for the Northern District of California, Case Number C04-03923. The Complaint alleges infringement of three patents: U.S. Patents Nos. 6,378,114 (“the ‘114 Patent”), 6,453,446 (“the ‘446 Patent”), and 6,725,438 (“the ‘438 Patent”). The ‘114 Patent was issued to Synopsys. The ‘446 and ‘438 Patents, however, were issued to Magma and claim inventions by Magma co-founder Dr. Lukas Van Ginneken. Synopsys alleges that it is the rightful owner of the ‘446 and ‘438 Patents and is entitled to assert them against Magma because the inventions claimed in the ‘446 and ‘438 Patents allegedly were made, conceived and developed by Dr. Van Ginneken while he was employed by Synopsys and were subject to an inventions assignment agreement. The Complaint alleges that by making, using, selling and distributing certain of its products, the Company is infringing the ‘114, ‘446, and ‘438 Patents. The Complaint seeks unspecified monetary damages, injunctive relief, trebling of damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenue or other benefits allegedly obtained by the Company as a result of its alleged infringement of the asserted patents.

On October 21, 2004, the Company filed its answer with counterclaims (“Answer”) to the Complaint. In its Answer, the Company raised various defenses and allegations, including: (i) the Company owns all right, title and interest in and the ‘446 and ‘438 Patents, because the inventions disclosed in those patents were developed by Dr. Van Ginneken while at the Company, and without use of Synopsys’ confidential information; (ii) the Company does not infringe the ‘114 Patent because the Company’s technology is fundamentally different from the inventions claimed in the ‘114 Patent; (iii) the ‘114 Patent is invalid; (iv) Synopsys lacks standing to bring any infringement action under the ‘114 Patent because International Business Machines Corporation (“IBM”), which is not a party to the lawsuit, is a co-owner of the ‘114 Patent by operation of law and as a result of a joint development agreement between IBM and Synopsys; (v) if Synopsys could somehow show that the ‘446 and ‘438 Patents were invented at Synopsys, IBM would be a joint owner of those patents by operation of law and as a result of the joint development agreement, and Synopsys would lack standing to sue on those patents; (vi) the Company cannot be liable for infringing any patents co-owned by IBM because the Company is licensed under those patents pursuant to the Company’s patent license agreement with IBM; and (vii) if Synopsys could somehow show that the ‘446 and ‘438 Patents were invented at Synopsys, the ‘446 and ‘438 Patents are invalid and not infringed. In its Answer, the Company further alleges that Synopsys is engaging in efforts to spread false and misleading statements about the Company and its products to the public. The Answer seeks, among other things, dismissal with prejudice of the Complaint, reaffirmation of the Company’s ownership interest in ‘446 and ‘438 Patents, and an order enjoining Synopsys’ unfair business practices.

The Company intends to vigorously defend against the claims asserted by Synopsys and to fully enforce its rights against Synopsys. However, the results of any litigation are inherently uncertain and the Company can not assure that it will be able to successfully defend against the Complaint. A favorable outcome for Synopsys could have a material adverse effect on the Company’s financial position, results of operations or cash flows. A trial date has not been set and discovery has not yet commenced.

In addition to the above, from time to time, the Company is involved in disputes that arise in the ordinary course of business. The number and significance of these disputes is increasing as the Company’s business expands and it grows larger. Any claims against the Company, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. As a result, these disputes could harm the Company’s business, financial condition, results of operations or cash flows.

ITEM  2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Recent Sales Of Unregistered Securities

None.

53

Issuer Purchases of Equity Securities

ISSUER PURCHASES OF EQUITY SECURITIES

Period	Total Number of Shares Purchased	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs *	Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
July 1 – July 31, 2004	0		N/A	0	$	0
August 1 – August 31, 2004	1,000,000	$	16.60	1,000,000		0
September 1 – September 30, 2004	0		N/A	0		0
Total	1,000,000	$	16.60	1,000,000		0

* On July 28, 2004, the Company announced that its Board of Directors had authorized the repurchase of up to 1,000,000 shares of Company common stock, as further described in Note 13 to the condensed consolidated financial statements. The repurchase program was completed during the quarter ended September 30, 2004.

ITEM  4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

Magma’s Annual Meeting of Stockholders (the “Annual Meeting”) was held on August 31, 2004. Two matters were voted on at the Annual Meeting. A brief description of each of these matters, and the results of the votes thereon, are as follows:

Proposal 1. Election of Directors.

Magma’s Board of Directors consists of seven members divided into three classes (Classes I through III). The Class III members of the Board of Directors were scheduled for election at the Annual Meeting, to serve until the 2007 annual meeting of stockholders, or until their successors are elected by the stockholders or appointed by the Board of Directors pursuant to the Company’s bylaws. The nominees of the Board to serve as the two Class III members were Rajeev Madhavan and Kevin C. Eichler. There were no other nominees. Messrs. Madhavan and Eichler were elected at the Annual Meeting as Class III directors by the following votes:

Nominee	For	Withheld
Rajeev Madhavan	27,602,014	3,765,330
Kevin C. Eichler	26,873,426	4,493,918

Magma’s other directors, whose terms of office continued after the Annual Meeting, are Roy E. Jewell and Thomas M. Rohrs (Class I) and Timothy J. Ng, Chester J. Silvestri and Wade Meyercord (Class II).

Proposal 2. Ratification of the appointment of PricewaterhouseCoopers LLP as Magma’s independent accountants for the fiscal year ending March 31, 2005.

For	Against	Abstain	Broker Non-Votes
31,092,210	273,858	1,276	—

ITEM  5. OTHER INFORMATION

The 2004 Employment Inducement Award Plan (“Inducement Plan”) was adopted by the Board of Directors on August 30, 2004. Under the Inducement Plan, the Company (with the approval of the Compensation Committee of the Board of Directors (the “Committee”) may grant non-qualified stock options to “New Hire” employees who are not executive officers of the Company. These employees may also be awarded restricted common shares, stock appreciation rights (“SARs”) or stock unit awards (“Stock Units”). The maximum

54

aggregate number of options, SARs, Stock Units and restricted shares that may be awarded under the Inducement Plan is 1,000,000 shares. The Committee determines whether an award may be granted, the number of shares/options awarded, the date an award may be exercised, vesting and the exercise price. Each award must be subject to an agreement between each applicable employee and the company. The term of the plan continues until May 4, 2011.

As of the date of this report, options to purchase fewer than 200,000 shares have been granted under the Inducement Plan. The Company believes that the adoption of the plan was not required to be disclosed on Form 8-K.

ITEM  6. EXHIBITS

(a) Exhibits.

Exhibit Number	Exhibit Description
3.1	Amended and Restated Certificate of Incorporation (incorporated by reference to the exhibit of the same number to the Company’s Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).
3.2	Certificate of Correction to Amended and Restated Certificate of Incorporation (incorporated by reference to the exhibit of the same number to the Company’s Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).
3.3	Amended and Restated Bylaws (incorporated by reference to the exhibit of the same number to the Company’s Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).
4.1	Form of Common Stock Certificate (incorporated by reference to the exhibit of the same number to Amendment No. 6 to the Company’s Registration Statement on Form S-1 (File No. 333-60838)).
4.2	Amended and Restated Investor’s Rights Agreement, dated July 31, 2001, by and among the Company’s and the parties who are signatories thereto (incorporated by reference to the exhibit of the same number to the Company’s Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).
10.1	2004 Employment Inducement Award Plan.
31.1	Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer.
31.2	Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer.
32.1	Section 1350 Certification of Principal Executive Officer.
32.2	Section 1350 Certification of Principal Financial Officer.

55

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	MAGMA DESIGN AUTOMATION, INC.
Dated: November 9, 2004	By	/s/    GREGORY C. WALKER
		Gregory C. Walker Senior Vice President—Finance and Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Signatory)

56

EXHIBIT INDEX

TO

MAGMA DESIGN AUTOMATION, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2004

Exhibit Number	Exhibit Description
3.1	Amended and Restated Certificate of Incorporation (incorporated by reference to the exhibit of the same number to the Company’s Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).
3.2	Certificate of Correction to Amended and Restated Certificate of Incorporation (incorporated by reference to the exhibit of the same number to the Company’s Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).
3.3	Amended and Restated Bylaws (incorporated by reference to the exhibit of the same number to the Company’s Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).
4.1	Form of Common Stock Certificate (incorporated by reference to the exhibit of the same number to Amendment No. 6 to the Company’s Registration Statement on Form S-1 (File No. 333-60838)).
4.2	Amended and Restated Investor’s Rights Agreement, dated July 31, 2001, by and among the Company’s and the parties who are signatories thereto (incorporated by reference to the exhibit of the same number to the Company’s Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).
10.1	2004 Employment Inducement Award Plan.
31.1	Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer.
31.2	Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer.
32.1	Section 1350 Certification of Principal Executive Officer.
32.2	Section 1350 Certification of Principal Financial Officer.

57