Mentor Graphics 10Q 2005 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934


For the Quarterly Period Ended March 31, 2004		Commission File No. 0-13442

MENTOR GRAPHICS CORPORATION

(Exact name of registrant as specified in its charter)


Oregon		93-0786033
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

8005 SW Boeckman Road Wilsonville, Oregon		97070-7777
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (503) 685-7000

NO CHANGE

(Former name, former address and former

fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) 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 the past 90 days. Yes x No ¨

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

Number of shares of common stock, no par value, outstanding as of May 3, 2004: 70,040,551

MENTOR GRAPHICS CORPORATION

Index to Form 10-Q


			Page Number
PART I FINANCIAL INFORMATION

	Item 1.	Financial Statements

	Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003		3

	Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003		4

	Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003		5

	Notes to Consolidated Financial Statements		6-13

	Item 2.	Management’s Discussion and Analysis of Results of Operations and Financial Condition	14-29

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	29-30

	Item 4.	Controls and Procedures	30

PART II OTHER INFORMATION

	Item 6.	Exhibits and Reports on Form 8-K	31

SIGNATURES			32

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Mentor Graphics Corporation

Condensed Consolidated Statements of Operations

(Unaudited)


Three months ended March 31,	2004			2003
*In thousands, except per share data*

Revenues:
System and software	$	94,521		$	91,812
Service and support		69,884			67,528

Total revenues		164,405			159,340

Cost of revenues:			��
System and software		4,562			4,815
Service and support		20,095			20,703
Amortization of purchased technology		2,466			2,209

Total cost of revenues		27,123			27,727

Gross margin		137,282			131,613

Operating expenses:
Research and development		48,383			42,876
Marketing and selling		63,706			59,189
General and administration		18,562			18,983
Amortization of intangible assets		782			1,145
Special charges		—			1,363

Total operating expenses		131,433			123,556

Operating income		5,849			8,057
Other income, net		1,230			487
Interest expense		(4,455	)		(4,045	)

Income before income taxes		2,624			4,499
Provision for income taxes		446			900

Net income	$	2,178		$	3,599

Net income per share:
Basic	$	.03		$	.05

Diluted	$	.03		$	.05

Weighted average number of shares outstanding:
Basic		69,803			67,335

Diluted		72,763			68,255

See accompanying notes to unaudited consolidated financial statements.

Mentor Graphics Corporation

Condensed Consolidated Balance Sheets

(Unaudited)


	As of March 31, 2004			As of December 31, 2003
*In thousands*

Assets
Current assets:
Cash and cash equivalents	$	73,219		$	68,333
Short-term investments		6,964			2,991
Trade accounts receivable, net of allowance for doubtful accounts of $4,106 and $4,149, respectively		209,889			223,670
Inventory, net		5,337			5,489
Prepaid expenses and other		24,418			21,675
Deferred income taxes		18,792			18,787

Total current assets		338,619			340,945

Property, plant and equipment, net		90,296			91,350
Term receivables, long-term		110,264			98,207
Goodwill		290,341			290,352
Intangible assets, net		34,278			35,929
Deferred income taxes		60,300			60,021
Other assets, net		26,888			23,884

Total assets	$	950,986		$	940,688

Liabilities and Stockholders’ Equity
Current liabilities:
Short-term borrowings	$	9,662		$	6,910
Accounts payable		16,207			18,105
Income taxes payable		35,407			35,122
Accrued payroll and related liabilities		52,630			80,484
Accrued liabilities		37,198			37,719
Deferred revenue		104,226			74,662

Total current liabilities		255,330			253,002

Notes payable		286,390			286,768
Other long-term liabilities		21,844			23,161

Total liabilities		563,564			562,931

Commitments and contingencies (Note 11)
Minority interest		3,383			3,391

Stockholders’ equity:
Common stock		301,300			294,180
Deferred compensation		(1,561	)		(2,601	)
Retained earnings		60,470			57,800
Accumulated other comprehensive income		23,830			24,987

Total stockholders’ equity		384,039			374,366

Total liabilities and stockholders’ equity	$	950,986		$	940,688

See accompanying notes to unaudited consolidated financial statements.

Mentor Graphics Corporation

Condensed Consolidated Statements of Cash Flows

(Unaudited)


Three months ended March 31,	2004			2003
*In thousands*

Operating Cash Flows:
Net income	$	2,178		$	3,599

Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of property, plant and equipment		5,888			5,792
Amortization		4,439			6,332
Deferred income taxes		(284	)		(302	)
Changes in other long-term liabilities and minority interest		(1,273	)		(1,186	)

Changes in operating assets and liabilities, net of effect of acquired businesses:
Trade accounts receivable		13,463			2,807
Prepaid expenses and other		(4,154	)		707
Term receivables, long-term		(12,211	)		(3,193	)
Accounts payable and accrued liabilities		(29,672	)		(10,006	)
Income taxes payable		367			(4,123	)
Deferred revenue		29,772			13,233

Net cash provided by operating activities		8,513			13,660

Investing Cash Flows:
Proceeds from sales and maturities of short-term investments		2,991			3,843
Purchases of short-term investments		(6,964	)		—
Purchases of property, plant and equipment		(4,820	)		(3,278	)
Purchases of intangible assets		(1,300	)		—
Acquisitions of businesses and equity interests		(3,809	)		(347	)

Net cash provided by (used in) investing activities		(13,902	)		218

Financing Cash Flows:
Proceeds from issuance of common stock		8,277			3,173
Net increase (decrease) in short-term borrowings		2,576			(930	)
Repayment of long-term notes payable		(499	)		(344	)

Net cash provided by financing activities		10,354			1,899

Effect of exchange rate changes on cash and cash equivalents		(79	)		(61	)

Net change in cash and cash equivalents		4,886			15,716
Cash and cash equivalents at beginning of period		68,333			34,969

Cash and cash equivalents at end of period	$	73,219		$	50,685

See accompanying notes to unaudited consolidated financial statements.

MENTOR GRAPHICS CORPORATION

Notes to Unaudited Condensed Consolidated Financial Statements

(In thousands, except per share amounts)

(1)

General - The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect all material normal recurring adjustments. However, certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the consolidated financial statements include adjustments necessary for a fair presentation of the results of the interim periods presented. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

The 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, 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.

(2)	*Summary of Significant Accounting Policies* –

Principles of Consolidation

The consolidated financial statements include the financial statements of the Company and its wholly owned and majority-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation.

The Company does not have off-balance sheet arrangements, financings or other relationships with unconsolidated entities or other persons, also known as special purpose entities. In the ordinary course of business, the Company leases certain real properties, primarily field office facilities and equipment, as described in Note 11.

Revenue Recognition

The Company derives system and software revenue from the sale of licenses of software products and emulation hardware systems. The Company derives service and support revenue from annual support contracts and professional services, which includes consulting services, training services and other services.

For the sale of licenses of software products and related service and support, the Company recognizes revenue in accordance with Statement of Position (SOP) 97-2, “Software Revenue Recognition”, as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions”. Revenue from perpetual license arrangements is recognized upon shipment, provided persuasive evidence of an arrangement exists, fees are fixed and determinable and collection is probable. Product revenue from term license installment agreements are recognized upon shipment and start of the license term, provided persuasive evidence of an arrangement exists, fees are fixed and determinable and collection is probable. The Company uses term license installment agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. In a term license agreement where the Company provides the customer with rights to unspecified or unreleased future products, revenue is recognized ratably over the license term.

The Company uses the residual method to recognize revenue when a license agreement includes one or more elements to be delivered at a future date if evidence of the fair value of all undelivered elements exists. If an undelivered element of the arrangement exists under the license arrangement, revenue is deferred based on vendor-specific objective evidence of the fair value of the undelivered element, as established by the price charged when such element is sold separately. If vendor-specific objective evidence of fair value does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered.

Revenue from annual maintenance and support arrangements is deferred and recognized ratably over the term of the contract. Revenue from consulting and training is recognized when the services are performed.

For the sale of emulation hardware systems and related service and support, the Company recognizes revenue in accordance with SEC Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition”, which supercedes SAB No. 101, “Revenue Recognition in Financial Statements”. Revenue is recognized when the title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the sales price is fixed and determinable and collection is probable. When the terms of sale include customer acceptance provisions and compliance with those provisions cannot be demonstrated until customer use, revenue is recognized upon acceptance. A limited warranty is provided on emulation hardware systems generally for a period of ninety days. The Company maintains an accrued warranty reserve to provide for these potential future costs and evaluates its adequacy on a quarterly basis. Service and maintenance revenues are recognized over the service period.

The Company adopted Emerging Issues Task Force (EITF) No. 00-21, “Revenue Arrangements with Multiple Deliverables” during 2003. The adoption of this issue did not have a material impact on the Company’s financial position or results of operations.

The Company adopted EITF No. 03-5, “Applicability of AICPA Statement Position 97-2, “Software Revenue Recognition,” to Non-Software Deliverables in an Arrangement Containing More-than-Incidental Software” during 2003. The adoption of this issue did not have a material impact on the Company’s financial position or results of operations.

Accounting for Stock-Based Compensation

Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” defines a fair value based method of accounting for employee stock options and similar equity instruments. As is permitted under SFAS No. 123, the Company has elected to continue to account for its stock-based compensation plans under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company has computed, for pro forma disclosure purposes, the value of all stock-based awards granted during the three months ended March 31, 2004 and 2003 using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:


Stock Option Plans Three months ended March 31,	2004		2003
Risk-free interest rate	3.0	%	2.9	%
Dividend yield	0	%	0	%
Expected life (in years)	4.3		4.1
Volatility	45	%	57	%

Employee Stock Purchase Plans (ESPPs) Three months ended March 31,	2004		2003
Risk-free interest rate	1.7	%	1.7	%
Dividend yield	0	%	0	%
Expected life (in years)	1.25		1.25
Volatility	45	%	86	%

The Company used expected volatility to estimate volatility for options granted during the three months ended March 31, 2004, and considers expected volatility to be more representative of prospective trends. Expected volatility is based on the option feature embedded in the Company’s convertible subordinated debentures (see Note 5), which is comparable to employee stock options. For options granted during the three months ended March 31, 2003, the Company used historic volatility. Using the Black-Scholes methodology, weighted average fair value of options granted during the three months ended March 31, 2004 and 2003 was $6.83 and $4.06 per share, respectively. The weighted average estimated fair value of purchase rights under the ESPPs during the three months ended March 31, 2004 and 2003 was $2.79 and $1.73, respectively.

Other than with respect to options assumed through acquisitions, no stock-based employee compensation cost is reflected in net income, as all options granted under the Company’s Stock Option Plans have an exercise price equal to the market value of the underlying common stock on the date of grant and the ESPPs are considered noncompensatory under APB Opinion No. 25. The Company recorded compensation expense for amortization of deferred compensation related to unvested stock options assumed through acquisitions of $374 and $511 for the three months ended March 31, 2004 and 2003, respectively. If the Company had accounted for its stock-based compensation plans in accordance with SFAS No. 123, the Company’s net income (loss) and net income (loss) per share would approximate the pro forma disclosures below:


Three months ended March 31,	2004			2003
Net income, as reported	$	2,178		$	3,599
Less: Total stock-based employee compensation expense determined under fair value based method, for all awards not previously included in net income, net of related tax benefit		(4,776	)		(5,451	)

Pro forma net loss	$	(2,598	)	$	(1,852	)

Basic net income per share – as reported	$	0.03		$	0.05
Basic net loss per share – pro forma	$	(0.04	)	$	(0.03	)
Diluted net income per share – as reported	$	0.03		$	0.05
Diluted net loss per share – pro forma	$	(0.04	)	$	(0.03	)

(3)

Net Income Per Share – Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive common shares consist of employee stock options, purchase rights from Employee Stock Purchase Plans and warrants using the treasury stock method and common shares issued assuming conversion of the convertible subordinated notes and convertible subordinated debentures, if dilutive.

The following provides the computation of basic and diluted net income per share:


Three months ended March 31,	2004		2003
Net Income	$	2,178	$	3,599

Weighted average shares used to calculate basic net income per share		69,803		67,335
Employee stock options and employee stock purchase plan		2,960		920

Weighted average common and potential common shares used to calculate diluted net income per share		72,763		68,255

Basic net income per share	$	0.03	$	0.05

Diluted net income per share	$	0.03	$	0.05

Options and warrants to purchase 7,294 and 12,721 shares of common stock were not included in the computation of diluted earnings per share for the three months ended March 31, 2004 and 2003, respectively. The options and warrants were excluded because the options were anti-dilutive as the exercise price was greater than the average market price of the common shares for the respective periods. The effect of the conversion of the Company’s convertible subordinated notes for the three months ended March 31, 2004, was anti-dilutive. If the convertible subordinated notes had been dilutive, the Company’s net income per share would have included additional earnings of $2,697 as well as additional incremental shares of 7,413 for the three months ended March 31, 2004. The shares issuable on conversion of the Company’s

convertible subordinated debentures have been excluded from dilutive common shares, as the circumstances that allow for conversion were not met. If the circumstances had been met and such conversion had been dilutive, additional earnings of $686 and incremental shares of 4,700 would have been included for the three months ended March 31, 2004.

(4)

Short-Term Borrowings –In July 2003, the Company renewed its syndicated, senior, unsecured credit facility that allows the Company to borrow up to $100,000. This facility is a three-year revolving credit facility, which terminates on July 14, 2006. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%, based on a pricing grid tied to a financial covenant. As a result, the Company’s interest expense associated with borrowings under this credit facility will vary with market interest rates. In addition, commitment fees are payable on the unused portion of the credit facility at rates between 0.35% and 0.50% based on a pricing grid tied to a financial covenant. The facility contains certain financial and other covenants, including financial covenants requiring the maintenance of specified liquidity ratios, leverage ratios and minimum tangible net worth. The Company had no short-term borrowings against the credit facility at March 31, 2004 and December 31, 2003. The Company’s credit facility prohibits the payment of dividends.

Other short-term borrowings include borrowings on multi-currency lines of credit, capital leases and other borrowings. Interest rates are generally based on the applicable country’s prime lending rate, depending on the currency borrowed. Other short-term borrowings of $9,662 and $6,910 were outstanding under these facilities at March 31, 2004 and December 31, 2003, respectively.

(5)

Long-Term Notes Payable – In August 2003, the Company issued $110,000 of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023 in a private offering pursuant to SEC Rule 144A. The Debentures have been registered with the SEC under the Securities Act of 1933. The Company pays interest on the Debentures quarterly in February, May, August and November, at a variable interest rate equal to 3-month LIBOR plus 1.65%. The effective interest rate was 2.80% for the three months ended March 31, 2004. The Debentures are convertible, under certain circumstances, into the Company’s common stock at a conversion price of $23.40 per share, for a total of 4,700 shares. These circumstances generally include (a) the market price of the Company’s common stock exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value of the common stock into which the Debentures are convertible, or (c) a call for redemption of the Debentures or certain other corporate transactions. The conversion price may also be adjusted based on certain future transactions. Some or all of the Debentures may be redeemed by the Company for cash on or after August 6, 2007. Some or all of the Debentures may be redeemed at the option of the holder for cash on August 6, 2010, 2013 or 2018.

In June 2002 the Company issued $172,500 of 6 7/8% Convertible Subordinated Notes (Notes) due 2007 in a private offering pursuant to SEC Rule 144A. The Notes have been registered with the SEC under the Securities Act of 1933. The Company pays interest on the Notes semi-annually in June and December. The Notes are convertible into the Company’s common stock at a conversion price of $23.27 per share, for a total of 7,413 shares. Some or all of the Notes may be redeemed by the Company for cash on or after June 20, 2005. The Notes rank pari passu with the Debentures.

Other long-term notes payable include multi-currency notes payable and capital leases. Interest rates are generally based on the applicable country’s prime lending rate, depending on the currency borrowed. Other long-term notes payable of $3,890 and $4,268 were outstanding under these agreements at March 31, 2004 and December 31, 2003, respectively.

(6)

Stock Repurchases –The board of directors has authorized the Company to repurchase shares in the open market. There were no repurchases in the three months ended March 31, 2004 and 2003. The Company considers market conditions, alternative uses of cash and balance sheet ratios when evaluating share repurchases.

(7)	*Supplemental Cash Flow Information -*The following provides additional information concerning supplemental disclosures of cash flow activities:


Three months ended March 31,	2004			2003
Interest paid	$	1,081		$	1,072

Income tax refunds, net of payments	$	(1,356	)	$	(890	)

(8)	*Comprehensive Income* - The following provides a summary of comprehensive income:


Three months ended March 31,	2004			2003
Net income	$	2,178		$	3,599
Change in accumulated translation adjustment		(342	)		491
Change in unrealized gain (loss) on derivative instruments		(815	)		378

Comprehensive income	$	1,021		$	4,468

(9)	*Special Charges* – For the three months ended March 31, 2004, the Company recorded no special charges.

For the three months ended March 31, 2003, the Company recorded special charges of $1,363. These charges primarily consisted of costs incurred for employee terminations. The Company rebalanced the workforce by 34 employees during the three months ended March 31, 2003. This reduction impacted several employee groups. Employee severance costs included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to quarter-end. These costs were expended during the second quarter of 2003. There have been no significant modifications to the originally estimated amount of these charges.

Accrued special charges are included in accrued liabilities and other long-term liabilities on the consolidated balance sheets. The following table shows changes in accrued special charges during 2004:


	Accrued Special Charges at December 31, 2003		2004 Payments			Accrued Special Charges at March 31, 2004 (1)
Emulation litigation settlement	$	1,536	$	(280	)	$	1,256
Employee severance and related Costs		2,681		(2,082	)		599
Lease termination fees and other facility costs		10,034		(584	)		9,450
Other costs		—		—			—

Total	$	14,251	$	(2,946	)	$	11,305

(1)	Of the $11,305 total accrued special charges at March 31, 2004, $7,206 represents the long-term portion of accrued lease termination fees and other facility costs. The remaining balance of $4,099 represents the short-term portion of accrued special charges.

(10)

Derivative Instruments and Hedging Activities – The Company is exposed to fluctuations in foreign currency exchange rates. To manage the volatility relating to these exposures, exposures are aggregated on a consolidated basis to take advantage of natural offsets. For exposures that are not offset, the Company enters into short-term foreign currency forward and option contracts to partially offset these anticipated exposures. The primary exposures that do not currently have natural offsets are the Japanese yen where the Company is in a long position and the Euro where the Company is in a short position. The Company formally documents all relationships between foreign currency contracts and hedged items as well as its risk management objectives and strategies for undertaking various hedge transactions. All hedges designated as cash flow hedges are linked to forecasted transactions and the Company assesses, both at inception of the hedge and on an ongoing basis, the effectiveness of the foreign exchange contracts in offsetting changes in the cash flows of the hedged items. The effective portions of the net gains or losses on foreign currency contracts are reported as a component of accumulated other comprehensive income in stockholders’ equity. Accumulated other comprehensive income associated with hedges of forecasted transactions is reclassified to the consolidated statement of operations in the same period as the forecasted transaction occurs. The Company discontinues hedge accounting prospectively when it is determined that a foreign currency contract is not highly effective as a hedge under the requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Any gain or loss deferred through that date remains in accumulated other comprehensive income until the forecasted transaction occurs at which time it is reclassified to the consolidated statement of operations. To the extent the transaction is no longer deemed probable of occurring, hedge accounting treatment is discontinued prospectively and amounts deferred are reclassified to other income or expense.

The fair value of foreign currency forward and option contracts, recorded in accrued liabilities in the consolidated balance sheet, was $841 at March 31, 2004. The fair value of foreign currency forward and option contracts, recorded in prepaid expenses and other in the consolidated balance sheet, was $11 at December 31, 2003.

The following provides a summary of activity in accumulated other comprehensive income relating to the Company’s hedging program:


Three months ended March,	2004			2003
Beginning balance	$	—		$	(171	)
Favorable (unfavorable) changes in fair value of cash flow hedges		(932	)		344
Net loss transferred to earnings		117			34

Net unrealized gain (loss)	$	(815	)	$	207

The remaining balance in accumulated other comprehensive income at March 31, 2004 represents a net unrealized loss on foreign currency contracts relating to hedges of forecasted revenues and expenses expected to occur during 2004. These amounts will be transferred to the consolidated statement of operations upon recognition of the related revenue and recording of the respective expenses. The Company expects substantially all of the balance in accumulated other comprehensive income to be reclassified to the consolidated statement of operations within the next year. The Company transferred $2 and $128 of deferred losses to system and software revenues relating to foreign currency contracts hedging revenues for the three months ended March 31, 2004 and 2003, respectively. The Company transferred a $115 deferred loss and a $94 deferred gain to operating expenses relating to foreign currency contracts hedging commission and other expenses for the three months ended March 31, 2004 and 2003, respectively.

The Company enters into foreign currency contracts to offset the earnings impact relating to the variability in exchange rates on certain short-term monetary assets and liabilities denominated in non-functional currencies. These foreign exchange contracts are not designated as hedges. Changes in the fair value of these contracts are recognized currently in earnings in other income, net to offset the remeasurement of the related assets and liabilities.

In accordance with SFAS No. 133, the Company excludes changes in fair value relating to time value of foreign currency contracts from its assessment of hedge effectiveness. The Company recorded income

relating to time value in other income, net of $138 and $139 and recorded expense in interest expense of $114 and $148 for the three months ended March 31, 2004 and 2003, respectively.

(11)	*Commitments and Contingencies* –

Leases

The Company leases a majority of its field office facilities under non-cancelable operating leases. In addition, the Company leases certain equipment used in its research and development activities. This equipment is generally leased on a month-to-month basis after meeting a six-month lease minimum.

Indemnifications

The Company’s license and services agreements include a limited indemnification provision for claims from third-parties relating to the Company’s intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5, “Accounting for Contingencies”. The indemnification is generally limited to the amount paid by the customer. At March 31, 2004, the Company is not aware of any material liabilities arising from these indemnifications.

Legal Proceedings

From time to time the Company is involved in various disputes and litigation matters that arise from the ordinary course of business. These include disputes and lawsuits relating to intellectual property rights, licensing, contracts and employee relations matters. The Company believes that the outcome of current litigation, individually and in the aggregate, will not have a material affect on the Company’s results of operations.

(12)

Segment Reporting –SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, requires disclosures of certain information regarding operating segments, products and services, geographic areas of operation and major customers. To determine what information to report under SFAS No. 131, the Company reviewed the Chief Operating Decision Makers’ (CODM) method of analyzing the operating segments to determine resource allocations and performance assessments. The Company’s CODMs are the Chief Executive Officer and the President.

The Company operates exclusively in the electronic design automation (EDA) industry. The Company markets its products and services worldwide, primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia and transportation industries. The Company sells and licenses its products through its direct sales force in North America, Europe, Japan and Pacific Rim, and through distributors where third parties can extend sales reach more effectively or efficiently. The Company’s reportable segments are based on geographic area.

All intercompany revenues and expenses are eliminated in computing revenues and operating income (loss). The corporate component of operating income represents research and development, corporate marketing and selling, corporate general and administration, special charges and merger and acquisition related charges. Corporate capital expenditures and depreciation and amortization are generated from assets allotted to research and development, corporate marketing and selling and corporate general and administration. Reportable segment information is as follows:


Three months ended March 31,	2004			2003
Revenues
Americas	$	65,030		$	79,526
Europe		43,821			42,420
Japan		38,795			24,024
Pacific Rim		16,759			13,370

Total	$	164,405		$	159,340

Operating income (loss)
Americas	$	32,828		$	43,579
Europe		21,263			21,784
Japan		28,408			14,596
Pacific Rim		12,361			9,862
Corporate		(89,011	)		(81,764	)

Total	$	5,849		$	8,057

The Company segregates revenue into three categories of similar products and services. These categories include Integrated Circuit (IC) Design, Systems Design and Professional Services. The IC Design and Systems Design categories include both product and support revenue. Revenue information is as follows:


Three months ended March 31,	2004		2003
Revenues
Integrated Circuit (IC) Design	$	115,742	$	104,098
Systems Design		41,936		49,897
Professional Services		6,727		5,345

Total	$	164,405	$	159,340

(13)	*Recent Accounting Pronouncements* –

In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition”. SAB No. 104 clarifies existing guidance regarding revenues for contracts that contain multiple deliverables to make it consistent with EITF No. 00-21. Adoption of this bulletin did not have a material impact on the Company’s financial position or results of operations as the Company’s revenue transactions are subject to SOP 97-2.

Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

(All numerical references in thousands, except for percentages)

OVERVIEW

The Company

The Company is a supplier of electronic design automation (EDA) systems — advanced computer software, emulation hardware systems and intellectual property designs and databases used to automate the design, analysis and testing of electronic hardware and embedded systems software in electronic systems and components. The Company markets its products and services worldwide, primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia and transportation industries. Through the diversification of the Company’s customer base among these various customer markets, the Company attempts to reduce its exposure to fluctuations within each market. The Company sells and licenses its products through its direct sales force and a channel of distributors and sales representatives. In addition to its corporate offices in Wilsonville, Oregon, the Company has sales, support, software development and professional service offices worldwide.

Business Environment

Beginning in late 2000, the electronics industry experienced a broad economic downturn. Since a majority of the Company’s business originates from electronics industry customers, the Company was negatively impacted. The semiconductor industry, a subset of the electronics industry, experienced the deepest downturn in its history. As a result of this downturn, customers reduced research and development (R&D) budgets, limited general investment in design tools and reduced engineering staff. In addition, many smaller companies and start-ups went out of business. The continued weakness in the semiconductor industry has caused companies to continue to limit EDA spending in 2003 and 2004. However, even in a depressed environment, customers still require the newest tools to solve leading-edge design problems. The Company attempts to fill those demands through its relatively young and diverse product portfolio. As a result, the Company had a solid year in 2003 and first quarter in 2004 despite the economic troubles facing many of its customers. Because the Company’s products address not only semiconductor design, but a wide range of systems design, the negative impact of the semiconductor industry downturn was partly mitigated. Strength in system design in the military and aerospace segments helped drive revenue growth for the Company in 2003. As customer demand expanded during this time, the Company was able to leverage its strength in system design relative to its major competitors. As the semiconductor industry began to stabilize in the second half of 2003 and first quarter of 2004, newer integrated circuit (IC) design tool sales increased. For the Company, this resulted in a strong second half of 2003 and first quarter of 2004 led by its physical verification product family.

In general, the Company’s management believes that EDA spending by semiconductor companies lags their economic financial recovery by several quarters for two primary reasons. First, because of the importance of R&D to the future of semiconductor companies, customers try to moderate R&D spending reductions during downturns in comparison to other expense items. As a result, R&D spending as a percentage of revenue increases. As revenues grow in the early stages of the recovery, customers constrain spending increases until R&D returns to more typical percentage of revenue levels. Second, as a result of reduced engineering staff, customers may hold excess software licenses of established tools. Hiring must resume before additional software licenses will be required. The exception is for newer software that customers have not previously purchased.

Due to the severity of the economic downturn, the Company’s management is not predicting a broad recovery of EDA spending in 2004. The Company will continue its strategy of developing best in class point tools with number one market share potential. This strategy is intended to create a diversified product portfolio for the Company that solves customers’ critical design problems. The Company’s management believes that this product strategy, in conjunction with a customer diversification strategy, has helped reduce the impact of marketplace fluctuations in the past and should continue to do so in the future.

License Model Mix

License model trends can have a material impact on various aspects of the Company’s business. See “Critical Accounting Estimates – Revenue Recognition” on page 16 for a description of the types of product licenses sold by the Company. As the mix among perpetual licenses, fixed term licenses (term) with upfront revenue recognition and

term licenses with ratable or due and payable revenue recognition shifts, revenues, earnings, cash flow and days sales outstanding (DSO) are either positively or negatively affected. The year ended December 31, 2003 marked the third consecutive year in which, as a percentage of product revenue, term revenue increased while perpetual revenue decreased. This trend was primarily the result of two factors. First, the Company’s customers are moving toward the term license model, which provides the customer with greater flexibility for product usage, including the ability to share the products between multiple locations and reconfigure consumption at regular intervals from a fixed product list. As such, some of the Company’s customers have converted their existing installed base from perpetual to term licenses. Second, the weakness in the United States economy has disproportionately impacted the Company’s smaller customers. Historically these customers have purchased under the perpetual license model.

Under this recent shift from perpetual licenses to term licenses with upfront revenue recognition, which the Company’s management views as a positive trend, the Company expects no measurable impact to earnings, but a negative impact on cash flow and DSO. As customers move away from perpetual licenses and into term licenses, the renewability and repeatability of the Company’s business is increased. This provides opportunity for increased distribution of newer products earlier in their lifecycles.

Product Developments

During 2003 and 2004, the Company continued to execute its strategy of focusing on new customer problem areas, as well as building upon its well-established product families. The Company’s management believes that customers, faced with leading-edge design challenges, choose the best products in each category to build their design environment. The Company generally has focused its internal development efforts on areas where it believes it can build a number one market position, or extend an existing number one market position.

Significant new products delivered by the Company in 2003 in the area of printed circuit board design included: BoardLink Pro (a tool that enables large and complex FPGAs to be efficiently incorporated into the design process), TeamPCB (a tool that allows multiple designers to simultaneously work on the same design without affecting each other’s work) and advanced high-speed design and analysis software.

In the Design-to-Silicon Division, the Company continued to extend the value of the Calibre platform, obtaining significant new customer engagements and orders with its resolution enhancement technology. During the year, the Company also worked on developing new design-for-manufacturing tools that are expected to debut later in 2004.

The Company launched its Scalable Verification Environment featuring a suite of tools designed to solve the verification challenges that design engineers face. According to Collett International, an industry analyst firm, engineers spend approximately 62% of their design effort verifying their designs. This dominance of verification in the design process has driven many customers to seek new solutions to enhance their verification abilities.

The Company’s management believes that the development and commercialization of EDA software tools is usually a multi-year process with limited customer adoption in the first years of tool availability. Once tools are adopted, however, their life spans tend to be long and healthy. The Company’s management believes that the Company’s relatively young and diverse product lines are positioned well for continued growth.

Q1 2004 Financial Performance

•

Total revenues were $164,405 for the three months ended March 31, 2004, a 3% increase over the comparable period of 2003, resulting largely from favorable currency effects from strengthening of the Japanese yen, the Euro and the British pound sterling. Both system and software revenue and service and support revenue were up 3%.

•

Product revenues split by license model was 47% term with upfront revenue recognition, 39% perpetual and 14% term with ratable or due and payable revenue recognition, compared to Q1 2003 product revenue splits of 46% term with upfront revenue recognition, 38% perpetual and 16% term with ratable or due and payable revenue recognition.

•

Service and support revenues for the three months ended March 31, 2004 were $69,884, a 3% increase over the comparable period of 2003 service and support revenues of $67,528, resulting largely from favorable currency effects from strengthening of the Japanese yen, the Euro and the British pound sterling.

•

By geography, year-over-year revenues decreased 18% in the Americas, primarily due to a decrease in Integrated Systems Design product revenues due to a large term deal for the three months ended March 31, 2003 as compared to the three months ended March 31, 2004, and increased 3% in Europe, 61% in Japan and 25% in Pacific Rim. The Americas contributed the largest share of revenue at nearly 40%.

•

Net income for the three months ended March 31, 2004 was $2,178, compared to a net income of $3,599 in the comparable period of 2003. The decrease was primarily due to an increase in operating expenses offset by increased revenues and lower special charges.

•

Trade accounts receivable, net decreased to $209,889 at March 31, 2004, down 6% from $223,670 at December 31, 2003. Average days sales outstanding increased from 100 days at December 31, 2003 to 115 days at March 31, 2004. The increase in days sales outstanding was primarily due to the decrease in revenue for the three months ended March 31, 2004 as compared to the three months ended December 31, 2003 and effect of annual support renewals in the first three months of 2004.

•

Cash generated by operating activities was $8,513 for the three months ended March 31, 2004 compared to $13,660 in the comparable period of 2003. At March 31, 2004, cash, cash equivalents and short-term investments were $80,183, up 12% from $71,324 at December 31, 2003.

CRITICAL ACCOUNTING ESTIMATES

The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities and contingencies as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The Company evaluates its estimates on an on-going basis. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company believes the following are the critical accounting estimates and judgments used in the preparation of its consolidated financial statements.

Revenue Recognition

The Company reports revenue in two categories based upon how the revenue is generated: (i) system and software and (ii) services and support.

System and software revenue - System and software revenues are derived from the sale of licenses of software products and emulation hardware systems.

The Company licenses software using two different license types:

Term licenses are for a specified time period, typically three years with payments spread over the license term, and do not provide the customer with the right to use the product after the end of the term. The Company generally recognizes product revenue from term installment license agreements upon shipment and start of the license term. The Company uses these agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. If the Company no longer had a history of collecting without providing concessions on term agreements, then revenue would be required to be recognized as the payments become due and payable over the license term. This change would have a material adverse impact on the Company’s near-term results of operations. In a situation in which a risk of concession may exist on a term license agreement, revenue is recognized on a due and payable basis. In a term license agreement where the Company provides the customer with rights to unspecified or unreleased future products, revenue is recognized ratably over the license term.

Perpetual licenses provide the customer with the right to use the product in perpetuity and typically do not provide for extended payment terms. The Company recognizes product revenue from perpetual license agreements upon delivery to the customer when the likelihood of product return is remote. If the agreement provides for customer payment terms that are different than the standard payment terms in the customer’s jurisdiction, product revenue is recognized as payments become due and payable.

Service and support revenue - Service and support revenues consist of revenues from support contracts and professional services, which include consulting services, training services and other services. The Company records service revenue as the services are provided to the customer. Support revenue is recognized over the support term. For multi-element arrangements that include support, support is allocated based on vendor specific objective evidence (VSOE) of the fair value of support. For term licenses, VSOE is established by the price charged when such support is offered as optional during the license term. For perpetual licenses, VSOE is established by the price charged when such support is sold separately.

The Company determines whether software product revenue recognition is appropriate based upon the evaluation of whether the following four criteria have been met:

1.	Persuasive evidence of an arrangement exists – An agreement signed by the customer and the Company.

2.	Delivery has occurred – The software has been shipped, the customer is in possession of the software or the software has been made available to the customer through electronic delivery.

3.	Fee is fixed and determinable – The amount of the fee and the due date have been fixed at execution of the arrangement without the possibility of future adjustments or concessions.

4.	Collectibility is probable – The customer is expected to pay for products or services without the Company providing future concessions to the customer.

Valuation of Trade Accounts Receivable

The Company maintains allowances for doubtful accounts on trade accounts receivable and term receivables, long-term for estimated losses resulting from the inability of its customers to make required payments. The Company evaluates the collectibility of its trade accounts receivable based on a combination of factors. The Company regularly analyzes its customer accounts. When it becomes aware of a specific customer’s inability to meet its financial obligations, such as in the case of bankruptcy or deterioration in the customer’s operating results or financial position, a specific reserve for bad debt is recorded to reduce the related receivable to the amount believed to be collectible. The Company also records unspecified reserves for bad debt for all other customers based on a variety of factors including length of time the receivables are past due, the financial health of the customers, the current business environment and historical experience. If circumstances related to specific customers change, estimates of the recoverability of receivables would be adjusted resulting in either additional selling expense or a reduction in selling expense in the period such determination was made.

Valuation of Deferred Tax Assets

Deferred tax assets are recognized for deductible temporary differences, net operating loss carryforwards and credit carryforwards if it is more likely than not that the tax benefits will be realized. The Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for valuation allowances. The Company has recorded a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. In the event the Company was to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase either income or contributed capital, or decrease goodwill, in the period such determination was made. Also, if the Company was to determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to increase the valuation allowance on such net deferred tax assets would be charged to expense in the period such determination was made.

Goodwill, Intangible Assets and Long-Lived Assets

The Company reviews long-lived assets and the related intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Recoverability of an asset is determined by comparing its carrying amount, including any associated intangible assets, to the forecasted undiscounted net cash flows of the operation to which the asset relates. If the operation is determined to be unable to recover the carrying amount of its assets, then intangible assets are written down first, followed by the other long-lived assets of the operation, to fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets. Goodwill and intangible assets with indefinite lives are tested for impairment annually and whenever there is an impairment indicator using a fair value approach. In the event that, in the future, it is determined that the Company’s goodwill, intangible or other long-lived assets have been impaired, an adjustment would be made that would result in a charge for the write-down in the period that determination was made.

Inventory

The Company purchases and commits to purchase inventory based upon forecasted shipments of its emulation hardware systems. The Company evaluates, on a quarterly basis, the need for inventory reserves based on projections of systems expected to ship within six months. Reserves for excess and obsolete inventory are established to account for the differences between forecasted shipments and the amount of purchased and committed inventory.

Restructuring Charges

The Company has recorded restructuring charges in connection with its plans to better align the cost structure with projected operations in the future. In accordance with Statement of Financial Accounting Standards (SFAS) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” the Company records liabilities for costs associated with exit or disposal activities when the liability is incurred. Prior to January 1, 2003, in accordance with Emerging Issues Task Force (EITF) No. 94-3, the Company accrued for restructuring costs when management made a commitment to an exit plan that specifically identified all significant actions to be taken.

The Company has recorded restructuring charges in connection with employee rebalances based on estimates of the expected costs associated with severance benefits. If the actual cost incurred exceeds the estimated cost, additional special charges will be recognized. If the actual cost is less than the estimated cost, a benefit to special charges will be recognized.

The Company has also recorded restructuring charges in connection with excess leased facilities to offset future rent, net of estimated sublease income that could be reasonably obtained, of the abandoned office space and to write-off leasehold improvements on abandoned office space. The Company worked with external real estate experts in each of the markets where properties are located to obtain assumptions used to determine the best estimate of the net loss.

The Company’s estimates of expected sublease income could change based on factors that affect the Company’s ability to sublease those facilities such as general economic conditions and the real estate market. If the real estate markets worsen and the Company is not able to sublease the properties as expected, additional adjustments may be required, which would result in additional special charges in the period such determination was made. Likewise, if the real estate market strengthens and the Company is able to sublease the properties earlier or at more favorable rates than projected, a benefit to special charges will be recognized.

RESULTS OF OPERATIONS

REVENUES AND GROSS MARGINS

System and Software

System and software revenues are derived from the sale of licenses of software products and emulation hardware systems. System and software revenues for the three months ended March 31, 2004 totaled $94,521 representing an increase of $2,709 or 3% over the comparable period of 2003. System and software revenues were favorably impacted by approximately 3% due to the strengthening of the Japanese yen, the Euro and the British pound sterling. The increase in software product revenue was also attributable to (i) an increase in Scalable Verification product revenues primarily attributable to the Modelsim product line and (ii) continued strength in the Design-to-Silicon product revenues primarily attributable to the Calibre product line. This increase was offset by a decrease in Integrated Systems Design product revenues due to a large term deal in the three months ended March 31, 2003.

System and software gross margin was 93% for the three months ended March 31, 2004 compared to 92% for the comparable period of 2003. Gross margin was favorably impacted for the three months ended March 31, 2004 due to a greater mix of higher margin software product revenue versus lower margin emulation hardware system revenue.

Amortization of purchased technology costs to system and software cost of revenues was $2,466 for the three months ended March 31, 2004 compared to $2,209 for the comparable period of 2003. The increase in amortization of purchased technology is primarily attributable to acquisitions in the second quarter of 2003. Purchased technology costs are amortized over three to five years to system and software cost of revenues.

Service and Support

Service and support revenues consist of revenues from support contracts and professional services, which include consulting services, training services and other services. Service and support revenues for the three months ended March 31, 2004 totaled $69,884 representing an increase of $2,356 or 3% from the comparable period of 2003. Service and support revenues were favorably impacted by approximately 3% due to the strengthening of the Japanese yen, the Euro and the British pound sterling.

Service and support gross margin was 71% for the three months ended March 31, 2004 compared to 69% for the comparable period of 2003. Service and support gross margin increased for the three months ended March 31, 2004 compared to the same period in 2003 primarily due to the strengthening of the Japanese yen, the Euro and the British pound sterling.

Geographic Revenues Information


Three months ended March 31,	2004		Change		2003
Americas	$	65,030	(18	)%	$	79,526
Europe		43,821	3	%		42,420
Japan		38,795	61	%		24,024
Pacific Rim		16,759	25	%		13,370

	$	164,405			$	159,340

Revenues in the Americas decreased for the three months ended March 31, 2004 as compared to the three months ended March 31, 2003 due to a decrease in Integrated Systems Design product revenues due to a large term deal in the three months ended March 31, 2003. Revenues outside the Americas represented 60% of total revenues for the three months ended March 31, 2004 and 50% for the comparable period of 2003. The effects of exchange rate differences from the European currencies to the United States dollar positively impacted European revenues by approximately 3% for the three months ended March 31, 2004. The effects of exchange rate differences from the Japanese yen to the United States dollar positively impacted Japanese revenues by approximately 9% for the three months ended March 31, 2004. Exclusive of currency effects, higher revenues in Japan were primarily attributable to higher software product sales and an increase in service and support revenue. Revenues in the Pacific Rim increased for the three months ended March 31, 2004 as compared to the three months ended March 31, 2003 primarily as a result of higher software product and support sales. Since the Company generates more than half of its revenues outside of the United States and expects this to continue in the future, revenue results may be impacted by the effects of future foreign currency fluctuations.

OPERATING EXPENSES


Three months ended March 31,	2004		Change		2003
Research and development	$	48,383	13	%	$	42,876
Marketing and selling	$	63,706	8	%	$	59,189
General and administration	$	18,562	(2	)%	$	18,983
Amortization of intangible assets	$	782	(32	)%	$	1,145
Special charges	$	—	(100	)%	$	1,363

Research and Development

R&D costs increased for the three months ended March 31, 2004 over the comparable period of 2003 primarily attributable to higher R&D headcount, including headcount in the systems design product line and due to a weaker United States dollar during 2004 that increased R&D expenses by approximately 2% for the three months ended March 31, 2004.

Marketing and Selling

Marketing and selling costs increased for the three months ended March 31, 2004 over the comparable period of 2003 primarily due to higher headcount and due to a weaker United States dollar during 2004 that increased marketing and selling expenses by approximately 2% for the three months ended March 31, 2004.

General and Administration

General and administration costs decreased for the three months ended March 31, 2004 as compared to the comparable period of 2003 primarily attributable to no emulation litigation related costs due to the settlement of the emulation litigation with Cadence Design System, Inc. in 2003, offset by an increase in outside service costs.

Amortization of Intangible Assets

Amortization of intangible assets decreased for the three months ended March 31, 2004 as compared to the comparable period of 2003 due to complete amortization of intangible assets related to certain prior year acquisitions.

Special Charges

For the three months ended March 31, 2004, the Company recorded no special charges.

Other Income, Net

Other income, net totaled $1,230 for the three months ended March 31, 2004 compared to $487 for the comparable period in 2003. Interest income was $1,632 for the three months ended March 31, 2004 compared to $1,447 for the comparable period of 2003. Interest income includes income relating to time value of foreign currency contracts of $138 compared to $139 for the comparable period in 2003. Other income, net was unfavorably impacted by a foreign currency loss of $126 in the three months ended March 31, 2004 compared to a foreign currency loss of $733 for the comparable period of 2003.

Interest Expense

Interest expense was $4,455 for the three months ended March 31, 2004 compared to $4,045 for comparable period in 2003. Interest expense is primarily attributable to of the Company’s convertible subordinated notes and debentures issued in June 2002 and August 2003, respectively. The Company recorded interest expense relating to the time value of foreign currency contracts of $114 compared to $148 for the comparable period of 2003.

Provision for Income Taxes

The provision for income taxes was $446 for the three months ended March 31, 2004 compared to $900 for the comparable period of 2003. On a quarterly basis, the Company evaluates its expected income tax expense or benefit based on its year to date operations and records an adjustment in the current quarter. The net tax provision is the result of the mix of profits earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates. The provision for income taxes differs from tax computed at the federal statutory income tax rate primarily due to the impact of the tax rate differential on earnings of foreign subsidiaries, offset in part by the impact of state taxes and the amortization of a deferred tax charge recorded in 2002.

The Company provides for United States income taxes on the earnings of foreign subsidiaries unless they are considered permanently invested outside of the United States. Upon repatriation, some of these earnings would generate foreign tax credits which may reduce the Federal tax liability associated with any future foreign dividend.

Under SFAS No. 109, “Accounting for Income Taxes”, deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. SFAS No. 109 provides for the recognition of deferred tax assets without a valuation allowance if realization of such assets is more likely than not. Based on the weight of available evidence, the Company has provided a valuation allowance against certain deferred tax assets. A portion of the valuation allowance for deferred tax assets relates to the difference between financial and tax reporting of employee stock option exercises, for which subsequently recognized tax benefits will be applied directly to increase contributed capital. A portion of the valuation allowance for deferred tax assets relates to

certain of the tax attributes acquired from IKOS, for which subsequently recognized tax benefits will be applied directly to reduce goodwill. The remainder of the valuation allowance was based on the historical earnings patterns within individual taxing jurisdictions that make it uncertain that the Company will have sufficient income in the appropriate jurisdictions to realize the full value of the assets. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis.

The Company has settled its federal income tax obligations through 1991 and is currently under an Internal Revenue Service examination in the United States for years 2000 and 2001. Additionally, the Company has been advised that the Internal Revenue Service will commence the examination of the 2002 federal income tax return during the second quarter. The results of these examinations are unknown at this time; however, the Company believes the provisions for income taxes for years since 1991 are adequate.

Effects of Foreign Currency Fluctuations

More than half of the Company’s revenues and approximately two-fifths of its expenses were generated outside of the United States for the first three months of 2004. For 2004 and 2003, approximately one-fourth of European and all Japanese revenues were subject to exchange rate fluctuations as they were booked in local currencies. Most large European revenue contracts are denominated and paid to the Company in the United States dollar while the Company’s European expenses, including substantial research and development operations, are paid in local currencies causing a short position in the Euro and the British pound sterling. In addition, the Company experiences greater inflows than outflows of Japanese yen as all Japanese-based customers contract and pay the Company in local currency. While these exposures are aggregated on a consolidated basis to take advantage of natural offsets, substantial exposure remains. For exposures that are not offset, the Company enters into short-term foreign currency forward and option contracts to partially offset these anticipated exposures. The option contracts are generally entered into at contract strike rates that are different than current market rates. As a result, any unfavorable currency movements below the strike rates will not be offset by the foreign currency option contract and could negatively affect operating results. These contracts address anticipated future cash flows for 90-day to one-year periods and do not hedge 100% of the potential exposures related to these currencies. As a result, the effects of currency fluctuations could have a substantial effect on the Company’s overall results of operations.

Foreign currency translation adjustment, a component of accumulated other comprehensive income reported in the stockholders’ equity section of the consolidated balance sheets, decreased to $25,580 at March 31, 2004 from $25,922 at December 31, 2003. This reflects the decrease in the value of net assets denominated in foreign currencies since year-end 2003.

LIQUIDITY AND CAPITAL RESOURCES

Cash, Cash Equivalents and Short-Term Investments

Total cash, cash equivalents and short-term investments at March 31, 2004 were $80,183 compared to $71,324 at December 31, 2003. Cash provided by operations was $8,513 in the first three months of 2004 compared to $13,660 during the same period in 2003. The decrease in cash flows from operating activities was primarily due to payment of payroll and related liabilities in the first three months of 2004. This decrease was partially offset by an increase in deferred revenue.

Cash used for investing activities, excluding short-term investments, was $9,929 and $3,625 for the three months ended March 31, 2004 and 2003, respectively. Cash used for investing activities included capital expenditures of $4,820 in the first three months of 2004 compared to $3,278 during the same period in 2003. Acquisition of businesses and equity interests was $3,809 for the three months ended March 31, 2004 compared to $347 for the comparable period in 2003. Purchases of intangible assets were $1,300 for the three months ended March 31, 2004. There were no purchases of intangible assets for the three months ended March 31, 2003.

Cash provided by financing activities was $10,354 and $1,899 in the first three months of 2004 and 2003, respectively. Cash and short-term investments were positively impacted by proceeds from issuance of common stock upon exercise of stock options and employee stock plan purchases of $8,277 and $3,173 during the three months ended March 31, 2004 and 2003, respectively. Cash provided by financing activities for the three months ended March 31, 2004 included proceeds from short-term borrowings of $2,576 compared to borrowings of $930 for the comparable period in 2003.

Trade Accounts Receivable, net

Trade accounts receivable, net decreased to $209,889 at March 31, 2004 from $223,670 at December 31, 2003. Excluding the current portion of term receivables of $110,163 and $119,627, average days sales outstanding were 55 days and 46 days at March 31, 2004 and December 31, 2003, respectively. Average days sales outstanding in total accounts receivable increased from 100 days at December 31, 2003 to 115 days at March 31, 2004. The increase in days sales outstanding was primarily due to the decrease in revenue for the three months ended March 31, 2004 as compared to the three months ended December 31, 2003 and effect of annual support renewals in the first three months of 2004. In the quarters where term contract revenue is recorded, only the first twelve months of the receivable is reflected in current trade accounts receivable. In the following quarters, the amount due in the next twelve months is reflected in current trade accounts receivable without the corresponding revenue.

Prepaid Expenses and Other

Prepaid expenses and other increased $2,743 from December 31, 2003 to March 31, 2004. The increase was primarily due to renewals of maintenance contracts and prepayments for royalties, benefits and sales commissions. The increase was partially offset by the receipt of an income tax refund of $1,494.

Term Receivables, Long-Term

Term receivables, long-term increased to $110,264 at March 31, 2004 compared to $98,207 at December 31, 2003. The balances were attributable to multi-year, multi-element term license sales agreements. Balances under term agreements that are due within one year are included in trade accounts receivable and balances that are due in more than one year are included in term receivables, long-term. The Company uses term agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. The increase was primarily attributable to new term agreements closed in the first three months of 2004, primarily in Japan.

Accrued Payroll and Related Liabilities

Accrued payroll and related liabilities decreased $27,854 from December 31, 2003 to March 31, 2004. The decrease was primarily due to payments of the 2003 annual and fourth quarter incentive compensation.

Deferred Revenue

Deferred revenue consists primarily of prepaid annual software support contracts. Deferred revenue increased $29,564 from December 31, 2003 to March 31, 2004. The increase was primarily due to higher renewal rates, support contracts moving from quarterly to annual billing cycles and higher business levels.

Capital Resources

Expenditures for property and equipment increased to $4,820 for the first three months of 2004 compared to $3,278 for the same period in 2003. Expenditures in the first three months of 2004 and 2003 did not include any individually significant projects. In the first three months of 2004, the Company acquired (i) Project Technology, for which the allocation of the total purchase price among intangible assets and in process research and development has not been determined, pending final appraisal from a third party, and (ii) a minority equity interest in M2000, a French company, which together resulted in total net cash payments of $3,009. Additionally, the Company paid $800 relating to a holdback on a prior year acquisition. There were no expenditures related to acquisitions for the three months ended March 31, 2003.

In August 2003, the Company issued $110,000 of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023 in a private offering pursuant to SEC Rule 144A for general corporate purposes and to fund the purchase of 1,750 shares of the Company’s stock. The Debentures have been registered with the SEC for resale under the Securities Act of 1933. Interest on the Debentures is payable quarterly at a variable interest rate equal to 3-month LIBOR plus 1.65%. The effective interest rate for the first three months of 2004 was 2.80%. The Company pays interest on the Debentures quarterly in February, May, August and November. The Debentures are convertible, under certain circumstances, into the Company’s common stock at a conversion price of $23.40 per share, for a total of 4,700 shares. These circumstances generally include (a) the market price of the Company’s common stock exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value of the common stock into which the Debentures are convertible, or (c) a call for redemption of the Debentures

or certain other corporate transactions. Some or all of the Debentures may be redeemed by the Company for cash on or after August 6, 2007. Some or all of the Debentures may be redeemed at the option of the holder for cash on August 6, 2010, 2013 or 2018.

In June 2002, the Company issued $172,500 of 6-7/8% Convertible Subordinated Notes (“Notes”) due 2007 in a private offering pursuant to SEC Rule 144A to fund the purchase of Innoveda. The Notes have been registered with the SEC under the Securities Act of 1933. The Company pays interest on the Notes semi-annually in June and December. The Notes are convertible into the Company’s common stock at a conversion price of $23.27 per share, for a total of 7,413 shares. Some or all of the Notes may be redeemed by the Company for cash on or after June 20, 2005.

In July 2003, the Company renewed its syndicated, senior, unsecured credit facility that allows the Company to borrow up to $100,000. This facility is a three-year revolving credit facility, which terminates on July 14, 2006. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%, based on a pricing grid tied to a financial covenant. As a result, the Company’s interest expense associated with borrowings under this credit facility will vary with market interest rates. In addition, commitment fees are payable on the unused portion of the credit facility at rates between 0.35% and 0.50% based on a pricing grid tied to a financial covenant. The facility contains certain financial and other covenants, including financial covenants requiring the maintenance of specified liquidity ratios, leverage ratios and minimum tangible net worth. The Company had no short-term borrowings against the credit facility at March 31, 2004.

The Company’s primary ongoing cash requirements will be for product development, operating activities, capital expenditures, debt service and acquisition opportunities that may arise. The Company’s primary sources of liquidity are cash generated from operations and borrowings under the revolving credit facility. The Company anticipates that current cash balances, anticipated cash flows from operating activities, including the effects of financing customer term receivables, and amounts available under existing credit facilities will be sufficient to meet its working capital needs on a short-term and long-term basis. The Company’s sources of liquidity could be adversely affected by a decrease in demand for the Company’s products or a deterioration of the Company’s financial ratios.

Off-Balance Sheet Arrangements

Outlook for Second Quarter 2004

Revenues for the second quarter are expected to be $170,000. Gross margin is expected to be 84% for the second quarter. Operating expenses are estimated to be about $133,000. The total of interest expense and other income, net is expected to be an expense of approximately $3,500. The tax rate is expected to be 17% for the quarter.

FACTORS THAT MAY AFFECT FUTURE RESULTS AND FINANCIAL CONDITION

The statements contained under “Outlook for Second Quarter 2004” above and other statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words “believes,” “expects,” “projections” and words of similar import, constitute forward-looking statements that involve a number of risks and uncertainties that are difficult to predict. Moreover, from time to time, the Company may issue other forward-looking statements. Forward-looking statements regarding financial performance in future periods, including the statements above under “Outlook for Second Quarter 2004”, do not reflect potential impacts of mergers or acquisitions or other significant transactions or events that have not been announced as of the time the statements are made. Actual outcomes and results may differ materially from what is expressed or forecast in forward-looking statements. The Company disclaims any obligation to update forward-looking statements to reflect future events or revised expectations. The following discussion highlights factors that could cause actual results to differ materially from the results expressed or implied by the Company’s forward-looking statements. Forward-looking statements should be considered in light of these factors.

Weakness in the United States and international economies may materially adversely affect the Company.

United States and international economies have experienced an economic downturn which has had an adverse affect on the Company’s results of operations. Weakness in these economies may continue to adversely affect the timing and receipt of orders for the Company’s products and the Company’s results of operations. Revenue levels are dependent on the level of technology capital spending, which include expenditures for EDA, software and other consulting services, in the United States and abroad. A number of telecommunications companies have in the recent past filed for bankruptcy protection, and others have announced significant reductions and deferrals in capital spending. A significant portion of the Company’s revenues has historically come from businesses operating in this sector. In addition, demand for the Company’s products and services may be adversely affected by mergers and company restructurings in the electronics industry worldwide which could result in decreased or delayed capital spending patterns.

The Company is subject to the cyclical nature of the integrated circuit and electronics systems industries, and the current downturn has, and any future downturns may, materially adversely affect the Company.

Purchases of the Company’s products and services are highly dependent upon new design projects initiated by integrated circuit manufacturers and electronics systems companies. The integrated circuit industry is highly cyclical and is subject to constant and rapid technological change, rapid product obsolescence, price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand. The integrated circuit and electronics systems industries experienced significant downturns, often connected with, or in anticipation of, maturing product cycles of both companies in these industries and their customers’ products and a decline in general economic conditions. These downturns caused diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices. During downturns such as the recent one, the number of new design projects decreases. The recent slowdown has reduced, and any future downturns are likely to further reduce, the Company’s revenue and could materially adversely affect the Company.

Fluctuations in quarterly results of operations due to the timing of significant orders and the mix of licenses used to sell the Company’s products could hurt the Company’s business and the market price of the Company’s common stock.

The Company has experienced, and may continue to experience, varied quarterly operating results. Various factors affect the Company’s quarterly operating results and some of these are not within the Company’s control, including the timing of significant orders and the mix of licenses used to sell the Company’s products. The Company receives a majority of its software product revenue from current quarter order performance, of which a substantial amount is usually booked in the last few weeks of each quarter. A significant portion of the Company’s revenue comes from multi-million dollar contracts, the timing of the completion of and the terms of delivery of which can have a material impact on revenue recognition for a given quarter. If the Company fails to receive expected orders in a particular quarter, particularly large orders, the Company’s revenues for that quarter could be adversely affected and the Company could fail to meet investors’ expectations which could adversely affect the Company’s stock price.

The Company uses fixed-term license agreements as a standard business practice. These multi-year, multi-element term license agreements are typically three years in length, with payments spread over the license term and with customers the Company believes are credit-worthy. These agreements increase the risk associated with collectibility from customers that can arise for a variety of reasons including ability to pay, product dissatisfaction, disagreements and disputes. If the Company is unable to collect under any of these multi-million dollar agreements, the Company’s results of operations could be adversely affected.

The Company uses these fixed-term license agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. If the Company no longer had a history of collecting without providing concessions on term agreements, then revenue would be required to be recognized as the payments become due and payable over the license term. This change would have a material impact on the Company’s results. In a situation in which a risk of concession may exist on a term license agreement, revenue is recognized on a due and payable basis.

The Company’s revenue is also affected by the mix of licenses entered into where the Company recognizes software product revenue as payments become due and payable or ratably over the license term as compared to revenue recognized at the beginning of the license term. The Company recognizes revenue ratably over the license term when the customer is provided with rights to unspecified or unreleased future products. A shift in the license mix toward increased ratable or due and payable revenue recognition would result in increased deferral of software product revenue to future periods and would decrease current revenue, possibly resulting in the Company not meeting revenue expectations.

The accounting rules governing software revenue recognition have been subject to authoritative interpretations that have generally made it more difficult to recognize software product revenue at the beginning of the license period. These new and revised standards and interpretations could adversely affect the Company’s ability to meet revenue projections and affect the Company’s stock price.

The gross margin on the Company’s software products is greater than that for the Company’s hardware products, software support and professional services. Therefore, the Company’s gross margin may vary as a result of the mix of products and services sold. Additionally, the margin on software products varies year to year depending on the amount of third-party royalties due to third parties from the Company for the mix of products sold. The Company also has a significant amount of fixed or relatively fixed costs, such as professional service employee costs and purchased technology amortization, and costs which are committed in advance and can only be adjusted periodically. As a result, a small failure to reach planned revenue would have a great negative effect on resulting earnings. If anticipated revenue does not materialize as expected, the Company’s gross margins and operating results would be materially adversely affected.

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

Forecasts of the Company’s income tax position and resultant effective tax rate are complex and subject to uncertainty as the Company’s income tax position for each year combines the effects of a mix of profits (losses) earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates as well as benefits from available deferred tax assets and costs resulting from tax audits. In order to forecast the Company’s global tax rate, pre-tax profits and losses by jurisdiction are estimated and tax expense by jurisdiction is calculated. If the mix of profits and losses or effective tax rates by jurisdiction are different than those estimates, the Company’s actual tax rate could be materially different than forecast.

Outcome of Internal Revenue Service and other tax authorities examinations could have a material adverse affect on the Company.

The Internal Revenue Service and other tax authorities regularly examine our income tax returns. Significant judgment is required in determining our provision for income taxes. In determining the adequacy of our income taxes, the Company assesses the likelihood of adverse outcomes resulting from the Internal Revenue Service and other tax authorities examinations. The ultimate outcome of these examinations cannot be predicted with certainty. Should the Internal Revenue Service or other tax authorities assess additional taxes as a result of examinations, the Company may be required to record charges to operations in future periods that could have a material impact on the results of operations, financial position or cash flows in the applicable period or periods recorded.

The lengthy sales cycle for the Company’s products and services and delay in customer consummation of projects makes the timing of the Company’s revenue difficult to predict.

The Company has a lengthy sales cycle that generally extends between three and six months. The complexity and expense associated with the Company’s products and services generally requires a lengthy customer evaluation and approval process. Consequently, the Company may incur substantial expenses and devote significant management effort and expense to develop potential relationships that do not result in agreements or revenue and may prevent the Company from pursuing other opportunities. In addition, sales of the Company’s products and services may be delayed if customers delay approval or commencement of projects because of customers’ budgetary constraints, internal acceptance review procedures, timing of budget cycles or timing of competitive evaluation processes.

Any loss of the Company’s leadership position in certain portions of the EDA market could have a material adverse affect on the Company.

The industry in which the Company competes is characterized by very strong leadership positions in specific portions of the EDA market. For example, one company may enjoy a large percentage of sales in the physical verification portion of the market while another will have a similarly strong position in mixed-signal simulation. These strong leadership positions can be maintained for significant periods of time as the software is difficult to master and customers are disinclined to make changes once their employees, as well as others in the industry, have developed familiarity with a particular software product. For these reasons, much of the Company’s profitability arises from niche areas in which it is the strong leader. Conversely, it is difficult for the Company to achieve significant profits in niche areas where other companies are the leaders. If for any reason the Company loses its leadership position in a niche, the Company could be materially adversely affected.

Intense competition in the EDA industry could materially adversely affect the Company.

Competition in the EDA industry is intense, which can lead to, among other things, price reductions, longer selling cycles, lower product margins, loss of market share and additional working capital requirements. The Company’s success depends upon the Company’s ability to acquire or develop and market products and services that are innovative and cost-competitive and that meet customer expectations.

The Company currently competes primarily with two large companies: Cadence Design Systems, Inc. and Synopsys, Inc. In June 2002, Synopsys completed its acquisition of Avant! Corporation and the combined company could improve its competitive position with respect to the Company.

The Company also competes with numerous smaller companies, a number of which have combined with other EDA companies. The Company also competes with manufacturers of electronic devices that have developed, or have the capability to develop, their own EDA products internally.

The Company may acquire other companies and may not successfully integrate them or the companies the Company has recently acquired.

The industry in which the Company competes has seen significant consolidation in recent years. During this period, the Company has acquired numerous businesses, and it is frequently in discussions with potential acquisition candidates and may acquire other businesses in the future. For example, the Company is presently engaged in acquisition discussions with several companies. While the Company expects to carefully analyze all potential transactions before committing to them, the Company cannot assure that any transaction that is completed will result in long-term benefits to the Company or its shareholders or that the Company’s management will be able to manage the acquired businesses effectively. In addition, growth through acquisition involves a number of risks. If any of the following events occurs after the Company acquires another business, it could materially adversely affect the Company:

•

difficulties in combining previously separate businesses into a single unit;

•

the substantial diversion of management’s attention from day-to-day business when evaluating and negotiating acquisition transactions and then integrating the acquired business;

•

the discovery after the acquisition has been completed of liabilities assumed with the acquired business;

•

the failure to realize anticipated benefits, such as cost savings and revenue enhancements;

•

the failure to retain key personnel of the acquired business;

•

difficulties related to assimilating the products of an acquired business in, for example, distribution, engineering and customer support areas;

•

unanticipated costs;

•

adverse effects on existing relationships with suppliers and customers; and

•

failure to understand and compete effectively in markets in which we have limited previous experience.

Acquired businesses may not perform as projected, which could result in impairment of acquisition-related intangible assets. Additional challenges include integration of sales channels, training and education of the sales force for new product offerings, integration of product development efforts, integration of systems of internal controls and integration of information systems. Accordingly, in any acquisition there will be uncertainty as to the achievement and timing of projected synergies, cost savings and sales levels for acquired products. All of these factors can impair the Company’s ability to forecast, meet revenue and earnings targets and manage effectively the Company’s business for long-term growth. The Company cannot assure that it can effectively meet these challenges.

Risks of international operations and the effects of foreign currency fluctuations can adversely impact the Company’s business and operating results.

The Company realizes approximately half of the Company’s revenue from customers outside the United States and approximately one third of the Company’s expenses are generated outside of the United States. Significant changes in exchange rates can have an adverse effect on the Company. For further discussion of foreign currency effects, see “Effects of Foreign Currency Fluctuations” discussion above. In addition, international operations subject the Company to other risks including longer receivables collection periods, changes in a specific country’s or region’s economic or political conditions, trade protection measures, import or export licensing requirements, loss or modification of exemptions for taxes and tariffs, limitations on repatriation of earnings and difficulties with licensing and protecting the Company’s intellectual property rights.

Delay in production of components or the ordering of excess components for the Company’s Mentor Emulation Division hardware products could materially adversely affect the Company.

The success of the Company’s Mentor Emulation Division depends on the Company’s ability to:

•

procure hardware components on a timely basis from a limited number of suppliers;

•

assemble and ship systems on a timely basis with appropriate quality control;

•

develop distribution and shipment processes;

•

manage inventory and related obsolescence issues; and

•

develop processes to deliver customer support for hardware

The Company’s inability to be successful in any of the foregoing could materially adversely affect the Company.

The Company occasionally commits to purchase component parts from suppliers based on sales forecasts of the Company’s Mentor Emulation Division’s products. If the Company cannot change or be released from these non-cancelable purchase commitments, or if orders for the Company’s products do not materialize as anticipated, the Company could incur significant costs related to the purchase of excess components which could become obsolete before the Company can use them. Additionally, a delay in production of the components could materially adversely affect the Company’s operating results.

The Company’s failure to obtain software or other intellectual property licenses or adequately protect the Company’s proprietary rights could materially adversely affect the Company.

The Company’s success depends, in part, upon the Company’s proprietary technology. Many of the Company’s products include software or other intellectual property licensed from third parties, and the Company may have to seek new licenses or renew existing licenses for software and other intellectual property in the future. The Company’s failure to obtain software or other intellectual property licenses or rights on favorable terms, or the need to engage in litigation over these licenses or rights, could materially adversely affect the Company.

The Company generally relies on patents, copyrights, trademarks, trade secret laws, licenses and restrictive agreements to establish and protect the Company’s proprietary rights in technology and products. Despite precautions the Company may take to protect the Company’s intellectual property, the Company cannot assure that third parties will not try to challenge, invalidate or circumvent these safeguards. The Company also cannot assure that the rights granted under the Company’s patents will provide it with any competitive advantages, that patents will be issued on any of the Company’s pending applications or that future patents will be sufficiently broad to protect the Company’s technology. Furthermore, the laws of foreign countries may not protect the Company’s proprietary rights in those countries to the same extent as United States law protects these rights in the United States.

The Company cannot assure you that the Company’s reliance on licenses from or to, or restrictive agreements with, third parties, or that patent, copyright, trademark and trade secret protections, will be sufficient for success and profitability in the industries in which it competes.

Future litigation proceedings may materially adversely affect the Company.

The Company cannot assure that future litigation matters will not have a material adverse effect on the Company. Any future litigation may result in injunctions against future product sales and substantial unanticipated legal costs and divert the efforts of management personnel, any and all of which could materially adversely affect the Company.

Errors or defects in the Company’s products and services could expose us to liability and harm the Company’s reputation.

The Company’s customers use the Company’s products and services in designing and developing products that involve a high degree of technological complexity and have unique specifications. Because of the complexity of the systems and products with which the Company works, some of the Company’s products and designs can be adequately tested only when put to full use in the marketplace. As a result, the Company’s customers or their end users may discover errors or defects in the Company’s software or the systems we design, or the products or systems incorporating the Company’s designs and intellectual property may not operate as expected. Errors or defects could result in:

•

loss of current customers and loss of, or delay in, revenue and loss of market share;

•

failure to attract new customers or achieve market acceptance;

•

diversion of development resources to resolve the problems resulting from errors or defects; and

•

increased service costs.

The Company’s failure to attract and retain key employees may harm the Company.

The Company depends on the efforts and abilities of the Company’s senior management, the Company’s research and development staff and a number of other key management, sales, support, technical and services personnel. Competition for experienced, high-quality personnel is intense, and the Company cannot assure that it can continue to recruit and retain such personnel. The failure by the Company to hire and retain such personnel would impair the Company’s ability to develop new products and manage the Company’s business effectively.

Terrorist attacks, such as the attacks that occurred on September 11, 2001, and other acts of violence or war may materially adversely affect the markets on which the Company’s securities trade, the markets in which the Company operates, the Company’s operations and the Company’s profitability.

Terrorist attacks may negatively affect the Company’s operations and investment in the Company’s business. These attacks or armed conflicts may directly impact the Company’s physical facilities or those of the Company’s suppliers or customers. Furthermore, these attacks may make travel and the transportation of the Company’s products more difficult and more expensive and ultimately affect the Company’s sales.

Any armed conflict entered into by the United States could have an impact on the Company’s sales and the Company’s ability to deliver products to the Company’s customers. Political and economic instability in some regions of the world may also result from an armed conflict and could negatively impact the Company’s business. The Company currently has operations in Pakistan Egypt and Israel, countries that maybe particularly susceptible to this risk. The consequences of any armed conflict are unpredictable, and the Company may not be able to foresee events that could have an adverse effect on the Company’s business.

More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economy. They also could result in or exacerbate economic recession in the United States or abroad. Any of these occurrences could have a significant impact on the Company’s operating results, revenues and costs and may result in volatility of the market price for the Company’s securities.

The Company’s articles of incorporation, Oregon law and the Company’s shareholder rights plan may have anti-takeover effects.

The Company’s board of directors has the authority, without action by the shareholders, to designate and issue up to 1,200,000 shares of incentive stock in one or more series and to designate the rights, preferences and privileges of each series without any further vote or action by the shareholders. Additionally, the Oregon Control Share Act and the Business Combination Act limit the ability of parties who acquire a significant amount of voting stock to exercise control over the Company. These provisions may have the effect of lengthening the time required for a person to acquire control of the Company through a proxy contest or the election of a majority of the board of directors. In February 1999, the Company adopted a shareholder rights plan which has the effect of making it more difficult for a person to acquire control of the Company in a transaction not approved by the Company’s board of directors. The potential issuance of incentive stock, the provisions of the Oregon Control Share Act and the Business Combination Act and the Company’s shareholder rights plan may have the effect of delaying, deferring or preventing a change of

control of the Company, may discourage bids for the Company’s common stock at a premium over the market price of the Company’s common stock and may adversely affect the market price of, and the voting and other rights of the holders of, the Company’s common stock.

Item 3. Quantitative And Qualitative Disclosures About Market Risk

(All numerical references in thousands, except for rates and percentages)

INTEREST RATE RISK

The Company is exposed to interest rate risk primarily through its investment portfolio, short-term borrowings and long-term notes payable. The Company does not use derivative financial instruments for speculative or trading purposes.

The Company places its investments in instruments that meet high credit quality standards, as specified in the Company’s investment policy. The policy also limits the amount of credit exposure to any one issuer and type of instrument. The Company does not expect any material loss with respect to its investment portfolio.

The table below presents the carrying value and related weighted-average fixed interest rates for the Company’s investment portfolio. The carrying value approximates fair value at March 31, 2004. In accordance with the Company’s investment policy, all investments mature in twelve months or less.


Principal (notional) amounts in United States dollars	Carrying Amount		Average Fixed Interest Rate
Cash equivalents – fixed rate	$	52,507	1.09	%
Short-term investments – fixed rate		6,964	1.05	%

Total fixed rate interest bearing instruments	$	59,471	1.09	%

The Company had convertible subordinated notes of $172,500 outstanding with a fixed interest rate of 6 7/8% at March 31, 2004. For fixed rate debt, interest rate changes affect the fair value of the notes but do not affect earnings or cash flow.

The Company had floating rate convertible subordinated debentures of $110,000 outstanding with a variable interest rate of 3-month LIBOR plus 1.65% at March 31, 2004. For variable interest rate debt, interest rate changes affect earnings and cash flow. If the interest rates on the variable rate borrowings were to increase or decrease by 1% for the year and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by approximately $1,100.

At March 31, 2004, Company had a three-year revolving credit facility, which terminates on July 14, 2006, which allows the Company to borrow up to $100,000. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%, based on a pricing grid tied to a financial covenant. As a result, the Company’s interest expense associated with borrowings under this credit facility will vary with market interest rates. The Company had no short-term borrowings against the credit facility at March 31, 2004.

The Company had other long-term notes payable of $3,890 and short-term borrowings of $9,662 outstanding at March 31, 2004 with variable rates based on market indexes. For variable rate debt, interest rate changes generally do not affect the fair market value, but do affect future earnings or cash flow. If the interest rates on the variable rate borrowings were to increase or decrease by 1% for the year and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by approximately $136.

FOREIGN CURRENCY RISK

The Company transacts business in various foreign currencies and has established a foreign currency hedging program to hedge certain foreign currency forecasted transactions and exposures from existing assets and liabilities.

Derivative instruments held by the Company consist of foreign currency forward and option contracts. The Company enters into contracts with counterparties who are major financial institutions and believes the risk related to default is remote. The Company does not hold or issue derivative financial instruments for trading purposes.

The Company enters into foreign currency option contracts for forecasted revenues and expenses between its foreign subsidiaries. These instruments provide the Company the right to sell/purchase foreign currencies to/from third parties at future dates with fixed exchange rates. As of March 31, 2004, the Company had options outstanding to sell Japanese yen with contract values totaling approximately $29,956 at a weighted average contract rate of 113.50 and had options outstanding to buy the Euro with contract values totaling $3,600 at a weighted average contract rate of 1.28.

The Company enters into foreign currency forward contracts to protect against currency exchange risk associated with expected future cash flows and existing assets and liabilities. For further discussion of foreign currency effects, see “Effects of Foreign Currency Fluctuations” discussion under Item 2. “Management’s Discussion and Analysis of Results of Operations and Financial Condition” above.

The table provides information as of March 31, 2004 about the Company’s foreign currency forward contracts. The information provided is in United States dollar equivalent amounts. The table presents the notional amounts, at contract exchange rates, and the weighted average contractual foreign currency exchange rates.


	Notional Amount		Weighted Average Contract Rate	Contract Currency
Forward Contracts:
Euro	$	38,936	1.23	USD
Japanese yen		34,998	107.95	JPY
Canadian dollar		5,001	1.34	CAD
British pound sterling		2,857	1.81	USD
Danish krona		1,778	6.10	DKK
Other		3,596	—

Total	$	87,166

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.

Internal Control Over Financial Reporting

There has been no change in the Company’s internal control over financial reporting that occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K.

(All numerical references in thousands)

(a)

Exhibits

31.1

Certification of Chief Executive Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2

Certification of Chief Financial Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Certification of Chief Executive Officer and Chief Financial Officer of Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b)	Reports on Form 8-K

On January 7, 2004, the Company filed a current report on Form 8-K to report under Item 12 that the Company announced preliminary financial results for the fourth quarter of 2003.

On January 27, 2004, the Company filed a current report on Form 8-K to report under Item 9 and 12 that on January 27, 2004, the Company had announced financial results for the fourth quarter of 2003 and the full year of 2003 and provided outlook for the first quarter of 2004 and the full year of 2004.

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.


Dated: May 10, 2004	MENTOR GRAPHICS CORPORATION
		(Registrant)

		/s/ Gregory K. Hinckley
		Gregory K. Hinckley President

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Avg

Mentor Graphics (MENT) Inactive 10-Q2005 Q1 Quarterly report

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