The accounting policies that most frequently require us to make estimates and judgments, and that are therefore critical to understanding our results of operations, are:
We report revenue in three categories: ratable, product and services.
Customers occasionally request the right to convert their existing TSLs to perpetual licenses. Customers may pay an incremental fee to convert the TSL to a perpetual license, which we recognize upon contract signing, in accordance with AICPA Technical Practice Aid (TPA) 5100.74, assuming all other revenue recognition criteria have been met. In some situations, the contract converting the TSL to a perpetual license is modified to such an extent that a new arrangement exists. The changes to the contract may include increases or decreases in the total technology under license, changes in payment terms, changes in license terms and other pertinent factors. In these situations, we account for all of the arrangement fees as a new sale and recognize revenue when all other revenue recognition criteria have been met. We have a policy that defines the specific circumstances under which such transactions are accounted for as a new perpetual license sale.
We make significant judgments related to revenue recognition. Specifically, in connection with each transaction involving our products (referred to as an “arrangement” in the accounting literature), we must evaluate whether: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) our fee is “fixed or determinable,” and (iv) “collectibility is probable.” We apply these criteria as discussed below.
We evaluate quarterly our intangible assets for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Intangible assets consist of purchased technology, contract rights intangibles, customer-installed base/relationships, trademarks and tradenames, covenants not to compete, customer backlog and capitalized software. Factors we consider important which could trigger an impairment review include significant under-performance relative to expected historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business or significant negative industry or economic trends. If this evaluation indicates that the value of the intangible asset may be impaired, we make an assessment of the recoverability of the net carrying value of the asset over its remaining useful life. If this assessment indicates that the intangible asset is not recoverable, based on the estimated undiscounted future cash flows of the acquired entity or technology over the remaining amortization period, we will reduce the net carrying value of the related intangible asset to fair value and may adjust the remaining amortization period. Any such impairment charge could be significant and could have a material adverse effect on our reported financial statements.
We evaluate quarterly goodwill for an indication of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. At a minimum, we complete this evaluation on an annual basis in accordance with Statement of Financial Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets. If this evaluation indicates that the value of the goodwill may be impaired, we make an assessment of the impairment of the goodwill using the two-step method prescribed by SFAS 142. Any such impairment charge could be significant and could have a material adverse effect on our reported financial statements.
The relative proportions of our domestic and foreign revenue and income directly affect our effective tax rate. We are also subject to changing tax laws in the multiple jurisdictions in which we operate. As of July 31, 2003, current net deferred tax assets and long-term liabilities totaled $286.1 million and $24.6 million, respectively. We believe it is more likely than not that our results of future operations will generate sufficient taxable income to utilize our net deferred tax assets. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for any valuation allowance, if we determine we would not be able to realize all or part of our net deferred tax assets in the future, we would charge to income an adjustment to the deferred tax assets in the period we make that determination.
Management estimates the collectibility of accounts receivable on an account-by-account basis, and establishes a specific reserve for any particular receivable when we determine collectibility is not probable. In addition, we provide a general reserve on all accounts receivable, which we calculate as a percentage, determined within a specified range of percentages of the outstanding balance in each aged group. In determining this percentage, we specifically analyze accounts receivable and historical bad debt expense, customer creditworthiness, current economic trends, international exposures (such as currency devaluation), and changes in our customer payment terms to evaluate the adequacy of the allowance for doubtful accounts. If the financial condition of our customers deteriorates, impairing their ability to make payments, we may need to establish additional allowances.
We review our investments in non-public companies on a quarterly basis and estimate the amount of any impairment incurred during the current period based on a specific analysis of each investment, considering the activities of and events occurring at each of the underlying portfolio companies during the quarter. Our portfolio companies operate in industries that are rapidly evolving and extremely competitive. For equity investments in non-public companies where we cannot readily determine market value, we assess each investment for indicators of impairment at each quarter end based primarily on achievement of business plan objectives and current market conditions, among other factors, and information available to us at the time of assessment. The primary business plan objectives we consider include achievement of planned financial results, completion of capital raising activities, the launching of technology, the hiring of key employees and the portfolio company’s overall progress on its business plan. If we determine an investment in a portfolio company is impaired, absent quantitative valuation metrics management estimates the impairment and/or the net realizable value of the portfolio investment based on public- and private-company market comparable information and valuations completed for companies similar to our portfolio companies. Future adverse changes in market conditions, poor operating results of underlying investments and other information obtained after our quarterly assessment could result in additional losses or an inability to recover the current carrying value of the investments thereby requiring a further impairment charge in the future.
Results of Operations
Adoption of Subscription Licenses; Impact on Revenue. Prior to the fourth quarter of fiscal 2000, we principally licensed our software via perpetual licenses and “term” licenses (a type of time-based license), with maintenance purchased separately. We generally recognize revenue from these licenses in the quarter we ship the product (or “up-front”), and recognize revenue from maintenance ratably over the support period.
In the fourth quarter of fiscal 2000, we discontinued term licenses and introduced TSLs. A TSL is a license to use one or more of our software products for a specified period of time and to receive support services (such as hotline support and updates) for a concurrent period of time. Since products and maintenance are bundled in TSLs, we generally recognize both product and service TSL revenue ratably over the term of the license, or, if later, as payments become due. Accordingly, when a customer buys a TSL, we recognize relatively little revenue during the quarter we initially deliver the product. We either record the remaining amount not recognized as deferred revenue on our balance sheet, or consider it operational or financial backlog and do not record it on the balance sheet. The amount recorded as deferred revenue is equal to the portion of the license fee invoiced or paid but not recognized. The amount considered backlog moves out of backlog and is recorded as deferred revenue when invoiced or as additional payments are made. We reduce deferred revenue as we recognize revenue. As a result, a TSL order will result in significantly lower current-period revenue than an equal-sized order for a perpetual license. Conversely, an order for a TSL will result in higher revenues recognized in future periods than an equal-sized order for a perpetual or term license. For example, a $120,000 order for a perpetual license will result in $120,000 of revenue recognized in the quarter the product is shipped and no revenue in future quarters. The same order for a 3-year TSL shipped at the beginning of the quarter will result in $10,000 of revenue recognized in the quarter the product is shipped and in each of the 11 succeeding quarters.
On an aggregate basis, introducing TSLs has had, and will continue to have, a significant impact on our reported revenue. When we adopted TSLs in the fourth quarter of fiscal 2000, our reported revenue dropped significantly. In each quarter since adoption, our ratable revenue has grown as TSL orders received each quarter contribute revenue that is “layered” over the revenue recognized from TSL orders received in prior quarters. This effect will repeat itself each quarter in varying degrees until the TSL model is fully phased in; during this transition period ratable revenue will continue to grow even if the overall level of TSL orders does not grow, and could grow even if the overall level of TSL orders declines in the near term. Since our introduction of TSLs, the average TSL duration has been approximately 13 quarters. Therefore, in general, the model will be largely phased in by the end of fiscal 2003. The Avant! acquisition extended the phase in period due to Avant!‘s heavier weighting towards perpetual licenses. The complete phase in period of the TSL model is difficult to predict, as it has been (i) lengthened by our acquisition of Avant!, whose license mix was more heavily weighted toward perpetual licenses and (ii) is somewhat dependent on the length of the individual TSLs we have booked, some of which have extended longer than 4 years. Over the long term, average revenue growth should track average orders growth.
Synopsys’ revenue in any given quarter depends upon the volume of perpetual orders shipped during the quarter, the amount of TSL revenue amortized from deferred revenue (or recognized out of backlog from TSL licenses shipped during a prior quarter), and, to a small degree, the amount of revenue recognized on TSL orders received during the quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain license mix of perpetual licenses and TSLs. The actual mix of licenses sold in any quarter, and more precisely, the amount of perpetual licenses sold during the quarter, affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may fall short of our revenue targets (if TSL orders are higher than expected), or may exceed them (if perpetual licenses are higher than expected). If we achieve the target license mix but the overall level of orders is below the target level, then we will not meet our revenue targets.
Backlog consists of (i) orders for software products sold under perpetual licenses and TSLs with customer-requested ship dates within three months which have not been shipped, (ii) orders for customer training and consulting services which are expected to be completed within one year, and (iii) subscription services, maintenance and support with contract periods extending up to fifteen months. In the case of a TSL, our backlog includes the uninvoiced amount of the committed non-cancelable order. Deferred revenue represents the portion of license, maintenance or service fees that have been invoiced or paid but not recognized as revenue. Aggregate backlog is considered to be backlog plus deferred revenue. At July 31, 2003, 42% of the aggregate TSL backlog is scheduled to be recognized as revenue in the first year from such date, 33% in the second year, 20% in the third year and 5% thereafter. At July 31, 2003, 46% of the total aggregate backlog is scheduled to be recognized as revenue in the first year, 31% in the second year, 19% in the third year and 4% thereafter.
The precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods. Our historical license order mix from our adoption of TSLs in August 2000 to the present has been 23% perpetual licenses and 77% ratable licenses, although the percentage of perpetual licenses in any given quarter has been as high as 32% and as low as 13%. The license mix for the three months ended July 31, 2003 was 21% perpetual licenses and 79% TSLs as compared to 32% perpetual licenses and 68% TSLs for the same period in fiscal 2002. Our target license mix for new software orders for the fourth quarter of fiscal 2003 is 21% to 26% perpetual licenses and 74% to 79% ratable licenses. Our target license mix for new software orders for fiscal 2003 is 20% to 25% perpetual licenses and 75% to 80% ratable licenses.
The average duration of TSLs booked for the three months ended July 31, 2003 was 3.9 years. Our target range for the average duration of TSLs during the fourth quarter of fiscal 2003 is 3.5 years to 3.8 years. The target range for the average duration of TSLs during fiscal 2003 is 3.4 years to 3.7 years.
Revenue
Total revenue for the three months ended July 31, 2003 increased 27% to $300.4 million as compared to $236.1 million for the same period in fiscal 2002. Total revenue for the nine months ended July 31, 2003 increased 44% to $860.5 million as compared to $597.3 million for the same period in fiscal 2002. The increase in total revenue for the three and nine months ended July 31, 2003 is primarily due to (i) the additional quarters that the TSL license model has been in effect and (ii) the Avant! acquisition in June 2002. The increase in revenues for the nine-month period ended July 31, 2003 also reflected license renewals with many of our largest Japanese customers, a relatively high proportion of which were perpetual licenses.
Ratable license revenue for the three months ended July 31, 2003 increased 58% to $160.9 million as compared to $102.1 million for the same period in fiscal 2002. Ratable license revenue for the nine months ended July 31, 2003 increased 90% to $450.2 million as compared to $236.6 million for the same period in fiscal 2002. The increase in ratable license revenue is due to the additional quarters that the TSL license model has been used, and to the increased volume of ratable license sales resulting from the Avant! merger.
Product revenue for the three months ended July 31, 2003 increased 24% to $74.7 million as compared to $60.1 million for the same period in fiscal 2002. Product revenue for the nine months ended July 31, 2003 increased 39% to $211.2 million as compared to $151.9 million for the same period in fiscal 2002. The increase in product revenue is primarily due to the increased volume of perpetual licenses resulting from the Avant! merger. During the second quarter of fiscal 2002, we began offering variable maintenance arrangements to certain customers that entered into perpetual license technology arrangements in excess of $2.0 million. These arrangements accounted for $52.2 million and $158.8 million of our product sales for the three and nine months ended July 31, 2003, respectively, as compared to $33.4 million and $62.6 million for the same periods in fiscal 2002, respectively.
Service revenue for the three months ended July 31, 2003 decreased 12% to $64.8 million as compared to $73.9 million for the same period in fiscal 2002. Service revenue for the nine months ended July 31, 2003 decreased 5% to $199.1 million as compared to $208.8 million for the same period in fiscal 2002. The decline in service revenue is primarily due to lower maintenance fees from variable maintenance perpetual arrangements, decreased consulting orders and maintenance renewals as our customers seek to reduce costs in light of current economic conditions, and the fact that our new licenses are predominantly TSLs with maintenance bundled with the software and recognized as ratable license revenue, not service revenue. We believe these factors will result in relatively flat service revenue for the fourth quarter of fiscal 2003.
Revenue Seasonality. Orders and revenue are typically lowest in our first fiscal quarter and highest in our fourth fiscal quarter, with a material decline between the fourth quarter of one fiscal year and the first quarter of the next fiscal year. The difference in revenue is driven largely by the volume of perpetual licenses we ship during the quarter, which, following the seasonal pattern of overall orders, typically declines from the fourth quarter to the first quarter.
Revenue — Product Groups. For management reporting purposes, we organize our products into five distinct product groups – Design Implementation, Verification and Test, Design Analysis, Intellectual Property (IP) and Professional Services. The following table summarizes the license and associated maintenance revenue attributable to these groups as a percentage of total Company revenue for the last eight quarters. Revenue from companies or products acquired during the periods covered are included from the original acquisition date through the end of the period. As a result of the Avant! merger, we redefined our product groups, effective in the third quarter of fiscal 2002. We have reclassified prior period amounts to reflect this reclassification and provide a consistent presentation.
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| Design Implementation | | | | 42 | % | | 49 | % | | 44 | % | | 46 | % | | 44 | % | | 42 | % | | 40 | % | | 42 | % |
| Verification and Test | | | | 26 | | | 24 | | | 26 | | | 26 | | | 27 | | | 34 | | | 38 | | | 34 | |
| Design Analysis | | | | 21 | | | 21 | | | 20 | | | 19 | | | 17 | | | 6 | | | 6 | | | 6 | |
| IP | | | | 7 | | | 4 | | | 6 | | | 5 | | | 5 | | | 9 | | | 8 | | | 9 | |
| Professional Services | | | | 4 | | | 2 | | | 4 | | | 4 | | | 7 | | | 9 | | | 8 | | | 9 | |
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Design Implementation. Design Implementation includes products used to design a chip from a high level functional description to a complete description of the transistors and connections that implement such functions that can be delivered to a semiconductor company for manufacturing. Design Implementation technologies include logic synthesis, physical synthesis, floor planning and place-and-route products and technologies. Our principal products in this category at July 31, 2003 were Design Compiler, Physical Compiler, Jupiter, Apollo and Astro. Between any two quarters, the percentage of total Company revenue from Design Implementation products fluctuates based on the mix of perpetual versus TSL orders received for those products during the quarter. For example, revenue for Design Implementation products increased significantly as a percentage of total revenue in the second quarter of fiscal 2003 due to a number of large orders, many of which were perpetual licenses, by Japanese customers. Design Implementation product revenue has increased significantly in absolute dollar terms since the Avant! acquisition in the third quarter of fiscal 2002, as this product group represented the largest portion of Avant!‘s revenue before the acquisition, but has generally remained stable as a percentage of total revenue, reflecting growth consistent with our overall averages.
Verification and Test. Verification and Test includes products used for verification and analysis performed at the system level, register transfer level and gate level of design, including simulation, system level design and verification, timing analysis, formal verification, test and related products. Our principal products in this category are VCS, PrimeTime, Vera, PathMill, Formality, DFT Compiler, TetraMax and SoCBIST, which are used in several different phases of chip design. As a percentage of total revenue, revenue from this product family fluctuated between 34% and 38% in the period from the fourth quarter of fiscal 2001 through the second quarter of fiscal 2002, principally attributable to the mix of perpetual versus TSL orders received for Verification and Test products during any given quarter. Beginning in the third quarter of fiscal 2002 and continuing through the third quarter of fiscal 2003, Verification and Test revenues remained stable in absolute dollar terms, but decreased as a percentage of total Company revenue principally because the Avant! acquisition added few verification products.
Design Analysis. Design Analysis includes products used for verification and analysis performed principally during the physical verification phase of chip design, including analog and mixed signal circuit simulation, design rule checking, power analysis, customer design, semiconductor process modeling and reliability analysis. Our principal products in this category are NanoSim, StarSim, HSPICE, StarRC, TCAD, Hercules, Proteus, PrimePower and Cosmos. Revenue from this product group increased both in absolute dollars and as a percentage of total revenue from a steady level of 6% to 21% in the third quarter of fiscal 2003 primarily due to products acquired in the Avant! acquisition, as the products added to our Design Analysis category represented the second largest portion of Avant!‘s revenue before the acquisition. We believe that the continued increase in contribution from these products since that quarter primarily reflects customers’ growing acceptance of design analysis technologies to address design challenges particular to small geometry ICs.
Intellectual Property. Our IP products include the DesignWare library of IC design components and verification models, and products acquired in the merger with inSilicon in September 2002. As a percentage of total revenue, revenue from this product group was relatively stable from the third quarter of fiscal 2001 through the second quarter of fiscal 2002, reflecting growth consistent with our overall average growth. Beginning in the third quarter of fiscal 2002, IP revenue as a percentage of total revenue decreased principally because the former Avant! products included few IP offerings, but increased in the third quarter of fiscal 2003 due to increased sales of our DesignWare cores and products acquired in the inSilicon merger.
Professional Services. The Professional Services group includes consulting and training activities. This group provides consulting services, including design methodology assistance, specialized telecommunications systems design services and turnkey design. As a percentage of total revenue, revenue from this product group declined from 9% in the fourth quarter of fiscal 2001 to 2% in the second quarter of fiscal 2003, reflecting the fact that Avant! did not have a significant professional services business and, as described above under “Revenue,” decreased consulting orders and maintenance renewals due to our customers’ efforts to reduce costs in light of current economic conditions.
Cost of Revenue
Total cost of revenue for the three months ended July 31, 2003 was $58.2 million as compared to $47.7 million for the same period in fiscal 2002. The increase is due primarily to an increase in amortization of contract rights intangible recorded as a result of our acquisitions in fiscal 2003 and 2002. The dollar increase in total cost of revenue for the nine months ended July 31, 2003 to $176.9 million as compared to $117.3 million for the same period in fiscal 2002 is due primarily to an increase in amortization of contract rights intangible, and to a lesser extent core/developed technology recorded as a result of our acquisitions in fiscal 2003 and 2002, additional royalties of $1.5 million and other special termination benefits, as discussed below under “Work Force Reduction,” of $1.2 million. Our total product costs are relatively fixed and do not fluctuate significantly with changes in revenue or changes in revenue recognition methods.
Cost of revenue amortization of intangible assets and deferred stock compensation includes the amortization of the contract rights intangible associated with certain executory contracts and the amortization of core/developed technology related to acquisitions which occurred during fiscal 2002 and 2003. Total amortization of intangible assets and deferred stock compensation included in cost of revenues is as follows:
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| Core/developed technology | | | $ | 4,308 | | $ | 10,222 | | $ | 12,925 | | $ | 10,222 | |
| Contract rights intangible | | | | 18,722 | | | 2,872 | | | 54,097 | | | 2,872 | |
| Other intangible assets | | | | 687 | | | 214 | | | 1,527 | | | 214 | |
| Deferred stock compensation | | | | 139 | | | 58 | | | 410 | | | 58 | |
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| Total | | | $ | 23,856 | | $ | 13,366 | | $ | 68,959 | | $ | 13,366 | |
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Temporary Shutdown of Operations
During the three months ended July 31, 2003, we had a four-day shutdown of operations in North America as a cost-saving measure. The savings relates primarily to salaries and benefits and are reflected in the unaudited condensed consolidated statement of income as follows:
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| Cost of revenue | | | $ | 874 | | $ | -- | |
| Research and development | | | | 617 | | | -- | |
| Sales and marketing | | | | 1,925 | | | -- | |
| General and administrative | | | | 1,379 | | | -- | |
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| Total | | | $ | 4,795 | | $ | -- | |
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Work Force Reduction
We reduced our workforce during the first quarter of fiscal 2003 and the second quarter of fiscal 2002. The purpose was to reduce expenses by decreasing the number of employees in all departments in domestic and foreign locations. As a result, we decreased our workforce by approximately 200 and 175 employees during the first quarter of fiscal 2003 and the second quarter of fiscal 2002, respectively. The associated charge for the nine months ended July 31, 2003 was $4.4 million as compared to $3.9 million for the same period in fiscal 2002. The charge consists of severance and other special termination benefits and is reflected in the unaudited condensed consolidated statement of income as follows:
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| Cost of revenue | | | $ | 1,167 | | $ | 678 | |
| Research and development | | | | 1,388 | | | 1,081 | |
| Sales and marketing | | | | 1,239 | | | 1,078 | |
| General and administrative | | | | 630 | | | 1,033 | |
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| Total | | | $ | 4,424 | | $ | 3,870 | |
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Research and Development
Research and development expenses for the three months ended July 31, 2003 increased 15% to $70.7 million as compared to $61.6 million for the same period in fiscal 2002. The increase consists primarily of (i) $5.1 million in research and development personnel and related costs as a result of acquisitions in fiscal 2002 and 2003 and additional employer payroll taxes incurred as a result of an increase in the number of stock option exercises during the current quarter; (ii) $3.8 million in human resources, information technology and facilities costs as a result of the increased research and development staffing; and (iii) $1.3 million in consulting services.
Research and development expenses for the nine months ended July 31, 2003 increased 32% to $206.6 million as compared to $156.9 million for the same period in fiscal 2002. The increase consists primarily of (i) $28.6 million in research and development personnel and related costs as a result of acquisitions in fiscal 2002 and 2003 and additional employer payroll taxes incurred as a result of an increase in the number of stock option exercises during the current quarter; (ii) $18.8 million in increased human resources, information technology and facilities costs to research and development as a result of the increase in research and development headcount as a percentage of total headcount; and (iii) $2.2 million in consulting services.
Sales and Marketing
Sales and marketing expenses for the three months ended July 31, 2003 increased 13% to $78.2 million as compared to $69.1 million for the same period in fiscal 2002. The increase consists primarily of (i) $9.0 million in additional sales and marketing personnel and related costs as a result of acquisitions in fiscal 2002 and 2003 and additional employer payroll taxes incurred as a result of an increase in the number of stock option exercises during the current quarter offset by savings from a four-day shutdown of operations in North America and (ii) $1.1 million in additional travel expenses as a result of trade shows occurring during the current quarter.
Sales and marketing expenses for the nine months ended July 31, 2003 increased 20% to $230.4 million as compared to $192.1 million for the same period in fiscal 2002. The increase consists primarily of (i) $38.6 million in additional sales and marketing personnel and related costs as a result of acquisitions in fiscal 2002 and 2003 and additional employer payroll taxes incurred as a result of an increase in the number of stock option exercises during the current quarter offset by savings from a four-day shutdown of operations in North America; (ii) $2.0 million in additional travel expenses as a result of trade shows occurring during the current quarter; and (iii) offset by a decrease of $2.7 million in human resources, technology and facilities costs to sales and marketing expenses as a result of a decrease in sales and marketing headcount as a percentage of total headcount.
General and Administrative
General and administrative expenses for the three months ended July 31, 2003 decreased 10% to $19.8 million as compared to $21.9 million for the same period in fiscal 2002. The decrease consists primarily of (i) a $5.2 million reduction in bad debt expense as $1.0 million of the reserve was reduced during the current period and $3.0 million of Avant! aged accounts receivable was collected compared to an increase in the reserve of $1.2 million in the prior year; (ii) a $2.8 million reduction in human resources, technology and facilities costs categorized as to general and administrative expenses as a result of a decrease in general and administrative headcount as a percentage of total headcount, and (iii) savings of $1.4 million from a four-day shutdown of operations in North America. These decreases were partially offset by an increase of (i) $3.0 million in additional general and administrative personnel and related costs as a result of fiscal 2002 and 2003 acquisitions, (ii) additional employer taxes incurred as a result of an increase in the number of stock option exercises during the current quarter; and (iii) $2.2 million in depreciation on upgrades to our information technology infrastructure.
General and administrative expenses for the nine months ended July 31, 2003 increased 14% to $66.6 million as compared to $58.2 million for the same period in fiscal 2002. The increase consists primarily of (i) $10.5 million in additional general and administrative personnel and related costs as a result of acquisitions since the last half of fiscal 2002; (ii) additional employer taxes incurred as a result of an increase in the number of stock option exercises during the current quarter; (iii) $6.0 million in depreciation on upgrades to our information technology infrastructure; (iv) $3.6 million in facilities costs and $2.5 million in maintenance agreements covering more software and computing equipment due to fiscal 2002 and 2003 acquisitions. These increases were offset by a decrease of (i) $12.6 million in human resources, technology and facilities costs to general and administrative expenses as a result of a decrease in general and administrative headcount as a percentage of total headcount; and (ii) the decrease in bad debt expense as explained above; and (iii) savings of $1.4 million from a four-day shutdown of operations in North America.
Integration Costs
Non-recurring integration costs incurred by the Company relate to merger activities which are not included in the purchase consideration under EITF 95-3. These costs are expensed as incurred. During the third quarter of 2002, integration costs totaled $117.3 million. These costs consisted primarily of (i) a premium of $95.0 million related to the contingently refundable insurance policy, (ii) $14.7 million related to write-downs of Synopsys facilities and property under the approved facility exit plan, (iii) severance costs for Synopsys employees who were terminated as a result of the merger and costs associated with transition employees totaled $6.2 million, and (iv) $1.3 million related to the write-off of software licenses owned by Synopsys which were originally purchased from Avant!.
In-Process Research and Development
Purchased in-process research and development (IPRD) for the three months ended July 31, 2003 was $1.6 million and represents the write-off of in-process technologies associated with our third quarter acquisition as described in Other Fiscal 2003 Acquisitions. IPRD for the nine months ended July 31, 2003 was $19.9 million and represents the write-off of in-process technologies associated with our third quarter acquisition and with the acquisition of Numerical. At the date of each of the acquisitions, the projects associated with the IPRD efforts had not yet reached technological feasibility and the research and development in process had no alternative future uses. Accordingly, these amounts were expensed on the respective acquisition dates. IPRD during the same periods in fiscal 2002 relates to the Avant! acquisition.
Amortization of Intangible Assets and Deferred Stock Compensation
Amortization of intangible assets and deferred stock compensation includes the amortization of trademarks, trade names, customer relationships and covenants not-to-compete and is included in operating expenses as follows:
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| Intangible assets | | | $ | 8,133 | | $ | 4,460 | | $ | 22,948 | | $ | 5,076 | |
| Deferred stock compensation | | | | 1,088 | | | 452 | | | 3,431 | | | 452 | |
| Goodwill | | | | -- | | | 3,908 | | | -- | | | 11,692 | |
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| Total | | | $ | 9,221 | | $ | 8,820 | | $ | 26,379 | | $ | 17,220 | |
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The increase in amortization of intangible assets is due primarily to fiscal 2002 and 2003 acquisitions partially offset by a decrease in goodwill amortization as a result of the adoption of SFAS 142 on November 1, 2002.
The following table presents the estimated future amortization of deferred stock compensation reported in both cost of revenue and operating expenses (in thousands):
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| 2003 - remainder of fiscal year | $ | 1,154 |
| 2004 | | 3,861 |
| 2005 | | 2,550 |
| 2006 | | 916 |
| 2007 and thereafter | | 267
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| Total estimated future amortization of | | |
| deferred stock compensation | $ | 8,748
|
Other Income, Net
Other income, net for the three months ended July 31, 2003 was $5.3 million and consisted primarily of: (i) realized gain on investments of $7.3 million; (ii) rental income of $1.1 million; (iii) interest income of $1.4 million; (iv) impairment charges related to certain assets in our venture portfolio of $1.9 million; (v) interest expense of $1.4 million; and (vi) other miscellaneous expenses including foreign exchange gains and losses recognized during the quarter of $1.2 million.
Other income, net for the three months ended July 31, 2002 was $11.4 million and consisted primarily of: (i) realized gain on investments of $10.3 million; (ii) rental income of $2.6 million; (iii) interest income of $2.4 million; and (iv) impairment charges related to certain assets in our venture portfolio of $4.0 million.
Other income, net for the nine months ended July 31, 2003 was $22.0 million and consisted primarily of: (i) realized gain on investments of $18.8 million; (ii) rental income of $6.3 million; (iii) interest income of $3.7 million; (iv) amortization of premium forwards and foreign currency forwards of $1.8 million; (v) impairment charges related to certain assets in our venture portfolio of $3.9 million; (vi) other miscellaneous expenses including foreign exchange gains and losses recognized during the quarter of $3.1 million; and (vii) interest expense of $1.6 million.
Other income, net for the nine months ended July 31, 2002 was $33.7 million and consisted primarily of: (i) realized gain on investments of $22.7 million; (ii) rental income of $7.5 million; (iii) interest income of $6.9 million; (iv) a net gain of $3.1 million related to the termination fee, net of costs incurred, for an Agreement and Plan of Merger with IKOS Systems, Inc. (IKOS) which was entered into by Synopsys on July 2, 2001 and terminated on December 7, 2001; and (v) impairment charges related to certain assets in our venture portfolio of $7.5 million.
Beginning in the fourth quarter of fiscal 2003, we expect a significantly lower level of other income.
Liquidity and Capital Resources
Cash, cash equivalents and short-term investments increased $153.4 million, or 37%, to $568.1 million at July 31, 2003 from $414.7 million at October 31, 2002. Cash provided by operations was $277.2 million for the nine months ended July 31, 2003. Cash was provided by net income adjusted for non-cash related items, for cash flows related to hedging activities, and by an increase in deferred revenue due to continued sales of TSL licenses. Cash used for changes in working capital balances included decreases in accounts payable, accrued liabilities and accounts receivable. Accounts payable and accrued liabilities decreased as a result of payments of merger–related accruals, commissions and year-end bonuses, partially offset by year-to-date accruals. Accounts receivable decreased due to the timing of installment billings to customers on long-term arrangements.
Cash used in investing activities was $215.1 million for the nine months ended July 31, 2003 as compared to cash provided by investing activities of $94.3 million for the same period in fiscal 2002. During the nine months ended July 31, 2003, the following occurred: (i) cash paid for acquisitions totaled $167.7 million; (ii) net purchases of investments totaled $11.9 million; and (iii) capital expenditures totaled $33.5 million. For the same period in fiscal 2002, the following occurred: (i) cash received from acquisitions totaled $235.0 million; (ii) purchase of contingently refundable insurance policy totaled $240.0 million; (iii) proceeds from net sales of investments totaled $136.4 million; and (iv) capital expenditures totaled $35.9 million.
Cash provided by financing activities was $53.0 million for the nine months ended July 31, 2003 as compared to cash provided by financing activities of $61.8 million for the same period in fiscal 2002. The decrease of $8.8 million in cash provided by financing activities is primarily due to an increase in proceeds of $176.1 million from the sale of shares pursuant to our employee stock option plans during the current quarter, offset by an increase in the purchase of treasury stock. During the nine months ended July 31, 2003, Synopsys repurchased treasury stock of $226.7 million as compared to $41.8 million during the same period of the prior year.
Accounts receivable, net of allowances, decreased $5.4 million, or 3%, to $201.8 million at July 31, 2003 from $207.2 million at October 31, 2002. Days sales outstanding, calculated based on revenues for the most recent quarter and accounts receivable at the balance sheet date, remained flat at 61 days from October 31, 2002 to July 31, 2003.
On March 1, 2003, we completed our acquisition of Numerical Technologies, Inc. We paid Numerical common stock holders $7.00 in cash in exchange for each share of Numerical common stock owned as of the merger date, or approximately $240.7 million in total, and $161.3 million net of cash held by Numerical at the merger date. We paid for Numerical common stock out of our cash, cash equivalents and short-term investments.
Factors That May Affect Future Results
Continued weakness in the semiconductor and electronics businesses will negatively impact our business.
Synopsys’ business depends on the semiconductor and electronics industries. These industries are cyclical, and characterized by rapid technological change, short product life cycles, supply and demand imbalances and fierce price competition. During 2001 and 2002, the semiconductor and electronics industries experienced steep declines in orders and revenue. This downturn has had, and continues to have, several negative impacts on our industry and on our business:
| | | | o | Semiconductor manufacturers have scrutinized carefully, and in many cases significantly reduced, their research and development investments, including their investments in electronic design automation (EDA) software. These manufacturers have limited visibility on demand for their products, and thus are likely to continue limiting R&D and EDA investments until visibility improves. |
| | | | o | Starts of new IC designs, a key driver in the demand for EDA software, have declined, partly due to the downturn and perhaps reflecting a long-term trend. Fewer new companies engaged in semiconductor design are being formed or funded. These companies are traditionally an important source of new business for us. |
| | | | o | A small number of our customers have gone out of business, while others have had to substantially curtail their operations. |
| | | | o | Many of our customers have demanded, and we have increasingly granted, extended payments terms on their purchases, negatively affecting our cash flow. |
| | | | o | Increased partnerships and/or mergers in the semiconductor and electronics industries can reduce the aggregate level of purchases of our products and services by the companies involved. |
Although there have been signs of a moderate recovery in the semiconductor and electronics businesses in 2003, further recovery remains uncertain and subject to significant risks, and it is thus not clear whether and when any such recovery will translate to increased R&D spending, and to higher spending in EDA. Should current conditions in the semiconductor and electronics industries continue or worsen, our business, operating results and financial condition will be materially and adversely affected.
Our revenue and earnings may fluctuate, which could cause our financial results not to meet expectations.
Many factors affect our revenue and earnings, making it difficult to predict revenue and earnings for any given fiscal period. Accordingly, our financial results may not meet investor and analyst expectations, which could cause our stock price to decline. Among these factors are customer demand, license terms, and the timing of revenue recognition on products and services sold.
The following are some of the specific factors that could affect our revenue and earnings in a particular quarter or over several fiscal periods:
| | | | o | Due to the complexity of our products, customers spend a great deal of time reviewing and testing them before making a purchase decision. Accordingly, our customers’ evaluation and purchase cycles do not necessarily match our quarterly periods. Further, sales of our products and services may be delayed if customers delay project approval or project starts because of budgetary constraints, internal review procedures or their budget cycles. |
| | | | o | We may receive a disproportionate volume of orders in the last one or two weeks of a quarter. However, the delay of a single order, especially a large order, beyond the end of a fiscal period could cause our orders and revenue for that period to be below our plan and any targets we may have published. |
| | | | o | Our business is seasonal. Our orders and revenue are typically lowest in our first fiscal quarter and highest in our fourth fiscal quarter, with a material decline between the fourth quarter of one fiscal year and the first quarter of the next fiscal year. |
| | | | o | We base our revenue and earnings targets for any fiscal period, in part, upon assumptions that we will achieve a certain volume of orders, and a mix of perpetual licenses (on which we recognize revenue in the quarter shipped) and TSLs (on which we recognize revenue over the license term) within a specified range, which we adjust from time to time. If we do not meet our overall orders targets, our revenue and earnings will likely not meet expectations, though if perpetual orders are higher than the expected range, our revenue and earnings for the period may be on or above target, but revenue in future periods would be lower than expected. Conversely, if we meet our overall orders target, but perpetual orders are below the expected range, our revenue will be below our target for the quarter (though the shortfall should be recognized in future quarters as TSL revenue is recognized over the term of license booked during the quarter). |
| | | | o | Accounting rules determine when we recognize revenue on our orders, and therefore impact how much revenue we will report in any given fiscal period. In general, we recognize TSL revenue ratably over the license term and recognize perpetual license revenue upon product delivery. For any given order, however, the specific terms we agree to with a customer may, under applicable accounting rules, require revenue treatment different from assumptions we have used in developing our financial plans. As a result, our revenue for the fiscal period may be higher or lower than it otherwise would have been, and different than our plan or any announced targets for the period. |
Stockholders should therefore not view our historical results as necessarily indicative of our future performance. If we do not meet investor or analyst expectations for a given quarter, or set targets for future quarters that do not meet investor or analyst expectations, the trading price of our common stock could significantly decline.
Competition may have a material adverse effect on our results of operations.
The EDA industry is highly competitive. If we fail to compete effectively, our business would be seriously and adversely affected.
We compete against other EDA vendors, and with customers’ internally developed design tools and internal design capabilities, for a share of our customers’ EDA budgets. In general, competition is based on product quality and features, post-sale support, interoperability with our own and other vendors’ products, price, payment terms and, as discussed below, the ability to offer a complete design flow. Our competitors include companies that offer a broad range of products and services, such as Cadence Design Systems, Inc. and Mentor Graphics Corporation, as well as companies that offer products focused on a discrete phase of the integrated circuit design process, such as Magma Design Automation, Inc., Verisity Design, Inc., and Nassda Corporation. In the current economic environment, price and payment terms have become increasingly important competitive factors. Since early fiscal 2002, we have regularly agreed to extended payment terms on our TSLs, negatively affecting cash flow from operations. In addition, in certain situations our competitors are aggressively discounting their products. These conditions could lead to lower average selling prices or to loss of customers, either of which would seriously harm our business.
We may not compete effectively, if we do not develop an integrated design flow product and other new products.
Increasingly, EDA companies compete on the basis of design flows involving integrated logic and physical design products rather than on the basis of individual point tools performing a discrete phase of the design process. If we do not successfully and timely develop integrated design flow products, or if we do not convince customers to adopt these products when developed, our competitive position could be significantly weakened.
Offering integrated design flow software will become increasingly important as ICs grow more complex. Many of our customers are moving to smaller geometries and system-on-chip designs, and we must continue to develop our products to address these trends. Our design products compete principally with design flow products from Cadence and Magma, which in some respects may be more integrated than our products. In January 2003 we introduced our Galaxy Design Platform, which partially integrates the full suite of Synopsys’ design implementation products. Our future success depends on our ability to further integrate our products in the Galaxy Design Platform, and continued customer acceptance and adoption of that platform. This effort will continue to require significant engineering and development work. We can provide no assurances that we will be able to offer a competitive complete design flow to customers.
To increase our revenues over the long term, we will have to continue maintaining and enhancing our existing products, introduce or acquire new products, gain broad customer acceptance of those products and generate growth in our consulting services business. In addition to the integration of our design implementation products in the Galaxy Design Platform, in May 2003 we announced our plans to integrate our functional verification products into the Discovery Verification Platform. Further, we are expanding our intellectual property design components offerings, and with the Numerical acquisition are attempting to bolster our suite of design-for-manufacturing products. It is difficult for us to predict the success of these product initiatives and the growth of the markets for these products. In the past, we, like all companies, have introduced new products that failed to meet our revenue expectations. Therefore, we can provide no assurances that we will successfully expand revenue from our existing, new or acquired products at the desired rate. If we fail to do so, it would materially and adversely affect our business, financial condition and results of operations.
Businesses we have acquired or that we may acquire in the future may not perform as projected.
We have acquired a number of companies in recent years, and as part of our efforts to increase revenue and expand our product and services offerings we may acquire additional companies. During 2002, we acquired Avant!, inSilicon and Co-Design, and to date during fiscal 2003, we acquired Numerical and InnoLogic Systems, Inc. and the verification IP assets of Qualis, Inc. Bidding for future acquisitions may be intense, which may make it difficult for us to acquire additional companies at an acceptable price, if at all.
In addition to direct costs, acquisitions pose a number of risks, including potential dilution of earnings per share, problems in integrating the acquired products into our business, difficulties in retaining key employees and integrating those employees into our company, challenges in insuring acquired products and the development practices of employees of acquired companies meet our quality standards, the failure to realize expected synergies or cost savings, the failure of acquired products to achieve projected sales, the drain on management time for acquisition-related activities, adverse effects on customer buying patterns and assumption of unknown liabilities. While we attempt to review proposed acquisitions carefully and negotiate terms that are favorable to us, we can provide no assurances that any acquisition will have a positive effect on our performance.
Customer payment defaults could adversely affect our financial condition and results of operations.
Our backlog consists principally of customer payment obligations not yet due that are attributable to software we have already delivered. These customer obligations are typically not cancelable, but will not yield the expected revenue and cash flow if the customer defaults and fails to pay amounts owed. In these cases, we will generally take legal action to recover amounts owed. Moreover, existing customers may seek to renegotiate pre-existing contractual commitments due to adverse changes in their own businesses. Though we have not, to date, experienced a material level of defaults, any material payment default by our customers or significant reductions in existing contractual commitments would have a material adverse effect on our financial condition and results of operations.
Product errors or defects could expose us to liability and harm our reputation.
Despite extensive testing prior to releasing our products, software products frequently contain errors or defects, especially when first introduced or when new versions are released. Software errors could affect the performance or interoperability of our products, could delay the development or release of new products or new versions of products and could adversely affect market acceptance or perception of our products. Our end users rely on our products as a critical component of their design cycles, and thus may have a greater sensitivity to product errors than customers for software products generally. Errors or delays in releasing new products or new versions of products could cause us to lose revenues or market share, increase our service costs, subject us to liability for damages, and divert our resources from other tasks, any one of which could adversely affect our business and operating results.
Stagnation of foreign economies, foreign exchange rate fluctuations or other international issues could adversely affect our performance.
During the nine months ended July 31, 2003, we derived 45% of our revenue from outside North America as compared to 35% and 37% during fiscal 2002 and 2001, respectively. While the recent outbreak of Severe Acute Respiratory Syndrome (SARS) appears to have abated, the impact of such illness has disrupted business operations, sales activities and decision-making in our industry, primarily overseas, but in some cases, domestically as well. If the SARS outbreak is not fully contained or a new outbreak of SARS occurs, it could have an adverse effect on sales of our products.
Foreign sales are vulnerable to regional or worldwide economic or political conditions, including the effects of international political conflict or hostilities. The global electronics industry experienced steep declines in 2001 and 2002, and though there have been signs of modest recovery in 2003, it is not yet clear whether such a modest recovery will translate to higher research and development spending, and thus to higher spending in EDA. In particular, a number of our largest European customers are in the telecommunications equipment business, which has been disproportionately affected during this period. While our sales in Japan were strong during the second quarter, accounting for 35% of the Company’s revenue, sales for the third quarter returned to historical levels; the Japanese economy remains relatively weak, and future growth is thus difficult to predict. Furthermore, achievement of our overall orders and revenue plans assume growth in the Asia Pacific region, which may not occur and could be difficult if growth in the rest of the world’s economies does not accelerate.
Fluctuations in the rate of exchange between the U.S. dollar and currencies of other countries in which we conduct business, principally the Euro and the Japanese yen, could materially and adversely affect our business, operating results and financial condition. Fluctuations in foreign currency exchange rates may make our products more expensive to foreign customers, increase the dollar cost of expenses denominated in non-dollar currencies or reduce the revenue realized from overseas sales. We attempt to hedge our risks related to certain forecasted accounts receivable and accounts payable, but not expenses denominated in foreign currencies. If a foreign currency increases in value relative to the dollar, then the dollar value of expenses denominated in that currency and forecasted accounts receivable increase. If a foreign currency decreases in value relative to the dollar, then the dollar value of expenses denominated in that currency and forecasted accounts receivable decrease. Changes in the dollar value of forecasted accounts receivable of our foreign subsidiaries would impact the revenue we recognize from such receivables. Exchange rates are subject to significant and rapid fluctuations, and therefore we cannot predict the prospective impact of exchange rate fluctuations on our business, operating results and financial condition.
A failure to recruit and retain key employees would have a material adverse effect on our ability to compete.
To be successful, we must attract and retain key technical, sales and managerial employees, including those who join Synopsys in connection with acquisitions. Despite recent economic conditions, skilled technical, sales and management employees remain in high demand. There are a limited number of qualified EDA and IC design engineers, and competition for these individuals is intense. Companies in the EDA industry and in the general electronics industry value experience at Synopsys, and our employees, including employees who have joined Synopsys in connection with acquisitions, are recruited aggressively. In the past, we have had high employee turnover, which may recur in the future. We can provide no assurances that we can continue to recruit and retain the technical and managerial personnel we need to run our business successfully. Our failure to do so could have a material adverse effect on our business, financial condition and results of operations.
In addition, recently enacted regulations of the Nasdaq National Market regarding stockholder approval of equity-compensation plans could make it more difficult for us to grant stock options to employees in the future. Also, the FASB has proposed a change to GAAP that may require us to begin accounting for options as a compensation expense commencing in the period in which they are granted which would have an adverse effect on our reported financial results. As a result, we may incur increased cash compensation costs in order to compensate for reduced stock option grants, may lose top employees to non-public start-up companies, or may generally find it more difficult to attract, retain and motivate employees, any one of which could materially and adversely affect our business.
Failing to protect our proprietary technology would have a material adverse effect on our financial condition and results of operations.
Our success depends, in part, upon our proprietary technology and other intellectual property rights. We rely on agreements with customers, employees and others, and on intellectual property laws to protect our proprietary technology. We can provide no assurances that these agreements will not be breached, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known or be independently developed by competitors. Moreover, certain foreign countries do not currently provide effective intellectual property protection; our ability to prevent the unauthorized use of our products in those countries is therefore limited.. If we do not obtain or maintain appropriate patent, copyright or trade secret protection, for any reason, or cannot fully defend our intellectual property rights in certain jurisdictions, our business, financial condition and results of operations could be materially and adversely affected.
In addition, from time to time we are subject to claims that our products infringe on third party intellectual property rights. Our customer agreements sometime provide for indemnification of the customer if the licensed products infringe on a third party’s rights. These types of claims can result in costly and time-consuming litigation, require us to enter into royalty arrangements, subject us to damages or injunctions restricting our sale of products, require us to refund license fees to our customers or to forgo future payments or require us to redesign certain of our products, any one of which could materially and adversely affect our business.
Our operating expenses do not fluctuate proportionately with fluctuations in revenues, which could materially adversely affect our results of operations if we have a revenue shortfall.
We base our operating expenses in part on our expectations of future revenue, and generally must commit to expense levels in advance of revenue. Since only a small portion of our expenses varies with revenue, a revenue shortfall translates directly into a reduction in net income. If we do not generate anticipated revenue or maintain expenses within expected ranges, however, our business, financial condition and results of operations would be materially and adversely affected.
We have adopted anti-takeover provisions, which may delay or prevent changes in control of management.
We have a number of provisions that could have anti-takeover effects. In 1997, our Board of Directors adopted a Preferred Shares Rights Plan, commonly referred to as a poison pill. In addition, our Board of Directors has the authority, without further action by its stockholders, to issue additional shares of common stock and to fix the rights and preferences of, and to issue authorized but undesignated shares of, preferred stock. These and other provisions of Synopsys’ Restated Certificate of Incorporation and Bylaws and the Delaware General Corporation Law may deter hostile takeovers or delay or prevent changes in control of management of Synopsys, including transactions in which Synopsys stockholders might otherwise receive a premium for their shares over then current market prices.
We are subject to changes in financial accounting standards, which may affect our reported financial results, or the way we conduct business.
We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP). These principles are subject to interpretation by the Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants (AICPA), the SEC and various bodies appointed by these organizations to interpret existing rules and create new accounting policies. Accounting policies affecting software revenue recognition, in particular, have been the subject of frequent interpretations, which have had a profound affect on the way we license our products. As a result of the enactment of the Sarbanes-Oxley Act and the related scrutiny of accounting policies by the SEC and by the various national and international accounting industry bodies, we expect the frequency of accounting policy changes to accelerate. Future changes in financial accounting standards, including pronouncements relating to revenue recognition, may have a significant effect on our reported results and may even affect our reporting of transactions completed before the change is effective.
The FASB has proposed a change to GAAP that may require us to begin accounting for options as a compensation expense commencing in the period in which they are granted which would have an adverse effect on our reported financial results. Synopsys currently accounts for stock options under Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation. As currently permitted by SFAS 123, we use the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, to measure compensation expense for stock-based awards to our employees. Under this standard, we do not consider stock option grants issued under our employee stock option plans to be compensation, because the exercise price is equal to the fair market value on the grant date, although as required by SFAS 123, we currently disclose the impact of “expensing” stock options in the notes to our consolidated financial statements. If this proposal is adopted, expensing stock options will significantly and adversely affect our reported results of operations.
Terrorist acts and acts of war may seriously harm our financial condition and results of operations.
Terrorist acts or acts of war (wherever located around the world) may damage or disrupt Synopsys, our employees, facilities, partners, suppliers, or customers, or cause unpredictable swings in foreign currency exchange rates, all of which could significantly impact our results of operations and expenses and financial condition. The potential for future terrorist attacks, the national and international responses to terrorist attacks or perceived threats to national security, and other acts of war or hostility have created many economic and political uncertainties that could adversely affect our business and results of operations in ways we cannot presently predict. We are predominantly uninsured for losses and interruptions caused by acts of war.
Computer viruses and denial of service attacks could seriously disrupt our business operations.
Recently, “hackers” and others have created a number of computer viruses or otherwise initiated “denial of service” attacks on computer networks and systems. While we diligently maintain our information technology infrastructure and continuously implement protections against such viruses or intrusions, if our defensive measures fail, or should similar defensive measures by our customers fail, our business could be materially and adversely affected.
If export controls affecting our products are expanded, our business will be adversely affected.
The U. S. Department of Commerce regulates the sale and shipment of certain technologies by U.S. companies to foreign countries. To date, we believe we have successfully complied with applicable export regulations. However, if the Department of Commerce places significant export controls on our existing, future or acquired products, our business will be materially and adversely affected.
An unfavorable government review of our tax returns or changes in our effective tax rates could adversely affect our operating results.
Our operations are subject to income and transaction taxes in the United States and in multiple foreign jurisdictions. We exercise judgment in determining our worldwide provision for income taxes, and in the ordinary course of our business, there may be transactions and calculations where the ultimate tax determination is uncertain. Although we believe our tax estimates are reasonable, we can provide no assurance that any final determination in a tax review will not be materially different than the treatment reflected in our historical income tax provisions and accruals. If additional taxes are assessed as a result of an audit or litigation, there could be a material effect on the Company’s income tax provision and net income in the period or periods for which that determination is made.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Interest Rate Risk
Our exposure to market risk for changes in interest rates relates primarily to our short-term investment portfolio. We place our investments in a mix of tax-exempt and taxable instruments that meet high credit quality standards, as specified in our investment policy. None of our investments are held for trading purposes. Our policy also limits the amount of credit exposure to any one issue, issuer and type of instrument.
The following table presents the carrying value and related weighted-average total return for our investment portfolio. The carrying value approximates fair value at July 31, 2003. In accordance with our investment policy, the weighted-average maturities of our total invested funds does not exceed one year.
| | Weighted- |
|---|
| | Average |
|---|
| Carrying | After Tax |
|---|
| Amount | Return |
|---|
|
|
|
|
| (in thousands) | |
|---|
| |
| Short-term investments-- fixed rate (U.S.) | | | $ | 141,809 | | 0 | .80% | |
| Money market funds-- variable rate (U.S.) | | | | 180,123 | | 0 | .89% | |
| Cash deposits and money market funds-- variable | | |
| rate (Ireland) | | | | 196,530 | | 0 | .78% | |
| |
|
| Total interest bearing instruments | | | $ | 518,462 | | 0 | .82% | |
| |
|
Foreign Currency Risk
At the present time, we hedge only (i) those currency exposures associated with certain assets and liabilities denominated in non-functional currencies and (ii) forecasted accounts receivable and accounts payable denominated in non-functional currencies. Our hedging activities are intended to offset the impact of currency fluctuations on the value of these balances. The success of these activities depends upon the accuracy of our estimates of balances denominated in various currencies and in fluctuations of foreign currencies. If a non-functional currency increases in value relative to the functional currency, then the value of expenses, assets, liabilities and forecasted accounts receivable denominated in that currency increases. If a non-functional currency declines in value relative to the functional currency, then the value of expenses, assets, liabilities and forecasted accounts receivable denominated in that currency decreases. Looking forward, to the extent our estimates of various balances denominated in foreign currencies prove not to be accurate, then we will record a gain or loss, depending upon the nature and extent of such inaccuracy. We can provide no assurances that our hedging transactions will be effective.
Foreign currency contracts entered into in connection with our hedging activities contain credit risk in that the counterparty may be unable to meet the terms of the agreements. We have limited these agreements to major financial institutions to reduce this credit risk. Furthermore, we monitor the potential risk of loss with any one financial institution. We do not enter into forward contracts for speculative purposes.
The following table provides information about our foreign currency contracts at July 31, 2003. Due to the short-term nature of these contracts, the contract rates approximate the weighted-average currency exchange rates at July 31, 2003. These forward contracts mature in approximately thirty days and contracts are rolled-forward on a monthly basis to match firmly committed transactions.
| USD Amount | Contract Rate |
|---|
|
|
|
|
| (in thousands) | |
|---|
| Forward Net Contract Values: | | | | | | | | |
| Japanese yen | | | $ | 103,129 | | | 117.7900 | |
| Euro | | | | 5,366 | | | 0.8725 | |
| Canadian dollar | | | | 4,599 | | | 1.3876 | |
| British pound sterling | | | | 4,671 | | | 0.6172 | |
| Israeli shekel | | | | 1,955 | | | 4.4250 | |
| Korean won | | | | 2,637 | | | 1183.3500 | |
| Singapore dollar | | | | 1,928 | | | 1.7540 | |
| Taiwan dollar | | | | 738 | | | 34.3700 | |
| Hong Kong dollar | | | | 5,489 | | | 7.8000 | |
| Chinese renminbi | | | | 6,254 | | | 8.2730 | |
| |
| | |
| | | | $ | 136,766 | | | | |
| |
| | | | | |
Net unrealized gains of approximately $18.0 million, net of tax on the outstanding forward contracts, as of July 31, 2003 are included in other comprehensive income on the unaudited condensed consolidated balance sheet as of July 31, 2003. Net cash outflows on maturing forward contracts during the quarter were $1.1 million.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. As of the end of the third fiscal quarter (the “Evaluation Date”), the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 14d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable, not absolute, assurance of achieving their control objectives. Subject to these limitations, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, the disclosure controls and procedures were effective in all material respects to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.
(b) Changes in Internal Controls. There were no changers in our internal controls over financial reporting during the quarter ended July 31, 2003 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
See Note 8,Legal Proceedings, of Notes to Unaudited Condensed Consolidated Financial Statements, which is incorporated by reference here.
ITEM 2. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We held our Annual Meeting of Stockholders at our Sunnyvale, California offices on June 20, 2003. Three matters were submitted to and approved by the stockholders as set forth below.
1. The stockholders elected nine directors to the Company’s Board of Directors, to hold office for a one-year term or until their respective successors are elected. The votes regarding this matter were as follows:
| Total Vote | Total Vote |
|---|
| For Each | Withheld From |
|---|
| Director | Each Director |
|---|
|
|
|
|---|
| Aart J. de Geus | | | | 64,543,335 | | | 853,818 | |
| Andy D. Bryant | | | | 66,672,194 | | | 1,724,959 | |
| Chi-Foon Chan | | | | 68,120,297 | | | 276,856 | |
| Bruce R. Chizen | | | | 67,117,246 | | | 1,279,907 | |
| Deborah A. Coleman | | | | 66,660,067 | | | 1,737,086 | |
| A. Richard Newton | | | | 67,124,206 | | | 1,272,947 | |
| Sasson Somekh | | | | 48,684,691 | | | 19,712,462 | |
| Roy Vallee | | | | 67,989,556 | | | 407,597 | |
| Steven C. Walske | | | | 67,066,099 | | | 1,331,054 | |
2. The stockholders approved an amendment to the Company’s Employee Stock Purchase Plan and International Employee Stock Purchase Plan to increase the number of shares of Common Stock reserved for issuance thereunder by 1,800,000 shares. The votes regarding this matter were as follows:
| For | Against | Abstain |
|---|
|
|---|
| 64,470,827 | | 3,429,399 | | 496,927 |
3. The stockholders approved a proposal to ratify the appointment of KPMG LLP as the Company’s independent auditors for the 2003 fiscal year. The votes regarding this matter were as follows:
| For | Against | Abstain |
|---|
|
|---|
| 67,470,374 | | 900,032 | | 26,747 |
ITEM 5. OTHER INFORMATION
Stock Option Plans
Under our 1992 Stock Option Plan (the 1992 Plan), 19,475,508 shares of common stock have been authorized for issuance. Pursuant to the 1992 Plan, the Board of Directors may grant either incentive or non-qualified stock options to purchase shares of common stock to eligible individuals at not less than 100% of the fair market value of those shares on the grant date. Stock options generally vest over a period of four years and expire ten years from the date of grant. At July 31, 2003, 4,597,083 stock options remain outstanding and 3,764,588 shares of common stock are reserved for future grants under this plan.
�� Under our Non-Statutory Stock Option Plan (the 1998 Plan), 26,623,534 shares of common stock have been authorized for issuance. Pursuant to the 1998 Plan, the Board of Directors may grant non-qualified stock options to employees, excluding executive officers. Exercisability, option price and other terms are determined by the Board of Directors, but the option price shall not be less than 100% of the fair market value of those shares on the grant date. Stock options generally vest over a period of four years and expire ten years from the date of grant. At July 31, 2003, 14,518,550 stock options remain outstanding and 4,402,117 shares of common stock were reserved for future grants under this plan.
Under our 1994 Non-Employee Directors Stock Option Plan (the Directors Plan), 900,000 shares have been authorized for issuance. The Directors Plan provides for automatic grants to each non-employee member of the Board of Directors upon initial appointment or election to the Board, reelection and for annual service on Board committees. The option price shall not be less than 100% of the fair market value of those shares on the grant date. Under the Directors Plan, new directors receive an option for 20,000 shares, vesting in equal installments over four years. In addition, each continuing director who is elected at an annual meeting of stockholders receives an option for 10,000 shares and an additional option for 5,000 shares for each Board committee membership, up to a maximum of two committee service grants per year. In August 2003, the Board amended the Directors Plan in order to reduce the size of the initial and committee grants to 15,000 and 2,500 shares, respectively. The annual and committee service option grants vest in full on the date immediately prior to the date of the annual meeting following their grant. In the case of directors appointed to the board between annual meetings, the annual and any committee grants are prorated based upon the amount of time since the last annual meeting. At July 31, 2003, 584,246 stock options remain outstanding and 55,173 shares of common stock were reserved for future grants under this plan.
We have assumed certain option plans in connection with business combinations. Generally, these options were granted under terms similar to the terms of our option plans at prices adjusted to reflect the relative exchange ratios. We terminated all assumed plans as to future grants upon completion of each of the business combinations.
We monitor dilution related to our option program by comparing net option grants in a given fiscal period to the number of shares outstanding. The dilution percentage is calculated as the new option grants for the fiscal period, net of options forfeited by employees leaving the Company, divided by the total outstanding shares at such fiscal period. The option dilution percentages were 0.4% and 3.4% for the nine months ended July 31, 2003 and fiscal 2002, respectively. We also have a share repurchase program under which we regularly repurchase shares from the open market.
A summary of the distribution and dilutive effect of options granted is as follows:
|
|
|
|---|
| NINE MONTHS | YEAR ENDED |
|---|
| ENDED JULY 31, | OCTOBER 31, |
|---|
| 2003 | 2002 |
|---|
|
|
|
|---|
| Total grants, net of returns and cancellations, during the | | |
| period as percentage of outstanding shares exclusive of | | |
| options assumed in acquisitions | 0.4%(1) | 3.4% |
| Grants to Named Executive Officers, as defined below, during | | |
| the period as percentage of total options granted | 12.0% | 9.3% |
| Grants to Named Executive Officers during the period as | | |
| percentage of outstanding shares | 0.3% | 0.5% |
| Total outstanding options held by Named Executive Officers as | | |
| percentage of total options outstanding | 16.6% | 13.7% |
| (1) | | Total grants, net of returns and cancellations, includes the cancellation of approximately 406,000 options from a former Named Executive Officer. If these options had been excluded from the calculation, the net grants for the nine months ended July 31, 2003 as a percentage of outstanding shares would have been 1.0%. |
A summary of our option activity and related weighted-average exercise prices for fiscal 2002 through the nine months ended July 31, 2003 is as follows:
| | | Options | | Outstanding |
|---|
| |
|
|
|
|
|---|
| | | | | Weighted- |
|---|
| Shares | | | | Average |
|---|
| Available for | | Number | | Exercise |
|---|
| Options | | of Shares | | Price |
|---|
|
|
|
|
|
|
|---|
| (in thousands, | | except per share | | amounts) |
|---|
| | |
|---|
| | |
|---|
| Balance at October 31, 2001 | 8,209 | | 25,920 | | $ 40.10 |
| Grants | (4,081) | | 4,081 | | $ 47.88 |
| Options assumed in acquisitions | -- | | 2,511 | | $ 37.16 |
| Exercises | -- | | (2,851) | | $ 34.43 |
| Cancellations | 1,585 | | (1,681) | | $ 42.93 |
| Additional shares reserved | 2,700 | | -- | | -- |
|
|
|
|
| |
| Balance at October 31, 2002 | 8,413 | | 27,980 | | $ 41.40 |
| Grants | (1,818) | | 1,818 | | $ 47.03 |
| Options assumed in acquisitions | -- | | 1,057 | | $ 49.59 |
| Exercises | -- | | (7,253) | | $ 36.72 |
| Cancellations | 1,476 | | (1,750) | | $ 47.86 |
| Additional shares reserved | 150 | | -- | | -- |
|
|
|
|
| |
| Balance at July 31, 2003 | 8,221 | | 21,852 | | $ 43.29 |
|
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|
|
| |
At July 31, 2003, a total of 19.5 million, 26.6 million and 900,000 shares were reserved for issuance under our 1992, 1998 and Directors Plans, respectively, of which 8.2 million shares were available for future grants. For additional information regarding our stock option activity during fiscal 2002 and 2001, please see Note 6 of Notes to Consolidated Financial Statements in our 2002 Annual Report on Form 10-K, as amended.
A summary of outstanding in-the-money and out-of-the-money options and related weighted-average exercise prices at July 31, 2003 is as follows:
| | | Exercisable | | | | Unexercisable | | | | Total | |
|---|
|
|
|
|
|
|
|
|
|
|
|
|
|
|---|
| | | | Weighted | | | | Weighted | | | | Weighted |
|---|
| | | | -Average | | | | -Average | | | | -Average |
|---|
| | | | Exercise | | | | Exercise | | | | Exercise |
|---|
| | Shares | | Price | | Shares | | Price | | Shares | | Price |
|---|
|
|
|
|
|
|
|
|
|
|
|
|
|
|---|
| (in thousands, except per share amounts) | |
|---|
| |
|---|
| In-the-Money | | 12,396 | | $42.53 | | 9,066 | | $42.76 | | 21,462 | | $42.63 |
| Out-of-the-Money (1) | | 237 | | $78.95 | | 153 | | $80.90 | | 390 | | $79.71 |
| |
| | | |
| | | |
| | |
| Total Options Outstanding | | 12,633 | | $43.21 | | 9,219 | | $43.40 | | 21,852 | | $43.29 |
| |
| | | |
| | | |
| | |
| | | (1) | | Out-of-the-money options are those options with an exercise price equal to or above the closing price of $62.82 on August 1, 2003, the last trading day of the third quarter of fiscal 2003. |
The following table sets forth further information regarding individual grants of options during the nine months ended July 31, 2003 for the Chief Executive Officer and each of the other four most highly compensated executive officers serving as such on July 31, 2003 whose compensation for fiscal 2002 exceeded $100,000 (the Named Executive Officers).
| | | | | | | | | | Potential | Realizable | Value at |
|---|
| | | | | | | | | | Assumed | Annual | Rates of |
|---|
| | | | | | | | | | Stock | Price | Appreciation |
|---|
| | Individual | | Grants | | | | | | for | Option | Term ($) |
|---|
| |
|
|
| | | | | |
|
|
|
|---|
| | Number of | | Percent of | | | | | | | | |
|---|
| | Securities | | Total Options | | Range of | | | | | | |
|---|
| | Underlying Options | | Granted to | | Exercise Prices | | | | | | |
|---|
| Name | | Granted(1) | | Employees(2) | | ($/Share) | | Expiration Date | | 5% | | 10% |
|---|
|
|
|
|
|
|
|
|
|
|
|
|
|
|---|
| Aart J. de Geus | | 46,550 | | 2.82% | | $40.92 - $58.56 | | 12/09/12-05/27/13 | | $ 1,337,746 | | $ 3,390,110 |
| Chi-Foon Chan | | 45,175 | | 2.74% | | $40.92 - $58.56 | | 12/09/12-05/27/13 | | $ 1,294,595 | | $ 3,280,759 |
| Vicki L. Andrews | | 25,575 | | 1.55% | | $40.92 - $58.56 | | 12/09/12-05/27/13 | | $ 751,905 | | $ 1,905,474 |
| Steven K. Shevick | | 51,975 | | 3.15% | | $40.92 - $58.56 | | 12/09/12-05/27/13 | | $ 1,420,207 | | $ 3,599,083 |
| Sanjiv Kaul | | 29,375 | | 1.78% | | $40.92 - $58.56 | | 12/09/12-05/27/13 | | $ 845,280 | | $ 2,142,105 |
| (1) | Sum of all option grants made during the nine months ended July 31, 2003 to such person. Options become exercisable ratably in a series of monthly installments over a four-year period from the grant date, assuming continued service to Synopsys, subject to acceleration under certain circumstances involving a change in control of Synopsys. Each option has a maximum term of ten years, subject to earlier termination upon the optionee’s cessation of service. |
| (2) | Based on a total of 1,651,169 shares subject to options granted to employees under Synopsys’ option plans during the nine months ended July 31, 2003. |
The following table provides the specified information concerning exercises of options to purchase our common stock and the value of unexercised options held by our Named Executive Officers during the nine months ended July 31, 2003:
| | | | | | Number | of | Securites | | Value of In | -the- | Money |
|---|
| | Shares | | | | Underlying | | Unexercised | | Options | | at |
|---|
| | Acquired On | | Value | | Options at | | July 31, 2003 | | July 31, | 2003 | (2) |
|---|
| Name | | Exercise | | Realized (1) | | Exercisable | / | Unexercisable | | Exercisable | / | Unexercisable |
|---|
|
|
|
|
|
|
|
|
|
|
|
|
|
|---|
| Aart J. de Geus | | -- | | -- | | 1,482,795 | | 292,455 | | $32,718,607 | | $ 5,562,034 |
| Chi-Foon Chan | | 100,000 | | 2,734,000 | | 881,432 | | 251,643 | | $16,567,424 | | $ 4,717,364 |
| Vicki L. Andrews | | 57,166 | | 1,417,088 | | 98,651 | | 136,324 | | $ 1,129,332 | | $ 2,166,714 |
| Steven K. Shevick | | 20,500 | | 596,806 | | 122,302 | | 91,473 | | $ 2,334,608 | | $ 1,695,146 |
| Sanjiv Kaul | | 140,412 | | 3,650,402 | | 128,987 | | 140,538 | | $ 1,670,136 | | $ 2,097,475 |
| (1) | Market value at exercise less exercise price. |
| (2) | Market value of underlying securities at August 1, 2003 ($62.82) minus the exercise price. |
The following table provides information regarding equity compensation plans approved and not approved by security holders at July 31, 2003 (in thousands, except price per share amounts):
| | | | | | Number of Securities |
|---|
| | | | | | Remaining Available for |
|---|
| | Number of Securities | | Weighted-Average | | Future Issuance Under |
|---|
| | to be Issued Upon | | Exercise Price of | | Equity Compensation |
|---|
| | Exercise of | | Outstanding | | Plans (Excluding |
|---|
| | Outstanding Options, | | Options,Warrants, | | Securities Reflected in |
|---|
| | Warrants, and Rights | | and Rights | | Column (a)) |
|---|
| Plan Category | | (a) | | (b) | | (c) |
|---|
|
|
|
|
|
|
|
|---|
| Employee Equity Compensation Plans | | | | | | |
| Approved by Stockholders (1) | | 5,181,329 | | $ 42.61 | | 8,118,544 (4) |
| Employee Equity Compensation Plans Not | | | | | | |
| Approved by Stockholders (2) | | 14,518,550 | | $ 43.91 | | 4,402,117 |
| |
| | | |
|
| Total | | 19,699,879 (3) | | $ 43.57 | | 12,520,661 (5) |
| |
| | | |
|
| (1) | | Synopsys’ stockholder approved equity compensation plans include the 1992 Plan, the Directors Plan and the Employee Stock Purchase Plans. |
| (2) | | Synopsys’ only non-stockholder approved equity compensation plan is the 1998 Plan. |
| (3) | | Does not include information for options assumed in connection with mergers and acquisitions. As of July 31, 2003, a total of 2,151,835 shares of our common stock were issuable upon exercise of such outstanding options. |
| (4) | | Includes 1,800,000 shares approved by shareholders on June 20, 2003 for addition to the Employee Stock Purchase Plan. |
| (5) | | Comprised of (i) 3,764,588 shares remaining available for issuance under the 1992 Plan, (ii) 4,402,117 shares remaining available for issuance under the 1998 Plan, (iii) 55,173 shares remaining available for issuance under the Directors Plan, and (iv) 4,298,783 shares remaining available for issuance under the Employee Stock Purchase Plans as of July 31, 2003. |
Pre-approvals of Non-Audit Services by Audit Committee
Pursuant to Section 10A(i)(3) of the Exchange Act, during the fiscal quarter ended July 31, 2003, the Chairperson of the Audit Committee pre-approved the following non-audit services to be performed by KPMG LLP, as its independent auditors, which approval was subsequently reported to the full Audit Committee at its next regularly scheduled meeting and ratified:
| 1. | Services relating to subsidiary merger plan; and |
| 2. | Consultation related to Sarbanes-Oxley Act compliance matters. |
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a.) Exhibits
3.1 Amended and Restated Certificate of Incorporation of Synopsys, Inc.
3.2 Restated Bylaws of Synopsys, Inc. (1)
4.1 Reference is made to Exhibits 3.1 and 3.2.
10.1 1994 Directors Stock Option Plan, as amended.
31.1 Certification of Chief Executive Officer furnished pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act
31.2 Certification of Chief Financial Officer furnished pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act
32.1 Certification of Chief Executive Officer and Chief Financial Officer furnished pursuant to Rule 13a-14(b) or Rule 15d-14(b)
of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code
_________________
| (1) | | Incorporated by reference from exhibit to Synopsys’ Quarterly Report on Form 10-Q for the quarterly period ended April 3, 1999. |
The Registrant filed a Report on Form 8-K with the SEC on May 21, 2003 reporting under Item 9 its results for its second fiscal quarter ended April 30, 2003.
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.
SYNOPSYS, INC.
|
|---|
| By: /s/ STEVEN K. SHEVICK |
|
| Steven K. Shevick |
| Chief Financial Officer |
| (Principal Financial Officer) |
| |
| Date: September 12, 2003 |
EXHIBIT INDEX
Exhibit No. Description
3.1 Amended and Restated Certificate of Incorporation of Synopsys, Inc.
3.2 Restated Bylaws of Synopsys, Inc. (1)
4.1 Reference is made to Exhibits 3.1 and 3.2.
10.1 1994 Directors Stock Option Plan, as amended.
31.1 Certification of Chief Executive Officer furnished pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act
31.2 Certification of Chief Financial Officer furnished pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act
32.1 Certification of Chief Executive Officer and Chief Financial Officer furnished pursuant to Rule 13a-14(b) or Rule 15d-14(b)
of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code
_________________
Incorporated by reference from exhibit to Synopsys’ Quarterly Report on Form 10-Q for the quraterly period ended April 3, 1999
