Form 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 Commission file number 0 - 13442 MENTOR GRAPHICS CORPORATION (Exact name of registrant as specified in its charter) Oregon 93-0786033 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 8005 SW Boeckman Road 97070-7777 Wilsonville, Oregon (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code (503) 685-7000 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, without par value Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $905,939,098 on March 4, 1999 based upon the last price of the Common Stock on that date reported in the Nasdaq National Market. On March 4, 1999, there were 65,588,351 shares of the Registrant's Common Stock outstanding. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or in any amendment to this Form 10-K. [X] DOCUMENTS INCORPORATED BY REFERENCE Part of Form 10-K into Document which incorporated ------------------------------------ ---------------------- Portions of the 1999 Proxy Statement Part III 13 Table of Contents Page - -------------------------------------------------------------------------------- Part I ......................................................................15 Item 1. Business .......................................................15 Item 2. Properties .....................................................20 Item 3. Legal Proceedings ..............................................20 Item 4. Submission of Matters to a Vote of Security Holders ............22 Part II .....................................................................23 Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters ....................................23 Item 6. Selected Consolidated Financial Data ...........................23 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ............................24 Item 7A. Quantitative and Qualitative Disclosures About Market Risk .....33 Item 8. Financial Statements and Supplementary Data ....................34 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure ............................49 Part III ....................................................................49 Item 10. Directors and Executive Officers of Registrant .................49 Item 11. Executive Compensation .........................................49 Item 12. Security Ownership of Certain Beneficial Owners and Management ..........................................49 Item 13. Certain Relationships and Related Transactions .................49 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ............................................50 14 PART I - -------------------------------------------------------------------------------- Item 1. Business This Form 10-K contains forward-looking statements that involve risks and uncertainties. Actual results may differ materially from the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those set forth under the caption "Factors That May Affect Future Results and Financial Condition" under "Item 7, Management's Discussion and Analysis of Results of Operations and Financial Condition." GENERAL Mentor Graphics Corporation (the Company) manufactures, markets and supports software and hardware Electronic Design Automation (EDA) products and provides related services which enable engineers to design, analyze, simulate, model, implement and verify the components of electronic systems. In addition to traditional EDA products, the Company's product offerings include (1) intellectual property (IP) products and services intended to increase design efficiency by delivering standard, reusable functions for the design of hardware components and (2) embedded systems software development and system verification tools intended to shorten product time-to-market by allowing for simultaneous development and testing of hardware and embedded software. The Company markets its products primarily to large companies in the communications, computer, consumer electronics, semiconductor, aerospace, and transportation industries. Customers use the Company's software in the design of such diverse products as supercomputers, automotive electronics, telephone-switching systems, cellular base stations and handsets, computer network hubs and routers, signal processors and personal computers. The Company licenses its products primarily through its direct sales force in North and South America (Americas), Europe, Japan and Pacific Rim, and through distributors where a direct sales presence is not warranted. The Company was incorporated in Oregon in 1981 and its common stock is traded on the Nasdaq National Market under the symbol MENT. The Company's executive offices are located at 8005 S.W. Boeckman Road, Wilsonville, Oregon 97070-7777. The telephone number at that address is (503) 685-7000. The Company Website address is www.mentor.com. PRODUCTS Customers use the Company's products in the design, analysis, simulation, modeling, implementation and verification of electronic designs for communications, computer, consumer electronics, semiconductor, aerospace, and transportation products. This use is intended to make design engineers more productive, make even complex designs more accurate and, thus, shrink time-to-market schedules. The electronic design process begins when an electrical engineer describes the architectural, behavioral, functional and structural characteristics of an integrated circuit (IC), printed circuit board (Board) or electronic system. In this process the engineer describes the overall product system architecture and then implements it by creating a design description, simulating the design to reveal electrical defects and reiterating the description until it meets the previously determined design specifications. Engineers use the Company's products to specify the components of the IC or Board, determine the interconnections among the components and define the components' associated physical properties. Engineers also use the Company's simulation products throughout the design process to identify design errors before the design is manufactured. Simulation also gives engineers the ability to test design alternatives. Engineers use the Company's verification products to identify functionality and performance issues while the cost to correct is still low. Verification Verification of electronic designs is addressed by Company products from several aspects, including simulation and emulation of the entire chip, execution of software on the virtual hardware prototype, and analysis of physical implementation effects and their impact on functionality, performance and quality. With advancements in IC technology, the Company believes that the fabrication of "deep submicron" physical feature dimensions is becoming commonplace, and a new threshold in IC complexity and system integration is being crossed. The term "deep submicron" is generally defined as any IC manufacturing process that has transistor gate lengths under 0.35u (microns). The Company's Calibre(R) product line is specifically engineered for physical verification of deep submicron circuit designs. 15 xCalibre(R) is the Company's brand for deep submicron IC backend physical extraction products. xCalibre's complete design flow provides technology for deep submicron parasitic extraction. Parasitic extraction is the process of creating an electrical model representation of the physical connections present between devices in an IC. xCalibre provides the ability to organize vast amounts of input data, extract parasitics to the desired level of accuracy, and manage this extracted data into a form usable by post-layout analysis tools. Advances in deep submicron process technology and IC complexity have forced designers to seek new solutions for physical extraction. xCalibre products close the gap between creating designs for deep submicron processes and verifying the physical implementation of those designs at a system level. Unlike other physical verification tools, xCalibre tools offer an open design flow that enables IC designers to take a massive database of electronic circuit information, split it up into manageable pieces for analysis, and reintegrate the information into the overall chip design. The Company's co-verification tools provide a means to verify the hardware and embedded software comprising an electronic system without having to build a hardware prototype. This improves the efficiency of the customers' product development cycles by giving customers more time to fix software bugs and resolve hardware-software interface errors. Seamless(TM) is the Company's hardware/software co-verification product family that enables simultaneous simulation of the hardware and software components of a system design. These tools verify the software-hardware interface by running the software against simulated models of the hardware. Seamless tools allow designers to verify software much earlier in the system design process instead of waiting until the hardware design has been completed, verified and manufactured into a prototype. Early verification of the system identifies functionality and performance issues while the cost to correct them is still small and reduces the overall design cycle. Seamless tools can be applied to Systems on Chips, application specific integrated circuits (ASICs) with embedded microcontroller cores, or microprocessor and digital signal processor (DSP) based board designs. Some products with embedded systems or processor-based board designs that benefit from using Seamless tools in the design process include cellular phones, telephone switching equipment, network hubs, routers, wireless base stations, automobile engine management modules, aircraft avionics and controls, and computer equipment. The Company's design-for-test, or "DFT", product line offers products which automate the process of making integrated circuits and systems testable and the generation of their test programs. The Company's DFT product brands include FastScan(TM), FlexTest(TM), DFTAdvisor(TM), DFTInsight(TM), MBISTArchitect(TM), LBISTArchitect(TM), BSDArchitect(TM), and CTIntegrator(TM)--an automated test solution for System on Chip designs incorporating IP products. The Company's simulation product line gives electrical designers representative or virtual data to reproduce conditions in a model that could occur in the performance of a system under different operating conditions. The Company's simulation products for system, Board, ASIC or field programmable gate array simulation include QuickSim II(TM), Quick HDL Pro(TM) and ModelSim(TM). As more ICs and Boards support both analog and digital circuits, designers need a unified simulation solution that allows both analog and digital analysis within the mixed-signal design. The Company offers a range of alternative tools for analog and mixed-signal designers. The tools provide a flow that begins with design entry or a language description, continues with verification and analysis options and finishes with a physical description for fabrication of hardware prototype. The Company's analog/mixed signal products include Analog Station II(TM), AccuParts(TM), Eldo(TM) and Accusim II(TM). Design Re-use and Embedded Systems Software The Company believes that the demand for tools to develop increasingly complex electronic systems cannot be entirely satisfied with traditional EDA tools. Under its Integrated System Design strategy, the Company has combined its EDA products with products and services that facilitate rapid development of complex systems through reusable design components referred to in the industry as "intellectual property" or "IP" and the integration of hardware and embedded systems development. The Company's Inventra brand IP products and related services are intended to increase engineering productivity through the use of predefined and preverified "building blocks" or "cores" of frequently used circuit functions for the design of hardware 16 components. Use of IP products allows designers to focus on optimizing system architecture and developing proprietary functionality. The Company believes that companies which integrate IP products into their design methodology can expect better quality products at lower costs and faster time-to-market. The Company provides IP products that are used in ASIC design, IC design, embedded software design and Board design. These products include circuit functions for a range of electronic consumer and communications applications including microprocessors, peripheral interface controllers, digital signal processors, and communications controllers cores. In 1998, the Company entered into an IP alliance with International Business Machines Corporation (IBM) under which the Company is licensed to offer the IBM PowerPC 401 and 405 embedded processor "cores" as part of its extensive library of proven commercial cores. The agreement is unique in that it is the first time a 32-bit microprocessor architecture is available through an independent IP provider. The Company also provides embedded systems software and development tools. Embedded systems control the function of hardware components dedicated to specialized tasks of such common consumer products as VCRs, telephones and fax machines. Embedded systems software is used in a range of other products in the aerospace, communications, medical instrumentation, transportation, computer, industrial and consumer markets. The Company's embedded systems software products include the VRTX(R) real-time operating system, the XRAY(R) family of debugger products and other software development tools including Microtec brand compilers, assemblers, linkers and simulators. System Design The Company's Board design tools allow designers to select from a library of parts to be included in a Board to simulate and test the performance of the Board, to test for manufacturability, to analyze thermal and signal integrity, and to output data which will allow the Board to be manufactured. "Boards," refers to a common way of packaging electronic circuits, consisting of epoxy material upon which ICs, ASICs and discrete components such as resistors and capacitors are mounted. Products within the Board design flow include Design Architect(R), Board Station(R), Board Architect(TM), Hybrid Station(R) and Library Management System. The Company's Field Programmable Gate Array (FPGA) solutions are comprised of a combination of products including ModelSim(TM) previously discussed, Leonardo Spectrum(TM), the Company's FPGA Synthesis product line and Renoir(TM) Hardware Description Language (HDL) graphical entry product line. Renoir(TM) provides a highly automated environment for the design of electronic systems, using graphical tools to capture or reuse high-level designs and functional behavior. The Monet(R) behavioral synthesis product line defined a new capability for designers, which the Company calls "architectural exploration." Architectural exploration allows designers to rapidly explore and determine the right architecture tradeoffs before they commit resources to creating a hardware prototype such as an IC. The Company's Interconnectix(TM) brand Interconnect Synthesis (IS) products combine the disciplines of timing and signal integrity analysis with the physical implementation of floorplanning, placement and routing for high-speed board design. IS products reduce the time consuming iteration cycle among placement, routing, analysis and rework. PLATFORMS The Company's software products are available on UNIX and Windows NT platforms in a broad range of price and performance levels. Platforms are purchased by customers primarily from Hewlett-Packard Company, Sun Microsystems, Inc. and Compaq Computer Corporation. These computer manufacturers have a substantial installed base and make frequent introductions of new products. MARKETING AND CUSTOMERS In 1998, the Company again focused its marketing and selling resources on a limited number of emerging products. Those products include the Calibre physical verification product, the xCalibre(R) physical extraction product, the Seamless(TM) CVE hardware/software co-verification tool, the IP products of its Inventra(TM) business unit, and the IS routing products of its Interconnectix business unit. The SimExpress(TM)/Celaro(TM) products of the Company's Meta Systems SRL (Meta) subsidiary are also marketed as emerging products outside of the U.S. The Company's marketing also emphasizes its Integrated System Design strategy for the integration of both hardware and software development for electronic systems, a direct sales force 17 and large corporate account penetration in the communications, computer, consumer electronics, semiconductor, aerospace, and transportation industries. The Company licenses its products primarily through its direct sales force in the Americas, Europe, Japan and Pacific Rim. The Company also licenses its products through distributors where a direct sales presence is not warranted. During the years ending December 31, 1998, 1997 and 1996 sales outside of the Americas accounted for 45 percent of total sales. The Company enters into foreign currency forward contracts to help mitigate the impact of foreign currency fluctuations. These contracts do not eliminate all potential impact of foreign currency fluctuations and significant exchange rate movements may have a material adverse impact on the Company's results. See pages 30-32, "Factors That May Affect Future Results and Financial Condition," for a discussion of the effect foreign currency fluctuation may have on the Company's business and operating results. Additional information relating to foreign and domestic operations is contained in Note 12 of Notes to Consolidated Financial Statements beginning on Page 46, below. No material portion of the Company's business is dependent on a single customer. The Company has traditionally experienced some seasonal fluctuations in receipts of orders, which are typically stronger in the second and fourth quarters of the year. Due to the complexity of the Company's products, the selling cycle can be three to six months or longer. During the selling cycle the Company's account managers, application engineers and technical specialists make technical presentations and product demonstrations to the customer. At some point during the selling cycle, the Company's products may also be "loaned" to customers for on-site evaluation. As is typical of many other companies in the electronics industry, the Company generally ships its products to customers within 180 days after receipt of an order, and a substantial portion of quarterly shipments tend to be made in the last month of each quarter. The Company licenses its products and some third party products pursuant to purchase and license agreements. The Company generally schedules deliveries only after receipt of purchase orders under these agreements. UNIVERSITY PROGRAMS The Company shares its technology and expertise with universities worldwide through its Higher Education Program (HEP). Founded in 1985 because the Company believes the success of the electronics industry is dependent upon highly skilled engineers, the HEP offers colleges and universities a cost-effective way to acquire the Company's products for teaching and academic research. This program helps to insure that engineering graduates enter industry proficient in the use of state-of-the-art tools and techniques. Through the HEP, the Company develops long term relationships with engineering colleges and universities around the world. The Company has partnerships with more than 330 colleges and universities worldwide. BACKLOG The Company's backlog of firm orders was approximately $77 million on December 31, 1998 as compared to $78 million on December 31, 1997. This backlog includes products not shipped and unfulfilled professional services and training. The Company does not track backlog for support services. Support services are typically delivered under annual contracts that are accounted for on a pro rata basis over the twelve-month term of each contract. Substantially all the December 31, 1998 backlog of orders is expected to ship during 1999. MANUFACTURING OPERATIONS The Company's manufacturing operations primarily consist of reproduction of the Company's software and documentation. In the Americas, manufacturing is substantially outsourced, with distribution to Western Hemisphere customers occurring from major West Coast sites in the U.S. Distribution centers in The Netherlands and Singapore serve their respective regions. The Company's line of accelerated verification products, which is comprised of both hardware and software, is manufactured in France. In 1998 the Company established an Irish company (Irish Company) and began transfer of its European manufacturing and distribution from the Netherlands to Ireland. The Irish Company will be responsible for manufacturing and distributing its products to the European, Middle East, and African markets through the Company's established sales channels. PRODUCT DEVELOPMENT The Company's research and development is focused on continued improvement of its existing products and the development of new products. During the years ended December 31, 1998, 1997 and 1996, the Company expensed $117,853,000, 18 $112,227,000 and $92,905,000 respectively, and capitalized $0, $0, and $5,691,000 respectively, related to product research and development. The Company also seeks to expand existing product offerings and pursue new lines of business through acquisitions. Acquisitions accommodate the Company's focused strategic requirements by filling gaps in existing products or technologies, eliminating dependencies on third parties and providing the Company with an avenue into new lines of business. The Company's future success depends on its ability to develop or acquire competitive new products that satisfy customer requirements. SUPPLIERS The Company seeks to provide its customers with software and IP products that address customers' electronic system design processes. Supplier products fill gaps in the Company's existing product lines and allow it to offer products which are needed by customers but which are not central to the Company's business. Supplier agreements are also used to explore possible new lines of business. Supplier agreements are typically multi-year agreements with royalty payments based on a percentage of product revenue. The agreements generally require an escrow of the supplier's source code. Customer support for supplier products is usually provided by the Company with the supplier providing backup support and research and development in the event of a problem with the product itself. CUSTOMER SUPPORT AND CONSULTING The Company has a worldwide organization to meet its customers' needs for software support. The Company offers support contracts providing software updates and support. Most of the Company's customers have entered into software support contracts. In November of 1998, the Software Support Professionals Association (SSPA) announced that the Company's Customer Support Division had won its 1999 SSPA STAR (Software Technical Assistance Recognition) Award in the Complex Support category. The STAR Awards are given annually to recognize excellence in six areas of software and technical support. Competing companies undergo a rigorous self-nominating process. Applicants are then evaluated by SSPA's Advisory Board. The winner in Complex Support category must demonstrate a consistently high level of support for mission-critical applications used in scientific, engineering, and other highly technical environments. The Company's Customer Support Division also won the STAR Award in 1993 and 1995. Mentor Consulting, the Company's consulting division, is comprised of a worldwide team of consulting professionals who provide services for System-on-Chip, Systems to Silicon Verification, Design Reuse, and High Performance Systems Design. The Company's consulting group was established in 1987. The services provided to customers by Mentor Consulting include advising customers on design process, design reuse and IC verification and test. Design process consulting helps customers improve how they design. Design reuse consulting helps customers modify existing designs for use in new designs. Mentor Consulting's mission is to team with customers' design groups to increase productivity while reducing costs and time-to-market. COMPETITION The markets for the Company's products are competitive and are characterized by price reductions, rapid technological advances in application software, operating systems and hardware, and new market entrants. The EDA and IP product industries tend to be labor intensive rather than capital intensive. This means that the number of actual and potential competitors is significant. While many competitors are large companies with extensive capital and marketing resources, the Company also competes with small companies with little capital but innovative ideas. The Company believes the main competitive factors affecting its business are breadth and quality of application software, product integration, ability to respond to technological change, quality of a company's sales force, price, size of the installed base, level of customer support and professional services. The Company believes that it generally competes favorably in these areas. The Company can give no assurance, however, that it will have financial resources, marketing, distribution and service capability, depth of key personnel or technological knowledge to compete successfully in its markets. The Company's principal competitors are Cadence Design Systems Inc., Synopsys Inc., Avant! Corporation, Quickturn Design Systems, Inc., IKOS Systems, Inc., Wind River Systems Inc. and numerous small companies. 19 EMPLOYEES The Company and its subsidiaries employed approximately 2,600 people full time as of December 31, 1998. The Company's success will depend in part on its ability to attract and retain employees who are in great demand. The Company continues to enjoy satisfactory employee relations. PATENTS AND LICENSES The Company holds 32 United States and 9 foreign patents on various technologies. In 1998, the Company was granted 12 patents and filed 38 patent applications worldwide. As of January 1999, the Company has a total of 51 patent applications filed and pending and an additional 29 in process but not yet filed. While the Company believes the pending applications relate to patentable technology, there can be no assurance that any patent will be issued or that any patent can be successfully defended. Although the Company believes that patents are less significant to the success of its business than technical competence, management ability, marketing capability and customer support, the Company believes that software patents are becoming increasingly important in the software industry. The Company regards its products as proprietary and protects all products with copyrights, trade secret laws, and internal non-disclosure safeguards, as well as patents, when appropriate, as noted above. The Company typically includes restrictions on disclosure, use and transferability in its agreements with customers and other third parties. Item 2. Properties The Company owns six buildings on 53 acres of land in Wilsonville, Oregon. The Company occupies 341,000 square feet, in five of those buildings, as its corporate headquarters. The Company leases the remaining building and portions of one headquarters building to third parties. The Company also owns an additional 98 acres of undeveloped land adjacent to its headquarters. All corporate functions and a majority of its domestic research and development operations are located at the Wilsonville site. The Company leases additional space in San Jose, California, where some of its domestic research and development takes place, and in various locations throughout the United States and in other countries, primarily for sales and customer service operations. Some additional research and development is done in locations outside the U.S. The Company believes that it will be able to renew or replace its existing leases as they expire and that its current facilities will be adequate through at least 1999. Item 3. Legal Proceedings During 1995, the Company filed suit in U.S. Federal District Court in Portland, Oregon, against Quickturn Design Systems, Inc. (Quickturn) for a declaratory judgment of non-infringement, invalidity and unenforceability of three of Quickturn's patents. These patents relate to products of Meta Systems SRL (Meta), a French company acquired by the Company in 1996 that manufactures and sells computers used for accelerated verification of hardware designs. Quickturn filed a counterclaim against the Company alleging infringement of six of Quickturn's patents, including the three patents subject to the declaratory judgment action. The counterclaim seeks a permanent injunction prohibiting sales of the Company's SimExpress products in the U.S., compensatory and punitive damages and attorneys' fees. Quickturn filed an administrative complaint with the U.S. International Trade Commission (ITC) in 1996 seeking to prohibit the distribution of SimExpress products in the U.S. In August 1996, the ITC issued a ruling effectively prohibiting the importation of this technology into the U.S. In August 1997, the ITC Administrative Law Judge recommended the imposition of evidentiary and monetary sanctions against the Company and Meta. This order has been appealed and no dollar amount of monetary sanctions has been set. In August 1997, the U.S. District Court in Portland, Oregon granted Quickturn a preliminary injunction prohibiting the Company from selling its SimExpress version 1.0 and 1.5 accelerated verification systems in the U.S. The injunction also prohibits the Company from shipping current U.S. inventory modified in the U.S. to any of its non-U.S. locations. In October 1997, Quickturn also filed an action against Meta and the Company in a German court alleging infringement by SimExpress of a European patent. 20 In December 1997, the ITC issued a Cease and Desist Order prohibiting the Company from importing SimExpress products or components and from providing repair or maintenance services to its existing U.S. customers. That order took effect in 1998. A trial in the U.S. District Court action is scheduled in June of 1999, in which Quickturn will seek a permanent injunction, compensatory damages, punitive damages, and attorneys' fees. An unfavorable ruling in this trial could involve substantial cost to the Company and effectively prevent the Company from manufacturing and selling its existing accelerated verification of hardware design products in the U.S. market. In February 1998, Meta filed a patent infringement action against Quickturn in the U.S. District Court for the Northern District of California in San Jose, California. The complaint, which is based on a patent licensed to the Company and Meta and which Meta has a right to enforce, seeks damages for infringement as a result of Quickturn's manufacture and sale of certain emulation equipment. Meta, which has been joined in the suit by Aptix Corporation of San Jose, California, will ultimately seek an injunction prohibiting further infringement by Quickturn. A trial date in the U.S. District Court has been set for the third quarter of 1999. In October 1998, Quickturn filed an action against Meta and the Company in France alleging infringement by SimExpress and Celaro of a European patent. On August 12, 1998 the Company commenced a $12.125 per share tender offer for all outstanding shares of Quickturn, or approximately $216,000,000 for approximately 17,800,000 Quickturn shares outstanding. The Company expected to finance this offer through its available cash balances and a new bank credit facility for which the Company had a definitive Credit Agreement. Quickturn's management and board of directors attempted to modify their bylaws to postpone a special shareholder meeting and attempted to install a deferred redemption provision in Quickturn's "poison pill" to preclude the closing of the Company's offer until at least July 1999. The Company litigated those actions in Delaware Chancery Court. The trial was completed on October 28, 1998 and a decision in favor of the Company was announced by the Delaware Chancery Court on December 3, 1998. On December 9, Quickturn and Cadence Design Systems, Inc. announced an agreement to merge. The Company sought to enjoin consummation of the proposed merger agreement and invalidate certain termination fees and stock option provisions of that agreement in a suit filed in the Delaware Court of Chancery on December 15, 1998. On January 8, 1999, the Company withdrew its tender offer. On July 2, 1998, the Company filed an action for declaratory judgment in the Federal District Court for the District of Oregon against Armagan Akar, a former employee of Mentor Graphics Singapore Ptd. Ltd. (MG Singapore), a wholly owned subsidiary of the Company. The declaratory judgment action requests the Oregon federal court to determine the obligations of the Company and MG Singapore to Mr. Akar in connection with a dispute regarding Mr. Akar's termination from MG Singapore. On or about July 27, 1998, Mr. Akar filed an action in the Superior Court of California for the County of Santa Clara alleging wrongful termination of employment. The complaint alleges that Mr. Akar's employment was terminated following his claimed notification to the Company and MG Singapore of violations of the U.S. Foreign Corrupt Practices Act occurring in the Company's operations located in the Peoples' Republic of China. Mr. Akar also alleges that one or more employees of MG Singapore made defamatory statements about him in connection with the termination of his employment. Mr. Akar seeks compensatory and exemplary damages. The Superior Court case was removed to the U.S. District Court for the Northern District of California and on November 2, 1998, that court granted the Company's motion to transfer the case to the U.S. District Court in Oregon. Mr. Akar has answered the Company's complaint in the declaratory judgment and has included his claims as counterclaims in that case. The Company intends to vigorously pursue its declaratory judgment action and to contest Mr. Akar's action and allegations, and does not believe that the outcome of the suit will have a material adverse effect on the Company's financial condition, results of operations or liquidity. 21 On or about August 6, 1998, three shareholders of Exemplar Logic, Inc. ("Exemplar"), a corporation owned more than 80% by the Company, filed an action in the Superior Court of California for the County of Alameda against the Company, Exemplar and certain employees of the Company who have served as directors of Exemplar. The complaint alleged that the Company breached a contract with Exemplar which provides that, under certain circumstances, the Company would take reasonable steps to support Exemplar in its efforts to complete an initial public offering of its equity, that the Company breached its alleged fiduciary duty as a majority shareholder of Exemplar, that the Company made false and misleading representations and concealments that defrauded Exemplar and that the Company conducted unfair business practices against Exemplar under California law. The Company, Exemplar and the plaintiffs subsequently entered into a Stand Still Agreement in which the plaintiffs agreed to dismiss their complaint without prejudice and the Company agreed to make reasonable efforts to come to a decision to i) take Exemplar public, ii) sell Exemplar to a third party or iii) acquire the Exemplar minority shareholders' interests prior to October 31, 1998. The plaintiffs dismissed the complaint and the Company and the Exemplar minority shareholders entered into a merger agreement under which the Company acquired the minority shareholders' interest on January 5, 1999. In addition to the above litigation, from time to time the Company is involved in various disputes and litigation matters that arise from the ordinary course of business. These include disputes and lawsuits relating to intellectual property rights, licensing, contracts, and employee relations matters. The Company believes that final resolution of such disputes and lawsuits will not have a material adverse effect on the Company's financial position or results of operations. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of the security holders of the Company during the fourth quarter of the fiscal year ended December 31, 1998. EXECUTIVE OFFICERS OF REGISTRANT The following are the executive officers of the Company: Has Served As An Executive Officer of the Name Position Age Company Since - ------------------------------------------------------------------------------ Walden C. Rhines President, Chief Executive 52 1993 Officer and Director Gregory K. Hinckley Executive Vice President, 52 1997 Chief Operating Officer and Chief Financial Officer G. M. "Ken" Bado Senior Vice President, 44 1996 World Trade Dean Freed Vice President, 40 1995 General Counsel and Secretary Anne Wagner Vice President, Marketing 46 1998 Anthony B. Adrian Vice President, 56 1998 Corporate Controller Dennis Weldon Treasurer 51 1998 - ------------------------------------------------------------------------------ The executive officers are elected by the Board of Directors of the Company at its annual meeting. Officers hold their positions until they resign, are terminated or their successors are elected. There are no arrangements or understandings between the officers or any other person pursuant to which officers were elected and none of the officers are related. Dr. Rhines has served as Director, President and Chief Executive Officer of the Company since October 1993. From 1972 to 1993, Dr. Rhines was employed by Texas Instruments Incorporated, a manufacturer of electrical and electronics products, where he held a variety of technical and management positions and was most recently Executive Vice President of Texas Instruments Semiconductor Group. Dr. Rhines is currently a director of Cirrus Logic, Inc., and Triquint Semiconductor, Inc., both semiconductor manufacturers. Mr. Hinckley has served as Executive Vice President, Chief Operating Officer and Chief Financial Officer since joining the Company in January 1997. From November 1995 until December 1996 he held the position of Senior Vice President with VLSI Technology, Inc. (VLSI), a manufacturer of complex ASICs. From August 1992 until December 1996, Mr. Hinckley 22 held the position of Vice President, Finance and Chief Financial Officer with VLSI. Mr. Hinckley is a director of OEC Medical Systems, Inc., a manufacturer of medical imaging equipment, and Amkor Technology, Inc., an IC packaging, assembly and test services company. Mr. Bado has served as Senior Vice President, World Trade since December 1996. From April 1994 to December 1996 he held the position of Vice President of the Americas. From February 1996 through December 1996 Mr. Bado also held the position of Vice President and General Manager, Professional Services. Mr. Bado was the Southern Area General Manager for North American Sales from January 1991 to April 1994. He has been employed by the Company since September 1988. Mr. Freed has served as Vice President, General Counsel and Secretary of the Company since July 1995. Mr. Freed served as Deputy General Counsel and Assistant Secretary of the Company from April 1994 to July 1995, and was Associate General Counsel and Assistant Secretary from 1990 to April 1994. He has been employed by the Company since January 1989. Ms. Wagner has served as Vice President, Marketing of Mentor Graphics since June 1998. From 1996 to 1998, Ms. Wagner was Vice President of Corporate Marketing for the SunSoft operating company of Sun Microsystems, Inc. From 1977 to 1996, Ms. Wagner was employed by National Semiconductor Corporation where her duties included Vice President, Marketing and Communications. Mr. Adrian has served as Vice President, Corporate Controller since joining the Company in January 1998. From August to December of 1997 he held the position of Vice President and Acting Controller for Wickland Oil Company, a petroleum marketing and distribution company. From January 1996 to August 1997 Mr. Adrian served as Managing Director of Wickland Terminals in Australia. From November 1992 to January 1996 Mr. Adrian served as Vice President and Controller of Wickland Oil. Mr. Weldon has served as Treasurer and Director of Business Development since February 1996. Mr. Weldon served as Director of Business Development from June 1994 to January 1996. From July 1991 to June 1994 Mr. Weldon served as Director of Finance. Mr. Weldon has been employed by the Company since July 1988. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The Company's Common Stock trades on the Nasdaq National Market under the symbol MENT. The following sets forth for the periods indicated the high and low sales prices for the Company's Common Stock, as reported by the Nasdaq National Market: Quarter ended March 31 June 30 September 30 December 31 - ---------------------------------------------------------------------------- 1998 High $ 11 1/8 $ 11 13/16 $ 11 1/16 $ 10 5/16 Low $ 8 1/8 $ 9 3/8 $ 6 19/32 $ 5 7/16 1997 High $ 11 $ 9 3/8 $ 12 1/2 $ 12 1/16 Low $ 8 5/8 $ 6 5/8 $ 8 1/2 $ 9 - ---------------------------------------------------------------------------- As of December 31, 1998, the Company had 1,073 stockholders of record. No dividends were paid in 1997 or 1998. The Company does not intend to pay dividends in the foreseeable future. Item 6. Selected Consolidated Financial Data In thousands, except per share data and percentages Year ended December 31, 1998 1997 1996 1995 1994 - --------------------------------------------------------------------------------------------- Statement of Operations Data Total revenues $ 490,393 $ 454,727 $ 447,886 $ 432,517 $ 390,119 Research and development $ 117,853 $ 112,227 $ 92,905 $ 86,782 $ 81,231 Operating income (loss) $ 4,742 $ (36,370) $ (9,849) $ 52,554 $ 30,980 Net income (loss) $ (519) $ (31,307) $ (4,978) $ 50,506 $ 30,453 Gross margin percent 75% 65% 70% 73% 73% Operating income (loss) as a percent of revenues 1% (8)% (2)% 12% 8% Per Share Data Net income (loss) per share - basic $ (0.01) $ (0.48) $ (0.08) $ 0.79 $ 0.50 Net income (loss) per share - diluted $ (0.01) $ (0.48) $ (0.08) $ 0.78 $ 0.49 Weighted average number of shares outstanding - basic 65,165 64,885 64,134 63,710 60,361 Weighted average number of shares outstanding - diluted 65,165 64,885 64,134 65,134 62,211 Balance Sheet Data Cash and investments, short-term $ 137,585 $ 137,060 $ 197,079 $ 211,996 $ 154,255 Cash and investments, long-term $ - $ - $ 30,000 $ 30,000 $ 30,000 Working capital $ 139,198 $ 148,191 $ 200,848 $ 213,491 $ 150,865 Property, plant and equipment, net $ 95,214 $ 103,452 $ 102,253 $ 99,605 $ 102,291 Total assets $ 464,123 $ 402,302 $ 513,359 $ 495,372 $ 429,290 Short-term borrowings $ 24,000 - $ 9,055 $ 9,358 $ 8,661 Long-term debt and other deferrals $ 1,425 $ 617 $ 56,375 $ 55,054 $ 53,123 Stockholders' equity $ 295,282 $ 277,537 $ 319,640 $ 326,226 $ 258,419 - --------------------------------------------------------------------------------------------- 23 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations All numerical references in thousands, except percentages and per share data NATURE OF OPERATIONS Mentor Graphics Corporation (the Company) is a supplier of electronic design automation (EDA) systems--advanced computer software, accelerated verification systems and intellectual property designs and data bases used to automate the design, analysis and testing of electronic hardware and embedded systems software in electronic systems and components. The Company markets its products and services primarily to customers in the communications, computer, semiconductor, consumer electronics, aerospace, and transportation industries. The Company sells and licenses its products through its direct sales force in North and South America (Americas), Europe, Japan and Pacific Rim, and through distributors where a direct sales presence is not warranted. In addition to its corporate offices in Wilsonville, Oregon, the Company has sales, support, software development and professional services offices worldwide. RECENT DEVELOPMENTS On August 12, 1998, the Company commenced a $12.125 per share tender offer for all outstanding shares of Quickturn Design Systems, Inc., a Delaware corporation (Quickturn), or approximately $216,000 for approximately 17,800 shares outstanding. In connection with this offer, the Company purchased 591 shares of Quickturn common stock for $4,522. The Company expected to finance this offer through its available cash balances and a new bank credit facility for which the Company had a definitive Credit Agreement. On January 8, 1999, the Company withdrew its tender offer and subsequently terminated its new credit facility. The Company incurred acquisition costs of approximately $9,000 of which $4,614 was capitalized and the remaining amount was not accrued as of December 31, 1998. Because the offer was withdrawn, these costs will be expensed and will be partially offset by a gain on the sale of the Quickturn stock of approximately $4,000 in the first quarter of 1999. On January 5, 1999, the Company purchased the remaining minority interest of its then 84% owned subsidiary, Exemplar Logic, Inc. (Exemplar) for cash and stock options valued at approximately $14,000. This business combination will be accounted for as a purchase. The cost of the acquisition will be allocated on the basis of estimated fair value of assets and liabilities assumed. In connection with the acquisition, the Company will record a charge to operations for the write-off of Exemplar's in-process research and development (R&D) that had not reached technological feasibility, the amount of which is yet to be determined. In 1998, the Company completed three business combinations which were accounted for as purchases. In March 1998, the Company purchased an additional ownership interest of 32% of its Korean distributor, Mentor Korea Co. LTD, for a total ownership interest of 51%. In November 1998, the Company purchased CLK Computer-Aided Design Inc. (CLK CAD) and OPC Technology Inc. (OPCT). The total purchase price including acquisition expenses for these acquisitions was $16,513. The purchase accounting allocations resulted in charges for in-process R&D of $8,500, goodwill capitalization of $6,613, and technology capitalization of $1,400. Results of operations of all acquisitions that were accounted for as purchases are included in the Company's Consolidated Financial Statements only from the date of acquisition forward. RESULTS OF OPERATIONS Revenues and Gross Margins Year ended December 31, 1998 Change 1997 Change 1996 - -------------------------------------------------------------------------------------------------- System and software revenues $ 277,396 18% $ 235,808 (3)% $ 242,147 System and software gross margins $ 250,860 38% $ 182,316 (10)% $ 202,951 Gross margin percent 90.4% 77.3% 83.8% Service and support revenues $ 212,997 (3)% $ 218,919 6% $ 205,739 Service and support gross margins $ 116,036 2% $ 113,378 2% $ 111,119 Gross margin percent 54.5% 51.8% 54.0% Total revenues $ 490,393 8% $ 454,727 2% $ 447,886 Total gross margins $ 366,896 24% $ 295,694 (6)% $ 314,070 Gross margin percent 74.8% 65.0% 70.1% - -------------------------------------------------------------------------------------------------- 24 SYSTEM AND SOFTWARE System and software revenues are derived from sales or licenses of software products, third party owned software products for which the Company pays royalties, accelerated verification systems and some workstation hardware. For 1998, the increase in software product revenues is attributable to growth of the Company's newer product offerings. The Company's newer products primarily focus on system verification and design re-use subsets of the EDA industry, which have experienced above industry average growth rates over the last year. In addition, improved demand for several of the Company's older product offerings is primarily attributable to recent product upgrades such as Year 2000 compliance and ports to the Windows NT platform. Accelerated verification revenue also improved in 1998 as next generation systems began shipping in the first half of the year. The Company's SimExpress accelerated verification product is not available in U.S. markets due to a 1997 court ruling. See "Part I-Item 3. Legal Proceedings" for further discussion. These increases occurred despite the weakening of the Japanese Yen versus the U.S. dollar which negatively impacted revenues. See "Geographic Revenues Information" for further discussion. For 1997 compared to 1996, the decrease in system and software revenue was attributable to a decline in software product sales partially offset by increased sales of accelerated verification systems. Software product revenues declined in 1997 due in part to an accelerated decline of the Company's older integrated circuit (IC) and also certain printed circuit board products. Gross margins were significantly higher for 1998 compared to 1997 due to lower costs for direct materials and overhead, lower third party product sales for which royalties were paid, lower purchased technology and capitalized software development costs amortization, and a write-down of certain previously capitalized software development costs in 1997. For 1997 compared to 1996, the decline in system and software gross margins as a percent of revenues was due to higher royalty costs, one-time inventory and capitalized software development cost adjustments and higher purchased technology amortization. Increased royalty costs in 1997 were primarily attributable to a write-off of costs associated with a non-refundable royalty contract where the committed costs were not recovered. In addition, the Company incurred an inventory write-down of all U.S. SimExpress systems inventory in 1997 as a result of the 1997 court ruling. See "Part I-Item 3. Legal Proceedings" for further discussion. Amortization of previously capitalized software development costs to system and software cost of revenues was zero in 1998 compared to $5,448 and $6,215 in 1997 and 1996, respectively. In addition, the Company recognized impairment in value of certain previously capitalized software development costs in 1997 primarily as a result of the accelerated decline in sales of older software product offerings. These costs, which totaled $5,358, were determined to be unrecoverable and were charged to system and software cost of revenues in the first quarter of 1997. Amortization of purchased technology costs to system and software cost of revenues was $2,278, $5,484 and $3,559 for 1998, 1997 and 1996, respectively. The decline in amortization in 1998 is attributable to a significant decline in business acquisitions in 1998 and 1997 and accelerated amortization of technologies in 1997 where assets were impaired or disposed of. Purchased technology costs are amortized over a three-year period to system and software cost of revenues. SERVICE AND SUPPORT Service and support revenues consist of revenues from annual software support contracts and professional services, which includes consulting services, training services, custom design services and other services. The decrease in service and support revenues in 1998 is due primarily to an approximate 20% decrease in professional service revenues offset by a slight increase in support revenues. The increase in service and support revenues in 1997 was due primarily to an approximate 20% increase in professional service revenues as well as a slight increase in software support revenues. For 1998, growth levels for software support revenues compared to software product revenues were lower due in part to the carryover effect of the prior year decline in software product revenues. For 1997, growth in software support revenues occurred despite a decline in software product revenues as the installed base of customers on support contracts increased during the year. Since growth in software support is dependent on continued success of the software product offerings, increases in the Company's installed customer base, and the impact of acquisitions, future software support revenue levels are difficult to predict. 25 Professional service revenues totaled approximately $49,000, $60,000 and $50,000 in 1998, 1997 and 1996, respectively. The decrease in 1998 is due to a more narrowly focused effort toward engagements that enable customers to better utilize the Company's products and away from out-source custom design service engagements. Consulting engagements with printed circuit board design customers also declined in 1998 due in part to lower printed circuit board software product sales in 1998. The increase in professional services in 1997 was attributable to consulting services and custom design services as demand for these services grew. Service and support gross margins increased in 1998 as a result of higher software support revenues and approximately flat software support cost of revenues. Professional service gross margins were negative in 1998 as several prior period contracts continued to require resources. In 1997, professional service gross margins were negative due to unprofitable contracts, most of which were entered into in 1996, where costs of completion exceeded the revenues. The Company has refined its contract approval practices to reduce the likelihood of entering into unprofitable custom design contracts. GEOGRAPHIC REVENUES INFORMATION Americas revenues including service and support revenues, increased by 8% from 1997 to 1998 and by 2% from 1996 to 1997. Revenues outside of the Americas represented 45% of total revenues in 1998, 1997 and 1996. European revenues increased by approximately 23% from 1997 to 1998 and 4% from 1996 to 1997. Increased European revenues are attributable to improved economic conditions primarily in the telecommunications industry and increased demand for newer product offerings in 1998. The effects of exchange rate differences from European currencies to the U.S. dollar for 1998 and 1997 were not significant. Japanese revenues decreased by approximately 17% from 1997 to 1998 and 7% from 1996 to 1997. The effects of exchange rate differences from the Japanese Yen to the U.S. dollar negatively impacted revenues by approximately 10% and 11% in 1998 and 1997, respectively. Exclusive of currency effects, lower revenue levels in Japan are the result of continued economic difficulties in 1998. Since the Company generates approximately half of its revenues outside of the U.S. and expects this to continue in the future, revenue results should continue to be impacted by the effects of future foreign currency fluctuations. OPERATING EXPENSES Year ended December 31, 1998 Change 1997 Change 1996 - ---------------------------------------------------------------------------------------------------- Research and development $ 117,853 5% $ 112,227 21% $ 92,905 Percent of total revenues 24.0% 24.7% 20.7% Marketing and selling $ 169,034 7% $ 157,343 7% $ 146,754 Percent of total revenues 34.5% 34.6% 32.8% General and administration $ 45,825 5% $ 43,636 7% $ 40,918 Percent of total revenues 9.3% 9.6% 9.1% Special charges $ 20,942 11% $ 18,858 57% $ 11,998 Percent of total revenues 4.3% 4.1% 2.7% Merger and acquisition related charges $ 8,500 - $ - (100)% $ 31,334 Percent of total revenues 1.7% - 7.0% - ---------------------------------------------------------------------------------------------------- RESEARCH AND DEVELOPMENT As a percent of revenue, R&D costs decreased slightly from 1997 to 1998 and increased from 1996 to 1997. During 1998, the Company disposed of several businesses which were not core to its strategy of system verification and design re-use which reduced R&D costs by approximately $6,000 compared to 1997. Increased spending for activities more closely aligned to Company strategy offset these savings. The increase in R&D spending in 1997 was also attributable to investment in core strategy areas and merger and acquisition activity. R&D costs increased in 1997 by approximately $8,000 as a result of prior year business purchases. These purchases during 1996 resulted in added expenses only from the date of acquisition and not for all prior periods presented as is the case for pooling of interest transactions. In addition, other business combinations accounted for as pooling of interests experienced higher R&D investment in 1997. During 1997 and 1998, the Company capitalized software development costs of $0, compared to $5,691 for 1996. This decrease in capitalization is due to timing and content of product development activities which resulted in a lower level of costs eligible for capitalization. Based on these lower eligible costs, product development activities have been expensed on a current basis. The Company does not expect significant capitalization in 1999. 26 MARKETING AND SELLING In 1998 the increase in marketing and selling costs was principally attributable to increased product sales through the Company's direct sales force and third party distributors offset in part by savings resulting from subsidiary divestitures totaling approximately $3,000. In 1997, the increase in marketing and selling costs was principally attributable to prior year business purchases and increased sales through third party distributors. The year to year impact of acquisitions on marketing and selling costs in 1997 was approximately $2,000. In addition, selling costs increased approximately $3,000 in 1997 as a result of increased third party sales channel revenue. A stronger U.S. dollar during 1998 and 1997 reduced expenses by approximately 10% and 11% in Japan, respectively. GENERAL AND ADMINISTRATION For 1998 compared to 1997 general and administrative (G&A) costs decreased as a percent of sales due to subsidiary divestitures and higher sales volume. For 1998, the absolute dollar increase in G&A is attributable to increased headcount to maintain and support business systems and support higher sales volume. The increase in general and administrative costs from 1996 to 1997 was a result of integration costs and additional headcount related to business purchases offset by certain administrative savings subsequent to integration of Microtec Research, Inc. (Microtec) and Interconnectix, Inc. (Interconnectix). Also in 1997, the Company experienced increased costs of information technology personnel as the global information system reached the implementation phase during the year. SPECIAL CHARGES During 1998, the Company recorded special charges of $20,942. The charges primarily consist of four subsidiary divestitures, moving of the European distribution center to Ireland to strengthen the Company's tax position, related terminations arising from the divestitures and the distribution center move, and impairment in value of certain assets. Substantially all of these costs were expended in 1998 and the remaining amount should be expended in the first half of 1999 and there have been no significant modifications to the amount of the charges. During 1997, the Company recorded special charges of $18,858. The charges consisted of disposals of subsidiaries and related employee terminations, early termination of an interest rate swap agreement, recognition of the impairment in value of certain goodwill and purchased technology and some streamlining of worldwide operations and reserves for various legal claims. Substantially all of the costs associated with these charges were expended in 1997 and the first half of 1998 and there have been no significant modifications to the amount of the charges. In 1996, the Company recorded special charges of $11,998. The Company downsized and redirected certain operations and re-targeted an incentive compensation program resulting in severance costs, facility lease and equipment abandonment costs and other costs totaling approximately $7,000. The Company also recognized a $5,000 write-down for impairment in value of goodwill and certain other assets associated with Meta Systems SRL (Meta) as the recoverability of these assets was adversely affected by the ongoing SimExpress patent litigation. MERGER AND ACQUISITION RELATED CHARGES In 1998, the Company incurred merger and acquisition related charges of $8,500 for in-process R&D related to two of the three business combinations accounted for as purchases. The charges were a result of allocating a portion of the acquisition costs to in-process product development that had not reached technological feasibility. In 1996, the Company incurred merger and acquisition related charges of $31,344 as a result of nine business combinations. Seven acquisitions were accounted for as purchases that resulted in charges for in-process R&D of $26,234. Two acquisitions were accounted for as pooling of interests and resulted in merger expenses of $4,410 and $700, respectively, which were associated with the elimination of duplicate facilities, severance costs, the write-off of certain property and equipment and legal and accounting fees associated with the merger activities. 27 OTHER INCOME (EXPENSE), NET Year ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Other income (expense), net $ (4,721) $ 3,319 $ 8,411 - -------------------------------------------------------------------------------- Other income (expense) was negatively impacted by increased legal costs primarily associated with the ongoing patent litigation with Quickturn which totaled $10,301 in 1998, compared to $4,675 and $3,611 in 1997 and 1996, respectively. The increase is attributable to license fees for certain intellectual property rights licensed from Aptix Corporation and expenses attributable to a patent infringement lawsuit filed jointly by a subsidiary of the Company and Aptix against Quickturn. See "Part I-Item 3. Legal Proceedings" for further discussion. Interest income was $7,771, $7,723 and $9,485 in 1998, 1997 and 1996, respectively. Interest expense was $768, $555 and $2,423 in 1998, 1997 and 1996, respectively. The decrease in interest income and interest expense in 1998 and 1997 versus 1996 is primarily attributable to lower average cash, cash equivalents, short-term investments and borrowings outstanding during 1998 and 1997 due to pay-down of short term lines of credit and the long term revolving credit facility. For 1999, exclusive of any changes in cash balances or interest rates, the increase in interest bearing term receivables should favorably affect interest income. In 1996, the Company sold common stock of two independent public companies for $6,744 that had carrying costs of $1,199, resulting in a gain of $5,545. PROVISION (BENEFIT) FOR INCOME TAXES The provision (benefit) for income taxes was $540, ($1,744), and $3,540 in 1998, 1997 and 1996, respectively. The tax provision (benefit) in all periods is the result of the mix of profits earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates. Because the Company's income tax position for each year combines the effects of available tax benefits in certain countries where the Company does business, benefits from available net operating loss carryforwards and tax expense for subsidiaries with pre-tax income, the Company's income tax position and resultant effective tax rate is uncertain for 1999 and beyond. EFFECTS OF FOREIGN CURRENCY FLUCTUATIONS Approximately half of the Company's revenues are generated outside of the United States. For 1998, 1997 and 1996, approximately half of European and all of Japanese revenues were subject to exchange rate fluctuations as they were booked in local currencies. The effects of these fluctuations were substantially offset by local currency cost of revenues and operating expenses, which resulted in an immaterial net effect on the Company's results of operations. The "accumulated other comprehensive income--foreign currency translation adjustment," as reported in the stockholders' equity section of the Consolidated Balance Sheets, increased to $14,176 at December 31, 1998, from $7,795 at the end of 1997. This reflects the increase in the value of net assets denominated in foreign currencies since year-end 1997 as a result of a stronger U.S. dollar at the close of 1997 versus 1998. NEW ACCOUNTING PRONOUNCEMENTS In March 1998, the American Institute of Certified Public Accountants issued Statement of Position (SOP) No. 98-1, "Software for Internal Use", which provides guidance on accounting for the cost of computer software developed or obtained for internal use. This statement of position is effective for financial statements for fiscal years beginning after December 15, 1998. The Company does not expect SOP 98-1 to have a material impact on its Consolidated Financial Statements. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 also requires that changes in the derivative's fair value be recognized currently in results of operations unless specific hedge accounting criteria are met. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. The Company does not expect SFAS No. 133 to have a material impact on its Consolidated Financial Statements. 28 In October 1998, the AICPA issued SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions". This SOP amends certain paragraphs of SOP 97-2 to require recognition of revenue using the "residual method" in circumstances outlined in the SOP. Under the residual method revenue is recognized as follows: (1) the total fair value of undelivered elements, as indicated by vendor specific objective evidence, is deferred and subsequently recognized in accordance with the relevant sections of SOP 97-2 and (2) the difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. SOP 98-9 is effective for fiscal years beginning after March 15, 1999. Also, the provisions of SOP 97-2 that were deferred by SOP 98-4 will continue to be deferred until the date SOP 98-9 becomes effective. The Company does not expect SOP 98-9 to have a material impact on its Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES Year Ended December 31, 1998 1997 - ----------------------------------------------------------------------------- Current assets $ 305,444 $ 272,339 Cash and investments, short-term $ 137,585 $ 137,060 Cash provided by operations $ 2,766 $ 13,854 Cash used for investing activities, excluding short-term investments $ (40,651) $ (35,606) Cash provided (used) by financing activities $ 35,261 $ (37,596) - ------------------------------------------------------------------------------ CASH AND INVESTMENTS Cash and short-term investments increased $525 during 1998. Cash provided by operations was $2,766, a decrease of $11,088 from 1997. A net loss of $519 and an increase in term receivables, long term of $32,965 negatively impacted cash provided by operations in 1998, offset by non-cash asset write-downs and business disposals totaling $20,828. In 1997, cash was negatively impacted by a net loss of $31,307 offset by non-cash asset write-downs and business disposals totaling $17,817. Cash used for investing activities was negatively impacted by the capital expenditures of $21,627 and $32,614 in 1998 and 1997, respectively. In 1998, purchase of equity interests totaled $19,024, compared to zero in 1997. In 1998, cash provided by financing activities was favorably impacted by short-term borrowings of $24,000 to meet short-term cash demands of foreign subsidiaries. In 1997, cash used by financing activities was negatively impacted by the pay-down of short term lines of credit and the long term revolving credit facility totaling $61,103 offset by the release of $30,000 in cash held as collateral previously classified as long term on the Consolidated Balance Sheets. Cash and short-term investments were positively impacted by the proceeds from issuance of common stock upon exercise of stock options and employee stock plan purchases in the amount of $11,381 and $9,447 in 1998 and 1997, respectively. In 1997, this increase was offset by repurchases of common stock of $15,940, compared to zero in 1998. TRADE ACCOUNTS RECEIVABLE The trade accounts receivable balance increased $19,834 from December 31, 1997 compared to December 31, 1998. Average days sales outstanding in accounts receivable increased slightly from 76 days at the end of 1997 to 78 days at the end of 1998. PREPAID EXPENSES AND OTHER Prepaid expenses and other increased $10,597 from December 31, 1997 to December 31, 1998. This increase is primarily due to capitalized acquisition costs related to the unsolicited tender offer for Quickturn of $4,614, which will be expensed in 1999 due to the Company's withdrawal of the offer. In addition, the accelerated verification systems inventory balance increased by $5,655. 29 TERM RECEIVABLES, LONG-TERM Term receivables, long-term increased to $36,430 at December 31, 1998 from $3,465 at December 31, 1997. The increase is primarily due to an increase in demand for multi-year, multi-element term license and perpetual license installment sales (term) agreements from the Company's top-rated credit customers. Balances under term agreements that are due within one year are included in trade accounts receivable and balances that are due in more than one year are included in term receivables, long-term. The Company uses term agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. CAPITAL RESOURCES Expenditures for property and equipment decreased to $21,627 for 1998 compared to $32,614 for 1997. The decrease in capital expenditures is a result of fewer individually significant projects in 1998 as compared to 1997. In 1998, the Company completed three business acquisitions and purchased Quickturn stock, which resulted in cash payments of $19,024. The Company anticipates that current cash balances, anticipated cash flows from operating activities, and existing credit facilities will be sufficient to meet its working capital needs for at least the next twelve months. FACTORS THAT MAY AFFECT FUTURE RESULTS AND FINANCIAL CONDITION The statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words "believes," "expects," and words of similar import, constitute forward-looking statements that involve a number of risks and uncertainties. Moreover, from time to time the Company may issue other forward-looking statements. The following discussion highlights factors that could cause actual results to differ materially from the forward-looking statements. The forward-looking statements should be considered in light of these factors. The Company competes in the highly competitive and dynamic EDA industry. The Company's success is dependent upon its ability to develop and market products that are innovative, cost-competitive and meet customer expectations. Competition in the EDA industry is intense, which can create adverse effects including, but not limited to, price reductions, lower product margins, loss of market share and additional working capital requirements. The Company's business is largely dependent upon the success and growth of the electronics industry. The outlook for the electronics industry for 1999 is uncertain due in part to adverse economic conditions in Asia and to potential slowing of growth in other regions. As a result, many companies in the electronics industry have announced employee layoffs and will likely curtail the number of electronic design projects and the level of demand for design automation capital which could result in decreased spending for the Company's products and services. In addition, there have been a number of mergers in the electronics industry, which could result in decreased or delayed capital spending patterns. The above business challenges for the electronics and related industries may have a material adverse effect on the Company's financial condition and results of operations. A material amount of the Company's software product revenue is usually the result of current quarter order performance of which the majority is usually booked in the last month of each quarter. In addition, the Company's revenue often includes multi-million dollar contracts. The timing of the completion of these contracts and the terms of delivery of software, hardware and other services can have a material impact on revenue recognition for a given quarter. The combination of these factors impairs and delays the Company's ability to identify shortfalls or overages from quarterly revenue targets. The Company uses term or installment sales agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. These multi-year, multi-element term license and perpetual license term agreements are from the Company's top-rated credit customers and average between one and three years in length. These agreements may increase the element of risk associated with collectibility from customers that can arise for a variety of reasons including ability to pay, product satisfaction or disagreements 30 and disputes. If collectibility for any of these multi-million dollar agreements becomes a problem the Company's results of operations could be adversely affected. The Company generally realizes approximately half of its revenues outside the U.S. and expects this to continue in the future. As such, the effects of foreign currency fluctuations can impact the Company's business and operating results. To hedge the impact of foreign currency fluctuations, the Company enters into foreign currency forward contracts. However, significant changes in exchange rates may have a material adverse impact on the Company's results of operations. International operations subject the Company to other risks including, but not limited to, changes in regional or worldwide economic or political conditions, government trade restrictions, limitations on repatriation of earnings, licensing and intellectual property rights protection. A significant percent of the Company's sales to European customers is U.S. dollar based. However, the Company is affected by the emergence of the new European Monetary Unit and is currently implementing and testing system changes to support transactions in this currency. Provided the Company's European Monetary Unit project is completed on a timely basis, the expense of the project, and its related effect on the Company's earnings, is not expected to be material. The Company is currently re-aligning its professional services business in an attempt to improve profitability by moving toward engagements that enable customers to better utilize the Company's products and away from out-source custom design service engagements. Business reorganizations can increase personnel management complexities including retention and hiring of key technical and management personnel. While the Company will attempt to improve the execution and pricing of its services, there can be no assurance that the challenges will be effectively met. The Company's operating expenses are generally committed in advance of revenue and are based to a large degree on future revenue expectations. Operating expenses are incurred in order to generate and sustain higher future revenue levels. If the revenue does not materialize as expected, the Company's results of operations can be adversely impacted. Acquisitions of complementary businesses are a part of the Company's overall business strategy. There are several risks associated with this strategy including integration of sales channels, training and education of the sales force for new product offerings, integration of product development efforts, retention of key employees, integration of systems of internal controls, and integration of information systems. All of these factors can impair the Company's ability to forecast, to meet quarterly revenue and earnings targets, to meet various debt obligations used to finance acquisitions and to effectively manage the business for long-term growth. There can be no assurance that these challenges will be effectively met. As a result of the acquisition of Meta Systems and its accelerated verification products, the Company has entered the hardware development and assembly business. Some risk factors include: procuring hardware components on a timely basis, assembling and shipping systems on a timely basis with appropriate quality control, developing new distribution and shipment processes, managing inventory, developing new processes to deliver customer support of the hardware and placing new demands on the sales force. In addition, the Company is engaged in litigation with Quickturn in which Quickturn has asserted that the Company and Meta are infringing Quickturn's patents. A trial is scheduled in June 1999 and no assurance can be given as to the outcome of such trial. This litigation may negatively affect demand for accelerated verification products for all vendors worldwide until the outcome is determined. This could result in lower sales of the Company's accelerated verification products and increase its risk of inventory obsolescence and could have a materially adverse effect on the Company's results of operations. The Company has been able to recruit and retain necessary personnel to research and develop, market, sell and service products that satisfy customers' needs. There can be no assurance that the Company can continue to recruit and retain such personnel. Generally accepted accounting principles require management to make estimates and assumptions that affect the reported amounts of assets, liabilities and contingencies at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates. 31 The Company is involved in various administrative matters and litigation. There can be no assurance that various litigation and administrative matters will not have a material adverse impact on the Company's consolidated financial position or results of operations. See "Part I-Item 3. Legal Proceedings" for further discussion. Due to the factors above, as well as other market factors outside the Company's control, the Company's future earnings and stock price may be subject to significant volatility. Past financial performance should not be considered a reliable indication of future performance. The investment community should use caution in using historical trends to estimate future results or trends. In addition, if future results vary significantly from expectations of analysts, the Company's stock price could be adversely impacted. YEAR 2000 The Company is aware of the potential inability of computer programs to adequately process date information after December 31, 1999 (Year 2000). The Company has conducted a review of its products, information technology and facilities computer systems to identify all software that could be affected by the Year 2000 issue and has developed or is developing implementation plans to address this issue. The Company has announced that its current release of software products is Year 2000 compliant. The effect of the Year 2000 issue with regard to the Company's product offerings is not expected to have any material adverse effect on its financial condition and results of operations. In addition to computers and related systems, the operations of the Company's office and facilities equipment, such as fax machines, photocopiers, telephone switched security systems, elevators and other common devices may be affected by the Year 2000 problem. The Company is currently assessing the potential effect of, and costs of remediating the Year 2000 problem on this equipment. The Company estimates that its total cost of completing any required modifications, upgrades or replacements of these internal systems should total approximately $2,000 in 1999. Identifiable expenditures through 1998 have totaled approximately $2,200. In addition, the Company has developed and is implementing a program to review the Year 2000 compliance status of computer software programs licensed from third parties and used in its internal business processes to obtain appropriate assurances of Year 2000 compliance from manufacturers of these products. The Company believes that it will be able to complete its Year 2000 compliance review and make any necessary modifications prior to the end of 1999. Provided the Company's Year 2000 projects are completed on a timely basis, the expense of these projects, and its related effect on the Company's financial condition and results of operations, is not expected to be material. However, the compliance of systems acquired from third parties is dependent on factors outside the Company's control. If key systems, or a significant number of systems fail as a result of Year 2000 problems, the Company could incur substantial expense and experience a disruption of business operations, which would potentially have a material adverse effect on the Company's financial condition and results of operations. Furthermore, the Company is making an assessment as to whether any of its customers, suppliers or service providers will be affected by the Year 2000 issue. Failure of the Company's customers, suppliers or service providers to comply with Year 2000 could have a material adverse impact on the Company's financial condition and results of operations. The purchasing patterns of customers and potential customers may be affected by Year 2000 issues as companies may be required to devote significant resources to correct or patch their current software systems for Year 2000 compliance. These expenditures may result in reduced funds available to purchase the Company's software products that could have a materially adverse effect on the Company's financial condition and results of operations. There can be no assurance that Year 2000 related operating problems or material expenses will not occur with the Company's computer systems or in connection with the interface to the Company's major vendors or suppliers. The Company is currently developing contingency plans to be implemented as part of its efforts to identify and correct Year 2000 problems affecting its internal systems. The Company expects to complete its contingency plans by the end of the second quarter of 1999. Depending on the systems affected, these plans could include, (a) accelerated replacement of affected equipment and software; (b) short to medium term use of back up equipment and software; (c) increased work hours for the Company personnel or use of contract personnel to provide manual workarounds for information systems; and (d) other similar approaches. 32 Item 7A. Quantitative and Qualitative Disclosures About Market Risk All numerical references in thousands, except rate data INTEREST RATE RISK The Company's exposure to market risk for changes in interest rates relates primarily to its investment portfolio. The Company does not use derivative financial instruments for speculative or trading purposes. The Company places its investments in instruments that meet high credit quality standards, as specified in the Company's investment policy. The policy also limits the amount of credit exposure to any one issuer and type of instrument. The Company does not expect any material loss with respect to its investment portfolio. The table below presents the carrying value and related weighted-average interest rates for the Company's investment portfolio. The carrying value approximates fair value at December 31, 1998. In accordance with the Company's investment policy all investments mature in twelve months or less. A nominal amount of non-interest bearing instruments has been included in the table below: Carrying Average Principal (notional) amounts in U.S. dollars: Amount Interest Rate - ---------------------------------------------------------------------------- Cash equivalents - fixed rate $ 118,512 4.46% Short-term investments - fixed rate 19,073 5.70% --------- ----- Total interest bearing instruments $ 137,585 4.63% ========= ===== - ---------------------------------------------------------------------------- FOREIGN CURRENCY RISK The Company enters into forward foreign exchange contracts as a hedge against foreign currency sales commitments and intercompany balances. To hedge its foreign currency against highly anticipated sales transactions, the Company also purchases foreign exchange options which permit but do not require foreign currency exchanges at a future date with another party at a contracted exchange price. Remeasurement gains and losses on forward and option contracts are deferred and recognized when the sale occurs. All subsequent remeasurement gains and losses are recognized as they occur to offset remeasurement gains and losses recognized on the related foreign currency accounts receivable balances. These contracts generally have maturities which do not exceed twelve months. At December 31, 1998 and 1997, the difference between the recorded value and the fair value of the Company's foreign exchange position related to these contracts was approximately zero. The fair value of these contracts was calculated based on dealer quotes. The Company does not anticipate non-performance by the counter-parties to these contracts. Looking forward, the Company does not expect any material adverse effect on its consolidated financial position, results of operations, or cash flows resulting from the use of these instruments. There can be no assurance that these strategies will be effective or that transaction losses can be minimized or forecasted accurately. The following table provides information about the Company's foreign exchange forward contracts at December 31, 1998. Due to the short-term nature of these contracts, the contract rate approximates the weighted-average contractual foreign currency exchange rate and the amount in U.S. dollars approximates the fair value of the contract at December 31, 1998. These forward contracts mature in approximately thirty days. The following table presents short-term forward contracts to sell and buy foreign currencies in U.S. dollars related to customer receivables and intercompany balances: Contract Short-term forward contracts: Amount Rate - ----------------------------------------------------------------- German mark $ 60,948 $ 1.67 French franc 19,461 5.59 Japanese yen 6,773 114.42 British pound sterling 3,304 1.67 Finnish markka 3,002 5.08 Other 6,634 - - ----------------------------------------------------------------- The unrealized gain (loss) on the outstanding forward contracts at December 31, 1998 was not material to the Company's consolidated financial statements. The realized gain (loss) on these contracts as they matured was not material to the Company's consolidated financial position, results of operations, or cash flows for the periods presented. 33 Item 8. Financial Statements and Supplementary Data CONSOLIDATED STATEMENTS OF OPERATIONS In thousands, except per share data Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------- Revenues: System and software $ 277,396 $ 235,808 $ 242,147 Service and support 212,997 218,919 205,739 --------- --------- --------- Total revenues 490,393 454,727 447,886 --------- --------- --------- Cost of revenues: System and software 26,536 53,492 39,196 Service and support 96,961 105,541 94,620 --------- --------- --------- Total cost of revenues 123,497 159,033 133,816 --------- --------- --------- Gross margin 366,896 295,694 314,070 --------- --------- --------- Operating expenses: Research and development 117,853 112,227 92,905 Marketing and selling 169,034 157,343 146,754 General and administration 45,825 43,636 40,918 Special charges 20,942 18,858 11,998 Merger and acquisition related charges 8,500 - 31,344 --------- --------- --------- Total operating expenses 362,154 332,064 323,919 --------- --------- --------- Operating income (loss) 4,742 (36,370) (9,849) Other income (expense), net (4,721) 3,319 8,411 --------- --------- --------- Income (loss) before income taxes 21 (33,051) (1,438) Provision (benefit) for income taxes 540 (1,744) 3,540 --------- --------- --------- Net loss $ (519) $ (31,307) $ (4,978) ========= ========= ========= Net loss per share: Basic $ (0.01) $ (0.48) $ (0.08) ========= ========= ========= Diluted $ (0.01) $ (0.48) $ (0.08) ========= ========= ========= Weighted average number of shares outstanding: Basic 65,165 64,885 64,134 ========= ========= ========= Diluted 65,165 64,885 64,134 ========= ========= ========= - ------------------------------------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. 34 CONSOLIDATED BALANCE SHEETS In thousands As of December 31, 1998 1997 - ----------------------------------------------------------------------------------------------------------- Assets Current assets: Cash and cash equivalents $ 118,512 $ 84,402 Short-term investments 19,073 52,658 Trade accounts receivable, net of allowance for doubtful accounts of $2,987 in 1998 and $2,426 in 1997 125,844 106,010 Other receivables 7,575 6,282 Prepaid expenses and other 23,503 12,906 Deferred income taxes 10,937 10,081 --------- --------- Total current assets 305,444 272,339 Property, plant and equipment, net 95,214 103,452 Term receivables, long-term 36,430 3,465 Other assets, net 27,035 23,046 --------- --------- Total assets $ 464,123 $ 402,302 ========= ========= Liabilities and Stockholders' Equity Current liabilities: Short-term borrowings 24,000 $ - Accounts payable 10,101 11,125 Income taxes payable 20,408 23,000 Accrued payroll and related liabilities 41,958 31,055 Accrued liabilities 33,295 30,119 Deferred revenue 36,484 28,849 --------- --------- Total current liabilities 166,246 124,148 Long-term debt - 120 Other long-term deferrals 1,425 497 --------- --------- Total liabilities 167,671 124,765 --------- --------- Minority Interest 1,170 - Stockholders' Equity: Common stock, no par value, authorized 100,000 shares; 65,739 and 64,367 issued and outstanding for 1998 and 1997, respectively 303,352 291,263 Incentive stock, no par value, authorized 1,200 shares; none issued - - Accumulated deficit (22,246) (21,521) Accumulated other comprehensive income - foreign currency translation adjustment 14,176 7,795 --------- --------- Commitments and contingencies Total stockholders' equity 295,282 277,537 --------- --------- Total liabilities and stockholders' equity $ 464,123 $ 402,302 ========= ========= - ----------------------------------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. 35 CONSOLIDATED STATEMENTS OF CASH FLOWS In thousands Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------- Operating Cash Flows: Net loss $ (519) $ (31,307) $ (4,978) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization of property, plant and equipment 27,235 27,516 21,472 Gain on sale of investments held for sale - - (5,545) Deferred taxes (2,223) (8,434) (5,988) Amortization of other assets 3,503 11,604 11,586 Write-down of assets 16,315 12,422 31,234 Business disposals 4,513 5,395 - Changes in operating assets and liabilities: Trade accounts receivable (15,210) 711 (11,201) Prepaid expenses and other (9,580) 5,036 (5,534) Term receivables, long-term (32,965) (3,465) - Accounts payable (848) (3,593) 3,458 Accrued liabilities 8,484 (2,662) 1,319 Other liabilities and deferrals 4,061 631 6,491 --------- --------- --------- Net cash provided by operating activities 2,766 13,854 42,314 --------- --------- --------- Investing Cash Flows: Net maturities (purchases) of short-term investments 33,585 (21,746) (5,018) Proceeds from sale of investments held for sale - - 6,744 Purchases of property, plant and equipment, net (21,627) (32,614) (23,931) Capitalization of software development costs - - (5,691) Purchases of equity interests (19,024) - (32,358) Purchases of technologies - (2,992) (2,583) --------- --------- --------- Net cash used by investing activities (7,066) (57,352) (62,837) --------- --------- --------- Financing Cash Flows: Proceeds from issuance of common stock 11,381 9,447 12,477 Proceeds (repayment) of short-term borrowings 24,000 (8,782) (263) Repayment of long-term debt (120) (52,321) (501) Repurchase of common stock - (15,940) (11,507) Decrease in cash and investments, long-term - 30,000 - --------- --------- --------- Net cash provided (used) by financing activities 35,261 (37,596) 206 --------- --------- --------- Effect of exchange rate changes on cash and cash equivalents 3,149 90 (953) --------- --------- --------- Net change in cash and cash equivalents 34,110 (81,004) (21,270) Cash and cash equivalents at beginning of period 84,402 165,406 186,676 --------- --------- --------- Cash and cash equivalents at end of period $ 118,512 $ 84,402 $ 165,406 ========= ========= ========= - ------------------------------------------------------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. 36 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Accumulated Retained Other Total Common Stock Earnings Comprehensive Comprehensive Stockholders' In thousands Shares Amount (Deficit) Income (Loss) Income (Loss) Equity - --------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1995 63,875 $ 294,917 $ 17,715 $ 13,594 $ 326,226 ------- --------- -------- -------- --------- Net loss - - (4,978) - (4,978) (4,978) Change in value of investments available for sale - - (2,951) - (2,951) (2,951) Foreign currency translation adjustment, net of tax benefit of $422 - - - (1,496) (1,496) (1,496) -------- Comprehensive loss - - - - $ (9,425) - ======== Stock issued under stock option and stock purchase plans and tax benefit associated with options 1,428 12,477 - - 12,477 Stock issued for acquisition of businesses 138 1,825 - - 1,825 Compensation related to nonqualified stock options granted - 44 - - 44 Repurchase of common stock (833) (11,507) - - (11,507) ------- --------- -------- -------- --------- Balance at December 31, 1996 64,608 297,756 9,786 12,098 319,640 ------- --------- -------- -------- --------- Net loss - - (31,307) - (31,307) (31,307) Foreign currency translation adjustment, net of tax benefit of $1,214 - - - (4,303) (4,303) (4,303) -------- Comprehensive loss - - - - $(35,610) - ======== Stock issued under stock option and stock purchase plans and tax benefit associated with options 1,414 9,447 - - 9,447 Repurchase of common stock (1,655) (15,940) - - (15,940) ------- --------- -------- -------- --------- Balance at December 31, 1997 64,367 291,263 (21,521) 7,795 277,537 ------- --------- -------- -------- --------- Net loss - - (519) - (519) (519) Foreign currency translation adjustment, net of tax expense of $1,800 - - - 6,381 6,381 6,381 -------- Comprehensive income - - - - $ 5,862 - ======== Stock issued under stock option and stock purchase plans and tax benefit associated with options 1,372 11,381 - - 11,381 Stock options issued for acquisition of business - 708 - - 708 Dividends to minority owners - - (206) - (206) ------- --------- -------- -------- --------- Balance at December 31, 1998 65,739 $ 303,352 $(22,246) $ 14,176 $ 295,282 ======= ========= ======== ======== ========= - --------------------------------------------------------------------------------------------------------------------------------- See accompanying notes to consolidated financial statements. 37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS All numerical references in thousands, except percentages and per share data 1 Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the financial statements of the Company and its wholly owned and majority-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Foreign Currency Translation Local currencies are the functional currencies for the Company's foreign subsidiaries except for the Netherlands and Singapore where the U.S. dollar is used as the functional currency. Assets and liabilities of foreign operations are translated to U.S. dollars at current rates of exchange, and revenues and expenses are translated using weighted average rates. Gains and losses from foreign currency translation are included as a separate component of stockholders' equity. Foreign currency transaction gains and losses are included as a component of other income and expense. Financial Instruments The Company enters into forward foreign exchange contracts as a hedge against foreign currency sales commitments and intercompany balances. To hedge its foreign currency against highly anticipated sales transactions, the Company also purchases foreign exchange options which permit but do not require foreign currency exchanges at a future date with another party at a contracted exchange price. Remeasurement gains and losses on forward and option contracts are deferred and recognized when the sale occurs. All subsequent remeasurement gains and losses are recognized as they occur to offset remeasurement gains and losses recognized on the related foreign currency accounts receivable balances. At December 31, 1998 and 1997, the Company had forward contracts and options outstanding of $100,122 and $57,818, respectively, to primarily buy and sell various foreign currencies. These contracts generally have maturities which do not exceed twelve months. At December 31, 1998 and 1997, the difference between the recorded value and the fair value of the Company's foreign exchange position related to these contracts was approximately zero. The fair value of these contracts was calculated based on dealer quotes. The Company does not anticipate non-performance by the counterparties to these contracts. The Company places its cash equivalents and short-term investments with major banks and financial institutions. The Company's investment policy limits its credit exposure to any one financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base, and their dispersion across different businesses and geographic areas. The carrying amounts of cash equivalents, short-term investments, trade receivables, accounts payable, and short term borrowings approximate fair value because of the short-term nature of these instruments. The Company does not believe it is exposed to any significant credit risk or market risk on its financial instruments. Cash, Cash Equivalents, and Short-Term Investments The Company classifies highly liquid investments purchased with an original maturity of three months or less as cash equivalents. Short-term investments consist of certificates of deposit, commercial paper and other highly liquid investments with original maturities in excess of three months. Short-term investments are classified as available for sale and are recorded at amortized cost, which approximates market value. These investments mature primarily in less than one year. Property, Plant and Equipment Property, plant and equipment is stated at cost. Expenditures for additions to property, plant and equipment are capitalized. The cost of repairs and maintenance is expensed as incurred. Depreciation of buildings and building equipment, and land improvements, is computed on a straight-line basis over lives of forty and twenty years, respectively. Depreciation of computer equipment and furniture is computed principally on a straight-line basis over the estimated useful lives of the assets, generally three to five years. Leasehold improvements are amortized on a straight-line basis over the lesser of the term of the lease or estimated useful lives of the improvements. 38 In accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", management reviews long-lived assets and the related intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Recoverability of these assets is determined by comparing the forecasted undiscounted net cash flows of the operation to which the assets relate, to the carrying amount including associated intangible assets of such operation. If the operation is determined to be unable to recover the carrying amount of its assets, then intangible assets are written down first, followed by the other long-lived assets of the operation, to fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets. Income Taxes The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts and tax balances of existing assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Revenue Recognition Revenues from system and software licenses are recognized at the time of shipment, except for those that include rights to future software products or have significant other delivery requirements. Product revenues from term or installment sales agreements which include either perpetual or term licenses are with the Company's top-rated credit customers and are recognized upon shipment while any maintenance revenues included in these arrangements are deferred and recognized ratably over the contract term. Revenues from subscription-type term license agreements, which include software, rights to future software products, and services, are deferred and recognized ratably over the term of the subscription period. Training and consulting contract revenues are recognized using the percentage of completion method or as contract milestones are achieved. In 1997, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) No. 97-2, "Software Revenue Recognition". In March 1998, the Financial Accounting Standards Board (FASB) approved SOP 98-4, "Deferral of the Effective Date of a Provision of 97-2, Software Revenue Recognition". SOP 98-4 defers for one year, the application of several paragraphs and examples in SOP 97-2 which limits the definition of vendor specific objective evidence (VSOE) of the fair value of various elements in a multiple element arrangement. The provisions of SOP's 97-2 and 98-4 have been applied to transactions entered into beginning January 1, 1998. Prior to 1997, the Company's revenue policy was in accordance with the preceding authoritative guidance provided by SOP 91-1, "Software Revenue Recognition". Software Development Costs The Company accounts for software development costs in accordance with SFAS No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed." Software development costs are capitalized beginning when a product's technological feasibility has been established by completion of a working model of the product and ending when a product is available for general release to customers. In 1997 and 1998, completion of a working model of the Company's products and general release have substantially coincided. As a result, the Company has not capitalized any software development costs during these periods since the amounts have not been material. Amortization of capitalized software development costs is calculated as the greater of the ratio that the current product revenues bear to estimated future revenues or the straight-line method over the expected product life cycle of approximately three years. Amortization is included in system and software cost of revenues in the Consolidated Statements of Operations and was $0, $5,448 and $6,215 for the years ended December 31, 1998, 1997, and 1996, respectively. 39 The Company recognized impairment in value of certain previously capitalized software development costs in the first quarter of 1997 primarily as a result of the accelerated decline in sales of older software product offerings. These costs, which totaled $5,358, were determined to be unrecoverable and were charged to system and software cost of revenues. All remaining previously capitalized software costs were amortized evenly over the final three quarters of 1997 to recognize the change in estimated useful lives of these older technologies. Goodwill and Intangibles Goodwill represents the excess of the aggregate purchase price over the fair value of the tangible and intangible assets acquired in the various acquisitions. Technology and goodwill costs are being amortized over a three to five year period to system and software cost of revenues and operating expenses, respectively. The Company recognized impairment in value of certain goodwill and purchased technology, which resulted in associated write-downs of $2,732 and $2,708 in 1998 and $2,056 and $2,370 in 1997, respectively. Total goodwill and purchased technology amortization expenses were $2,935, $6,263 and $4,190 for the years ended December 31, 1998, 1997, and 1996, respectively. Net Income (Loss) Per Share In 1997, the Company adopted SFAS No. 128 "Earnings Per Share" which provides that "basic net income (loss) per share" and "diluted net income (loss) per share" for all prior periods presented are to be computed using the weighted average number of common shares outstanding during each period, with diluted net income per share including the effect of potentially dilutive common shares. Common stock equivalents related to stock options are anti-dilutive in a net loss year and, therefore, are not included in 1998, 1997 and 1996 diluted net loss per share. Comprehensive Income (Loss) On January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes standards for reporting and presentation of comprehensive income and its components in a full set of financial statements. Comprehensive income (loss) consists of net income (loss), foreign currency translation adjustment and net unrealized gains (losses) on securities and is presented in the consolidated statement of stockholders' equity. The Statement requires only additional disclosures in the consolidated financial statements; it does not affect the Company's financial position or results of operations. Prior year financial statements have been reclassified to conform to the requirements of SFAS No. 130. Use of Estimates Generally accepted accounting principles require management to make estimates and assumptions that affect the reported amount of assets, liabilities and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Reclassifications and Restatements Certain reclassifications have been made in the accompanying consolidated financial statements for 1996 and 1997 to conform with the 1998 presentation. 2 Special Charges Following is a summary of the major elements of the special charges: Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------ Employee severance $ 4,982 $ 2,322 $ 3,486 Asset impairments 7,377 5,541 5,000 Business disposals 4,513 5,395 - Reserves for various claims 1,860 3,950 - Other 2,210 1,650 3,512 -------- -------- -------- Total $ 20,942 $ 18,858 $ 11,998 ======== ======== ======== - ------------------------------------------------------------------------ 40 During 1998, the Company recorded special charges of $20,942. The charges primarily consist of four subsidiary divestitures, moving of the European distribution center to Ireland to strengthen the Company's tax position, related terminations arising from the divestitures and the distribution center move, and impairment in value of certain assets. Substantially all of these costs were expended in 1998 and the remaining amount should be expended in the first half of 1999 and there have been no significant modifications to the amount of the charges. During 1997, the Company recorded special charges of $18,858. The charges consisted of subsidiary divestitures and related employee terminations, early termination of an interest rate swap agreement, recognition of the impairment in value of certain goodwill and purchased technology and some streamlining of worldwide operations and reserves for various legal claims. Substantially all of the costs associated with these charges were expended in 1997 and the first half of 1998 and there have been no significant modifications to the amount of the charges. In 1996, the Company recorded special charges of $11,998. The Company downsized and redirected certain operations and re-targeted an incentive compensation program resulting in severance costs, facility lease and equipment abandonment costs and other costs totaling approximately $7,000. The Company also recognized a $5,000 write-down for impairment in value of goodwill and certain other assets associated with its Meta Systems subsidiary, as the recoverability of these assets was adversely affected by the ongoing SimExpress patent litigation. 3 Mergers and Acquisitions Results of operations for all pooling of interest transactions are included in the Company's Consolidated Financial Statements for all periods presented. Results of operations of all acquisitions accounted for as purchases are included in the Company's Consolidated Financial Statements only from the date of acquisition forward. In 1998, the Company completed three business combinations which were accounted for as purchases. In March 1998, the Company purchased an additional ownership interest of 32% of its Korean distributor, Mentor Korea Co. LTD (MGK) for a total ownership interest of 51%. In November 1998, the Company purchased CLK Computer-Aided Design Inc. (CLK CAD) and OPC Technology Inc. (OPCT). CLK CAD is primarily engaged in developing and marketing timing driven placement and optimization tools for deep submicron designs. OPCT is primarily engaged in developing and marketing software, which extends the life of optical lithography, by modifying IC physical layout to compensate for manufacturing distortions prior to design tape out. The total purchase price including acquisition expenses for all 1998 purchase acquisitions was $16,513. The Company paid the purchase price in cash and notes payable for MGK and OPCT and in cash and stock options for CLK CAD. The cost of each acquisition was allocated on the basis of estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in charges for in-process research and development (R&D) of $8,500, goodwill capitalization of $6,613, and technology capitalization of $1,400. In connection with these acquisitions, the Company recorded one-time charges to operations for the write-off of OPCT's and CLK CAD's in-process R&D. The value assigned to in-process R&D related to research projects for which technological feasibility had not been established. The value was determined by estimating the net cash flows from the sale of products resulting from the completion of such projects, and discounting the net cash flows back to their present value. The Company then estimated the stage of completion of the products at the date of the acquisition based on R&D costs that had been expended as of the date of acquisition as compared to total R&D costs at completion. The percentages derived from this calculation were then applied to the net present value of future cash flows to determine the in-process charge. The nature of the efforts to develop the in-process technology into commercially viable products principally related to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the product can be produced to meet its design specification, including function, features and technical performance requirements. The estimated net cash 41 flows from these products were based on management's estimates of related revenues, cost of sales, R&D costs, selling, general and administrative costs and income taxes. The Company will monitor how underlying assumptions compare to actual results. The separate results of operations of the acquisitions were not material compared to the Company's overall results of operations, and accordingly pro-forma financial statements of the combined entities have been omitted. In 1996, the Company completed nine business combinations, two of which were accounted for as pooling of interests and seven of which were accounted for as purchases. The Company purchased dQdt, Inc. (dQdt), Meta Systems SRL, (Meta), Seto Software GmbH (Seto), Royal Digital Centers, Inc. (Royal Digital), Open Networks Engineering, Inc. (ONE), Systolic Technology, LTD (Systolic), and CAE Technology, Inc. (CAE) in April 1996, May 1996, June 1996, August 1996, November 1996, November 1996 and December 1996, respectively. The total purchase price including acquisition expenses for all 1996 purchase acquisitions was $40,708. The purchase accounting allocations resulted in charges for in-process research and development (R&D) of $26,234, goodwill capitalization of $5,517, and technology capitalization of $8,957. The purchase accounting allocations performed on 1996 acquisitions were substantially the same as those performed on 1998 acquisitions. In January and August of 1996, the Company completed the acquisitions of Microtec Research, Inc. (Microtec) and Interconnectix, Inc. (Interconnectix), respectively. These acquisitions were accounted for as pooling of interests. A total of 6,223 and 2,133 shares of the Company's common stock were issued for Microtec and Interconnectix, respectively. Merger expenses of $5,110 were incurred associated with the elimination of duplicate facilities, severance costs, the write-off of certain property and equipment and legal and accounting fees associated with the merger activities. 4 Income Taxes Domestic and foreign pre-tax income (loss) is as follows: Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------- Domestic $ (15,759) $ (17,976) $ (10,023) Foreign 15,780 (15,075) 8,585 --------- --------- --------- Total $ 21 $ (33,051) $ (1,438) ========= ========= ========= - ------------------------------------------------------------------------- The provision (benefit) for income taxes is as follows: Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------- Current: Federal $ 1,113 $ 3,730 $ 3,563 State 122 150 118 Foreign 1,528 2,810 5,847 --------- --------- --------- Total current 2,763 6,690 9,528 --------- --------- --------- Deferred: Federal (1,308) (5,848) (6,093) Foreign (915) (2,586) 105 --------- --------- --------- Total deferred (2,223) (8,434) (5,988) --------- --------- --------- Total $ 540 $ (1,744) $ 3,540 ========= ========= ========= - ------------------------------------------------------------------------- The effective tax expense (benefit) differs from the statutory federal tax expense (benefit) as follows: Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------- Federal tax $ 7 $ (11,568) $ (503) State tax, net of Federal benefit 79 98 77 Impact of international operations (3,785) 6,485 (6,594) Non-deductible acquisition costs 6,080 - 13,835 Other, net (1,841) 3,241 (3,275) --------- --------- --------- Effective tax expense (benefit) $ 540 $ (1,744) $ 3,540 ========= ========= ========= - ------------------------------------------------------------------------- The significant components of deferred income tax expense are as follows: Year ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Net changes in deferred tax assets and liabilities $ 362 $ (14,800) $ (3,462) Increase (decrease) in the valuation allowance for deferred tax assets (2,585) 6,366 (2,526) -------- --------- --------- Total $ (2,223) $ (8,434) $ (5,988) ======== ========= ========= - -------------------------------------------------------------------------------- The tax effects of temporary differences and carryforwards which gave rise to significant portions of deferred tax assets were as follows: As of December 31, 1998 1997 - ------------------------------------------------------------------------------ Deferred tax assets: Depreciation of property and equipment $ 1,859 $ 1,199 Reserves and allowances 2,436 2,235 Accrued expenses not currently deductible 5,906 9,502 Net operating loss carryforwards 31,384 29,614 Tax credit carryforwards 20,549 23,629 Purchased technology 1,858 1,540 Other, net 5,373 2,008 -------- -------- Total gross deferred tax assets 69,365 69,727 Less valuation allowance (52,303) (54,888) -------- -------- Net deferred tax asset $ 17,062 $ 14,839 ======== ======== - ------------------------------------------------------------------------------ 42 The Company has established a valuation allowance for certain deferred tax assets, including those for net operating loss and tax credit carryforwards. Such a valuation allowance is recorded when it is more likely than not that some portion of the deferred tax assets will not be realized. The portion of the valuation allowance for deferred tax assets for which subsequently recognized tax benefits will be applied directly to contributed capital is $13,888 as of December 31, 1998. This amount is attributable to differences between financial and tax reporting of employee stock option transactions. As of December 31, 1998, the Company, for federal income tax purposes, has net operating loss carryforwards of approximately $44,755 and research and experimentation credit carryforwards of $13,975. For state income tax purposes, as of December 31, 1998 the Company has net operating loss carryforwards totaling $114,769 from multiple jurisdictions, research and experimentation credits of $3,823 and child care and facility credits of $583. If not used by the Company to reduce income taxes payable in future periods, net operating loss carryforwards will expire between 2002 through 2011, and research and experimentation credit carryforwards between 1999 through 2012. The Company has not provided for Federal income taxes on approximately $150,968 of undistributed earnings of foreign subsidiaries at December 31, 1998, since these earnings have been invested indefinitely in subsidiary operations. Upon repatriation, some of these earnings would generate foreign tax credits which will reduce the Federal tax liability associated with any future foreign dividend. The Company has settled its Federal income tax obligations through 1991. The Company believes the provisions for income taxes for years since 1991 are adequate. 5 Property, Plant and Equipment A summary of property, plant and equipment follows: As of December 31, 1998 1997 - ------------------------------------------------------------------------------- Computer equipment and furniture $ 146,683 $ 155,433 Buildings and building equipment 49,555 53,702 Land and improvements 15,560 14,658 Leasehold improvements 17,786 15,320 --------- --------- 229,584 239,113 Less accumulated depreciation and amortization (134,370) (135,661) --------- --------- Property, plant and equipment, net $ 95,214 $ 103,452 ========= ========= - ------------------------------------------------------------------------------- The Company has entered into agreements to lease portions of its facility sites in Wilsonville, OR, Santa Clara, CA, and Warren, NJ. Under terms of these agreements approximately 280 square feet of space was rented to third parties and are expected to result in rental receipts of $5,253 in 1999. 6 Short-Term Borrowings Short-term borrowings from time to time include drawings by subsidiaries under multi-currency unsecured credit agreements. Interest rates are generally based on the applicable country's prime lending rate depending on the currency borrowed. The weighted average interest rate on short-term borrowings during 1998 and 1997 was approximately 6%. The Company has available lines of credit of approximately $15,500 as of December 31, 1998. Certain agreements require compensatory balances, which the Company has met. No borrowings were outstanding under these agreements at December 31, 1998. In 1998, the Company entered into a committed revolving loan with a bank that remains in effect until 2001, which gives the Company the ability to borrow up to $100,000 and is available for general operating purposes. As of December 31, 1998 the Company had short-term borrowings of $24,000 outstanding on this revolving loan. The revolving loan has a variable rate, which is calculated based on the Company's financial position and operating performance and is subject to certain loan covenants. The Company paid underwriting fees of $600 for this agreement, which will be amortized over its life. In 1998, the Company entered into a committed revolving loan with a bank that gave the Company the ability to borrow up to $200,000 and was available primarily for the unsolicited tender offer of Quickturn Design Systems Inc. (Quickturn). In connection with this arrangement the Company paid underwriting fees of $1,250, which were capitalized as acquisition costs as of December 31, 1998. The revolving loan had a variable rate, which was calculated based on the Company's financial position and operating performance and was subject to certain loan covenants. Subsequent to December 31, 1998, the Company terminated this new credit facility and will expense the capitalized underwriting fees in the first quarter of 1999. 43 7 Incentive Stock The Board of Directors has the authority to issue incentive stock in one or more series and to determine the relative rights and preferences of the incentive stock. 8 Employee Stock and Savings Plans The Company has three common stock option plans which provide for the granting of incentive and nonqualified stock options to key employees, officers, and non-employee directors of the Company and its subsidiaries. The three stock option plans are administered by the Compensation Committee of the Board of Directors, and permit accelerated vesting of outstanding options upon the occurrence of certain changes in control of the Company. The Company also has a stock plan that provides for the sale of common stock to key employees of the Company and its subsidiaries. Shares can be awarded under the plan at no purchase price as a stock bonus and the stock plan also provides for the granting of nonqualified stock options. SFAS No. 123 "Accounting for Stock-Based Compensation" defines a fair value based method of accounting for an employee stock option and similar equity instrument. As is permitted under SFAS No. 123, the Company has elected to continue to account for its stock-based compensation plans under APB Opinion No. 25. The Company has computed, for pro forma disclosure purposes, the value of all options granted during 1998, 1997 and 1996 using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following weighted average assumptions for grants: Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------- Risk-free interest rate 5.5% 6.25% 6% Expected dividend yield 0% 0% 0% Expected life (in years) 5.5 5.5 5.5 Expected volatility 61% 46% 63% - ------------------------------------------------------------------- Using the Black-Scholes methodology, the total value of options granted during 1998, 1997 and 1996 was $29,797, $17,862 and $32,375, respectively, which would be amortized on a pro forma basis over the vesting period of the options. The weighted average fair value of options granted during 1998, 1997 and 1996 was $10.23, $6.43, and $6.29 per share, respectively. If the Company had accounted for its stock-based compensation plans in accordance with SFAS No. 123, the Company's net loss and net loss per share would approximate the pro forma disclosures below: Year ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------------ Net loss $ (7,915) $ (37,663) $ (12,447) Net loss per share, basic and diluted $ (0.12) $ (0.58) $ (0.19) - ------------------------------------------------------------------------------ The effects of applying SFAS No. 123 in this pro forma disclosure are not indicative of future amounts. SFAS No. 123 does not apply to awards prior to January 1, 1995, and additional awards are anticipated in future years. The following table summarizes information about options outstanding and exercisable at December 31, 1998: ----------- Outstanding ------------ ---- Exercisable ---- Range of Remaining Weighted Weighted Exercise Number of Contractual Average Number of Average Prices Shares Life (Years) Price Shares Price - ------------------------------------------------------------------------------ $ 0.07 - 6.00 950 6.04 $ 3.87 689 $ 4.71 $ 6.68 - 7.31 214 6.49 $ 7.08 117 $ 7.03 $ 7.50 - 7.75 2,483 7.75 $ 7.74 1,204 $ 7.75 $ 8.31 - 8.81 219 9.66 $ 8.48 7 $ 8.57 $ 8.88 - 9.00 1,278 8.10 $ 9.00 336 $ 9.00 $ 9.13 - 10.00 1,079 8.05 $ 9.68 386 $ 9.66 $10.06 - 10.06 1,896 9.15 $ 10.06 2 $ 10.06 $10.13 - 15.88 1,037 5.91 $ 12.18 803 $ 12.19 $17.13 - 18.25 78 6.63 $ 17.31 48 $ 17.32 $19.76 - 19.76 32 1.36 $ 19.76 32 $ 19.76 ------ ----- -------- ----- -------- $00.07 - 19.76 9,266 7.72 $ 8.84 3,624 $ 8.69 ====== ===== ======== ===== ======== - ------------------------------------------------------------------------------ Options under all four plans generally become exercisable over a four to five-year period from the date of grant or from the commencement of employment at prices generally not less than the fair market value at the date of grant. The excess of the fair market value of the shares at the date of grant over the option price, if any, is charged to operations ratably over the vesting period. At December 31, 1998, 27,810 shares were reserved for issuance and 2,008 shares were available for future grant. Stock options outstanding, the weighted average exercise price and transactions involving the stock option plans are summarized as follows: 44 Shares Price - ----------------------------------------------------------------- Balance at December 31, 1995 6,073 $ 9.17 Granted 5,113 9.83 Exercised (1,013) 5.38 Canceled (3,323) 13.27 -------- -------- Balance at December 31, 1996 6,850 8.23 Granted 2,832 9.23 Exercised (620) 5.69 Canceled (957) 9.25 -------- -------- Balance at December 31, 1997 8,105 8.65 Granted 2,995 8.77 Exercised (665) 5.86 Canceled (1,169) 9.09 -------- -------- Balance at December 31, 1998 9,266 $ 8.84 ======== ======== - ----------------------------------------------------------------- In May 1989, the shareholders adopted the 1989 Employee Stock Purchase Plan and reserved 1,400 shares for issuance. The shareholders have subsequently amended the plan to reserve an additional 4,000 shares for issuance. Under the plan, each eligible employee may purchase up to six hundred shares of stock per quarter at prices no less than 85% of its fair market value determined at certain specified dates. Employees purchased 707 and 794 shares under the plan in 1998 and 1997, respectively. At December 31, 1998, 363 shares remain available for future purchase under the plan. The plan will expire upon either issuance of all shares reserved for issuance or at the discretion of the Board of Directors. There are no plans to terminate the plan at this time. In 1997, the Company repurchased 1,655 shares, approximately 800 of which were repurchased immediately prior to the Employee Stock Purchase Plan (ESPP) purchases and then reissued to plan participants. The remaining shares were repurchased in the fourth quarter of 1997 to be reissued to participants of the ESPP in 1998. The market value of all repurchases was $15,940. During 1998, the Company did not repurchase any shares. The Company has an employee savings plan (the Savings Plan) that qualifies as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the Savings Plan, participating U.S. employees may defer a portion of their pretax earnings, up to the Internal Revenue Service annual contribution limit. The Company currently matches 50% of eligible employee's contributions, up to a maximum of 6% of the employee's earnings. Employer matching contributions vest over 5 years, 20% for each year of service completed. The Company's matching contributions to the Savings Plan were $2,765, $2,730, and $2,299, in 1998, 1997, and 1996, respectively. 9 Commitments The Company leases a majority of its field office facilities under non-cancelable operating leases. In addition, the Company leases certain equipment used in its research and development activities. This equipment is generally leased on a month-to-month basis after meeting a six-month lease minimum. The Company rents its Japanese facilities under two-year cancelable leases allowing a six-month notice of cancellation. The total remaining commitment under these cancelable leases, which expire December 2000, is $5,145, of which the first six months payments of $1,430 are included in the schedule below. Future minimum lease payments under all non-cancelable operating leases are approximately as follows: Annual periods ending December 31, - -------------------------------------------------------------- 1999 $ 18,452 2000 13,022 2001 9,307 2002 7,912 2003 7,279 Later years 18,486 -------- Total $ 74,458 ======== - -------------------------------------------------------------- Rent expense under operating leases was $21,623, $19,598, and $15,480 for the years ended December 31, 1998, 1997, and 1996, respectively. 10 Other Income (Expense), Net Other income (expense) is comprised of the following: Year ended December 31, 1998 1997 1996 - --------------------------------------------------------------------- Interest income $ 7,771 $ 7,723 $ 9,485 Interest expense (768) (555) (2,423) Litigation related costs (10,301) (4,675) (3,611) Gain (loss) on sale of investments - - 5,545 Other, net (1,423) 826 (585) -------- -------- -------- Total $ (4,721) $ 3,319 $ 8,411 ======== ======== ======== - --------------------------------------------------------------------- 45 11 Supplemental Cash Flow Information The following provides additional information concerning supplemental disclosures of cash flow activities: Year ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------- Cash paid for: Interest expense $ 599 $ 829 $ 2,198 Income taxes $ 2,475 $ 3,307 $ 1,984 Issuance of stock and stock options for purchase of business $ 708 - $ 1,825 - -------------------------------------------------------------------------- 12 Segment Reporting The Company operates exclusively in the EDA industry. The Company markets its products primarily to customers in the communications, computer, semiconductor, consumer electronics, aerospace, and transportation industries. The Company sells and licenses its products through its direct sales force in North and South America (Americas), Europe, Japan and Pacific Rim, and through distributors where a direct sales presence is not warranted. The Company's reportable segments are based on geographic area. All intercompany revenues and expenses are eliminated in computing revenues and operating income (loss). The corporate component of operating income (loss) represents research and development, corporate marketing and selling, corporate general and administration, special, and merger and acquisitions related charges. Corporate capital expenditures and depreciation and amortization are generated from assets allotted to research and development, corporate marketing and selling, and corporate general and administration. Reportable segment information is as follows: Year ended December 31 1998 1997 1996 - -------------------------------------------------------------------------- Revenues Americas $ 271,159 $ 250,236 $ 244,972 Europe 146,559 119,501 114,678 Japan 54,582 65,662 70,902 Pacific Rim 18,093 19,328 17,334 --------- --------- --------- Total $ 490,393 $ 454,727 $ 447,886 ========= ========= ========= Operating Income (Loss) Americas $ 174,245 $ 130,673 $ 158,974 Europe 42,631 24,132 8,229 Japan 16,697 21,575 7,541 Pacific Rim 8,209 5,377 27,436 Corporate (237,040) (218,127) (212,029) --------- --------- --------- Total $ 4,742 $ (36,370) $ (9,849) ========= ========= ========= Depreciation and Amortization Americas $ 1,943 $ 2,198 $ 2,071 Europe 7,887 8,283 4,431 Japan 1,044 1,019 1,183 Pacific Rim 1,385 833 674 Corporate 18,479 26,787 24,699 --------- --------- --------- Total $ 30,738 $ 39,120 $ 33,058 ========= ========= ========= Capital Expenditures: Americas $ 4,886 $ 4,309 $ 4,598 Europe 10,469 8,707 5,178 Japan 803 1,317 649 Pacific Rim 503 1,541 1,071 Corporate 4,966 16,740 12,435 --------- --------- --------- Total $ 21,627 $ 32,614 $ 23,931 ========= ========= ========= Identifiable Assets: Americas $ 251,709 $ 259,417 $ 330,609 Europe 136,851 71,868 105,582 Japan 36,447 34,860 42,634 Pacific Rim 39,116 36,157 34,534 --------- --------- --------- Total $ 464,123 $ 402,302 $ 513,359 ========= ========= ========= - -------------------------------------------------------------------------- 46 13 Subsequent Events On August 12, 1998, the Company commenced a $12.125 per share tender offer for all outstanding shares of Quickturn Design Systems, Inc., a Delaware corporation (Quickturn), or approximately $216,000 for approximately 17,800 shares outstanding. In connection with this offer, the Company purchased 591 shares of Quickturn common stock for $4,522. The Company expected to finance this offer through its available cash balances and a new bank credit facility for which the Company had a definitive Credit Agreement. On January 8, 1999, the Company withdrew its tender offer and subsequently terminated its new credit facility. The Company incurred acquisition costs of approximately $9,000 of which $4,614 was capitalized and the remaining amount was not accrued as of December 31, 1998. Because the offer was withdrawn, these costs will be expensed and will be partially offset by a gain on the sale of the Quickturn stock of approximately $4,000 in the first quarter of 1999. On January 5, 1999, the Company purchased the remaining minority interest of its then 84% owned subsidiary, Exemplar Logic, Inc. (Exemplar) for cash and stock options valued at approximately $14,000. This business combination will be accounted for as a purchase. The cost of the acquisition will be allocated on the basis of estimated fair value of assets and liabilities assumed. In connection with the acquisition, the Company will record a charge to operations for the write-off of Exemplar's in-process product development that had not reached technological feasibility, the amount of which is yet to be determined. On February 10, 1999, the Company adopted a Shareholder Rights Plan and declared a dividend distribution of one Right for each outstanding share of Common Stock, payable to holders of record on March 5, 1999. Under certain conditions, each Right may be exercised to purchase 1/100 of a share of Series A Junior Participating Incentive Stock at a purchase price of $95, subject to adjustment. The Rights are not presently exercisable and will only become exercisable if a person or group acquires or commences a tender offer to acquire 15% of the Common Stock. If a person or group acquires 15% of the Common Stock, each Right will be adjusted to entitle its holder to receive, upon exercise, Common Stock (or, in certain circumstances, other assets of the Company) having a value equal to two times the exercise price of the Right or each Right will be adjusted to entitle its holder to receive, upon exercise, common stock of the acquiring company having a value equal to two times the exercise price of the Right, depending on the circumstances. The Rights expire on February 10, 2009 and may be redeemed by the Company for $0.01 per Right. The Rights do not have voting or dividend rights, and until they become exercisable, have no dilutive effect on the earnings of the Company. 14 Quarterly Financial Information - Unaudited A summary of quarterly financial information follows: Quarter ended March 31 June 30 September 30 December 31 - ----------------------------------------------------------------------------------- 1998 Total revenues $ 108,008 $ 119,117 $ 117,933 $ 145,335 Gross margin $ 77,205 $ 86,058 $ 88,605 $ 115,028 Operating income (loss) $ (6,434) $ 1,121 $ 10,179 $ (124) Net income (loss) $ (7,454) $ 804 $ 7,703 $ (1,572) Net income (loss) per share, diluted and basic $ (0.12) $ 0.01 $ 0.12 $ (0.02) 1997 Total revenues $ 101,559 $ 114,638 $ 116,006 $ 122,524 Gross margin $ 53,732 $ 76,968 $ 77,642 $ 87,352 Operating income (loss) $ (32,144) $ 2,831 $ 1,059 $ (8,116) Net income (loss) $ (28,149) $ 3,732 $ 1,901 $ (8,791) Net income (loss) per share, diluted and basic $ (0.43) $ 0.06 $ 0.03 $ (0.14) - ----------------------------------------------------------------------------------- 47 Report of Management Management of Mentor Graphics Corporation is responsible for the preparation of the accompanying consolidated financial statements. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances and necessarily include some amounts which represent the best estimates and judgments of management. The consolidated financial statements have been audited by KPMG Peat Marwick LLP, independent auditors, whose report is included below. The Audit Committee of the Board of Directors is comprised of three directors who are not officers or employees of Mentor Graphics Corporation or its subsidiaries. These directors meet with management and the independent auditors in connection with their review of matters relating to the Company's annual financial statements, the Company's system of internal accounting controls, and the services of the independent auditors. The Committee meets with the independent auditors, without management present, to discuss appropriate matters. The Committee reports its findings to the Board of Directors and also recommends the selection and engagement of independent auditors. Gregory K. Hinckley Executive Vice President and Chief Operating Officer/Chief Financial Officer Walden C. Rhines President and Chief Executive Officer Independent Auditors' Report To the Stockholders and Board of Directors Mentor Graphics Corporation: We have audited the accompanying consolidated balance sheets of Mentor Graphics Corporation and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mentor Graphics Corporation and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998 in conformity with generally accepted accounting principles. KPMG Peat Marwick LLP Portland, Oregon February 1, 1999, except for note 13, which is as of February 10, 1999 48 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 10. Directors and Executive Officers of Registrant The information required by this item concerning the Company's Directors is included under "Election of Directors" in the Company's 1999 Proxy Statement and is incorporated herein by reference. The information concerning the Company's Executive Officers is included herein on page 22 under the caption "Executive Officers of the Registrant." The information required by Item 405 of Regulation S-K is included under "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's 1999 Proxy Statement and is incorporated herein by reference. Item 11. Executive Compensation The information required by this item is included under "Compensation of Directors," and "Information Regarding Executive Officer Compensation" in the Company's 1999 Proxy Statement and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item is included under "Election of Directors" and "Information Regarding Beneficial Ownership of Principal Shareholders and Management" in the Company's 1999 Proxy Statement and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions The information required by this item is not applicable to the Company. 49 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1 Financial Statements: The following consolidated financial statements are included in Item 8: Page - ----------------- -------------------------------------------------------------- Consolidated Statements of Operations for the years ended December 31, 1998, 1997 and 1996 ............................................34 Consolidated Balance Sheets as of December 31, 1998 and 1997 ................35 Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996 ............................................36 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1998, 1997 and 1996 ......................................37 Notes to Consolidated Financial Statements ..................................38 Independent Auditors' Report ................................................48 (a) 2 Financial Statement Schedule: The schedule and report listed below are filed as part of this report on the pages indicated: Schedule Page - -------------------------------------------------------------------------------- II Valuation and Qualifying Accounts .......................................52 Independent Auditors' Report on Financial Statement Schedule ................52 All other financial statement schedules have been omitted since they are not required, not applicable or the information is included in the Consolidated Financial Statements or Notes. (a) 3 Exhibits 3. A. 1987 Restated Articles of Incorporation. Incorporated by reference to Exhibit 4A to the Company's Registration Statement on Form S-3 (Registration No. 33-23024). B. Articles of Amendment of 1987 Restated Articles of Incorporation. C. Bylaws of the Company. 4. A. Rights Agreement, dated as of February 10, 1999, between the Company and American Stock, Transfer & Trust Co. Incorporated by reference to Exhibit 4.1 to the Company's Current Report on Form 8-K filed on February 19, 1999. 10.*A. 1982 Stock Option Plan. Incorporated by reference to Exhibit 10.A to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1994 (1994 10-K). *B. Nonqualified Stock Option Plan. Incorporated by reference to Exhibit 10.C to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. *C. 1986 Stock Plan. Incorporated by reference to Exhibit 10.C to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1997 (1997 10-K). *D. 1987 Non-Employee Directors' Stock Option Plan. Incorporated by reference to Exhibit 10.D to the Company's 1994 10-K. *E. Form of Indemnity Agreement entered into between the Company and each of its executive officers and directors. *F. Form of Severance Agreement entered into between the Company and each of its executive officers. G. Lease dated November 20, 1991, for 999 Ridder Park Drive and 1051 Ridder Park Drive, San Jose, California. Incorporated by reference to Exhibit 10.M to the Company's Form SE dated March 25, 1992. H. Credit Agreement between Mentor Graphics Corporation and Bank of America National Trust and Savings Association, dated February 6, 1998. Incorporated by reference to Exhibit 10.6 to the Company's 1997 10-K. 21. List of Subsidiaries of the Company. 23. Consent of Accountants. * Management contract or compensatory plan or arrangement (b) No reports on Form 8-K were filed by the Company during the last quarter of 1998. 50 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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, on March 15, 1999. MENTOR GRAPHICS CORPORATION By /s/ WALDEN C. RHINES ----------------------------------------- Walden C. Rhines President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant on March 15, 1999, in the capacities indicated. Signature Title --------------------------------------------------------------------------- (1) Principal Executive Officer: /s/ WALDEN C. RHINES President, Chief Executive Officer ----------------------------- and Director Walden C. Rhines (2) Principal Financial Officer: /s/ GREGORY K. HINCKLEY Executive Vice President, Chief Operating ----------------------------- Officer and Chief Financial Officer Gregory K. Hinckley (3) Principal Accounting Officer: /s/ ANTHONY B. ADRIAN Vice President, Corporate Controller ----------------------------- Anthony B. Adrian (4) Directors: /s/ JON A. SHIRLEY Chairman of the Board ----------------------------- Jon A. Shirley /s/ MARSHA B. CONGDON Director ----------------------------- Marsha B. Congdon /s/ JAMES R. FIEBIGER Director ----------------------------- James R. Fiebiger /s/ DAVID A. HODGES Director ----------------------------- David A. Hodges /s/ FONTAINE K. RICHARDSON Director ----------------------------- Fontaine K. Richardson 51 Schedule II MENTOR GRAPHICS CORPORATION AND SUBSIDIARIES Valuation and Qualifying Accounts (In Thousands) Beginning Ending Description Balance Additions Deductions Balance - ---------------------------------------------------------------------------------------------------------- Year ended December 31, 1996 Allowance for doubtful accounts/1 $ 3,291 $ 1,168 $ 1,296 $ 3,163 Allowance for obsolete inventory/2 $ 389 $ 308 $ 292 $ 405 Year ended December 31, 1997 Allowance for doubtful accounts/1 $ 3,163 $ 1,220 $ 1,957 $ 2,426 Allowance for obsolete inventory/2 $ 405 $ 4,626 $ 500 $ 4,531 Year ended December 31, 1998 Allowance for doubtful accounts/1 $ 2,426 $ 2,578 $ 2,017 $ 2,987 Allowance for obsolete inventory/2 $ 4,531 $ - $ 162 $ 4,369 - ---------------------------------------------------------------------------------------------------------- /1 Deductions primarily represent accounts written off during the period. /2 Deductions represent inventory scrapped during each period. Independent Auditors' Report The Board of Directors and Stockholders Mentor Graphics Corporation: Under date of February 1, 1999, except for note 13, which is as of February 10, 1999, we reported on the consolidated balance sheets of Mentor Graphics Corporation and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998, which are included in the annual report on Form 10-K for the year 1998. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related consolidated financial statement schedule as listed in the accompanying index. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG Peat Marwick LLP Portland, Oregon February 1, 1999, except for note 13, which is as of February 10, 1999 52