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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2002

OR

For the transition period from ___________ to ___________

Commission file number 0-16617

ALTERA CORPORATION

101 INNOVATION DRIVE
SAN JOSE, CALIFORNIA 95134
(Address of principal executive offices)(zip code)

408-544-7000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days.

Yes [X]      No [  ]

Number of shares of common stock outstanding at November 5, 2002: 382,532,853

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PART I FINANCIAL INFORMATION

ITEM 1: Financial Statements

ALTERA CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands)

See accompanying notes to condensed consolidated financial statements.

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ALTERA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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ALTERA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)

See accompanying notes to condensed consolidated financial statements.

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ALTERA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1 — Organization and Basis of Presentation:

The accompanying unaudited condensed consolidated financial statements of Altera Corporation and subsidiaries, referred to herein as “we”, “us”, or “our”, have been prepared by us in accordance with accounting principles generally accepted in the United States of America. This financial information reflects all adjustments which are, in the opinion of our management, of a normal recurring nature and necessary to present fairly the statements of financial position as of September 30, 2002, results of operations for the three and nine months ended September 30, 2002 and September 30, 2001, and cash flows for the nine months ended September 30, 2002 and September 30, 2001. The December 31, 2001 balance sheet was derived from audited financial statements on that date. All significant intercompany transactions and balances have been eliminated.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates, and material effects on our operating results and financial position may result.

These condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2001 included in our Annual Report on Form 10-K, as filed on March 8, 2002 with the Securities and Exchange Commission, or SEC. The results of operations for the three and nine months ended September 30, 2002 are not necessarily indicative of the results to be expected for any future periods.

The interim periods ended on the Friday nearest September 30th. For presentation purposes, the interim financial statements and accompanying notes refer to our interim periods ending as of September 30th.

Note 2 — Balance Sheet Details:

The inventories at September 30, 2002 and December 31, 2001 were comprised of the following (in thousands):

As a result of unfavorable economic conditions and diminished demand for semiconductor products beginning in late 2000, we experienced a sharp decline in sales and recorded total inventory charges of $154.5 million in 2001. These inventory charges were recorded in cost of sales in our consolidated statement of operations and related primarily to excess inventory for our APEX 20KE, FLEX 10KE, and MAX 7000A product families and assembly packaging materials. We had gross margin benefits of $1.4 million during the second quarter of 2002 and $5.4 million during the third quarter of 2002 resulting from releases of inventory reserves due to the sale of inventory previously reserved in 2001.

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Property and equipment at September 30, 2002 and December 31, 2001 were comprised of the following (in thousands):

Note 3 — Restructuring and Other Special Charges:

During 2001, we recorded restructuring and other special charges of $47.7 million in connection with our plan to reduce future operating expenses and to align our organization’s cost structure with a reduction in projected sales resulting from unfavorable economic conditions. The charges consisted of severance and fringe benefits related to our workforce reduction of approximately 152 employees primarily in selling, general, and administrative functions. The charges also included the write-down associated with the spin-off of Northwest Logic, Inc., the write-down of certain equipment and intangible assets, the consolidation of excess facilities, and the termination of certain license agreements. In addition, we made a one-time payment of $20.0 million as part of our patent litigation settlement with Xilinx, Inc. These charges were classified as operating expenses in our consolidated statement of operations for the year ended December 31, 2001.

The following table summarizes the charges in 2001 and the activity related to the restructuring liability during the first nine months of 2002 (in thousands):

Cash expenditures relating to workforce reductions have been substantially paid as of June 30, 2002. Amounts related to non-cancelable leases will be paid over their respective terms through the third quarter of 2005. The restructuring liability, totaling $0.6 million as of September 30, 2002, is included in accrued liabilities in the condensed consolidated balance sheet.

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Note 4 — Comprehensive Income (Loss):

The components of comprehensive income (loss), net of tax, are as follows (in thousands):

Accumulated other comprehensive income (loss) presented in the accompanying condensed consolidated balance sheets consists of the accumulated unrealized gain (loss) on available-for-sale investments, net of tax.

Note 5 — Income Per Share:

In accordance with SFAS No. 128, “Earnings Per Share,” we compute basic income (loss) per share by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period (excluding the dilutive effect of stock options and restricted stock). Diluted income per share reflects the dilution of potential common shares outstanding during the period. In computing diluted income per share, we adjust share count by assuming that all in-the-money options are exercised and that we repurchase shares with the proceeds of these hypothetical exercises along with the tax benefit resulting from the hypothetical option exercises. We further assume that any unamortized deferred stock-based compensation is also used to repurchase shares. In determining the hypothetical shares repurchased, we use the average stock price for the period.

Diluted income per share excludes out-of-the-money stock options and unvested restricted stock totaling 37.9 million shares for the three months ended September 30, 2002 and 28.7 million shares for the nine months ended September 30, 2002, as their effect is anti-dilutive. Anti-dilutive options and unvested restricted stock totaled 12.3 million shares for the three months ended September 30, 2001 and 24.4 million shares for the nine months ended September 30, 2001. While these options are currently anti-dilutive, they could be dilutive in the future. A reconciliation of basic and diluted income (loss) per share is presented below (in thousands, except per share amounts):

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Note 6 — Common Stock Repurchases:

During the third quarter of 2002, we repurchased 3.1 million shares of common stock for an aggregate cost of $36.7 million. For the first nine months of 2002, we repurchased 7.8 million shares of common stock for an aggregate cost of $126.0 million. In October 2002, our Board of Directors approved an increase in the shares authorized for repurchase from 48.0 million shares to 68.0 million shares. Since the inception of our repurchase program in 1996 through the end of the third quarter of 2002, we have repurchased 44.9 million of the 68.0 million shares authorized for repurchase. The repurchased shares were retired upon acquisition.

Note 7 — Deferred Stock-Based Compensation:

We recorded deferred stock-based compensation of $1.1 million during the nine months ended September 30, 2002 and $283,000 during the nine months ended September 30, 2001. Deferred stock-based compensation represents the difference between the sale price and the quoted market price of our stock on the date that restricted stock is sold to certain new employees. We amortize deferred stock-based compensation over the vesting period of three to four years. Amortization of deferred stock-based compensation was $2.9 million for the three months ended September 30, 2002 and $8.5 million for the nine months ended September 30, 2002. Amortization of deferred stock-based compensation was $3.3 million for the three months ended September 30, 2001 and $15.6 million for the nine months ended September 30, 2001. The restricted stock sold to the employees is subject to our repurchase rights under certain circumstances. At September 30, 2002, 566,011 shares were subject to our repurchase rights at the original sale prices.

Note 8 — New Accounting Pronouncements:

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This Statement requires that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 will be effective for exit or disposal activities that are initiated after December 31, 2002.

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ITEM 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as information contained in “Future Results; Risk Factors” below and elsewhere in this report, contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and actual results may differ materially from those projected in the forward-looking statements as a result of various factors. Forward-looking statements are generally written in the future tense and/or are preceded by words such as “will,” “may,” “should,” “could,” “expect,” “suggest,” “believe,” “anticipate,” “intend,” “plan,” or other similar words. Forward-looking statements include statements regarding (1) our gross margins and factors that affect gross margins, such as the costs of raw materials, our ability to absorb manufacturing costs, trends in selling prices, and the sale of previously reserved inventory; (2) our ability to control and reduce operating expenses; (3) our research and development efforts; (4) the commercial success of our new products; (5) trends in future sales; (6) the availability of funds and cash to finance operations; (7) our ability to hold our fixed income investments until maturity; and (8) future economic conditions.

     The forward-looking statements contained in this report and any prediction of our future results of operations involve a number of risks and uncertainties, many of which are outside of our control. Some of these risks and uncertainties are described in proximity to the forward-looking statements. Factors that could cause actual results to differ materially from projected results include, but are not limited to, risks associated with the following, which are described in more detail later in this report:

	•		our ability to compete successfully in the highly competitive semiconductor industry;
	•		our ability to define, develop, and sell new products that achieve market acceptance;
	•		our dependence on independent subcontractors for the supply of finished silicon wafers;
	•		our dependence on independent subcontractors, located primarily in Asia, for the testing and assembly of our semiconductor products;
	•		conditions outside the control of our independent subcontractors;
	•		the ability of our intellectual property rights to provide meaningful protection from our competitors;
	•		the significant costs of intellectual property litigation;
	•		our exposure to warranty-related liabilities;
	•		our dependence on distributors to generate sales and fulfill our customer orders;
	•		the length of our design-in and sales cycle;
	•		our dependence on international sales for a significant portion of our total sales;
	•		our potential tax liability as a multinational corporation;
	•		the fluctuation of our gross margins;
	•		general economic conditions and the cyclical nature of the semiconductor industry;
	•		the fluctuation of our quarterly operating results;
	•		our ability to attract and retain key technical and management personnel;

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	•		earthquakes and other catastrophic events; and
	•		limited insurance coverages.

     Although we believe that the assumptions underlying the forward-looking statements contained in this report are reasonable, any of the assumptions could be inaccurate due to the risks and uncertainties associated with our business. Therefore, forward-looking statements included in this report could be inaccurate. In light of the significant risks and uncertainties inherent in the forward-looking statements included in this report, you should not interpret the inclusion of such information as a representation by us that the results or conditions described in such statements will be achieved.

CRITICAL ACCOUNTING POLICIES

     The preparation of our financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires our management to make judgments and estimates that affect the amounts reported in our financial statements and accompanying notes. Our management believes that we consistently apply judgments and estimates and such consistent application results in financial statements and accompanying notes that fairly represent all periods presented. However, any factual errors or errors in these judgments and estimates may have a material impact on our statement of operations and financial conditions. Critical accounting policies, as defined by the SEC, are those that are most important to the portrayal of our financial condition and results of operations and require our management’s most difficult and subjective judgments and estimates of matters that are inherently uncertain. Our critical accounting policies include those regarding (1) revenue recognition; (2) the valuation of inventories; and (3) the valuation of property, equipment, and intangible assets.

Revenue Recognition

     We sell our products to original equipment manufacturers, or OEMs, and to electronics component distributors who resell products to OEMs. We recognize revenue on products sold to OEMs upon shipment, but defer recognition of revenue on products sold to distributors until the products are resold. More than ninety-five percent of our products are sold to distributors for subsequent resale to OEMs or their subcontract manufacturers. Our revenue reporting is highly dependent on receiving pertinent and accurate data from our distributors in a timely fashion. Distributors provide us periodic data regarding the product, price, quantity, and end customer on their shipments as well as the quantities of our products they still have in stock. We have developed robust systems for receiving that information and have additionally developed cross-checks for verifying the accuracy of the reported information. We also perform audits of our distributors’ information systems and inventories. We believe that the information supplied to us by our distributors is materially accurate and complete. If distributors incorrectly report their sales or mis-state their inventory of our products, it could lead to inaccurate reporting of our revenues and income.

Valuation of Inventories

     Inventories are recorded at the lower of cost on a first-in-first-out basis (approximated by standard cost) or market. We reserve inventory that is excess to projected customer demand, and the creation of such reserves results in a write-down of inventory to net realizable value and a charge to cost of goods sold. Historically, it has been difficult to forecast customer demand especially at the part-number level. Many of the orders we receive from our customers and distributors request delivery of product on a relatively short notice and with lead times less than our manufacturing cycle time. In order to provide competitive delivery times to our customers, we build and stock a certain amount of inventory in anticipation of customer demand that may not materialize. Moreover, as is common in the semiconductor industry, we allow customers to cancel orders with minimal advance notice. Thus, even product built to satisfy specific customer orders may not ultimately be required to fulfill customer demand. We routinely compare our inventory against projected demand and as a result frequently record immaterial inventory charges to provision for excess and obsolete inventories. Nevertheless, at any point in time, some portion of our unreserved inventory is subject to the risk of being materially in excess to projected demand. In 2001, as a result of a large and unforecasted decline in sales, we determined that a significant portion of our inventory was excess to projected demand and recorded inventory charges of $154.5 million. While we endeavor to accurately predict demand and stock commensurate inventory levels, we may record unanticipated material inventory write-downs in the future.

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Valuation of Property, Equipment, and Intangible Assets

     We evaluate the recoverability of our property, equipment, and intangible assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We regularly compare the carrying value of long-lived assets to our projection of future undiscounted cash flows attributable to such assets and in the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the asset’s fair value. Actual useful lives and future cash flows could be different from those estimated by our management. These differences could have a material effect on our future operating results.

     In 2001, we recorded a charge of $13.3 million for the impairment of (1) production and other equipment that has been removed from service or is being held for sale, (2) purchased intangible assets related to technology acquired in previous acquisitions but no longer being used, and (3) investments in development stage enterprises that were in financial distress. These charges were classified as operating expenses in our consolidated statements of operations.

RESULTS OF OPERATIONS

Sales

     We offer three main types of semiconductor products: (1) field-programmable gate arrays, or FPGAs, which consist of our Stratix, APEX, APEX II, FLEX, ACEX, Excalibur, and Mercury families; (2) general-purpose complex programmable logic devices, or CPLDs, which consist of our MAX and Classic families; and (3) low-cost, masked devices, which consist of our HardCopy and Mask Programmed Logic Device, or MPLD, families.

     We classify our products into three categories: New, Mainstream, and Mature and Other Products. These categories are based on the process technologies used to manufacture our products, and as our products mature, we adjust the categories and restate prior data to reflect the current category composition.

	•		New Products include ACEX 1K, APEX 20KC, APEX 20KE, APEX II, MAX 7000B, Excalibur, HardCopy, Mercury, and Stratix families;
	•		Mainstream Products include APEX 20K, FLEX 6000, FLEX 10KA, FLEX 10KE, MAX 3000A, and MAX 7000A families; and
	•		Mature and Other Products include Classic, FLEX 8000, FLEX 10K, MAX 7000, MAX 7000S, and MAX 9000 families, MPLD, configuration and other devices, tools, and intellectual property.

     Sales during the three months ended September 30, 2002 were $180.1 million compared to $174.2 million for the three months ended September 30, 2001, representing a 3% increase in sales year over year. Sales during the nine months ended September 30, 2002 were $531.0 million compared to $676.9 million for the nine months ended September 30, 2001, representing a 22% decline in sales year over year.

     The decline in the year-to-date sales comparison is the result of five consecutive sequential declines in quarterly sales beginning in the fourth quarter of 2000 and ending in the fourth quarter of 2001. The protracted deceleration resulted in a peak-to-trough decline in quarterly sales of nearly 60%. This period of decline was the result of a general economic downturn and softening demand for products manufactured by our customers, especially those in the communications and computing equipment markets. Our customers, in response to reduced demand for their products, acted to reduce their inventories resulting in an inventory contraction throughout the entire supply chain. The reduction in end-market demand coupled with the inventory contraction resulted in significant sales declines for the semiconductor industry including the programmable logic segment. As the rate of decline in our customers’ markets moderated and as customers achieved reduced inventories consistent with their reduced sales levels, they began to procure more semiconductors including our products. This increase in demand, coupled with increasing sales of our New Products, led to sequential sales increases of 6% during the first quarter of 2002, 4% during the second quarter of 2002, and an additional 1% during the third quarter of 2002. We expect fourth quarter sales to be between $176.5 million and $183.7 million. We also expect that, during the fourth quarter of 2002, sales will continue to grow in our New Products, as well as in the Consumer and Industrial and Automotive markets, but sales will decline in the Communications and Computer and Storage markets. We cannot assure you that this

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will occur and if unstable and unfavorable economic conditions persist or worsen, our sales could be below our expectations.

     Sales by product category, as a percentage of total sales, were as follows for the three and nine months ended September 30, 2002 and 2001:

     New Products represented 30% of total sales for the three months ended September 30, 2002, up from 16% of total sales for the three months ended September 30, 2001. New Products for the nine months ended September 30, 2002 represented 25% of total sales, up from 12% over the same period a year ago. Our New Products have been developed and introduced to the marketplace over the last several years. These products have improved features and higher densities than their predecessors. As a result of increased customer demand for programmable logic devices, or PLDs, with higher densities and enhanced performance, we have experienced a shift in sales to our newer products from our more mature products. Sales of New Products grew 95% during the three months ended September 30, 2002 and 62% during the nine months ended September 30, 2002 compared to the same periods a year ago. We expect that sales of our New Products will continue to increase as design win momentum in our New Products continues to be strong, but we cannot assure you that this will occur.

     Sales of Mainstream Products declined 14% during the three months ended September 30, 2002 and 33% during the nine months ended September 30, 2002 compared to the same periods a year ago. Sales of Mature and Other Products declined 15% during the three months ended September 30, 2002 and 33% during the nine months ended September 30, 2002 compared to the same periods a year ago. The declines in both product categories for all comparable periods were driven by continued softness in end-markets, discontinuation of certain product lines by some customers, excess inventory at various customers, as well as price declines.

     The semiconductor industry is intensely competitive and our products are subject to price erosion. New products generally have higher selling prices that typically decline over a product’s life cycle. Our strategy is to offset the overall reduction in sales that results from declining selling prices by introducing new products. This strategy is dependent on successful development and roll-out of new products and the market’s acceptance of those products. We believe that we have been generally successful in that regard, but can give no assurance of future success. Unless future new products are developed and introduced in a timely fashion and achieve market acceptance, future sales will decline.

     Effective January 1, 2002, we adopted a new methodology for revenue classification by market segment. The market segment data is derived by analysis that involves interpretation and extrapolation and relies on information provided to us by our distributors and end customers; actual percentages may be different. Sales by market segment, as a percentage of total sales, were as follows for the three months ended September 30, 2002 and June 30, 2002, and for the nine months ended September 30, 2002:

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     Despite the unfavorable economic conditions and reduced capital spending for communications equipment, we continued to generate the largest percentage of our sales from the Communications market segment. The Communications market segment includes the networking, telecommunication, and wireless sectors. We believe that the Communications market will continue to be our largest market segment in the foreseeable future.

     Compared to the second quarter of 2002, third quarter sales into the Communications market segment declined 8%, Industrial and Automotive increased 4%, Computer and Storage declined 3%, and Digital Consumer increased 33%. The 8% sequential decline in the Communications market segment was driven primarily by a decline in wireless and telecommunication business. The 4% increase in the Industrial and Automotive market segment was driven primarily by growth in manufacturing, test and measurement equipment, medical, and automotive business. The 33% increase in the Digital Consumer market segment was driven primarily by growth in digital broadcast business. For the three and nine months ended September 30, 2002, no single end customer provided more than 10% of our sales. Sales for the three and nine months ended September 30, 2002 are not necessarily indicative of the results to be expected for any future periods. If unstable and unfavorable economic conditions persist or worsen, our sales could decrease.

     Sales by geography, as a percentage of total sales, were as follows for the three and nine months ended September 30, 2002 and 2001:

     North America sales represented 38% of total sales for the three months ended September 30, 2002, down from 44% of total sales for the three months ended September 30, 2001. North America sales for the nine months ended September 30, 2002 represented 42% of total sales, down from 45% over the same period a year ago. The percentage of sales for North America declined as certain end customers shifted their production to subcontract manufacturing sites located in Asia Pacific, thereby resulting in the transfer of some of our sales from North America to Asia Pacific. In absolute dollars, for the three and nine months ended September 30, 2002 compared to the same periods a year ago, we saw declines in North America and Europe primarily due to a general economic downturn and softening end-market demand especially in the Communications and Computer and Storage sectors. Sales in Japan increased slightly during the third quarter of 2002 compared to the same period a year ago.

     Compared to the second quarter of 2002, third quarter sales in North America declined 10% primarily due to the transfer of more sales from North America to Asia Pacific. Sales in Europe declined 3% primarily

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due to its seasonal slow period. We expect that sales will continue to transfer from North America, Europe, and Japan to Asia Pacific in the foreseeable future.

Gross Margin

     Gross margins were 64% for the three months ended September 30, 2002 and 62% for the nine months ended September 30, 2002. These percentages included benefits of $5.4 million for the three months ended September 30, 2002 and $6.8 million for the nine months ended September 30, 2002 resulting from the release of inventory reserves due to the sale of inventory previously reserved in 2001. Excluding this inventory reserve release benefit, gross margins were 61% for the three months ended September 30, 2002 and 60% for the nine months ended September 30, 2002.

     Gross margins were 63% for the three months ended September 30, 2001 and 47% for the nine months ended September 30, 2001. These percentages included a $116.1 million write-down of inventories, which was charged against cost of sales in the second quarter of 2001. Excluding this inventory write-down, gross margins were 63% for the three months ended September 30, 2001 and 64% for the nine months ended September 30, 2001. The write-down reflected our evaluation that much of our inventory was excess to projected demand. Through the first three quarters of 2000, we experienced rapid growth in demand for our products. Because we believed that strong demand would continue and because we desired to reduce lead times and improve customer service levels, we ordered significant volumes of wafers for delivery in the fourth quarter of 2000 and first quarter of 2001. Demand began to fall precipitously in the fourth quarter of 2000, rendering many of the wafers that we had ordered excess to projected demand. The products that we procure from our wafer suppliers are custom and unique to us. Once our supplier begins production, we are obliged to take delivery of, and pay for, the material we have ordered. Our wafer suppliers’ manufacturing cycle times are often as long as three months and sometimes longer. This long manufacturing cycle time as contrasted to our customers’ desire for short delivery lead times necessitates that we order material based upon internal forecasts of demand. In the future, to the extent that we misestimate total demand, or the mix of demand, we may degrade customer service to unacceptably low levels or may procure materials that prove to be excess to projected demand, which will result in additional charges against cost of sales.

     Excluding the 2002 inventory reserve release benefit and 2001 inventory write-down, gross margins were 61% for the three months ended September 30, 2002 and 63% for the same period last year; gross margins were 60% for the nine months ended September 30, 2002 and 64% for the same period last year. On this basis, the decreases in gross margins for the three and nine months ended September 30, 2002 over the same periods last year were due to declines in selling prices, coupled with fixed unit costs resulting from high inventory levels and reduced factory activity contributing to under-absorbed manufacturing overhead.

     Excluding the impact of reserve releases relating to the sale of previously reserved inventory, we expect that gross margin will be relatively flat in the fourth quarter compared to the third quarter of 2002. This expectation is based on anticipated improvement in manufacturing overhead absorption as we ramp production for certain products, and on anticipated lower die costs resulting from improved yields and lower wafer prices, offset by declines in selling prices. Additionally, we anticipate that gross margins will benefit by several hundred basis points from the sale of reserved inventory for the next several quarters including the fourth quarter. The actual amount of the benefit is dependent on the mix of products ordered by customers, is subject to significant volatility, and is difficult to reliably predict.

Research and Development

     Research and development expenses for the three months ended September 30, 2002 were $48.4 million, or 27% of sales, compared to $40.2 million, or 23% of sales, for the three months ended September 30, 2001. Research and development expenses for the nine months ended September 30, 2002 were $133.5 million, or 25% of sales, compared to $131.2 million, or 19% of sales, for the nine months ended September 30, 2001. Research and development expenses include expenditures for labor, masks, prototype wafers, the amortization of deferred stock-based compensation for employees engaged in research and development activities, and expenses for the development of process technologies, new packages, and software to support new products and design environments.

     Research and development expenses increased $8.2 million, or 21%, for the three months ended September 30, 2002 over the same period a year ago. The increase was primarily attributable to higher spending on prototype wafers. Research and development expenses increased $2.3 million, or 2%, for the

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nine months ended September 30, 2002 over the same period a year ago. The increase was primarily attributable to higher spending on prototype wafers. Historically, the level of research and development expenses has fluctuated in part due to the timing of the purchase of masks and prototype wafers used in the development of new products. We expect that research and development expenses will remain relatively flat in the fourth quarter of 2002.

     We will continue to make significant investments in the development of new products and focus our efforts on the development of new PLDs and hardware that utilize advanced semiconductor wafer fabrication processes, as well as related development software. We are currently investing in the development of our Cyclone, Stratix, Stratix GX, and HardCopy families, our Quartus II software, and Excalibur embedded processor solutions, as well as other future products. We expect these new products to be successful in the marketplace, but we cannot assure you that such products will achieve market success. Some of our recent major achievements are summarized below:

	•		In September 2002, we announced the Cyclone device family, a low-cost FPGA family. Cyclone devices include a focused combination of features, density, and performance. Cyclone devices target designers of high-volume systems in the consumer, communications, industrial, and automotive markets by delivering the benefits of programmable devices at lower prices.
	•		In the second quarter of 2002, we began shipping our Stratix device family. To date, we have shipped four members of our Stratix device family to customers. Stratix devices have smaller die sizes than our previous product families and offer high levels of integration with more memory, logic elements, and digital signal processing, or DSP, functionality. The new high-performance Stratix architecture allows for easier integration of complex functions into a single PLD.
	•		In March 2002, we completed the roll out of all of our first generation ARM-based Excalibur embedded processor solutions including the ARM-based hard core processor and the Nios soft core processor, which we believe provide designers a reduction in overall development cost and accelerated time-to-market compared to ASIC solutions. Utilizing the Nios soft core and ARM-based hard core embedded processors, customers can integrate more functionality into PLDs.
	•		Introduced in the first quarter of 2002, our SOPC Builder is an automated system generation tool, which combines system building blocks into a complex design implemented in our high-density PLDs. When combined with our Excalibur embedded processor solutions, SOPC Builder enables the creation of complex systems that include on-chip memory, a processor core, I/O functions, and application-specific intellectual property.
	•		We began shipping our HardCopy devices in 2001. Our Hardcopy devices facilitate a seamless migration path from the largest PLDs to a low-cost, non-programmable alternative for customers willing to purchase large volumes of our HardCopy devices. HardCopy devices are currently offered to support our high-density APEX 20KE and APEX 20KC devices and will be developed to support additional high-density devices in the future. We believe the combination of PLDs and HardCopy devices will deliver the benefits of fast time-to-market, flexibility, and lower costs that are important to customers in today’s markets.

Selling, General, and Administrative

     Selling, general, and administrative expenses for the three months ended September 30, 2002 were $41.2 million, or 23% of sales, compared to $48.7 million, or 28% of sales for the three months ended September 30, 2001. Selling, general, and administrative expenses for the nine months ended September 30, 2002 were $127.0 million, or 24% of sales, compared to $167.5 million, or 25% of sales for the nine months ended September 30, 2001. Selling, general, and administrative expenses primarily include salary expenses related to sales, marketing, and administrative personnel, commissions and incentives, depreciation, legal, advertising, and travel and entertainment expenses.

     Selling, general, and administrative expenses decreased $7.5 million, or 16%, for the three months ended September 30, 2002 and $40.5 million, or 24%, for the nine months ended September 30, 2002 over the same periods a year ago. The decreases were primarily due to spending control measures including the restructuring programs implemented during 2001, lower expenses for labor, advertising, recruiting, travel, and

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entertainment, as well as reduced litigation expenses stemming from the settlement of our litigation with Xilinx and Lattice Semiconductor Corporation. We expect that selling, general, and administrative expenses will increase slightly to approximately $42.0 million for the fourth quarter of 2002.

Restructuring and Other Special Charges

     During 2001, we recorded restructuring and other special charges of $47.7 million in connection with our plan to reduce future operating expenses and to align our organization’s cost structure with a reduction in projected sales resulting from unfavorable economic conditions. The charges consisted of severance and fringe benefits related to our workforce reduction of approximately 152 employees primarily in selling, general, and administrative functions. The charges also included the write-down associated with the spin-off of Northwest Logic, the write-down of certain equipment and intangible assets, the consolidation of excess facilities, and the termination of certain license agreements. In addition, we made a one-time payment of $20.0 million as part of our patent litigation settlement with Xilinx. These charges were classified as operating expenses in our consolidated statement of operations for the year ended December 31, 2001.

     The following table summarizes the charges in 2001 and the activity related to the restructuring liability during the first nine months of 2002 (in thousands):

     Cash expenditures relating to workforce reductions have been substantially paid as of June 30, 2002. Amounts related to non-cancelable leases will be paid over their respective terms through the third quarter of 2005. The restructuring liability, totaling $0.6 million as of September 30, 2002, is included in accrued liabilities in the condensed consolidated balance sheet.

Income (Loss) from Operations

     Income from operations was $25.4 million, or 14% of sales, for the three months ended September 30, 2002 compared to $20.7 million, or 12% of sales for the three months ended September 30, 2001. For the nine months ended September 30, 2002, income from operations was $66.7 million, or 13% of sales, compared to a loss from operations of $9.1 million, or 1% of sales, for the nine months ended September 30, 2001. The increase in operating income for the three months ended September 30, 2002 over the same period last year was primarily due to an increase in sales. The increase in operating income for the nine months ended September 30, 2002 over the same period last year was primarily due to the inventory and restructuring charges taken during the second quarter of 2001. Excluding these charges, income from operations for the nine months ended September 30, 2001 was $137.8 million, or 20% of sales. On that basis, the decrease in operating income compared to last year was due to a decrease in sales and gross margin percentage, partially offset by a decrease in total operating expenses.

Interest and Other Income, Net

     Interest and other income was $6.3 million for the three months ended September 30, 2002 compared to $9.1 million for the three months ended September 30, 2001. Interest and other income was $20.0 million for the nine months ended September 30, 2002 compared to $33.4 million for the nine months ended September 30, 2001. Interest and other income consists mainly of interest income generated from investments in high-quality fixed income securities. The decline in interest and other income for the three months ended

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September 30, 2002 compared to the same period last year was primarily due to a decline in market interest rates. The decline for the nine months ended September 30, 2002 compared to the same period last year was primarily due to a decline in market interest rates as well as a lower average investment balance.

Provision for Income Taxes

     Our effective income tax rate was 26% for the three months ended September 30, 2002 compared to 30% for the three months ended September 30, 2001. The reduction in the effective tax rate was primarily due to the increased impact of benefits relating to tax-exempt income and research and development tax credits, as well as a change in the geographic mix of income.

Financial Condition, Liquidity, and Capital Resources

     We ended the third quarter of 2002 with $885.3 million of cash, cash equivalents, and short-term investments available to finance our operating activities and future growth. Since our inception, we have used a combination of equity and debt financing and cash generated from operations to support our operating activities, capital expenditures, acquisitions and investments, and repurchases of our common stock under our stock repurchase program. We believe the available sources of funds including cash, cash equivalents, short-term investments, and cash we expect to generate from operations will be adequate to finance our activities for at least the next year.

     Cash and cash equivalents increased $35.4 million or 24%, to $180.4 million at September 30, 2002 from $145.0 million at December 31, 2001. The increase resulted from $199.3 million provided by operating activities, partially offset by $54.4 million used for investing activities and $109.5 million used for financing activities. Our positive cash flow from operations was mainly attributable to net income, depreciation and amortization, a decrease in other current assets resulting primarily from the receipt of a tax refund, decreases in inventory, and deferred taxes, as well as an increase in accrued compensation. These items were partially offset by an increase in accounts receivable.

     For the nine months ended September 30, 2002, cash used for investing activities of $54.4 million consisted of purchases of short-term investments and capital equipment. These items were partially offset by proceeds from the maturity and sale of short-term investments. Cash used for financing activities of $109.5 million resulted from the repurchase of our common stock, which was partially offset by the net proceeds from the issuance of our common stock to our employees.

Impact of Currency Translation and Inflation

     We purchase the majority of our materials and services in U.S. dollars and transact our foreign sales in U.S. dollars. We have, in the past, entered into forward contracts to hedge against currency fluctuations associated with contractual commitments denominated in foreign currencies. As of September 30, 2002, we had no open forward contracts; however, we may enter into similar contracts from time to time to hedge foreign exchange exposure. To date, inflation has not significantly impacted our financial results, but could in the future.

New Accounting Pronouncements

     In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This Statement requires that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 will be effective for exit or disposal activities that are initiated after December 31, 2002.

Stock Option Plans

     Our stock option program is a broad-based, long-term retention program intended to attract, motivate, and retain talented employees as well as align stockholder and employee interests. We currently grant stock options under two plans: the 1996 Stock Option Plan, which provides for the periodic issuance of stock options

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to our employees, and the 1998 Director Stock Option Plan, which provides for the periodic issuance of stock options to members of our Board of Directors who are not employees. The majority of the options granted under these plans will generally vest over four years. All options have a maximum term of ten years.

     We monitor dilution related to our option program by comparing net option grants in a given year to the number of shares outstanding. The dilution percentage is calculated as the new option grants for the year, net of options forfeited by employees leaving the company, divided by the total outstanding shares at the beginning of the year. The option grant dilution percentages were 1.1% for the nine months ended September 30, 2002, 2.3% in fiscal year 2001, and 2.8% in fiscal year 2000. We also have a share repurchase program where we regularly repurchase shares from the open market to offset dilution related to our option program.

     For 2001, options granted to our named executive officers, or NEOs, amounted to 1.7 million shares, or 14.4% of the approximately 12.1 million shares of the total options granted. Because we hired a new Chief Executive Officer in 2000 and another executive officer in 2001, our NEOs differ for fiscal years 2000 and 2001. Therefore, for comparison purposes, our NEOs for the periods presented are defined as the Chief Executive Officer and the four other most highly compensated executive officers as disclosed in our 2001 Proxy Statement dated March 19, 2002. No options have been granted to our NEOs for the first nine months of 2002, as grants to officers are generally made once a year in December. For additional information regarding options granted to our NEOs in 2001 and 2000, please refer to the “Executive Compensation” section of our 2001 and 2000 Proxy Statements filed with the SEC.

     A summary of the distribution and dilutive effect of options granted is as follows:

     A summary of our stock option activity and related weighted average exercise prices from 2001 through the first nine months of 2002 is as follows (in thousands, except price per share amounts):