UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended June 30, 2004

OR

Commission File Number: 000-18805

ELECTRONICS FOR IMAGING, INC.

303 Velocity Way, Foster City, CA 94404
(Address of principal executive offices, including zip code)

(650) 357 - 3500
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

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

The number of shares of Common Stock outstanding as of July 30, 2004 was 53,553,923.

INDEX

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PART I            FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Electronics for Imaging, Inc.

See accompanying notes to condensed consolidated financial statements.

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Electronics for Imaging, Inc.

See accompanying notes to condensed consolidated financial statements.

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Electronics for Imaging, Inc.

See accompanying notes to condensed consolidated financial statements.

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Electronics for Imaging, Inc.

1. Basis of Presentation

The unaudited interim condensed consolidated financial statements of Electronics for Imaging, Inc., a Delaware corporation (the “Company”), as of and for the interim period ended June 30, 2004, have been prepared on the same basis as the audited consolidated financial statements as of and for the year ended December 31, 2003, contained in the Company’s Annual Report to Stockholders on Form 10-K. In the opinion of management, the unaudited interim condensed consolidated financial statements of the Company include all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the financial position of the Company and the results of its operations and cash flows, in accordance with accounting principles generally accepted in the United States of America. The interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements referred to above and the notes thereto. Certain prior year balances have been reclassified to conform with the current year presentation.

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

The interim results of the Company are subject to fluctuation. As a result, the Company believes the results of operations for the interim period ended June 30, 2004 are not necessarily indicative of the results to be expected for any other interim period or the full year.

2. Accounting for Derivative Instruments and Hedging

Statement of Financial Accounting Standard (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133, and SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an Amendment of SFAS No. 133 requires companies to reflect the fair value of all derivative instruments, including those embedded in other contracts, as assets or liabilities in an entity’s balance sheet. The Company determined that its only derivative is an embedded derivative contained in its 1.50% Senior Convertible Debentures, which was determined to have an insignificant value.

3. Stock-based Employee Compensation

As permitted under SFAS No. 123 Accounting for Stock-Based Compensation, as amended, the Company has elected to use the intrinsic value method as set forth in Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees. Accordingly, no stock-based compensation costs related to stock options have been recorded in the income statement. The Company has determined pro forma net earnings and net earnings per share information as if the fair value method described in SFAS 123 had been applied to its employee stock-based compensation and had been recognized as compensation expense.

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4. Comprehensive Income

The Company’s comprehensive income, which includes net income, market valuation adjustments and currency translation adjustments, is as follows:

5. Earnings Per Share

The following table represents unaudited disclosures of basic and diluted earnings per share for the periods presented below:

Anti-dilutive weighted average shares of common stock of 2,448,534 and 4,545,069 as of June 30, 2004 and 2003, respectively, have been excluded from the effect of dilutive securities because the options’ exercise prices were greater than the average market price of the common stock for the periods then ended. The convertible debentures issued June 4, 2003 are considered contingently convertible securities and were excluded from the earnings per share calculations for all periods presented. The debentures represent 9,084,192 potential shares of common stock issuable upon conversion.

6. Acquisitions

2003 Acquisitions

Best GmbH

In January 2003 the Company acquired Best GmbH, a German-based software company that provides proofing products for worldwide print and publishing markets, for approximately $9.6 million in cash. The acquisition was accounted for as a purchase business combination and accordingly, the purchase price has been allocated to the tangible and identifiable intangible assets acquired and liabilities assumed on the basis of their fair values on the date

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of acquisition. The following table summarizes the allocation of the purchase price to assets acquired and liabilities assumed:

The amounts allocated to intangible assets are being amortized using the straight-line method over their respective estimated useful lives; developed technology has a five-year life and all other acquired intangibles have a ten-year life.

Printcafe Software, Inc.

In October 2003 the Company acquired Printcafe Software, Inc. (“Printcafe”) for total consideration of approximately $33.4 million, paid in cash and common stock of the Company. Approximately 12.8 million shares of Printcafe common stock were issued and outstanding on that date, of which approximately 8.8 million shares of Printcafe common stock were redeemed for $22.9 million and approximately 1.9 million shares of Printcafe common stock were exchanged for approximately 0.2 million shares of the Company’s common stock, valued at $5.0 million. The remaining 2.1 million shares of stock were acquired by the Company for $5.5 million earlier in 2003. The Company applied the equity method of accounting for its investment in Printcafe and accordingly recorded a charge of $1.6 million based upon its share of Printcafe’s losses for the pre-acquisition period. The Company incurred $1.0 million of capitalized transaction-related costs including legal fees, accounting fees and other consulting fees and assumed stock options with a fair value of $0.6 million. The Company assumed liabilities in excess of assets on the date of acquisition of $14.9 million. The acquisition was accounted for as a purchase business combination and accordingly, the purchase price has been allocated to the tangible and identifiable intangible assets acquired and liabilities assumed on the basis of their estimated fair values on the date of acquisition as follows:

The amounts allocated to intangible assets are being amortized using the straight-line method over their respective estimated useful lives; developed technology has a four-year life and all other acquired intangibles, including customer relationships, have a five-year life.

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T/R Systems, Inc.

In November 2003 the Company acquired T/R Systems, Inc., for approximately $20.0 million in cash. The acquisition was accounted for as a purchase business combination and accordingly, the purchase price has been allocated to the tangible and identifiable intangible assets acquired and liabilities assumed on the basis of their estimated fair values on the date of acquisition. The following table summarizes the allocation of the purchase price to assets acquired and liabilities assumed:

The amounts allocated to intangible assets are being amortized using the straight-line method over their respective estimated useful lives; developed technology has a three-year life, customer relationships have a four-year life and the remaining acquired intangibles have a five- to seven-year life.

2004 Acquisitions

Automated Dispatch Systems Inc.

In February 2004 the Company acquired Automated Dispatch Systems, Inc. (“ADS”), for approximately $11.8 million in cash. The acquisition was accounted for as a purchase business combination and accordingly, the purchase price has been allocated to the tangible and identifiable intangible assets acquired and liabilities assumed on the basis of their estimated fair values on the date of acquisition. The following table summarizes the allocation of the purchase price to assets acquired and liabilities assumed:

The amounts allocated to intangible assets are being amortized using the straight-line method over their respective estimated useful lives; developed technology has a three-year life, customer relationships have a four-year life and the remaining acquired intangibles have a five-year life.

Valuation Methodology

Intangible assets acquired consist of developed technology, patents, trademarks and trade names and customer relationships. The amount allocated to the purchased in-process research and development (“IPR&D”) was determined using established valuation techniques and was expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed. The value of this IPR&D was determined

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by estimating the costs to develop the purchased IPR&D into a commercially viable product, estimating the resulting net cash flows from the sale of the products resulting from the completion of the IPR&D and discounting the net cash flows back to their present value at rates ranging from 25% to 30%. The percentage of completion for in-process projects acquired ranged from 10% to 90%. Schedules were based on management’s estimate of tasks completed and the tasks to be completed to bring the project to technical and commercial feasibility. IPR&D was included in operating expenses as part of other acquisition-related charges.

Pro forma Information

The unaudited pro forma information set forth below represents the revenues, net income and earnings per share of the Company and its 2003 and 2004 acquisitions as if the acquisitions were effective as of the beginning of the periods presented and includes certain pro forma adjustments, including the adjustment of amortization expense to reflect purchase price allocations, interest income to reflect net cash used for the purchase and the related income tax effects of these adjustments.

The unaudited pro forma information is not intended to represent or be indicative of the consolidated results of operations of EFI that would have been reported had the acquisitions been completed as of the beginning of the periods presented and should not be taken as representative of the future consolidated results of operations or financial condition of EFI.

2004 Divestiture

In February 2004 the Company sold certain assets related to its Unimobile business for cash of $5.3 million, including $1.1 million of cash held in escrow for up to eighteen months after the sale. The Company recognized a gain on sale of $3.0 million after accounting for the intangible and tangible assets of $1.8 million and related liabilities of $0.5 million.

7. Balance Sheet Components

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8. Goodwill and Other Identified Intangible Assets

As required under SFAS 142, Goodwill and Other Intangible Assets, the Company performed an annual review in 2003 and determined that no impairments needed to be recorded against the goodwill account at that time. The 2004 annual review for impairment is scheduled for the third quarter of 2004. The acquisition of ADS and additional purchase price adjustments associated with prior year acquisitions increased goodwill by $9.5 million for the first six months of 2004.

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Aggregate amortization expense was $3.5 million and $7.0 million for the three and six months ended June 30, 2004, respectively and $1.3 million and $2.6 million for the three and six months ended June 30, 2003, respectively. As of June 30, 2004 future estimated amortization expense related to intangible assets is estimated to be:

9. Long-term Debt

On June 4, 2003 the Company sold $240.0 million of its 1.50% convertible senior debentures due in 2023 (the “Debentures”) in a private placement. The Debentures have been registered with the Securities and Exchange Commission under the Securities Act of 1933 pursuant to a registration statement declared effective in January 2004. The Debentures are unsecured senior obligations of the Company, paying interest semi-annually in arrears at an annual rate of 1.50%. Additional interest at a rate of 0.35% per annum will be paid if the average market price of the debentures for the five trading days ending on the third trading day immediately preceding the first day of the relevant six-month period equals 120% or more of the principal amount of the debentures, beginning in the sixth year after issuance. The Debentures are convertible before maturity into shares of EFI common stock at a conversion price of approximately $26.42 per share of common stock but only upon the stock trading at or above $31.70 per share for 20 consecutive trading days during the last 30 consecutive trading days of the preceding fiscal quarter, or upon the occurrence of certain other specified events. The Company may redeem the Debentures at its option, on or after June 1, 2008 at a redemption price equal to par plus accrued interest, if any. In addition, holders of the Debentures may require the Company to repurchase all or some of the Debentures on June 1, 2008, 2013 and 2018 at a price equal to 100% of the principal amount plus accrued interest, including contingent interest, if any. The Company will pay the repurchase price for any debentures repurchased on June 1, 2008 in cash, but may choose to pay the repurchase price in cash, common stock of the Company, or any combination thereof in 2013 and 2018. Additionally, a holder may require the Company to repurchase all or a portion of that holder’s debentures if a fundamental change, as defined in the indenture, occurs prior to June 1, 2008 at 100% of their principal amount, plus any accrued and unpaid interest, including contingent interest, if any. The Company may choose to pay the repurchase price in cash, common stock of the Company, or any combination thereof.

Maturities of long-term debt are approximately $24,000 per year for the next five years.

10. Commitments and Contingencies

Off-Balance Sheet Financing - Synthetic Lease Arrangement

The Company is a party to two synthetic leases covering its Foster City facilities. The first lease (“1997 Lease”) was entered into in 1997 to fund the construction of an approximately 295,000 square foot building. The second lease (“1999 Lease”) was entered into in 1999 to fund the construction of an approximately 165,000 square-foot building. The Company may, at its option, purchase the facilities during or at the end of the term of the leases for the amount expended by the respective lessor to construct the facilities ($56.8 million for the 1997 Lease and $43.1 million for the 1999 Lease). In conjunction with the 1997 and 1999 Leases, the Company has entered into separate ground leases with the lessors for approximately 35 years. The Company has guaranteed to the lessors a residual value associated with the buildings equal to approximately 82% of their funding. The Company has assessed its exposure in relation to the first loss guarantee under the 1997 Lease and believes that there is no deficiency to the guaranteed value at June 30, 2004. The Company intends to renegotiate the 1999 Lease, and as part of that process will perform a valuation at that time. If there is a decline in value, the Company will record a loss associated with the residual value guarantee.

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The 1997 Lease, which expired in July 2004, requires the Company to meet certain financial covenant requirements related to cash to debt, fixed charge coverage ratio, leverage ratio and consolidated tangible net worth as defined in the lease agreement. If the Company maintains pledged collateral, then a limited subset of these covenants must be met. The tangible net worth financial covenant requires us to maintain a minimum tangible net worth as of the end of each quarter. There are other covenants regarding mergers, liens and judgments and lines of business. The Company is in compliance with all of the covenants, either directly, or through the existence of the pledged collateral. The pledged collateral under the 1997 Lease (approximately $69.9 million at June 30, 2004) has been classified as restricted on the balance sheet. The Company could be required to purchase the building covered by the 1997 Lease if the Company were to default on any indebtedness in excess of $10.0 million, to not appeal a judgment in excess of $10.0 million, or where a creditor has commenced enforcement proceedings on an order for payment of money in excess of $10.0 million. The Company is liable to the lessor for the full purchase amount of the buildings if it defaults on its covenants.

The Company has negotiated a new lease to replace the expired 1997 Lease. The new lease expires in July 2014, and is similar to the 1999 Lease in the covenants structure but with lesser amounts necessary in net worth and tangible net worth in order to remain in compliance.

The 1999 Lease, which has a initial seven-year term, requires the Company to meet certain financial covenant requirements related to fixed charge coverage ratio, consolidated net worth and consolidated tangible net worth as defined in the lease agreement. The tangible net worth financial covenant requires us to maintain a minimum tangible net worth as of the end of each quarter. There are other covenants regarding mergers, liens and judgments and lines of business. The Company is in compliance with all of the covenants. The Company is liable to the lessor for the full purchase amount of the buildings if it defaults on its covenants. The funds pledged under the 1999 Lease (approximately $43.1 million at June 30, 2004) are in a LIBOR-based interest bearing account and are restricted as to withdrawal at all times. With regards to the 1999 Lease the Company is considered a Tranche A lender of $35.3 million of the $43.1 million, while the lessor is considered a Tranche B lender for the remaining $7.8 million.

The Company is treated as the owner of these buildings for federal income tax purposes.

Effective July 1, 2003, the Company has applied the accounting and disclosure rules set forth in Interpretation No. 46 Consolidation of Variable Interest Entities, as revised (“FIN 46R”) for variable interest entities (“VIEs”). The Company has evaluated its synthetic lease agreements to determine if the arrangements qualify as variable interest entities under FIN 46R. The Company determined that the synthetic lease agreements do qualify as VIEs; however, because the Company is not the primary beneficiary under FIN 46R it is not required to consolidate the VIEs in the financial statements.

Purchase Commitments

The Company sub-contracts with other companies to manufacture its products. During the normal course of business the sub-contractors procure components based upon orders placed by the Company. If the Company cancels all or part of the order, it may still be liable to the sub-contractors for the cost of the components purchased by the sub-contractors for placement in its products. The Company periodically reviews the potential liability and the adequacy of the related reserve. The Company’s consolidated financial position and results of operations could be negatively impacted if the Company were required to compensate the sub-contract manufacturers for amounts in excess of the related reserve.

Product Warranties

Financial Accounting Standards Board Interpretation No 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”) requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee. The Company’s products are generally accompanied by a 12-month warranty, which covers both parts and labor. The Company accrues for warranty costs as part of its cost of sales based on associated material product costs and technical support labor costs. The warranty provision is based upon historical experience by product, configuration and geographic region.

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Changes in the warranty reserves for the six months ended June 30, 2004 and 2003 were as follows:

Legal Proceedings

Over the past several years, Mr. Jan R. Coyle, an individual living in Nevada, has repeatedly demanded that the Company buy technology allegedly invented by his company, Kolbet Labs. In December 2001, Mr. Coyle threatened to sue the Company and its customers for allegedly infringing his soon to be issued patent and for allegedly misappropriating his alleged trade secrets. The Company believes Mr. Coyle’s claims are baseless and completely without merit. Therefore, on December 11, 2001, the Company filed a declaratory relief action in the United States District Court for the Northern District of California, asking the Court to declare that the Company and its customers have not breached any nondisclosure agreement with Mr. Coyle or Kolbet Labs, nor has it infringed any alleged patent claims or misappropriated any alleged trade secrets belonging to Mr. Coyle or Kolbet Labs through its sale of Fiery, Splash or EDOX print controllers. The Company also sought an injunction enjoining both Mr. Coyle and Kolbet Labs from bringing or threatening to bring a lawsuit against the Company, its suppliers, vendors, customers and users of its products for breach of contract and misappropriation of trade secrets. On March 26, 2002, the Northern District of California Court dismissed the Company’s complaint citing the Court’s lack of jurisdiction over Mr. Coyle. The Company appealed the Court’s dismissal to the Court of Appeals for the Federal Circuit in Washington D.C., who reversed the dismissal of our case and remanded it back to the Northern District of California Court. Mr. Coyle and Kolbet Labs subsequently moved to dismiss our complaint under the Declaratory Judgment Act. The Court granted dismissal on February 17, 2004. On February 17, 2004, the Company filed a second declaratory relief action in the Northern District of California against Mr. Coyle and Kolbet Labs. On February 27, 2004, the Company filed a notice of appeal which is pending in Court of Appeals for the Federal Circuit in Washington, D.C. The Company is pursuing both of its cases against Mr. Coyle and Kolbet Labs.

On February 26, 2002, Mr. Coyle’s company, J&L Electronics, filed a complaint against the Company in the United States District Court for the District of Nevada alleging patent infringement, breach of non-disclosure agreements, misappropriation of trade secrets, violations of federal antitrust law and related causes of action. The Company denied all of the allegations and management believed this lawsuit to be without merit. On March 28, 2003, the Federal District Judge dismissed the complaint for lack of jurisdiction over us. J&L Electronics appealed the dismissal to the Court of Appeals for the Federal Circuit. On February 9, 2004, the Court of Appeals for the Federal Circuit affirmed the dismissal of J&L Electronics’ complaint. J&L appealed to the U.S. Supreme Court who denied his petition on January 12, 2004. Although Mr. Coyle lost both of his appeals, he caused J&L Electronics to initiate yet another legal action, this time in Arizona.

On May 3, 2004, J&L Electronics, filed a complaint against the Company in the United States District Court for the District of Arizona alleging patent infringement, breach of non-disclosure agreements, misappropriation of trade secrets, violations of federal antitrust law and related causes of action. The Company believes that the patent is invalid and the lawsuit is without merit and intends to defend itself accordingly.

On June 25, 2003, a securities class action complaint was filed against Printcafe Software, Inc., now a wholly owned subsidiary of the Company and certain of Printcafe’s officers in the United States District Court for the Western District of Pennsylvania. The complaint alleges that the defendants violated Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 due to allegedly false and misleading statements in connection with Printcafe’s initial public offering and subsequent press releases. The Company acquired Printcafe in October 2003. On June 28, 2004, an amended complaint was filed in the action adding additional Printcafe directors as defendants. The Company believes that the lawsuit is without merit and intends to defend itself accordingly.

In addition, the Company is involved from time to time in litigation relating to claims arising in the normal course of its business.

Indemnifications

In the normal course of business, we provide indemnifications of varying scope to customers against claims of intellectual property infringement or other possible claims made by third parties arising from the use of our products.

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Historically, costs related to these indemnification provisions have not been significant and we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations.

As permitted under Delaware law, we have agreements whereby we indemnify our executive officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that limits our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

11. Subsequent events

In July 2004 we negotiated a new lease to replace the 1997 Lease upon its expiration. The new lease expires in July 2014, and has covenants and a residual value guarantee similar to the 1999 Lease in structure but with lesser amounts necessary in net worth and tangible net worth in order to remain in compliance. The funds pledged under the new lease total $56.9 million and are in a LIBOR-based interest bearing account and will be classified as long-term restricted investments on the balance sheet.

Subsequent to the close of the second quarter, the Company reached a settlement agreement with the Internal Revenue Service regarding a tax audit for the years 1999, 2000 and 2001. The Company expects to record a financial statement benefit for this settlement in the third quarter.

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

The following discussion and analysis should be read in conjunction with our financial statements and the related notes thereto contained elsewhere in this Quarterly Report on Form 10-Q. Except for the historical information contained herein, the discussion in this Quarterly Report on Form 10-Q contains certain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, beliefs, expectations, forecasts and intentions. The cautionary statements made in this document should be read as applicable to all related forward-looking statements wherever they appear in this document. Our actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include those discussed below in “Factors that Could Adversely Affect Performance,” as well as those discussed elsewhere herein. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to update any forward- looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Please see the discussion of critical accounting policies in our Annual Report on Form 10-K for the year ended December 31, 2003.

Results of Operations

The following tables set forth items in our condensed consolidated statements of income as a percentage of total revenue for the three-month and six-month periods ended June 30, 2004 and 2003 and the percentage change from 2004 over 2003. These operating results are not necessarily indicative of our results for any future period.

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Revenue

We classify our revenue into three major categories, Servers, Embedded Products and Professional Printing Applications, along with a Miscellaneous category for other sources of revenue. The first category, “Servers”, is made up of stand-alone servers, which connect digital copiers with computer networks. This category includes the Fiery, Splash, Edox, and MicroPress color and black and white server products. The second category, “Embedded Products”, consists of embedded desktop controllers, bundled solutions, design-licensed solutions and software RIPs (Raster Image Processor) primarily for the office market. The third category, “Professional Printing Applications”, consists of software technology centered on printing workflow, print management information systems, proofing and web submission and job tracking tools. Miscellaneous revenue consists of spares, and the enterprise solutions suite of products consisting of scanning solutions, field dispatching solutions and mobile printing solutions.

Our revenues increased 23% to $109.1 million in the second quarter of 2004, compared to $88.7 million in the second quarter of 2003, with a 16% decrease in unit volume between the two periods. For the six-month period ended June 30, 2004, revenues were $215.8 million, a 24% increase over the same period in 2003, while the unit volume decreased by 11%. Sales of our stand-alone servers and professional printing applications accounted for a significant portion of the increase in revenue for both the three-month and six- month period comparisons, while the decrease in volume was driven by the divestiture of eBeam.

The following is a breakdown of categories of revenue, both in terms of absolute dollars and as a percentage (%) of total revenue. Also shown is volume as a percentage (%) of total units shipped by product category.

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For the three-month period ended June 30, 2004, the servers category made up 42% of total revenue, a 25% increase over the same period in 2003. For the same period comparison, the volume of servers shipped increased 21%. The servers category made up 45% of total revenue and 25% of total unit volume for the six-month period ended June 30, 2004 and it made up 45% of total revenue and approximately 18% of total unit volume for the six-month period ended June 30, 2003. For both the three-month and six-month period comparisons, the increase in revenue and increase in unit volume in this category was due in part to the launch of a new series of Fiery servers over the last 2 quarters and to sales of our Micropress server product, which we acquired through our acquisition of T/R Systems in November 2003.

For the three-month period ended June 30, 2004, the embedded products category made up 34% of total revenue, a 1% decrease over the same period in 2003. The embedded products category made up 32% of total revenue and 74% of total unit volume for the six-month period ended June 30, 2004. It made up approximately 38% of total revenue and 74% of total unit volume for the same period a year ago. A significant percentage of embedded product revenue is attributable to EFI’s design-licensed solutions, which have a lower average selling price but higher gross margin than embedded products. The amount of design license solutions as a percentage of the total revenue segment is growing thus putting additional pressure on the top line results.

For the three months ended June 30, 2004 and 2003, the professional printing applications category made up 17% and 5% of total revenue, respectively. For the six months ended June 30, 2004 and 2003, the professional printing applications category made up 15% and 4% of total revenue, respectively. The majority of the increase in this category for both comparisons came from the print management information system products acquired through the

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Printcafe transaction in addition to substantial growth in the other software products such as graphic arts package, color profiler, and bundled software packages. We recorded an approximate 30% revenue growth for the three months ended June 30, 2004 compared to the same period in 2003 when the revenues from acquired companies are added to our revenues in the prior year. Because this category consists of software sales, we do not have any associated unit volumes.

The miscellaneous category has decreased from 11% of total revenue in the three-month period ended June 30, 2003 to 7% of total revenue in the three-month period ended June 30, 2004 while volumes in this category decreased from 10% of total volume to 1% of total volume for the same period comparison. The miscellaneous category has decreased from 13% of total revenue in the six month period ended June 30, 2003 to 8.0% of total revenue in the six month period ended June 30, 2004 while volumes in this category decreased from 8% of total volume to 1% of total volume for the same period comparison. The decrease in revenue is mostly attributable to reduced sales of spare components, the divestiture of the eBeam product line and the sale of the Unimobile assets, partially offset with the revenue from ADS which was acquired in February 2004. The decrease in volume is due to the divestiture of the eBeam product line, which in the first 6 months of 2003 accounted for 96% of the volumes in this category.

To the extent our major product categories do not grow over time in absolute terms, or if we are not able to meet demand for higher unit volumes, it could have a material adverse effect on our operating results. There can be no assurance that any new controller products that we introduce in the future will be qualified by all or any of our OEM customers, or that such products will successfully compete, be accepted by the market, or otherwise effectively replace the volume of revenue and/or income from our older products. Market acceptance of our software products, products acquired through acquisitions and other products, such as DocSend, cannot be assured.

We also believe that in addition to the factors described above, price reductions for all of our products will affect revenues in the future. We have previously and will likely in the future reduce prices for our products. Depending upon the price-elasticity of demand for our products, the pricing and quality of competitive products, and other economic and competitive conditions, such price reductions may have an adverse impact on our revenues and profits. While we have managed to improve gross margins in the past through the utilization of fewer contract manufacturers, obtaining favorable component pricing from our suppliers and through an increase in higher gross margin software sales and design license sales, this trend may not continue. If we are not able to compensate for lower gross margins resulting from price reductions with increased sales volumes, our results of operations could be adversely affected. In addition, our revenue in the future may depend more upon sales of products with relatively lower gross margins such as embedded controllers for printers, and color and black-and-white copiers, and stand-alone controllers for black-and-white copiers or sales of our design-licensed solutions, which have lower per unit sales prices, but higher gross margins. If we are not able to compensate for such lower gross margins, or lower per unit revenues with an increased volume of sales of such products, our results of operations may be adversely affected.

Revenue and volume by geographic area for the three-month and six-month periods ended June 30, 2004 and June 30, 2003 were as follows:

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The Americas region increased by 37% to $118.4 million in sales during the first six months of 2004 from approximately $86.6 million in the first six months of 2003, largely attributable to sales of the newly acquired products from Printcafe and ADS, as well as increases in the server category. Revenues in the Japan region increased by 44% to approximately $30.0 million during the first six months of 2004 from approximately $20.9 million in the first six months of 2003. A significant portion of this increase can be attributed to greater demand for design-licensed color solutions, which are sold to OEM customers in Japan, for incorporation into their products, which are then shipped from Japan to other countries. The Rest-of-World region, which includes the Asia Pacific but excludes Japan, showed a decrease of 19% for the six months ended June 30, 2004 largely due to design license products being shipped to Japan rather than directly into the region, while Europe also showed a moderate increase in revenue, due in part to increased sales of professional printing applications products and print servers.

Shipments to some of our OEM customers are made to centralized purchasing and manufacturing locations, which in turn sell through to other locations, making it difficult to obtain accurate geographical shipment data. Accordingly, we believe that export sales of our products into each region may differ from what is reported. We expect that export sales will continue to represent a significant portion of our total revenue.

Substantially all of our revenue for the last three years was attributable to sales of products through our OEM customers and independent distributor channels. During 2004, we have continued to work on both increasing the number of OEM customers and expanding the size of existing relationships with OEM customers. For the six months ended June 30, 2004 and 2003, three customers - Canon, Konica Minolta, and Xerox - provided more than 10% of our revenue individually and approximately 67% of our revenue in aggregate for both periods. No assurance can be given that our relationships with these and other significant OEM customers will continue or that we will be successful in increasing the number of our OEM customers or the size of our existing OEM relationships. Several of our OEM customers have reduced or discontinued their purchases from us at various times in the past and any customer could do so in the future. Such reductions or discontinuations have in the past and could in the future have a significant negative impact on our consolidated financial position and results of operations.

In addition to our server and embedded products sold through our OEM’s, we have diversified into new markets and distribution channels with our Professional Printing Applications. This category of our revenue has grown to 17% of our revenue in the second quarter of 2004. Outside of sales of our Professional Printing Applications to our OEMs, we have no significant customers in this category.

We continue to develop new products and technologies for each of our product lines and intend to continue to introduce new generations of server and controller products and other new product lines with current and new OEM customers, distribution partners, and end-user in 2004 and beyond. No assurance can be given that the introduction or market acceptance of current or future products will be successful.

Gross Margins

For the quarter ended June 30, 2004 our gross margin was 65% compared to approximately 60% for the same period a year ago. The improvement came from increased sales of design-licensed solutions and an increase in software

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sales both of which traditionally have higher gross margins than our other products. We believe that gross margin will continue to be impacted by a variety of factors. These factors include the market prices that can be achieved on our current and future products, the availability and pricing of key components (including DRAM, Processors, and Postscript interpreter software), third party manufacturing costs, product, channel, and geographic mix, the success of our product transitions and new products, the pace of migration to a design-licensed business model for embedded products, competition with third parties and our OEM customers, and general economic conditions in the United States and abroad. Consequently, we anticipate gross margins will fluctuate from period to period.

Operating Expenses

Operating expenses as a percentage of revenue amounted to approximately 53% and 51% respectively for the three-month periods ended June 30, 2004 and 2003 and 54% and 51% for the six-month periods ended June 30, 2004 and 2003, respectively. Operating expenses increased by 30% in the three-month period ended June 30, 2004 compared to the three-month period ended June 30, 2003, and increased 28% in the six months ended June 30, 2004 compared to the same period in 2003. The addition of Printcafe and T/R Systems in late 2003 and ADS in mid-February 2004 contributed the majority of the increase in operating expenses.

We anticipate that operating expenses may increase in future periods both in absolute dollars and as a percentage of revenue as investments are made in new business areas and direct and channel relationships in our sales organization.

The components of operating expenses are detailed below.

			Research and Development
			Expenses for research and development consist primarily of personnel expenses and, to a lesser extent, consulting, depreciation, and costs of prototype materials. Research and development expenses were 25% and 26% of revenue for the second quarter of 2004 and 2003, respectively. For the six months ended June 30, 2004 and 2003, research and development expenses were 26%.
			In absolute dollars, research and development increased by approximately $4.4 million in the second quarter of 2004 from the second quarter of 2003. Research and development expenses related to our recent acquisitions partially offset by the reduction in costs from the eBeam and Unimobile divestitures contributed the majority of the increase for the quarter ending June 30, 2004. The remaining increase consisted of increased payroll costs from merit increases and increased headcount.
			Research and development expenses increased by approximately $8.7 million year over year for the six months ended June 30, 2004. Research and development expenses related to our recent acquisitions partially offset by the reduction in costs from the eBeam and Unimobile divestitures accounted for the majority of the increase for the six months ending June 30, 2004. The remaining increase consisted of increased payroll costs from merit increases and additional employees.
			We believe that the development of new products and the enhancement of existing products are essential to our continued success, and intend to continue to devote substantial resources to research and new product development efforts. Accordingly, we expect that our research and development expenses may increase in absolute dollars and also as a percentage of revenue in the future.
			Sales and Marketing
			Sales and marketing expenses include personnel expenses, costs of trade shows, marketing programs, and promotional materials, sales commissions, travel and entertainment expenses, depreciation, and costs associated with sales offices in the United States, Europe, Asia, and other locations around the world. Sales and marketing expenses for the three-month period ended June 30, 2004 were approximately $20.1 million or 19% of revenue compared to approximately $15.2 million or 17% of revenue for the three months ended June 30, 2003. The increase in absolute dollars was approximately $4.9 million for the quarter. The majority of the increase came from costs related to the former Printcafe, T/R Systems and ADS operations as well as increased trade show expenses, partially offset by a decrease in expenses related to the divestiture of the eBeam and Unimobile businesses.

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			In addition, sales and marketing expenses, particularly those incurred in Europe, where we have a significant presence, were negatively impacted by the weakening US dollar, increasing expenses from year to year slightly. While the costs in the local currency may have stayed relatively constant, the translated US dollar costs have increased.
			Sales and marketing expenses for the six-month period ended June 30, 2004 were approximately $39.0 million or 18% of revenue compared to approximately $29.9 million or 17% of revenue for the six months ended June 30, 2003. The majority of the increase in absolute dollars of approximately $9.1 million is comprised of costs related to the operations of the former Printcafe, T/R Systems, and ADS businesses, offset with a decrease in expenses due to the spin-off of eBeam and Unimobile groups. Expense for tradeshows increased as well, adversely impacting the six-month comparison. In addition, sales and marketing expenses, particularly those incurred in Europe, where we have a significant presence, were negatively impacted by the weakening US dollar, increasing expenses slightly from year to year. While the costs in the local currency may have stayed relatively constant, the translated US dollar costs have increased.
			We expect that our sales and marketing expenses may increase in absolute dollars as we continue to actively promote our products, introduce new products and services, and continue to build our sales and marketing organization, particularly in Europe and Asia Pacific, and as we grow our software solutions and other new product lines which require greater sales and marketing support from us. We also expect that if the US dollar remains volatile against the euro or other currencies, sales and marketing expenses reported in US dollars could fluctuate.
			General and Administrative
			General and administrative expenses consist primarily of personnel expenses and, to a lesser extent, depreciation and facility costs, professional fees, and other costs associated with public companies. General and administrative expenses were approximately $6.8 million or 6% of revenue for the quarter ended June 30, 2004, compared to approximately $5.0 million or 6% of revenue for the quarter ended June 30, 2003. The increase in absolute dollars of approximately $1.8 million primarily came from costs related to the acquired organizations and increased legal, auditing and tax-consulting expenses including costs related to compliance with the Sarbanes-Oxley Act of 2002. We expect that general and administrative costs will increase both as a percentage of revenue and in absolute dollars in 2004 due to additional costs that will be incurred for compliance with the Sarbanes-Oxley Act. We also expect that if the US dollar remains volatile against the euro or other currencies, general and administrative expenses reported in US dollars could fluctuate.
			General and administrative expenses were approximately $13.4 million or 6% of revenue for the six months ended June 30, 2004, compared to approximately $10.0 million or 6% of revenue for the six months ended June 30, 2003. The increase in absolute dollars of approximately $3.4 million primarily came from costs related to the acquired organizations, increased employee salary and bonus expense, and increased legal, auditing, and tax-consulting expenses including costs related to compliance with the Sarbanes-Oxley Act of 2002. We expect that general and administrative costs will increase both as a percentage of revenue and in absolute dollars in 2004 due to additional costs that will be incurred for compliance with the Sarbanes-Oxley Act. We also expect that if the US dollar remains volatile against the euro or other currencies, general and administrative expenses reported in US dollars could fluctuate.
			Amortization of Identified Intangibles and other Acquisition-related Expense
			Amortization of identified intangibles and other acquisition-related expense for the three months ended June 30, 2004 was approximately $3.5 million compared to approximately $1.3 million for the three months ended June 30, 2003. Amortization of identified intangibles was approximately $7.0 million and approximately $2.6 million for the six months ended June 30, 2004 and 2003, respectively. The increase was attributable to the amortization of identified intangibles related to the acquisitions made in late 2003 and early 2004. In-process research and development was $1.0 million for the first half of 2004 for the ADS acquisition and approximately $1.2 million for the first half of 2003 for the Best acquisition.

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Interest and Other Income, net

		Interest and Other Income, Net
		Interest income is derived mainly from our short-term investments, net of investment fees. For the three months ended June 30, 2004 interest and other income was approximately $2.8 million, while for the three months ended June 30, 2003 it was approximately $3.0 million. The decrease was driven by declining interest rates. For the six months ended June 30, 2004 interest and other income was approximately $5.9 million, while for the six months ended June 30, 2003 it was approximately $5.6 million.
		Interest Expense
		Interest expense for the first six months of 2004 includes the interest expense and debt amortization costs of approximately $2.6 million related to our 1.50% senior convertible debt issued in June 2003. We had approximately $0.4 million in interest expense for the first six months of 2003.
		Gain on Sale of Assets
		We recognized approximately $3.0 million in the six months ended June 30, 2004 from the sale of assets related to Unimobile.

Income Taxes

Our effective tax rate was 30% and 27% for the three-month periods ended June 30, 2004 and 2003, respectively and 31% and 27% for the six-month periods ended June 30, 2004 and 2003. The rate increased in 2004 due to the in-process research and development write-off related to the ADS acquisition, the expiration of the United States research and development credit on June 30, 2004, decreased investments in tax-exempt securities, and increased income before taxes. In each of these periods, we benefited from tax-exempt interest income, research and development credits, and benefits from foreign sales in achieving a consolidated effective tax rate lower than that prescribed by the respective Federal and State taxing authorities.

Liquidity and Capital Resources

Cash, cash equivalents and short-term investments decreased by $1.2 million to $622.9 million as of June 30, 2004, from $624.1 million as of December 31, 2003. Working capital decreased by $0.2 million to $665.0 million as of June 30, 2004, down from $665.2 million as of December 31, 2003. We invest cash in excess of our operating needs in short-term investments.

Net cash provided by operating activities was $33.9 million for the six-month period ended June 30, 2004. Net income of $21.1 million was adjusted by $12.1 million for non-cash charges of depreciation and amortization, the write-off of in-process research and development cost, bad-debt expense and deferred compensation and $3.0 million related to the gain on the sale of assets. Changes in current assets and liabilities increased cash by $3.5 million, with decreases in cash resulting from accounts payable and accrued liabilities, offset with increases in cash from accounts receivable, income taxes payable, and inventories. The accounts receivable balance declined, thus providing cash because of improved collections. Inventory balances were down as we decreased our finished goods inventory and consumed raw materials that were purchased over the last several quarters.

Sales in excess of purchases of short-term investments were $47.0 million for the six-month period ended June 30, 2004, to provide funds for our common stock repurchase program and acquisitions. In February 2004, we acquired ADS for approximately $11.6 million, net of cash received in the transaction. In March 2004, we sold assets from our Unimobile group and received $4.1 million in proceeds. Our capital expenditures generally consist of investments in computer equipment and furniture for use in our operations. We purchased approximately $3.2 million of equipment during the six-month period ended June 30, 2004, net of retirements.

Net cash used by financing activities of $19.4 million in the six-month period ended June 30, 2004, was the result of $20.1 million from the exercises of common stock options and the issuance of stock under our Employee Stock

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Purchase Plan, less $39.4 million used for the repurchase of shares of our common stock. The Board of Directors authorized $50.0 million for the repurchase of our common stock in 2003, of which $15.1 million remains available. We expect to spend the remaining authorized funds before the end of 2004.

Inventory

Our inventory consists primarily of memory subsystems, processors and ASICs, which are sold to third-party contract manufacturers responsible for manufacturing our products. Should we decide to purchase components and do our own manufacturing, or should it become necessary for us to purchase and sell components other than the processors, ASICs or memory subsystems for our contract manufacturers, inventory balances and potentially fixed assets would increase significantly, thereby reducing our available cash resources. Further, the inventory we carry could become obsolete thereby negatively impacting our consolidated financial position and results of operations. We also rely on several sole-source suppliers for certain key components and could experience a significant negative impact on our consolidated financial position and results of operations if such supplies were reduced or not available.

Purchase Commitments

We may be required to compensate our sub-contract manufacturers for components purchased for orders subsequently cancelled by us. We periodically review the potential liability and the adequacy of the related reserve. Our financial condition and results of operations could be negatively impacted if we were required to compensate the sub-contract manufacturers in an amount significantly in excess of the accrued liability.

Indemnifications

In the normal course of business, we provide indemnifications of varying scope to customers against claims of intellectual property infringement or others possible claims made by third parties arising from the use of our products. Historically, costs related to these indemnification provisions have not been significant and we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations.

As permitted under Delaware law, we have agreements whereby we indemnify our executive officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that limits our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

Legal Proceedings

Over the past several years, Mr. Jan R. Coyle, an individual living in Nevada, has repeatedly demanded that we buy technology allegedly invented by his company, Kolbet Labs. In December 2001, Mr. Coyle threatened to sue us and our customers for allegedly infringing his soon to be issued patent and for allegedly misappropriating his alleged trade secrets. We believe Mr. Coyle’s claims are baseless and completely without merit. Therefore, on December 11, 2001, we filed a declaratory relief action in the United States District Court for the Northern District of California, asking the Court to declare that we and our customers have not breached any nondisclosure agreement with Mr. Coyle or Kolbet Labs, nor have we infringed any alleged patent claims or misappropriated any alleged trade secrets belonging to Mr. Coyle or Kolbet Labs through our sale of Fiery, Splash or EDOX print controllers. We also sought an injunction enjoining both Mr. Coyle and Kolbet Labs from bringing or threatening to bring a lawsuit against us, our suppliers, vendors, customers and users of our products for breach of contract and misappropriation of trade secrets. On March 26, 2002, the Northern District of California Court dismissed our complaint citing the Court’s lack of jurisdiction over Mr. Coyle. We appealed the Court’s dismissal to the Court of Appeals for the Federal Circuit in Washington D.C., who reversed the dismissal of our case and remanded it back to the Northern District of California Court. Mr. Coyle and Kolbet Labs subsequently moved to dismiss our complaint under the Declaratory Judgment Act. The Court granted dismissal on February 17, 2004. On February 17, 2004, we filed a second declaratory relief action in the Northern District of California against Mr. Coyle and Kolbet Labs. On February 27, 2004, we filed a notice of appeal which is pending in Court of Appeals for the Federal Circuit in Washington, D.C. We are pursuing both of our cases against Mr. Coyle and Kolbet Labs.

On February 26, 2002, Mr. Coyle’s company, J&L Electronics, filed a complaint against us in the United States District Court for the District of Nevada alleging patent infringement, breach of non-disclosure agreements, misappropriation of trade secrets, violations of federal antitrust law and related causes of action. We denied all of the allegations and management believed this lawsuit to be without merit. On March 28, 2003, the Federal District Judge dismissed the

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complaint for lack of jurisdiction over us. J&L Electronics appealed the dismissal to the Court of Appeals for the Federal Circuit. On February 9, 2004, the Court of Appeals for the Federal Circuit affirmed the dismissal of J&L Electronics’ complaint. J&L appealed to the U.S. Supreme Court who denied his petition on January 12, 2004. Although Mr. Coyle lost both of his appeals, he has caused J&L Electronics to initiate yet another legal action, this time in Arizona.

On May 3, 2004, J&L Electronics, filed a complaint against us in the United States District Court for the District of Arizona alleging patent infringement, breach of non-disclosure agreements, misappropriation of trade secrets, violations of federal antitrust law and related causes of action. We believe that the patent is invalid and the lawsuit is without merit and intend to defend ourselves accordingly.

On June 25, 2003, a securities class action complaint was filed against Printcafe Software, Inc., now our wholly owned subsidiary and certain of Printcafe’s officers in the United States District Court for the Western District of Pennsylvania. The complaint alleges that the defendants violated Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 due to allegedly false and misleading statements in connection with Printcafe’s initial public offering and subsequent press releases. We acquired Printcafe in October 2003. On June 28, 2004, an amended complaint was filed in the action adding additional Printcafe directors as defendants. We believe that the lawsuit is without merit and intend to defend ourselves accordingly.

In addition, we are involved from time to time in litigation relating to claims arising in the normal course of our business.

Off-Balance Sheet Financing

Synthetic Lease Arrangements

We are a party to two synthetic leases covering our Foster City facilities. The first lease (“1997 Lease”) was entered into in 1997 to fund the construction of an approximately 295,000 square foot building. The second lease (“1999 Lease”) was entered into in 1999 to fund the construction of an approximately 165,000 square-foot building. We may, at our option, purchase the facilities during or at the end of the term of the leases for the amount expended by the respective lessor to construct the facilities ($56.8 million for the 1997 Lease and $43.1 million for the 1999 Lease). In conjunction with the 1997 and 1999 Leases, we have entered into separate ground leases with the lessors for approximately 35 years. We have guaranteed to the lessors a residual value associated with the buildings equal to approximately 82% of their funding. We may be liable to the lessor for the amount of the residual guarantee if we either fail to renew the lease or do not purchase or locate a purchaser for the leased building at the end of the lease term. If we determine that there is a decline in the value of the building before the end of the lease, we would be required to record a loss in our financial statements for that decline.

The 1997 Lease, which expired in July 2004, requires us to meet certain financial covenant requirements related to cash to debt, fixed charge coverage ratio, leverage ratio and consolidated tangible net worth as defined in the lease agreement. If we maintain pledged collateral, then a limited subset of these covenants must be met. The tangible net worth financial covenant requires us to maintain a minimum tangible net worth as of the end of each quarter. There are other covenants regarding mergers, liens and judgments and lines of business. We are in compliance with all of the covenants, either directly, or through the existence of the pledged collateral. The pledged collateral under the 1997 Lease (approximately $69.9 million at June 30, 2004) has been classified as restricted on the balance sheet. We could be required to purchase the building covered by the 1997 Lease if we were to default on any indebtedness in excess of $10.0 million, to not appeal a judgment in excess of $10.0 million, or where a creditor has commenced enforcement proceedings on an order for payment of money in excess of $10.0 million. We are liable to the lessor for the full purchase amount of the buildings if we default on our covenants.

We have negotiated a new lease to replace the expired 1997 Lease. The new lease expires in July 2014, and is similar to the 1999 Lease in the covenants structure but with lesser amounts necessary in net worth and tangible net worth in order to remain in compliance.

The 1999 Lease, which has a seven-year initial term, requires us to meet certain financial covenant requirements related to fixed charge coverage ratio, consolidated net worth and consolidated tangible net worth as defined in the lease agreement. The tangible net worth financial covenant requires us to maintain a minimum tangible net worth as of the end of each quarter. There are other covenants regarding mergers, liens and judgments and lines of business.

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We are in compliance with all of the covenants. We are liable to the lessor for the full purchase amount of the buildings if we default on our covenants. The funds pledged under the 1999 Lease (approximately $43.1 million at June 30, 2004) are in a LIBOR-based interest bearing account and are restricted as to withdrawal at all times. With regards to the 1999 Lease we are considered a Tranche A lender of $35.3 million of the $43.1 million, while the lessor is considered a Tranche B lender for the remaining $7.8 million.

We are treated as the owner of these buildings for federal income tax purposes.

Effective July 1, 2003, we have applied the accounting and disclosure rules set forth in Interpretation No. 46 Consolidation of Variable Interest Entities, as revised (“FIN 46R”) for variable interest entities (“VIEs”). We have evaluated the synthetic lease agreements to determine if the arrangements qualify as variable interest entities under FIN 46R. We determined that the synthetic lease agreements do qualify as VIEs; however, as we are not the primary beneficiary under FIN 46R we are not required to consolidate the VIEs in our financial statements.

Liquidity and Capital Resource Requirements

Based on past performance and current expectations, we believe that our cash and cash equivalents, short-term investments and cash generated from operations will satisfy our working capital needs, capital expenditures, acquisition needs, investment requirements, stock repurchases, commitments (see Note 10 of the Notes to the Condensed Consolidated Financial Statements) and other liquidity requirements associated with our existing operations through at least the next 12 months. We believe that the most strategic uses of our cash resources include acquisitions, strategic investments to gain access to new technologies, repurchase of shares of our common stock and working capital. In connection with our new synthetic lease, we will transfer approximately $56.9 million from current restricted cash and short-term investments to long-term restricted investments during the third quarter of 2004. There are no transactions, arrangements and other relationships with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of our requirements for capital resources.

DISCLOSURES ON STOCK OPTION PROGRAMS

Option Program Description

Our stock option program is a broad-based, long-term retention program that is intended to attract and retain talented employees and align stockholder and employee interests. We consider our option program critical to our operation and productivity and essentially all of our employees participate. The program consists of a broad-based plan under which options may be granted to all employees, directors, and consultants. Option vesting periods range from 2 - 4 years, with an average vesting period of 3.5 years.

Distribution and Dilutive Effect of Options

*See Executive Options for listed officers; these are defined by the Securities and Exchange Commission for the proxy as the Chief Executive Officer and each of the four other most highly compensated executive officers. We have only three executive officers, including the Chief Executive Officer.

We have implemented a stock trading program for our Board of Directors, corporate executive officers and other insiders, under Rule 10b5-1 of the Securities and Exchange Act of 1934. When there is no material non-public information available, Rule 10b5-1 allows corporate insiders to establish plans that permit prearranged future

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sales of his or her securities. Under our trading plan, corporate insiders prepare a written plan to sell shares on a prearranged basis over a set period of time. An independent broker then executes the pre-planned trades, according to the plan’s instructions, without regard to any subsequent non-public information the individual might receive. Once the insider’s plan is in place, he or she cannot influence the broker’s trading activities of our stock. Additionally, our insiders that participate in the plan are only allowed to sell our stock through the plan. Currently, the following Section 16 officers and directors are participating in our Rule 10b5-1 stock trading program: Dan Maydan, Guy Gecht, Fred Rosenzweig and Joseph Cutts.

General Option Information

Summary of Option Activity

In-the-Money and Out-of-the-Money Option Information