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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2003.

Commission File No. 0-13442

MENTOR GRAPHICS CORPORATION

(Exact name of registrant as specified in its charter)

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

NO CHANGE

(Former name, former address and former

fiscal year, if changed since last report)

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

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

Number of shares of common stock, no par value, outstanding as of May 1, 2003: 67,405,564

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MENTOR GRAPHICS CORPORATION

INDEX TO FORM 10-Q

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Mentor Graphics Corporation

Consolidated Statements of Operations

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Mentor Graphics Corporation

Consolidated Balance Sheets

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Mentor Graphics Corporation

Consolidated Statements of Cash Flows

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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MENTOR GRAPHICS CORPORATION

Notes to Unaudited Consolidated Financial Statements

(In thousands, except per share amounts)

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

Principles of Consolidation

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

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

Revenue Recognition

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

For the sale of licenses of software products and related service and support, the Company recognizes revenue in accordance with Statement of Position (SOP) 97-2, “Software Revenue Recognition”, as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions”. Revenue from perpetual license arrangements is recognized upon shipment, provided persuasive evidence of an arrangement exists, fees are fixed or determinable and collection is probable. Product revenue from fixed-term license installment agreements, which are with the Company’s top-rated customers, are recognized upon shipment and start of the license term, provided all other revenue recognition criteria have been met. The Company uses fixed-term license installment agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. Revenue from subscription-type term license agreements, which typically include rights to future software products, is deferred and recognized ratably over the term of the subscription period.

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

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

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

Accounting for Stock-Based Compensation

Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” defines a fair value based method of accounting for employee stock options and similar equity instruments. As is permitted under SFAS No. 123, the Company has elected to continue to account for its stock-based compensation plans under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company has computed, for pro forma disclosure purposes, the value of all stock-based awards granted during the three months ended March 31, 2003 and 2002 using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:

Using the Black-Scholes methodology, weighted average fair value of options granted during the three months ended March 31, 2003 and 2002 was $4.06 and $13.91 per share, respectively. The weighted average estimated fair value of purchase rights under the ESPPs during the three months ended March 31, 2003 and 2002 was $1.73 and $5.91, respectively.

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

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

Options and warrants to purchase 12,721 and 516 shares of common stock were not included in the computation of diluted earnings per share for the three months ended March 31, 2003 and 2002, respectively. The options and warrants were excluded because the options were anti-dilutive as the exercise price was greater than the average market price of the common shares for the respective periods. The effect of the conversion of the Company’s convertible subordinated notes for the three months ended March 31, 2003 was anti-dilutive. If the assumed conversion of convertible subordinated notes had been dilutive, the Company’s net income per share would have included additional earnings of $2,604 and additional incremental shares of 7,413 for the three months ended March 31, 2003.

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Other long-term notes payable include multi-currency notes payable and capital leases. Interest rates are generally based on the applicable country’s prime lending rate, depending on the currency borrowed. Other long-term notes payable of $4,956 and $5,185 were outstanding under these agreements at March 31, 2003 and December 31, 2002, respectively.

For the three months ended March 31, 2002, the Company recorded special charges of $789. These charges primarily consisted of costs incurred for employee terminations. The Company rebalanced the workforce by 19 employees during March 2002. This reduction primarily impacted research and development due to the overlap of employee skill sets as a result of acquisitions. Employee severance costs included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to quarter-end. These costs were expended during 2002. There were no significant modifications to the amount of these charges.

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Accrued special charges are included in accrued liabilities and other long-term liabilities on the consolidated balance sheets. The following table shows changes in accrued special charges during 2003:

In February 2002, the Company acquired Accelerated Technology, Inc. (ATI), a provider of embedded software based in Mobile, Alabama. The acquisition was an investment aimed at expanding the Company’s product offering and driving revenue growth, which supported the premium paid over the fair market value of the individual assets. The total purchase price including acquisition costs was $23,288, which included the fair value of a warrant issued of $361. The excess of liabilities assumed over tangible assets acquired was $1,808. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process research and development (R&D) of $4,000, goodwill of $16,668, technology of $6,500, other identified intangible assets of $880, net of related deferred tax liability of $2,952. The technology is being amortized to cost of goods sold over five years. Of the $880 other identified intangible assets, $480 was determined to have an indefinite life at the time of acquisition and was not being amortized. Based upon the Company’s review of its intangible assets lives, it was determined that as of January 1, 2003, this asset had an estimated remaining life of five years. Accordingly, the Company began amortizing this asset over five years to operating expenses. The remaining $400 is being amortized, primarily over five years, to operating expenses.

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The fair value of foreign currency forward and option contracts, recorded in prepaid expenses and other in the consolidated balance sheet, was $1,561 and $1,116 at March 31, 2003 and December 31, 2002, respectively.

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

The remaining balance in accumulated other comprehensive income at March 31, 2003 represents a net unrealized gain on foreign currency contracts relating to hedges of forecasted revenues and commission expenses expected to occur during 2003. These amounts will be transferred to the consolidated statement of operations upon recognition of the related revenue and recording commission expense. The Company expects substantially all of the balance in accumulated other comprehensive income to be reclassified to the consolidated statement of operations within the next year. The Company transferred $128 deferred loss and $516 deferred gain to system and software revenues relating to foreign currency contracts hedging revenues for the three months ended March 31, 2003 and 2002, respectively. The Company transferred $94 deferred gain and $90 deferred loss to marketing and selling expense relating to foreign currency contracts hedging commission expenses for the three months ended March 31, 2003 and 2002, respectively.

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

In accordance with SFAS No. 133, the Company excludes changes in fair value relating to time value of foreign currency contracts from its assessment of hedge effectiveness. The Company recorded income relating to time value in other income, net of $139 and $259 and recorded expense in interest expense of $148 and $90 for the three months ended March 31, 2003 and 2002, respectively.

Leases

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

Indemnifications

The Company’s license and services agreements include a limited indemnification provision for claims from third-parties relating to the Company’s intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5, “Accounting for Contingencies”. The indemnification is limited to the amount paid by the customer. At March 31, 2003, the Company is not aware of any material liabilities arising from these indemnifications.

Legal Proceedings

In October 1997, Quickturn, a competitor, filed an action against the Company’s German subsidiary in a German District Court alleging infringement by the Company’s SimExpress emulation product of a European patent 0437491 (EP’491). The Company was unable to challenge the validity of EP’491 under an assignor estoppel theory and the German court ruled in April 1999 that the German subsidiary’s sales of SimExpress violated EP’491 and awarded unspecified damages. In February 2001, in unrelated litigation, the Federal Patent Court in Germany ruled that EP’491 is null and void in Germany. The German District Court, in response to the nullification of the Quickturn patent, suspended its April 1999 judgment of infringement against SimExpress. The Company has appealed the court’s application of assignor estoppel. Quickturn has appealed the invalidation of EP’491. The German Supreme Court is expected to hear both appeals.

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In October 1998, Quickturn filed an action against Meta and the Company in France alleging infringement by SimExpress and Celaro, the Company’s second generation emulation product, of EP’491. There have been no rulings by the French court regarding the merits of this case to date.

The Company had two consolidated lawsuits pending against Quickturn and Cadence in United States District Court for the Northern District of California alleging that Quickturn’s Mercury or MercuryPlus products infringe six Company-owned patents and alleging a misappropriation of trade secrets. In February 2003, the jury in this case returned a verdict in favor of Quickturn and Cadence on all counts.

A subsidiary of the Company, IKOS Systems, Inc., currently has pending against Quickturn and Cadence a patent infringement lawsuit against the parties’ Palladium product. Quickturn and Cadence currently have pending against the Company a patent infringement lawsuit against the Company’s Vstation product. There has been no substantive activity in either lawsuit.

In addition to the above litigation, from time to time the Company is involved in various disputes and litigation matters that arise from the ordinary course of business. These include disputes and lawsuits relating to intellectual property rights, licensing, contracts and employee relation matters.

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

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

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

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. This statement nullifies Emerging Issues Task Force Issue No. 94-3 (EITF 94-3), “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity is recognized when the liability is incurred. Under EITF 94-3, a liability for an exit cost as defined in EITF 94-3 was recognized at the date of an entity’s commitment to an exit plan. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. On January 1, 2003, the Company adopted SFAS No. 146. Adoption of these provisions did not have a material impact on the Company’s financial position or results of operations.

In November 2002, the Emerging Issues Task Force reached a consensus on Issue No. 00-21 (EITF 00-21), “Revenue Arrangements with Multiple Deliverables”. EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 will be effective for interim periods beginning after June 15, 2003. The Company does not expect this issue to have a material impact on its consolidated financial position or results of operations.

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In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”. FIN No. 45 requires that upon issuance of a guarantee, a guarantor must recognize a liability for the fair value of an obligation assumed under a guarantee. FIN No. 45 also requires additional disclosures by a guarantor in its financial statements about the obligations associated with guarantees issued. The initial recognition and measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN No. 45 are effective for financial statements issued after December 15, 2002. On January 1, 2003, the Company adopted FIN No. 45. Adoption of these provisions did not have a material impact on the Company’s financial position or results of operations.

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

(All numerical references in thousands, except for percentages)

CRITICAL ACCOUNTING POLICIES

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

Revenue Recognition

The Company generally records product revenue from fixed-term installment license agreements upon shipment and start of the license term. In addition, support revenue is recognized over the license term and is allocated based on vendor specific objective evidence of the fair value of support, as established by the price charged when such support is sold separately. These installment license agreements are typically for three years. The Company uses these agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. The agreements are with the Company’s top-rated customers. If the Company no longer had a history of collecting without providing concessions on term agreements, then revenue would be required to be recognized as the payments become due over the license term. This change would have a material impact on the Company’s results. Additionally, if customers fail to make the contractual payments under the installment license agreements, the Company would have to recognize a bad debt charge. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required, which would result in an additional selling expense in the period such determination was made.

Valuation of Trade Accounts Receivable

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

Valuation of Deferred Tax Assets

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

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Goodwill, Intangible Assets and Long-Lived Assets

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

Inventory

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

Restructuring Charges

The Company has recorded restructuring charges in connection with its plans to better align the cost structure with projected operations in the future. Effective January 1, 2003, in accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” the Company records liabilities for costs associated with exit or disposal activities when the liability is incurred. Prior to January 1, 2003, in accordance with EITF Issue 94-3, the Company accrued for restructuring costs when management made a commitment to an exit plan that specifically identified all significant actions to be taken.

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

The Company has also recorded restructuring charges in connection with excess leased facilities to offset future rent, net of estimated sublease income that could be reasonably obtained, of the abandoned office space and to write-off leasehold improvements on abandoned office space. The Company worked with external real estate experts in each of the markets where properties are located to obtain assumptions used to determine the best estimate of the accrual. The Company’s estimates of expected sublease income could change based on factors that affect the Company’s ability to sublease those facilities such as general economic conditions and the real estate market. Changes to the amount of estimated sublease income will be recognized as either an increase or a reduction to special charges in the period that the change to the liability is incurred.

RESULTS OF OPERATIONS

REVENUES AND GROSS MARGINS

System and Software

System and software revenues for the three months ended March 31, 2003 totaled $91,812 representing an increase of $23,911 or 35% over the comparable period of 2002. The increase was primarily attributable to an increase in software product revenue due to strength in the board design software product line, which was partially attributable to the acquisitions in 2002, and continued strength in the Physical Verification and Analysis product line. In addition, system and software revenues for the three months ended March 31, 2003 were favorably impacted by the strengthening of the Euro and the Japanese yen.

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System and software gross margin was 95% for the three months ended March 31, 2003 compared to 93% for the comparable period of 2002. Gross margin was favorably impacted for the three months ended March 31, 2003 due to a greater mix of higher margin software product revenue versus lower margin emulation hardware system revenue. Amortization of purchased technology costs to system and software cost of revenues was $2,209 for the three months ended March 31, 2003 compared to $472 for the comparable period of 2002. The increase in amortization of purchased technology was attributable to acquisitions in 2002.

Service and Support

Service and support revenues for the three months ended March 31, 2003 totaled $67,528 representing an increase of $7,425 or 12% from the comparable period of 2002. The increase was primarily attributable to board design software support revenue and accelerated verification support revenue resulting from acquisitions in 2002 and strength in Physical Verification and Analysis support revenue primarily due to renewals by existing customers. This increase was partially offset by a 13% decrease in consulting and training revenue as a result of cuts in spending by the Company’s customers due to the continued downturn of the economy.

Service and support gross margin was 69% for the three months ended March 31, 2003 compared to 67% for the comparable period of 2002. The increase in overall service and support gross margins was due to higher emulation support revenue as a result of the IKOS acquisition in 2002 over a relatively constant cost structure. Additionally, gross margin was favorably impacted by cuts in professional service costs as a result of workforce rebalances by the Company in 2002.

Geographic Revenues Information

Revenues increased in the Americas in 2003 primarily as a result of acquisitions in 2002. Revenues outside the Americas represented 50% of total revenues for the three months ended March 31, 2003 and 53% for the comparable period of 2002. The effects of exchange rate differences from the European currencies to the U.S. dollar positively impacted European revenues by approximately 4% for the three months ended March 31, 2003. Exclusive of currency effects, higher revenue in Europe was primarily due to higher software product and support sales. The effects of exchange rate differences from the Japanese yen to the U.S. dollar positively impacted Japanese revenues by approximately 9% for the three months ended March 31, 2003. Exclusive of currency effects, lower revenue in Japan was primarily due to lower software product sales. Higher revenues in Pacific Rim were attributable to growth in both product and support sales. Since the Company generates approximately half of its revenues outside of the U.S. and expects this to continue in the future, revenue results should continue to be impacted by the effects of future foreign currency fluctuations.

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OPERATING EXPENSES

Research and Development

As a percent of revenues, R&D costs decreased for the three months ended March 31, 2003 as compared to the comparable period of 2002. The increase in absolute dollars for the three months ended March 31, 2003 compared to the comparable period of 2002 was primarily attributable to acquisitions in 2002, resulting in higher R&D headcount and related costs.

Marketing and Selling

As a percent of revenues, marketing and selling costs remained flat for the three months ended March 31, 2003 as compared to the comparable period of 2002. The increase in absolute dollars for the three months ended March 31, 2003 as compared to the comparable period of 2002 was primarily attributable to an increase in variable compensation due to growth in revenues.

General and Administration

As a percent of revenues, general and administration costs decreased for the three months ended March 31, 2003 as compared to the comparable period of 2002. The increase in absolute dollars for the three months ended March 31, 2003 as compared to the comparable period of 2002, is primarily attributable to an increase in variable compensation due to growth in operating income.

Amortization of Intangible Assets

As a percent of revenues and in absolute dollars, amortization of intangibles increased for the three months ended March 31, 2003 compared to the comparable period of 2002. The increase was attributable to amortization related to intangible assets acquired through acquisitions in 2002.

Special Charges

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

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For the three months ended March 31, 2002, the Company recorded special charges of $789. These charges primarily consisted of costs incurred for employee terminations. The Company rebalanced the workforce by 19 employees during March 2002. This reduction primarily impacted research and development due to the overlap of employee skill sets as a result of acquisitions. Employee severance costs included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to quarter-end. These costs were expended during 2002. There were no significant modifications to the amount of these charges.

Merger and Acquisition Related Charges

For the three months ended March 31, 2003, the Company incurred no merger and acquisition related charges.

In February 2002, the Company acquired Accelerated Technology, Inc. (ATI), a provider of embedded software based in Mobile, Alabama. The acquisition was an investment aimed at expanding the Company’s product offering and driving revenue growth which supported the premium paid over the fair market value of the individual assets. The total purchase price including acquisition costs was $23,288, which included the fair value of a warrant issued of $361. The excess of liabilities assumed over tangible assets acquired was $1,808. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process research and development (R&D) of $4,000, goodwill of $16,668, technology of $6,500, other identified intangible assets of $880, net of related deferred tax liability of $2,952. The technology is being amortized to cost of goods sold over five years. Of the $880 other identified intangible assets, $480 was determined to have an indefinite life at the time of acquisition and was not being amortized. In 2003, the Company began amortizing this asset over five years to operating expenses. The remaining $400 is being amortized, primarily over five years, to operating expenses.

Other Income, Net

Other income, net totaled $487 for the three months ended March 31, 2003 compared to $4,002 for the comparable period of 2002. Interest income was $1,447 for the three months ended March 31, 2003 compared to $2,138 for the comparable period of 2002, which included income relating to the time value of foreign currency contracts of $139 and $259, respectively. Foreign currency loss was $733 for the three months ended March 31, 2003 compared to a gain of $2 for the comparable period of 2002 due to fluctuations in currency rates. In addition, other income was favorably impacted by a gain on sale of investment of $2,438 for the three months ended March 31, 2002.

Interest Expense

Interest expense was $4,045 for the three months ended March 31, 2003 compared to $291 for the comparable period of 2002. Interest expense increased primarily as a result of the issuance of the Company’s convertible subordinated notes in June 2002.

Provision for Income Taxes

The provision for income taxes was $900 for the three months ended March 31, 2003 compared to $439 for the comparable period of 2002. The net tax provision is the result of the mix of profits earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates. The provision for income taxes differs from tax computed at the federal statutory income tax rate due to the impact of nondeductible charges mostly related to acquisitions, offset by the realized benefit of net operating loss carryforwards, foreign tax credits and earnings permanently reinvested in foreign operations.

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

Under SFAS No. 109, “Accounting for Income Taxes”, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. SFAS No. 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based on the weight of available evidence, the Company has provided a valuation allowance against certain deferred tax assets. The portion of the valuation allowance for deferred tax assets related to the difference between financial and tax reporting of employee stock option exercises, for which subsequently recognized tax benefits will be applied directly to contributed capital, will be maintained until such benefits are actually realized on the Company’s income tax returns. The remainder of the valuation allowance was based on the historical earnings patterns within individual taxing jurisdictions that make it uncertain that the Company will have sufficient income in the appropriate jurisdictions to realize the full value of the assets. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis.

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Effects of Foreign Currency Fluctuations

Approximately half of the Company’s revenues are generated outside of the United States. For 2003 and 2002, approximately one-fourth of European and all Japanese revenues were subject to exchange rate fluctuations as they were booked in local currencies. The effects of these fluctuations were substantially offset by local currency cost of revenues and operating expenses, which resulted in an immaterial net effect on the Company’s results of operations.

Foreign currency translation adjustment, a component of accumulated other comprehensive income reported in the stockholders’ equity section of the Consolidated Balance Sheets, increased to $18,097 at March 31, 2003, from $17,606 at the end of 2002. This reflects the increase in the value of net assets denominated in foreign currencies since year-end 2002 as a result of a weaker U.S. dollar at March 31, 2003.

LIQUIDITY AND CAPITAL RESOURCES

Cash, Cash Equivalents and Short-Term Investments

Total cash, cash equivalents and short-term investments at March 31, 2003 were $50,699 compared to $38,826 at December 31, 2002. Cash provided by operating activities was $13,660 for the three months ended March 31, 2003 as compared to $3,701 for the comparable period of 2002. The increase in cash provided by operating activities was primarily due to an increase in working capital in addition to an increase in non-cash expenses as a result of amortization related to a deferred tax charge recorded in the fourth quarter of 2002.

Cash used for investing activities, excluding short-term investments, was $3,625 and $106,435 for the three months ended March 31, 2003 and 2002, respectively. Cash used for investing activities included capital expenditures of $3,278 and $4,291 for the three months ended March 31, 2003 and 2002, respectively. Acquisition of businesses was $347 for the three months ended March 31, 2003 related to acquisitions completed during 2002 compared to $102,144 for the comparable period in 2002.

Cash provided by financing activities was $1,899 and $28,113 for the three months ended March 31, 2003 and 2002, respectively. Cash provided by financing activities for the three months ended March 31, 2002 included $22,000 in proceeds from short-term borrowings. Cash and short-term investments were positively impacted by the proceeds from issuance of common stock upon exercise of stock options and employee stock plan purchases in the amount of $3,174 and $8,274 for the three months ended March 31, 2003 and 2002, respectively.

Trade Accounts Receivable

Trade accounts receivable decreased to $157,701 at March 31, 2003 from $159,657 at December 31, 2002. Excluding the current portion of term receivables of $85,120 and $81,697, average days sales outstanding were 41 days and 39 days at March 31, 2003 and December 31, 2002, respectively. Average days sales outstanding in total accounts receivable increased from 80 days at the end of 2002 to 89 days at the end of the first quarter of 2003. The increase in total accounts receivable days sales outstanding was primarily due a greater mix of term contract revenue in each of the last four quarters. In the quarters where term contract revenue is recorded only about one-third, or twelve months, of the receivable is reflected in current trade accounts receivable. In the following quarters, the same amount is reflected in current trade accounts receivable without the corresponding revenue. The Company sold $12,876 of short-term accounts receivable in the first quarter of 2003 compared to $13,441 sales of short-term accounts receivable in the fourth quarter of 2002. The Company records a sale when it is considered to have surrendered control of such receivables under the provisions of SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”

Inventory, Net

Inventory, net increased $2,243 from December 31, 2002 to March 31, 2003. The increase was primarily due to purchases based on forecasted shipments of next generation emulation hardware products.

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Prepaid Expenses and Other

Prepaid expenses and other increased $279 from December 31, 2002 to March 31, 2003. The increase was primarily due to annual renewals of maintenance contracts and prepaid royalty payments. The increase was partially offset by the receipt of a $2,000 income tax refund for an income tax receivable acquired in the IKOS acquisition in 2002.

Term Receivables, Long-Term

Term receivables, long-term increased to $82,053 at March 31, 2003 compared to $78,431 at December 31, 2002. The balances were attributable to multi-year, multi-element term license sales agreements principally from the Company’s top-rated credit customers. Balances under term agreements that are due within one year are included in trade accounts receivable and balances that are due in more than one year are included in term receivables, long-term. The Company uses term agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. The increase was primarily attributable to additional term agreements, partially offset by run-off of balances on older term agreements.

Accrued Payroll and Related Liabilities

Accrued payroll and related liabilities decreased $5,019 from December 31, 2002 to March 31, 2003. The decrease was primarily due to payments of the 2002 annual and fourth quarter incentive compensation partially offset by an increase in accrued payroll taxes due to timing of payment.

Accrued Liabilities

Accrued liabilities decreased $3,194 from December 31, 2002 to March 31, 2003. The decrease was primarily due to payment of restructure costs. This decrease was partially offset by accrued interest expense for the semi-annual interest payments related to the Company’s convertible subordinated notes issued in June 2002.

Deferred Revenue

Deferred revenue consists primarily of prepaid annual software support contracts. Deferred revenue increased $13,473 from December 31, 2002 to March 31, 2003. Deferred revenue increased due to annual support renewals for the three months ended March 31, 2003.

Capital Resources

Expenditures for property and equipment decreased to $3,278 for the three months ended March 31, 2003 compared to $4,291 for the comparable period of 2002. Expenditures in the three months ended March 31, 2003 and 2002 did not include any individually significant projects.

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

The Company anticipates that current cash balances, anticipated cash flows from operating activities and amounts available under existing credit facilities will be sufficient to meet its working capital needs on a short-term and long-term basis.

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

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OUTLOOK

In the calculation of earnings, gross margin and operating expenses before amortization of intangible assets and special charges, the Company excludes amortization of intangible assets and write-offs of in-process R&D from acquisitions. Also excluded are special charges such as restructure expenses and asset impairments. The Company believes that excluding these items provides investors with a representation of its core performance, and a pro forma base line for assessing the future earnings potential of the Company.

Second Quarter 2003

Revenues are expected to be between $156,000 and $162,000. Gross margin, excluding amortization of purchased technology, is expected to be approximately 84%, while gross margin on a GAAP basis is expected to be in the range of 82% to 83%. Operating expenses, excluding special charges and amortization of intangible assets, are expected to be approximately $123,000, while operating expenses on a GAAP basis are expected to be $124,000. The total of other income, net and interest expense is expected to be approximately $3,000 of expense. Earnings, excluding special charges and amortization of intangible assets, are expected to be between $0.06 and $0.11 per share, while earnings on a GAAP basis are expected to be between $0.02 and $0.07 per share. The tax rate is expected to be 20% for the quarter.

Full Year 2003

Revenues for the year 2003 are expected in the range of $665,000. Gross margin, excluding the amortization of purchased technology, is expected to average 84% for the year, while gross margin on a GAAP basis is expected to average 83%. Operating expenses, exclusive of special charges, merger and acquisition related charges and amortization of intangible assets are estimated to increase about 10% over 2002 levels. Operating expenses on a GAAP basis are estimated to increase about 2% over 2002 levels The total of interest expense and other income, net is expected to be an expense of approximately $11,000 primarily due to interest on the convertible subordinated notes for the year. Earnings, excluding special charges and amortization of intangible assets, are expected to be $0.55 per share, while earnings on a GAAP basis are expected to be $0.39 per share. The tax rate is expected to be 20% for the year.

Reconciliation of Pro Forma Financial Information

The following table shows a reconciliation of the forward-looking financial information on a GAAP basis to the forward-looking pro forma financial information:

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FACTORS THAT MAY AFFECT FUTURE RESULTS AND FINANCIAL CONDITION

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

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

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

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

Purchases of the Company’s products and services are highly dependent upon new design projects initiated by integrated circuit manufacturers and electronics systems companies. The integrated circuit industry is highly cyclical and is subject to constant and rapid technological change, rapid product obsolescence, price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand. The integrated circuit and electronics systems industries have experienced significant downturns, often connected with, or in anticipation of, maturing product cycles of both companies in these industries and their customers’ products and a decline in general economic conditions. These downturns have caused diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices. Certain integrated circuit manufacturers and electronics systems companies announced a slowdown of demand and production in 2001, which continued in 2002. During downturns such as the current one, the number of new design projects decreases. The current slowdown has reduced, and any future downturns are likely to further reduce, the Company’s revenue and could materially adversely affect the Company.

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

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

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

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The Company’s revenue is also affected by the mix of licenses entered into in connection with the sale of software products. The Company’s software licenses fall into three general categories: perpetual, fixed-term and subscription. With perpetual and fixed-term licenses, the Company recognizes software product revenue at the beginning of the license period, while with subscription licenses the Company recognizes software product revenue ratably over the license period. Accordingly, a shift in the license mix toward increased subscription licenses would result in increased deferral of software product revenue to future periods and would decrease current revenue, possibly resulting in the Company not meeting revenue expectations.

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

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

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

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

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

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

The Company currently competes primarily with two large companies: Cadence Design Systems, Inc. and Synopsys, Inc. In June 2002, Synopsys completed its acquisition of Avant! Corporation and the combined company could improve its competitive position with respect to the Company. The Company also competes with numerous smaller companies, a number of which have combined with other EDA companies. The Company also competes with manufacturers of electronic devices that have developed, or have the capability to develop, their own EDA products internally.

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

The Company realized approximately half of the Company’s revenue from customers outside the United States for each of the years ended December 31, 2000, 2001 and 2002. To hedge against the impact of foreign currency fluctuations, the Company enters into foreign currency forward and option contracts. However, significant changes in exchange rates may have a material adverse impact on the Company. In addition, international operations subject the Company to other risks including, but not limited to, longer receivables collection periods, changes in a specific country’s or region’s economic or political conditions, trade protection measures, import or export licensing requirements, loss or modification of exemptions for taxes and tariffs, limitations on repatriation of earnings and difficulties with licensing and protecting the Company’s intellectual property rights.

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

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

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

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

Current litigation with Quickturn, a subsidiary of Cadence Design Systems, Inc., over certain patents could affect the Company’s ability to sell the Company’s emulation products.

The Company has been sued by Quickturn, which alleges that the Company and certain of the Company’s emulation hardware products have infringed certain Quickturn patents. This litigation could adversely affect the Company’s ability to sell the Company’s emulation hardware products in various jurisdictions worldwide and may decrease demand for the Company’s emulation hardware products worldwide. Such litigation could also result in lower sales of emulation hardware products, increase the risk of inventory obsolescence and have a material adverse effect on the Company.

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

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

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

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

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Intellectual property infringement by or against us could materially adversely affect the Company.

There are numerous patents held by the Company and the Company’s competitors in the EDA industry, and new patents are being issued at a rapid rate. It is not always economically practicable or possible to determine in advance whether a product or any of its components infringes the patent rights of others. As a result, from time to time, the Company may be forced to respond to, or prosecute, intellectual property infringement claims to protect the Company’s rights or defend a customer’s rights. These claims, regardless of merit, could consume valuable management time, result in costly litigation and cause product shipment delays, all of which could materially adversely affect the Company. In settling these claims, the Company may be required to enter into royalty or licensing agreements with the third parties claiming infringement. These royalty or licensing agreements, if available, may not have terms acceptable to the Company. Any potential intellectual property litigation could force the Company to do one or more of the following: