CADENCE DESIGN SYSTEMS INC - 10-Q Quarterly 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

On October 2, 2004, 270,336,902 shares of the registrant’s common stock, $0.01 par value, were outstanding.

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

The Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, or this Quarterly Report, have been prepared by Cadence Design Systems, Inc., or Cadence, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, Cadence believes that the disclosures contained in this Quarterly Report comply with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended, for a Quarterly Report on Form 10-Q and are adequate to make the information presented not misleading. These Condensed Consolidated Financial Statements are meant to be, and should be, read in conjunction with the Consolidated Financial Statements and the notes thereto included in Cadence’s Annual Report on Form 10-K for the fiscal year ended January 3, 2004, or the 2003 Annual Report.

The unaudited Condensed Consolidated Financial Statements included in this Quarterly Report reflect all adjustments (which include only normal, recurring adjustments and those items discussed in these Notes) that are, in the opinion of management, necessary to state fairly the results for the periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full fiscal year.

Preparation of the Condensed Consolidated Financial Statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the Condensed Consolidated Financial Statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

In Cadence’s 2003 Annual Report, Cadence restated its Consolidated Financial Statements as of and for the fiscal year ended December 28, 2002, and for the first three quarters of fiscal 2003. The accompanying Condensed Consolidated Financial Statements present restated results for the three and nine months ended September 27, 2003. For the three and nine months ended September 27, 2003, adjustments were made to income (loss) on equity investments, amortization of deferred stock compensation, revenue, amortization of internally developed software, foreign currency transaction gains (losses), other expense, and the tax effect of these restatement adjustments. Adjustments were also made to reclassify amortization of certain intangible assets from Amortization of acquired intangibles to Cost of product, Cost of services and Cost of maintenance.

The table below provides a pro forma illustration of the financial results of operations as if Cadence had accounted for its grants of employee stock options under the fair value method of Statement of Financial Accounting Standards, or SFAS, No. 123, “Accounting for Stock–Based Compensation”. The impact of employee stock options on the pro forma financial results of operations was estimated at the date of grant using the Black-Scholes option pricing model. Cadence used expected volatility, as well as other economic data, to estimate the volatility for the option grants during the three and nine months ended October 2, 2004 and September 27, 2003, because management believes the amount yielded by this method is representative of prospective trends. Cadence determined the estimated fair values of its options granted and shares purchased under its employee stock purchase plans, or ESPPs, for the three and nine months ended October 2, 2004 and

The following table illustrates the effect on net income (loss) and net income (loss) per share as if Cadence had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” to stock-based compensation:

In April 2004, Cadence acquired Neolinear, Inc., or Neolinear, a privately-held developer of rapid analog design technology. Cadence purchased Neolinear to acquire key personnel and technology. As discussed in Note 5, prior to the acquisition Cadence held an equity investment in Neolinear of approximately $3 million, representing 12% ownership. In accordance with SFAS No. 141, “Business Combinations,” Cadence accounted for the acquisition of Neolinear as a step acquisition. The aggregate initial purchase price was $78.1 million, which included the payment of cash, the fair value of assumed options and acquisition costs. The purchase price and goodwill will increase if certain performance goals related to revenue targets and product development are achieved over a period of approximately four years following the acquisition. Neolinear’s results of operations and the estimated fair values of the assets acquired and liabilities assumed have been included in Cadence’s Condensed Consolidated Financial Statements from the date of acquisition.

The following table summarizes the preliminary allocation of the purchase price for Neolinear and the estimated amortization period for the acquired intangibles:

The $7.0 million of purchase price allocated to acquired in-process technology was determined through established valuation techniques. The acquired in-process technology was immediately expensed because technological feasibility had not been established, and no future alternative use exists. The write-off of acquired in-process technology is a component of operating expenses in the Condensed Consolidated Statements of Operations.

The $38.3 million of goodwill was assigned to the Product segment. The goodwill is not expected to be deductible for income tax purposes.

During the three months ended October 2, 2004, Cadence acquired a company for an aggregate initial purchase price of $9.2 million, which included the payment of cash, the fair value of assumed options and acquisition costs. The $5.9 million of goodwill recorded in connection with this acquisition was assigned to the Product segment and is not expected to be deductible for income tax purposes. The acquired company’s

Cadence allocated $2.0 million of the purchase price to acquired in-process technology, which was determined through established valuation techniques. The acquired in-process technology was immediately expensed because technological feasibility had not been established, and no future alternative use exists. The write-off of acquired in-process technology is a component of operating expenses in the Condensed Consolidated Statements of Operations.

Comparative pro forma financial information for all acquisitions completed in fiscal 2004 to date have not been presented because their effect on results of operations was not material to Cadence’s Condensed Consolidated Financial Statements.

For a number of Cadence’s acquisitions, payment of a portion of the purchase price is contingent upon the acquired entity’s achievement after the completion of the transaction of certain performance goals, which relate to one or more of the following criteria: revenue, bookings, product proliferation, product development, and employee retention. The specific performance goal levels, and amounts and timing of contingent purchase price payments, vary with each acquisition.

In the three months ended October 2, 2004, Cadence recorded $6.0 million of goodwill as contingent purchase price payable to stockholders of acquired companies. The $6.0 million of goodwill consisted of $3.5 million of actual cash payments and $2.5 million of accrued cash payments.

In the nine months ended October 2, 2004, Cadence recorded $33.4 million of goodwill as contingent purchase price payable to stockholders of acquired companies. The $33.4 million of goodwill consisted of $14.5 million of actual cash payments, $2.5 million of accrued cash payments and the issuance of shares of Cadence’s common stock valued at $16.4 million. In addition, during the nine months ended October 2, 2004, Cadence recognized deferred stock compensation of $1.3 million in connection with these acquisitions and in accordance with Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation (an Interpretation of APB No. 25)”.

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, Cadence conducts an annual impairment analysis of goodwill. During the third quarter of 2004, Cadence completed its annual impairment analysis. Based on the results of the impairment review, Cadence has determined that no indicators of impairment existed for any of its reporting units during 2004. Accordingly, no impairment charge has been recognized.

Cadence’s annual impairment review process compares the fair value of each reporting unit to its carrying value, including the goodwill related to the reporting unit. To determine the reporting unit’s fair value, Cadence utilizes a combination of the income and market valuation approaches.

The income approach provides an estimate of fair value based on the discounted expected future cash flows. These expected future cash flows are based on Cadence’s assumed market segment growth rates, assumed market segment share growth rates, estimated costs and appropriate discount rates based on the reporting units’ weighted average cost of capital as determined by considering the observable weighted average cost of capital of comparable companies. Cadence’s estimates of market segment growth, market segment share growth and costs are based on historical data, various internal estimates and a variety of external sources, and are developed as part of Cadence’s routine long-range planning process.

such as size, growth, profitability, risk and return on investment are also analyzed and compared to comparable companies. Various price or market multiples are then applied to the reporting units’ operating results to arrive at an estimate of fair value.

In determining its overall conclusion of reporting unit fair value, management considers the estimated values derived from both the income and market valuation approaches. The weighting applied to the market approach depends on the similarity of the comparable businesses to the reporting unit.

The changes in the carrying amount of goodwill for our Product and Services segments (no goodwill is carried for our Maintenance segment) for the nine months ended October 2, 2004 were as follows:

Goodwill resulting from acquisitions during the nine months ended October 2, 2004 includes adjustments to the initial allocation of the purchase price subsequent to the acquisition. During the nine months ended October 2, 2004, Cadence recorded other adjustments of $2.6 million in the carrying amount of goodwill, primarily as a result of a $1.1 million decrease in the initial purchase price related to the 2003 acquisition of Celestry Design Technologies, Inc., a $0.7 million decrease related to the 2003 acquisition of Get2Chip.com, Inc. and a $0.5 million decrease related to the 2002 acquisition of Simplex Solutions, Inc.

Acquired intangibles with finite lives as of October 2, 2004 and January 3, 2004 were as follows:

For the three months ended October 2, 2004, amortization of acquired intangibles was $26.7 million, as compared to $27.8 million for the same period in 2003. For the nine months ended October 2, 2004, amortization of acquired intangibles was $79.2 million, as compared to $79.1 million for the same period in 2003.

Amortization of costs from existing technology is included in Cost of product and Cost of services. Amortization of costs from acquired maintenance contracts is included in Cost of maintenance.

Cadence accounts for its marketable securities as available-for-sale and classifies them as Short-term investments in the Condensed Consolidated Balance Sheets. There were no net recognized gains or losses from sales of marketable securities during the three months ended October 2, 2004. Net recognized gains from the sale of marketable securities were $3.3 million for the nine months ended October 2, 2004. There were no net recognized gains or losses from sales of marketable securities for the three and nine months ended September 27, 2003.

There were no recognized losses from other-than-temporary declines in the market value of marketable securities for the three months ended October 2, 2004. Recognized losses from other-than-temporary declines in the market value of marketable securities totaled $0.7 million in the nine months ended October 2, 2004. There were no recognized losses from other-than-temporary declines in the market value of marketable securities in the three and nine months ended September 27, 2003.

Cadence uses either the cost or equity method of accounting for its long-term, non-marketable investment securities included in Other assets in the Condensed Consolidated Balance Sheets. Cadence recorded net gains of $0.7 million and $4.7 million from the sale of non-marketable investment securities during the three and nine months ended October 2, 2004, respectively. There were no recognized gains or losses on the sale of non-marketable investment securities during the three and nine months ended September 27, 2003. If Cadence determines that an other-than-temporary decline in fair value exists for a non-marketable equity security, it writes down the investment to its fair value and records the related write-down as an investment loss in its Condensed Consolidated Statements of Operations.

The following table presents the carrying value of Cadence’s non-marketable securities made directly by Cadence or indirectly through Telos Venture Partners, L.P., Telos Venture Partners II, L.P., and Telos Venture Partners III, L.P.

Cadence recorded write-downs due to other-than-temporary declines in value of its cost method investments of $1.1 million and $2.3 million during the three and nine months ended October 2, 2004, respectively. Cadence recorded write-downs due to other-than-temporary declines in value of $0.3 million and $4.8 million during the three and nine months ended September 27, 2003, respectively. These write-downs are included in Other income (expense), net, in the Condensed Consolidated Statements of Operations.

During the first nine months of 2004, Cadence’s voting interest ranged from approximately 10% to approximately 49% of the following privately-held companies, which Cadence accounted for under the equity method of accounting: Accent S.r.l, Ammocore Technology, Inc., Clear Shape Technologies, Inc., Coventor, Inc., CoWare, Inc., E-Z-CAD, Inc., Fyre Storm, Inc., Hierarchical Design, Inc., Integrated Memory Logic, Inc., iReady Corporation, Lorentz Solutions, Inc., Neolinear, Inc., Rio Design Automation, Inc., Theta Microelectronics, Inc. and ZCIST Co., Ltd. On April 15, 2004, Cadence acquired all of the outstanding capital stock of Neolinear, Inc, as more fully described above in Note 3.

During the first nine months of 2003, Cadence’s voting interest ranged from approximately 10% to approximately 49% of the following privately-held companies, which Cadence accounted for under the equity method of accounting: Accent S.r.l., Ammocore Technology, Inc., Coventor, Inc., CoWare, Inc., Fyre Storm, Inc., Hierarchical Design, Inc., Integrated Memory Logic, Inc., iReady Corporation, Neolinear, Inc., Theta Microelectronics, Inc. and ZCIST Co., Ltd.

The following table presents summary operating data of our equity method investees for the three and nine months ended October 2, 2004:

In accordance with the equity method of accounting, Cadence records its proportional share of the investee’s gains or losses in Other income (expense), net. Cadence records its interest in equity method gains and losses in the quarter following occurrence because it is not practicable to obtain investee financial statements prior to the issuance of Cadence’s Condensed Consolidated Financial Statements. Cadence’s proportional share of its investees’ net losses was $3.8 million and $16.2 million for the three and nine months ended October 2, 2004, respectively. Cadence’s proportional share of its investees’ net losses was $1.5 million and $7.1 million for the three and nine months ended September 27, 2003, respectively. As of October 2, 2004, the difference between the carrying value of Cadence’s investments in these investee companies and Cadence’s share of the underlying net assets of the investee companies was immaterial.

Cadence initiated a separate plan of restructuring in each year beginning in 2001, in an effort to reduce operating expenses and improve operating margins and cash flows.

The restructuring plans initiated in 2001, 2002 and 2003, or the 2001 Restructuring, 2002 Restructuring and 2003 Restructuring, respectively, were intended to decrease costs by reducing workforce and consolidating facilities and resources, to align Cadence’s cost structure with expected revenues. The 2001 and 2002 Restructurings primarily related to Cadence’s design services business and certain other busi-

During the first quarter of 2004, Cadence commenced a new plan of restructuring, or the 2004 Restructuring, which was also intended to decrease costs and realize efficiencies by reducing workforce and resources throughout the company to align Cadence’s cost structure with projected revenues.

The asset-related portion of the 2004 Restructuring was accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The severance and benefits charges under this restructuring plan were accounted for in accordance with SFAS No. 112, “Employers’ Accounting for Postemployment Benefits – An Amendment of Financial Accounting Standards Board, or FASB, Statements No. 5 and 43.”

Closure and space reduction costs included in these restructurings were comprised of payments required under leases less any applicable estimated sublease income after the properties were abandoned, lease buyout costs and costs to maintain facilities during the period after abandonment. To estimate the lease loss, which is the loss after Cadence’s cost recovery efforts from subleasing a building, Cadence management made certain assumptions related to the time period over which the relevant building would remain vacant and sublease terms, including sublease rates and contractual common area charges.

Since 2001, Cadence has recorded facilities consolidation charges of $85.0 million related to space reductions or closures of 34 sites. As of October 2, 2004, 24 of these sites had been vacated and space reductions occurred at the remaining ten sites.

As of October 2, 2004, Cadence’s best estimate of the lease loss related to all worldwide restructuring activities initiated since 2001 is $34.2 million. This amount will be adjusted in the future based upon changes in the assumptions used to estimate the lease loss. The lease loss could range as high as $51.8 million if sublease rental rates decrease in applicable markets or if it takes longer than currently expected to find a suitable tenant to sublease the facilities.

Restructuring and other charges (credits) recorded by plan of restructuring for the three months ended October 2, 2004 were as follows:

Restructuring and other charges (credits) recorded by plan of restructuring for the nine months ended October 2, 2004 were as follows:

Total restructuring and other costs accrued as of October 2, 2004 were $44.2 million, consisting of $17.4 million in Accounts payable and accrued liabilities and $26.8 million in Other long-term liabilities in the Condensed Consolidated Balance Sheets. Cadence expects to pay substantially all of the asset-related and severance and benefits-related restructuring liabilities for all its restructuring plans prior to 2006 and all of the facilities-related restructuring liabilities for all its restructuring plans prior to 2016.

Activity for the three and nine months ended October 2, 2004 associated with each plan of restructuring is discussed below.

The 2004 Restructuring is expected to result in the termination of approximately 121 employees. Costs resulting from this restructuring include severance payments, severance-related benefits and outplacement services. All terminations and termination benefits associated with this restructuring were communicated to the affected employees prior to October 2, 2004, with all termination benefits expected to be paid by July 2, 2005.

The following table presents the activity associated with restructuring and other charges related to the 2004 Restructuring for the three months ended October 2, 2004:

The following table presents the activity associated with restructuring and other charges related to the 2004 Restructuring for the nine months ended October 2, 2004:

Cadence incurred $1.2 million and $2.1 million of expense in the three and nine months ended October 2, 2004, respectively, related to the 2003 Restructuring. These expenses were primarily comprised of additional expenses incurred for facilities included in the 2003 Restructuring, but vacated during the three months ended October 2, 2004 and, to a lesser extent, contract termination charges and expenses incurred to sublease facilities and storage and disposal charges associated with facilities vacated as part of the 2003 Restructuring. The expenses were partially offset by the reversal of a portion of the severance-related accrual for payroll taxes, benefits and outplacement services in excess of the remaining expected obligation.

The following table presents the activity associated with restructuring and other charges related to the 2003 Restructuring for the three months ended October 2, 2004:

The following table presents the activity associated with restructuring and other charges related to the 2003 Restructuring for the nine months ended October 2, 2004:

During the third quarter of 2004, Cadence reduced its expenses related to the 2002 Restructuring by $0.6 million due to a reduction in the estimated lease loss related to a facility included in the 2002 Restructuring and the reversal of a portion of the severance and benefits accrual in excess of the remaining expected obligation.

The following table presents activity associated with restructuring and other charges related to the 2002 Restructuring for the three months ended October 2, 2004:

The following table presents activity associated with restructuring and other charges related to the 2002 Restructuring for the nine months ended October 2, 2004:

Cadence did not record significant charges under the 2001 Restructuring for the three months ended October 2, 2004. Facilities-related charges recorded during the first nine months of 2004 of $0.5 million related primarily to changes in lease loss estimates and costs associated with facilities vacated as part of the 2001 Restructuring.

The following table presents the activity associated with restructuring and other charges related to the 2001 Restructuring for the three months ended October 2, 2004:

The following table presents the activity associated with restructuring and other charges related to the 2001 Restructuring for the nine months ended October 2, 2004:

In August 2003, Cadence issued $420.0 million principal amount of Zero Coupon Zero Yield Senior Convertible Notes due 2023, or the Notes, to two initial purchasers in a private offering for resale to qualified institutional buyers pursuant to SEC Rule 144A. Cadence received net proceeds of approximately $406.4 million after transaction fees of approximately $13.6 million that were recorded in Other assets and are being amortized to interest expense using the straight-line method over five years, which is the duration of the first redemption period. The Notes were issued by Cadence at par and bear no interest. The Notes are convertible into Cadence common stock initially at a conversion price of $15.65 per share, which would result in an aggregate of 26.8 million shares issued upon conversion, subject to adjustment upon the occurrence of specified events. Cadence may redeem for cash all or any part of the Notes on or after August 15, 2008 for 100.00% of the principal amount. The holders may require Cadence to repurchase for cash all or any portion of their Notes on August 15, 2008 for 100.25% of the principal amount, on August 15, 2013 for 100.00% of the principal amount or on August 15, 2018 for 100.00% of the principal amount. The Notes do not contain any restrictive financial covenants.

On September 30, 2004, the Financial Accounting Standards Board, or FASB, reached a consensus on Emerging Issues Task Force Issue No. 04-08, “Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share”, or EITF 04-08. For all periods in which the Notes are outstanding, EITF 04-08 will require Cadence to include in diluted earnings per share the approximately 26.8 million shares of Cadence common stock into which the Notes may be converted, using the “if-converted” method. The adoption of EITF 04-08 will require Cadence to restate previously reported diluted earnings per share for all periods in which the Notes were outstanding. Cadence expects EITF 04-08 to become effective in the fourth quarter of 2004, which coincides with the expected effective date of SFAS No. 128R, “Earnings per Share, an amendment of FASB Statement No. 128”. Cadence does not expect a material impact on restated diluted earnings per share for any periods after the issuance of the Notes in August 2003.

In November 2003, Cadence filed with the SEC a resale registration statement with respect to the Notes. This registration statement was declared effective by the SEC on April 29, 2004.

Concurrently with the issuance of the Notes, Cadence entered into convertible notes hedge transactions with JP Morgan Chase Bank whereby Cadence has options to purchase up to 26.8 million shares of Cadence’s common stock at a price of $15.65 per share. These options expire on August 15, 2008 and must be settled in net shares. The cost of the convertible notes hedge transactions to Cadence was approximately $134.6 million.

In addition, Cadence sold warrants to JP Morgan Chase Bank for the purchase of up to 26.8 million shares of Cadence’s common stock at a price of $23.08 per share. The warrants expire on various dates from February 2008 through May 2008 and must be settled in net shares. Cadence received approximately $56.4 million in cash proceeds for the sales of these warrants.

From time to time, Cadence is involved in various disputes and litigation matters that arise in the ordinary course of business. These include disputes and lawsuits related to intellectual property, mergers and acquisitions, licensing, contract law, distribution arrangements and employee relations matters. Periodically, Cadence reviews the status of each significant matter and assesses its potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, Cadence accrues a liability for the estimated loss at the low end of the range. Legal proceedings are subject to uncertainties, and the outcomes are difficult to predict. Because of such uncertainties, accruals are based only on the best information available at the time. As additional information becomes available, Cadence reassesses the potential liability related to pending claims and litigation matters and may revise estimates.

While the outcome of these litigation matters cannot be predicted with any certainty, management does not believe that the outcome of any current matters will have a material adverse effect on Cadence’s consolidated financial position or results of operations.

Cadence provides its customers with a warranty on sales of hardware products for a 90-day period. These warranties are accounted for in accordance with SFAS No. 5, “Accounting for Contingencies”, or SFAS No. 5. To date, Cadence has not incurred any significant costs related to warranty obligations.

Cadence’s product license and services agreements include a limited indemnification provision for claims from third parties relating to Cadence’s intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5. The indemnification is generally limited to the amount paid by the customer. To date, claims under such indemnification provisions have not been significant.

From time to time, Cadence has provided, and may in the future provide, guarantees to third parties on behalf of a foreign subsidiary. These guarantees are generally related to maintaining operations in a certain locality or to secure leases or other operating obligations of a subsidiary. The maximum exposure on these guarantees is not significant, either individually or in the aggregate.

Basic net income (loss) per share is computed by dividing net income (loss) during the period, the numerator, by the weighted average number of shares of common stock outstanding, the denominator. Diluted net income (loss) per share gives effect to equity instruments considered to be potential common shares, if dilutive, computed using the treasury stock method of accounting. During the three and nine months ended September 27, 2003, dilutive net loss per share was computed without giving effect to equity instruments considered to be potential common shares because the impact would have been antidilutive.

The following is a reconciliation of the weighted average common shares used to calculate basic net income (loss) per share to weighted average common and potential common shares used to calculate diluted net income (loss) per share:

The following table presents the potential shares of Cadence common stock outstanding at October 2, 2004 and September 27, 2003 that were not included in the computation of diluted net income (loss) per

In August 2001, the Cadence Board of Directors authorized a program to repurchase shares of Cadence’s common stock with a value of up to $500 million in the aggregate.

The table below presents the shares repurchased under Cadence’s stock repurchase program for the three and nine months ended October 2, 2004 and September 27, 2003:

The total cost of repurchased shares in the nine months ended September 27, 2003 was $213.8 million, including $211.0 million in cash paid for shares during the nine months ended September 27, 2003, and $2.8 million in cash paid for shares after September 27, 2003 to settle share repurchase transactions initiated during the period. As of October 2, 2004, the remaining repurchase authorization under this program totaled $122.9 million.

The following table presents the common shares issued under Cadence’s ESPPs for the three and nine months ended October 2, 2004 and September 27, 2003:

At October 2, 2004, Cadence had four other stock-based employee compensation plans (excluding director plans). Cadence accounts for these plans under the recognition and measurement principles of Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Under APB Opinion No. 25, compensation expense is recognized if an option’s exercise price on the measurement date is below the fair value of Cadence’s common stock. The compensation, if any, is amortized to expense over the vesting period.

Using the Black-Scholes option pricing model, the weighted average fair value of options granted during the three months ended October 2, 2004 was $3.98, as compared to $7.06 during the three months ended September 27, 2003. The weighted average fair value of options granted during the nine months ended October 2, 2004 was $5.11, as compared to $5.71 during the nine months ended September 27, 2003.

For fixed awards, Cadence amortizes deferred stock compensation to expense using the straight-line method over the period that the stock options and restricted stock vest, which is generally three to four years. For variable awards, stock-based compensation expense is recognized on an accelerated basis in accordance with FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans”. For the three months ended October 2, 2004 and September 27, 2003, Cadence recorded amortization of deferred stock compensation of $5.8 million and $11.6 million, respectively. For the nine months ended October 2, 2004 and September 27, 2003, Cadence recorded amortization of deferred stock compensation of $21.9 million and $25.6 million, respectively.

The following table presents the activity recorded in deferred compensation included in the accompanying Condensed Consolidated Balance Sheet as of October 2, 2004:

During the nine months ended October 2, 2004, Cadence issued 1.5 million shares of restricted stock to certain employees. As reflected in the table above, Cadence recorded deferred stock compensation of $21.0 million in the accompanying Condensed Consolidated Balance Sheets in connection with these incentive stock awards.

Other comprehensive income (loss) includes foreign currency translation gains and unrealized gains and losses on marketable securities that are available-for-sale, net of related tax effects. These transactions have been excluded from Net income (loss) and are reflected instead in Stockholders’ Equity.

The following table sets forth the activity in Other comprehensive income (loss):

Cadence’s chief operating decision maker is its President and Chief Executive Officer, or CEO. Cadence’s CEO reviews Cadence’s consolidated results within three segments: Product, Services and Maintenance.

The Product segment includes revenue and associated costs from software licensing, and sales and leases of hardware technology and intellectual property. The Services segment includes revenue and associated costs to provide methodology and design services either to assist companies in developing electronic designs or to assume responsibility for the design effort for customers that outsource this work. The Maintenance segment includes revenue and associated costs primarily for a technical support organization. Maintenance agreements are offered to customers either as part of Cadence’s product license agreements or separately.

Segment income (loss) from operations is defined as gross margin less operating expenses (Marketing and sales, Research and development and General and administrative), Amortization of deferred stock compensation, Restructuring and other charges, Write-off of acquired in-process technology, Interest expense and Other income (expense), net. Information about the profitability of Cadence’s segments is available only to the extent of gross margin by segment and write-off of acquired in-process technology. Operating expenses, Amortization of deferred stock compensation, Restructuring and other charges, Interest expense and Other income (expense), net, are not managed by segment. Cadence neither identifies nor allocates among its segments Operating expenses, Amortization of deferred stock compensation, Restructuring and other charges, Interest expense and Other income (expense), net, because the information is not available by segment and is not reviewed by Cadence’s CEO in making decisions about resources to be allocated among the segments or to assess their performance. There are no differences between the accounting policies used to measure profit and loss for segments and those used on a consolidated basis. Revenue is defined as revenue from external customers only.

Cadence neither identifies nor allocates its assets by operating segment. Accordingly, assets are not being reported by segment because the information is not available by segment and is not reviewed by Cadence’s CEO in making decisions about resources to be allocated among the segments or to assess their performance.

The following tables present information about reported segments for the three months ended October 2, 2004 and September 27, 2003:

The following tables present information about reported segments for the nine months ended October 2, 2004 and September 27, 2003:

Internationally, Cadence markets and supports its products and services primarily through its subsidiaries. Revenue is attributed to geography based on the country in which the customer is domiciled. Long-lived assets are attributed to geography based on the country where the assets are located. Until June 28, 2003, Cadence licensed most of its software products in Japan through a distributor, Innotech Corporation, or

Innotech, of which Cadence is an approximately 15% stockholder. In June 2003, Cadence purchased certain assets from Innotech, including distribution rights for certain customers in Japan. Since June 2003, Cadence has directly licensed its software products to customers for which Cadence acquired the distribution rights from Innotech.

In the three months ended October 2, 2004, one customer accounted for 13% of total revenue, while during the three months ended September 27, 2003, one customer accounted for 15% of total revenue. In the nine months ended October 2, 2004, and the nine months ended September 27, 2003, no one customer accounted for more than 10% of total revenue.

On October 22, 2004, the federal American Jobs Creation Act of 2004, or the Act, was signed into law. A key provision of the Act is a one-time incentive to repatriate foreign earnings at a reduced effective tax rate. Cadence must meet several requirements to qualify for the incentive, including the payment of an inter-company cash dividend from the foreign subsidiary, and a Board of Directors approved plan to reinvest the dividend in the United States. Cadence is currently studying the impact of the repatriation provisions of the Act on its plans to indefinitely reinvest our foreign earnings. As of October 2, 2004 and based upon the tax laws in effect at that time, it was Cadence’s intention to continue to indefinitely reinvest our undistributed foreign earnings and, accordingly, no deferred tax liability has been recorded in connection therewith.

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

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q, or this Quarterly Report, and in conjunction with our Annual Report on Form 10-K for the fiscal year ended January 3, 2004, referred to as the 2003 Annual Report. Certain of such statements, including, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, statements regarding the deployment of our products, statements regarding our reliance on third parties and other statements using words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “should,” “will” and “would,” and words of similar import and the negatives thereof, constitute forward-looking statements. These statements are predictions based upon our current expectations about future events. Actual results could vary materially as a result of certain factors, including but not limited to, those expressed in these statements. We refer you to the “Factors That May Affect Future Results,” “Results of Operations,” “Disclosures About Market Risk,” and “Liquidity and Capital Resources” sections contained in this Quarterly Report on Form 10-Q, and the risks discussed in our other SEC filings, which identify important risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements.

We urge you to consider these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report. All subsequent written or oral forward-looking statements attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The forward-looking statements included in this Quarterly Report are made only as of the date of this Quarterly Report. We do not intend, and undertake no obligation, to update these forward-looking statements.

We license electronic design automation, or EDA, software, sell or lease hardware technology and intellectual property and provide design and methodology services throughout the world to help manage and accelerate electronic product development processes. Our broad range of products and services are used by the world’s leading electronics companies to design and develop complex integrated circuits, or ICs, and personal and commercial electronic systems.

As part of our strategy, we have acquired companies, businesses and third party intellectual property to obtain technology and key personnel, and we expect to continue making acquisitions in the future.

Over the last several years, IC manufacturers and electronics companies experienced a downturn in demand and production, which resulted in reduced research and development spending by many of our customers. In the second half of 2003 and the first three quarters of 2004, IC manufacturers and electronics companies appear to have experienced a gradual recovery, but they have continued to spend cautiously through the third quarter of 2004. In response to the general downturn in the economy, and in the electronics industry in particular, we have initiated significant restructuring activities over the past several years, including during the first three quarters of 2004, to better align our cost structure with projected demand for our products and services and their resulting projected revenues.

We have identified certain items that management uses as performance indicators to manage our business, including revenue, certain elements of operating expenses and cash flow from operations, and we describe these items more fully in the “Results of Operations” below.

We continue to experience a customer preference for renewable license types, which are term and subscription, and expect the timing of license renewals to continue to impact our results of operations.

Product revenue recognized from backlog comprised approximately 60% of total product revenue in 2003, 45% in 2002, and 30% in 2001. This trend is primarily due to increasing customer preference for subscription licenses and customer requirements for more flexible payment terms.

In our 2003 Annual Report, we restated our Consolidated Financial Statements as of and for the fiscal year ended December 28, 2002, and for the first three quarters of fiscal 2003. Our Condensed Consolidated Financial Statements present restated results for the three and nine months ended September 27, 2003. For the three and nine months ended September 27, 2003, adjustments were made to income (loss) on equity investments, amortization of deferred stock compensation, revenue, amortization of internally developed software, foreign currency transaction gains (losses), other expense and the tax effect of these restatement adjustments. Adjustments were also made to reclassify amortization of certain intangible assets from Amortization of acquired intangibles to Cost of product, Cost of services and Cost of maintenance.

In April 2004, we acquired Neolinear, Inc., or Neolinear, a privately-held developer of rapid analog design technology. We purchased Neolinear to acquire key personnel and technology. Prior to the acquisition we held an equity investment in Neolinear of approximately $3 million, representing 12% ownership. In accordance with Statement of Financial Accounting Standards, or SFAS, No. 141, “Business Combinations,” we accounted for the acquisition of Neolinear as a step acquisition. The aggregate initial purchase price was $78.1 million, which included the payment of cash, the fair value of assumed options and acquisition costs. The purchase price and goodwill will increase if certain performance goals related to revenue targets and product development are achieved over a period of approximately four years following the acquisition. Neolinear’s results of operations and the estimated fair values of the assets acquired and liabilities assumed have been included in our Condensed Consolidated Financial Statements from the date of acquisition.

During the three months ended October 2, 2004, we acquired a company for an aggregate initial purchase price of $9.2 million, which included the payment of cash, the fair value of assumed options and acquisition costs. We purchased the company to acquire key personnel and technology. The acquired company’s results of operations and the estimated fair values of the assets acquired and liabilities assumed have been included in our Condensed Consolidated Financial Statements from the date of acquisition.

For a number of our acquisitions, payment of a portion of the purchase price is contingent upon the acquired entity’s achievement of certain performance goals, which relate to one or more of the following criteria: revenue, bookings, product proliferation, product development, and employee retention. The specific performance goal levels, and amounts and timing of contingent purchase price payments, vary with each acquisition.

In the three months ended October 2, 2004, we recorded $6.0 million of goodwill as contingent purchase price payable to stockholders of acquired companies. The $6.0 million of goodwill consisted of $3.5 million of actual cash payments and $2.5 million of accrued cash payments.

In the nine months ended October 2, 2004, we recorded $33.4 million of goodwill as contingent purchase price payable to stockholders of acquired companies. The $33.4 million of goodwill consisted of $14.5 million of actual cash payments, $2.5 million of accrued cash payments, and the issuance of shares of Cadence’s common stock valued at $16.4 million. In addition, during the nine months ended October 2, 2004, we recognized deferred stock compensation of $1.3 million, in accordance with Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation (an Interpretation of APB No. 25)”.

In connection with our acquisitions completed prior to October 2, 2004, we may be obligated to pay up to an aggregate of $55.9 million in cash during the next 12 months and an additional $41.4 million in cash during the three years following the next 12 months if certain performance goals related to one or more of the following criteria are achieved in full: revenue, bookings, product proliferation, product development and employee retention.

In preparing our Condensed Consolidated Financial Statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, operating income (loss) and net income (loss), as well as on the value of certain assets and liabilities on our Condensed Consolidated Balance Sheets. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly. We believe that the assumptions, judgments and estimates involved in the accounting for revenue recognition, accounting for income taxes, valuation of long-lived and intangible assets and goodwill, and restructuring charges have the greatest potential impact on our Condensed Consolidated Financial Statements; therefore, we consider these to be our critical accounting estimates. Historically, our assumptions, judgments and estimates relative to our critical accounting estimates have not differed materially from actual results.

We apply the provisions of Statement of Position, or SOP, 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” to all product revenue transactions where the software is not incidental. We also apply the provisions of SFAS No. 13, “Accounting for Leases,” to all hardware lease transactions. We recognize revenue when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed or determinable, collection of the resulting receivable is probable, and vendor-specific objective evidence of fair value, or VSOE, exists.

Persuasive evidence of an arrangement – For subscription and term licenses and hardware leases, we use the signed contract as evidence of an arrangement. For perpetual licenses, hardware sales, maintenance renewals and small fixed-price service projects, such as training classes and small, standard methodology service engagements of approximately $10,000 or less, we use a purchase order as evidence of an arrangement. For all other service engagements, we use a signed professional services agreement and a statement of work to evidence an arrangement. Sales through our Japanese distributor, Innotech Corporation, or Innotech, are evidenced by a master agreement governing the relationship, together with binding purchase orders from the distributor on a transaction-by-transaction basis.

Product delivery – Software and the corresponding access keys are generally delivered to customers electronically. Occasionally, we will deliver the software on a compact disc with standard transfer terms of free-on-board shipping point. Our software license agreements generally do not contain acceptance provisions. With respect to hardware, delivery of an entire system is deemed to occur upon its installation.

Fee is fixed or determinable – We assess whether a fee is fixed or determinable at the outset of the arrangement, primarily based on the payment terms associated with the transaction. We generally use installment contracts for term and subscription licenses and we have established a history of collecting under the original contract without providing concessions on payments, products or services. Our installment contracts generally have payment periods that are equal to or less than the term of the licenses, the payments are generally collected quarterly, and periodic payments are generally made in equal or nearly equal installments. Significant judgment is involved in assessing whether a fee is fixed or determinable, including assessing whether a contract amendment constitutes a concession. Our experience has been that we are able to determine whether a fee is fixed or determinable. While we do not expect that experience to change, if we no longer had a history of collecting under the original contract without providing concessions on term licenses, revenue from term licenses would be required to be recognized when payments under the installment contract become due and payable. This change could have a material impact on our results of operations.

Collection is probable – We assess collectibility at the outset of the arrangement based on a number of factors, including the customer’s past payment history and its current creditworthiness. If in our judgment collection of a fee is not probable, we defer the revenue until the uncertainty is removed, which generally means revenue is recognized upon our receipt of cash payment. Our experience has been that we are able to estimate whether collection is probable. While we do not expect that experience to change, if we were to

determine that collection is not probable for any license arrangement with installment payment terms, revenue from such license would be recognized generally upon the receipt of cash payment. This change could have a material impact on our results of operations.

Vendor-Specific Objective Evidence – Our VSOE for certain product elements of an arrangement is based upon the pricing in comparable transactions when the element is sold separately. VSOE for maintenance is generally based upon the customer’s stated annual renewal rates. VSOE for services is generally based on the price charged when the services are sold separately. For multiple element arrangements, VSOE must exist to allocate the total fee among all delivered and undelivered elements in the arrangement. If VSOE does not exist for all elements to support the allocation of the total fee among all delivered and undelivered elements of the arrangement, revenue is deferred until such evidence does exist for the undelivered elements, or until all elements are delivered, whichever is earlier. If VSOE of all undelivered elements exists but VSOE does not exist for one or more delivered elements, revenue is recognized using the residual method. Under the residual method, the VSOE of the undelivered elements is deferred, and the remaining portion of the arrangement fee is recognized as revenue as elements are delivered. Our experience has been that we are able to estimate VSOE. While we do not expect that experience to change, if we could no longer support VSOE for undelivered elements of multiple element arrangements, revenue would be deferred until we have VSOE for the undelivered elements or all elements are delivered, whichever is earlier. This change could have a material impact on our results of operations.

Services revenue – Services revenue consists primarily of revenue received for performing methodology and design services. Revenue from service contracts is recognized either on the time and materials method, as work is performed, or on the percentage-of-completion method. For contracts with fixed or not-to-exceed fees, we estimate on a monthly basis the percentage-of-completion, which is based on the completion of milestones relating to the arrangement. We have a history of accurately estimating project status and the costs necessary to complete projects. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances and specification and testing requirement changes. If different conditions were to prevail such that accurate estimates could not be made, then the use of the completed contract method would be required and the recognition of all revenue and costs would be deferred until the project was completed. This change could have a material impact on our results of operations.

We provide for the effect of income taxes in our Condensed Consolidated Financial Statements in accordance with SFAS No. 109, “Accounting for Income Taxes”, or SFAS No. 109, and Financial Accounting Standards Board Interpretation No. 18, or FIN No. 18, “Accounting For Income Tax in Interim Periods (An Interpretation of APB Opinion No. 28)”. Under SFAS No. 109, income tax expense (benefit) is recognized for the amount of taxes payable or refundable for the current year, and for deferred tax assets and liabilities for the tax consequences of events that have been recognized in an entity’s financial statements or tax returns. FIN No. 18 specifies that tax payable (or tax benefit) for an interim period related to ordinary income (or loss) shall be computed at an estimated annual effective tax rate and the tax payable (or tax benefit) related to all other items shall be individually computed and recognized when items occur. Estimates of the annual effective tax rate at the end of interim periods are based on our evaluations of possible future events and transactions and may be subject to subsequent refinement or revision.

We must make significant assumptions, judgments and estimates to determine our current provision for income taxes, our deferred tax assets and liabilities and any valuation allowance to be recorded against our deferred tax assets. Our judgments, assumptions and estimates relating to the current provision for income taxes take into account estimates of the annual pre-tax book income and the geographic mix of income, current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. Changes in our estimates of the geographic mix of income or the annual pre-tax income, tax law or our interpretation of tax laws and developments in current and future tax audits could significantly impact the amounts provided for income taxes in our results of operations, financial position or cash flows. Our assumptions, judgments and estimates, relating to the value of our net deferred tax assets, take into account predictions of the amount and category of future taxable income from potential sources including tax

planning strategies that would, if necessary, be implemented to prevent a loss carryforward or tax credit carryforward from expiring unused. Actual operating results and the underlying amount and category of income in future years could render our current assumptions, judgments and estimates of recoverable net deferred taxes inaccurate, thus materially affecting our results of operations and financial position.

See the factors affecting future results below entitled “Our operating results could be adversely affected as a result of changes in our effective tax rates”, “We have received an examination report from the Internal Revenue Service proposing a tax deficiency in certain of our tax returns, and the outcome of the examination or any future examinations involving similar claims may have a material adverse effect on our results of operations and cash flows” and “Forecasting our estimated annual effective tax rate is complex and subject to uncertainty, and material differences between forecasted and actual tax rates could have a material impact on our results of operations”.

At least annually we review goodwill resulting from business combinations for impairment in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.”

Our annual impairment review process compares the fair value of each reporting unit to its carrying value, including the goodwill related to the reporting unit. To determine the reporting unit’s fair value, we utilize a combination of the income and market valuation approaches.

The income approach provides an estimate of fair value based on the discounted expected future cash flows. These expected future cash flows are based on our assumed market segment growth rates, assumed market segment share growth rates, estimated costs and appropriate discount rates based on the reporting units’ weighted average cost of capital as determined by considering the observable weighted average cost of capital of comparable companies. Our estimates of market segment growth, our market segment share growth and costs are based on historical data, various internal estimates and a variety of external sources, and are developed as part of our routine long-range planning process.

The market approach provides an estimate of the fair value of the equity of a business by comparing it to publicly traded companies in similar lines of business. The conditions and prospects of companies in similar lines of business depend on common factors such as overall demand for their products and services. Factors such as size, growth, profitability, risk and return on investment are also analyzed and compared to comparable companies. Various price or market multiples are then applied to our reporting units’ operating results to arrive at an estimate of fair value.

In determining our overall conclusion of reporting unit fair value, we considered the estimated values derived from both the income and market valuation approaches. The weighting applied to the market approach depends on the similarity of the comparable businesses to the reporting unit.

We review long-lived assets, including certain identifiable intangibles, for impairment whenever events or changes in circumstances indicate that we will not be able to recover the asset’s carrying amount in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

For long-lived assets to be held and used, including acquired intangibles, we initiate our review whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. Recoverability of an asset is measured by comparing its carrying amount to the expected future undiscounted cash flows expected to result from the use and eventual disposition of that asset, excluding future interest costs that would be recognized as an expense when incurred. Any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair market value. Significant management judgment is required in:


	•	identifying a triggering event that arises from a change in circumstances;

	•	forecasting future operating results; and

	•	estimating the proceeds from the disposition of long-lived or intangible assets.

Material impairment charges could be necessary should different conditions prevail or different judgments be made.

We account for restructuring charges in accordance with SEC Staff Accounting Bulletin No. 100, “Restructuring and Impairment Charges.” Beginning in fiscal 2001, we have undertaken significant restructuring initiatives. All restructuring activities initiated prior to fiscal 2003 were accounted for in accordance with Emerging Issues Task Force of the Financial Accounting Standards Board, or EITF, No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” and EITF No. 88-10, “Costs Associated with Lease Modifications or Terminations.” For restructuring activities initiated after fiscal 2002, we accounted for the facilities and asset-related portions of these restructurings in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” and SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, respectively. The severance and benefits charges were accounted for in accordance with SFAS No. 112, “Employers’ Accounting for Postemployment Benefits – An Amendment of FASB Statements No. 5 and 43.”

These restructuring initiatives have required us to make a number of estimates and assumptions related to losses on excess facilities vacated or consolidated, particularly estimating when, if at all, we will be able to sublet vacated facilities and if we do, the sublease terms. Closure and space reduction costs that are part of our restructuring charges include payments required under leases, less any applicable estimated sublease income after the facilities are abandoned, lease buyout costs and certain contractual costs to maintain facilities during the abandonment period.

In addition, we have recorded estimated provisions for termination benefits and outplacement costs, and other restructuring costs. We regularly evaluate the adequacy of our restructuring accrual, and adjust the balance based on changes in estimates and assumptions. We may incur future charges for new restructuring activities as well as changes in estimates to amounts previously recorded.

We primarily generate revenue from licensing our EDA software and selling or leasing hardware technology and intellectual property, providing maintenance for our software and hardware and providing design and methodology services. We principally utilize three license types: subscription, term and perpetual. The different license types provide a customer with different rights to use our products such as (i) the right to access new technology, (ii) the duration of the license, and (iii) payment terms. Customer decisions regarding these aspects of license transactions determine the license type, timing of revenue recognition and potential future business activity. For example, if a customer chooses a fixed term of use, this will result in either a subscription or term license. A business implication of that decision is that at the expiration of the license period the customer must decide whether to continue using the technology and therefore renew the license agreement. Because larger customers generally use products from two or more of our five product groups, rarely will a large customer completely terminate its relationship with us at expiration of the license. See “Critical Accounting Estimates” above for additional discussion of licenses types and timing of revenue recognition.

To the extent a customer obtains rights to remix to new technology or more flexible payment terms, revenue is recognized over the life of the agreement. This distinction is a critical determinant of revenue recognition. For example, a $3.0 million, 3-year product subscription license would result in $1.0 million of revenue recognized per year, or $250,000 per quarter. However, a $3.0 million, 3-year product term license, assuming equal or near equal payments and no rights to new technology, would result in $3.0 million of revenue recognized upon delivery, which is generally in the first quarter of the arrangement, and no revenue recognized in succeeding quarters. Because our model leads to a substantial portion of our revenue being recognized over multiple periods, we do not believe that pricing volatility is a material component of the

The amount of product revenue in future periods will depend, among other things, on the terms and timing of our contract renewals or additional product sales with existing customers, the size of such transactions or renewals, and sales to new customers. Product revenue in any period is also affected by the extent to which customers prefer subscription, term or perpetual licenses, and the extent to which contracts contain flexible payment terms. Revenue is also affected by changes in the extent to which existing contracts contain flexible payment terms and changes in license types (e.g., subscription to term) for existing customers. Contract renewals, and consequently product revenues, are also affected by the competitiveness of our products.

We analyze our software and hardware businesses by product group, combining revenues for both product and maintenance because of their interrelationship. We have formulated a design solution strategy that combines our design technologies into “platforms”, which are included in the various product groups described below. We introduced our first platform in September 2002. The data described below for product groups for periods before a platform was introduced aggregates the revenues from the individual products associated with that particular platform. The first table below shows our revenue for the three and nine month periods of 2004 and 2003 by segment (one of which is maintenance), whereas the second table below shows revenue percentages by product group, with each product group including its associated maintenance revenue.

Functional Verification: Products in this group, which include the Incisive^TM functional verification platform, are used to verify that the high level, logical specification of an integrated circuit design is correct.

Digital IC Design: Products in this group, which include the Encounter^TMdigital IC design platform, are used to accurately convert the high-level, logical specification of a digital integrated circuit into a detailed physical blueprint of the integrated circuit, which is used for creation of the photomasks used in chip manufacture.

Custom IC Design: Our custom design products, which include the Virtuoso® custom design platform, are used for integrated circuits that must be designed at the transistor level, including analog, radio frequency, memories, high performance digital blocks, and standard cell libraries.

Design for Manufacturing: Included in this product group are our physical verification and analysis products. These products are used to analyze and verify that the physical blueprint of the integrated circuit has been constructed correctly and can be manufactured successfully.

System Interconnect: This product group consists of our printed circuit board and integrated circuit package design products, including the Allegro® system interconnect design platform, which enables consistent co-design of integrated circuits, IC packages, and printed circuit boards.

Product revenue was higher in the three months ended October 2, 2004, as compared to the same period in 2003, primarily because of increased revenue from sales of certain Design for Manufacturing, Custom IC

Design and Functional Verification products. Product revenue was higher in the nine months ended October 2, 2004, as compared to the same period in 2003, primarily because of increased revenue from sales of certain intellectual property, as well as from certain Functional Verification and System Interconnect products.

Additional financial information about our segments can be found in Note 11 to our Condensed Consolidated Financial Statements.

The following table shows for the past five consecutive quarters the percentage of product and related maintenance revenue contributed by each of our five product groups, and Services and other:

The percentage of revenue from a particular platform may vary from quarter to quarter due to the timing and extent of term license renewals for existing customers and the particular technologies they elect to purchase.

As a percentage of total revenue, Design for Manufacturing increased in the three months ended October 2, 2004, as compared to the three months ended July 3, 2004, due to higher revenues from our physical verification and analysis products.

In the nine months ended October 2, 2004, we recognized $11.0 million of revenue from the sale of intellectual property, or IP. This sale of IP is included in Services and other in the preceding table and in Product revenue in the accompanying Condensed Consolidated Statement of Operations. The decrease in Services and other as a percentage of total revenue from the second quarter to the third quarter of 2004 is primarily due to this sale of IP in the second quarter of 2004.

Other increases and decreases in the percentage of revenue attributed to each of our product groups for the third quarter of 2004 are primarily due to higher revenues in Design for Manufacturing in the third quarter of 2004 and the timing of the sale of IP during the second quarter of 2004.

The rate of revenue change may vary geographically due to differences in the timing and extent of term license renewals for existing customers in those regions. In addition, both our domestic and international businesses have been affected by the revenue trends discussed above in this section.

Changes in foreign currency exchange rates caused our revenue to increase by $3.3 million in the three months ended October 2, 2004, as compared to the three months ended September 27, 2003, primarily due to a strengthening of the Japanese yen in relation to the U.S. dollar. Changes in foreign currency exchange rates caused revenue to increase by $13.4 million in the nine months ended October 2, 2004, as compared to the nine months ended September 27, 2003, also primarily due to a strengthening of the Japanese yen in relation to the U.S. dollar.

Cost of product revenue includes costs associated with the sale or lease of our hardware and licensing of our software products. Cost of product revenue primarily includes the cost of employee salary and benefits, amortization of intangible assets directly related to Cadence products, the cost of technical documentation and royalties payable to third-party vendors. Cost of product revenue associated with our Cadence Verification Acceleration, or CVA, hardware products also includes materials, assembly labor and overhead. These additional manufacturing costs make our cost of hardware product higher, as a percentage of revenue, than our cost of software product.

Cost of product revenue increased $9.6 million in the third quarter of 2004, as compared to the third quarter of 2003, primarily due to an increase of $8.4 million in cost of goods sold for our hardware business and an increase in amortization of intangible assets of $2.6 million. These increases were partially offset by a $1.0 million decrease in royalty expenses. Cost of product revenue increased $8.9 million for the nine months ended October 2, 2004, as compared to the same period in 2003, primarily due to an increase of $14.3 million in cost of goods sold for our hardware business and an increase in amortization of acquired intangibles of $2.0 million, partially offset by a decrease of $3.3 million in royalty expenses and a decrease of $3.6 million in amortized software costs.

Cost of product revenue in the future will depend primarily upon the actual mix of hardware and software product contracts in any given period and the degree to which we license and incorporate third-party technology in our products licensed or sold in any given quarter.

Cost of services revenue primarily includes costs of employee salary and benefits, costs to maintain the infrastructure necessary to manage a services organization and provisions for contract losses, if any. Cost of services revenue decreased $2.0 million in the nine months ended October 2, 2004, as compared to the same period in 2003, primarily due to a decrease in salary and benefit costs. As a result, services gross margin as a percentage of services revenue increased for the nine months ended October 2, 2004.

Cost of maintenance revenue includes the cost of customer services, such as hot-line and on-site support, production employees and documentation of maintenance updates. Cost of maintenance revenue decreased

$0.7 million in the three months ended October 2, 2004, as compared to same period in 2003, due to lower information technology costs and other general operating expenses. Cost of maintenance revenue decreased $3.6 million in the nine months ended October 2, 2004, as compared to the same period in 2003, primarily due to a $2.2 million decrease in information technology, facilities and general operating expenses and a $1.4 million decrease in salary and benefits. Gross margin as a percentage of maintenance revenue increased for the same periods in 2004 as compared to 2003 due to decreased costs of maintenance.

Overall operating expenses increased $1.2 million in the three months ended October 2, 2004, as compared to the same period in 2003. Overall operating expenses decreased by $5.7 million in the nine months ended October 2, 2004, as compared to the same period in 2003, primarily as a result of cost reductions from our 2003 restructuring activities described more fully below in “Restructuring and Other Charges”. We expect our operating expenses in absolute dollars to be approximately the same during the fourth quarter of 2004 as they were for the third quarter of 2004.

Foreign currency exchange rates increased operating expenses by $2.0 million in the three months ended October 2, 2004, and $8.1 million in the nine months ended October 2, 2004, as compared to the same periods in 2003, primarily due to a strengthening of the euro, British pound and Japanese yen in relation to the U.S. dollar.

Marketing and sales expense decreased $4.0 million in the three months ended October 2, 2004, as compared to the same period in 2003, due to a $1.9 million decrease in salaries and benefits and a $2.1 million decrease in meeting and tradeshow expenses. Marketing and sales expense decreased $8.9 million in the nine months ended October 2, 2004, as compared to the same period in 2003, primarily due to a $7.3 million decrease in commission payments to Innotech as a result of our acquisition from Innotech of distribution rights to certain of its customers, a $2.6 million reduction in depreciation related to prior restructuring activities and a $4.2 million reduction in facilities and information technology expenses, partially offset by a $5.4 million increase in salaries and benefits.

Research and development expense increased $1.1 million in the three months ended October 2, 2004, as compared to the same period in 2003, primarily due to a $5.9 million increase in salaries and benefits, partially offset by a $3.0 million reduction in outside development costs and a $1.5 million reduction in depreciation related to prior restructuring activities. Research and development expense increased $5.9 million in the nine

General and administrative expense increased $4.1 million in the three months ended October 2, 2004, as compared to the same period in 2003, primarily due to a $4.9 million increase in legal expenses partly resulting from the reversal in 2003 of the legal expense accrual related to the settlement with Mentor Graphics. In addition, salaries and benefits increased $1.0 million during the three months ended October 2, 2004 as compared to the same period in 2003. These increases were partially offset in 2004 by a reduction of $2.0 million in bad debt expenses. General and administrative expenses decreased $2.7 million in the nine months ended October 2, 2004, as compared to the same period in 2003, primarily due to a $5.5 million reduction in legal and consulting expenses and a $1.6 million decrease in bad debt expense, partially offset by a $2.8 million increase in salaries and benefits and a $1.5 million increase in costs associated with Sarbanes-Oxley section 404 compliance.

Amortization of acquired intangibles decreased $3.6 million in the three months ended October 2, 2004, as compared to the same period in 2003, primarily due to a $3.4 million decrease in the amortization of acquired intangibles reflecting the full amortization of intangible assets from prior year acquisitions.

Amortization of acquired intangibles decreased $1.6 million in the nine months ended October 2, 2004, as compared to the same period in 2003, primarily due to a $4.5 million decrease in the amortization of acquired intangibles reflecting the full amortization of intangible assets from prior years’ acquisitions, partially offset by a $2.9 million increase in the amortization of acquired intangibles in connection with the acquisitions of Verplex Systems, Inc. and Neolinear, Inc.

We amortize deferred stock compensation related to fixed awards using the straight-line method over the period that the stock options and restricted stock vest. We recognize stock compensation expense related to variable awards using an accelerated method over the period that the stock options and restricted stock are earned.

Amortization of deferred stock compensation decreased $5.8 million for the three months ended October 2, 2004, as compared to the same period in 2003, due to a $7.5 million decrease in the amortization of deferred stock compensation primarily related to our acquisitions of Silicon Perspective Corporation and Verplex Systems, Inc., and a $1.4 million decrease in the amortization of deferred stock compensation related to certain stock options and warrants. This decrease was partially offset by a $3.1 million increase in the amortization of deferred stock compensation related to incentive stock grants. Amortization of deferred stock compensation decreased $3.7 million for the nine months ended October 2, 2004, as compared to the same period in 2003, due to an $11.4 million decrease in the amortization of deferred stock compensation primarily

related to our acquisition of Silicon Perspective Corporation. This decrease was partially offset by a $7.7 million increase in deferred stock compensation related to incentive stock grants and certain stock options. We expect that amortization of deferred stock compensation expense will increase during the remainder of 2004 due to increased incentive stock grants during 2004.

We initiated a separate plan of restructuring in each year beginning in 2001 in an effort to reduce operating expenses and improve operating margins and cash flows.

The restructuring plans initiated in 2001, 2002 and 2003, or the 2001 Restructuring, 2002 Restructuring and 2003 Restructuring, respectively, were intended to decrease costs by reducing workforce and consolidating facilities and resources, to align our cost structure with expected revenues. The 2001 and 2002 Restructurings primarily related to our design services business and certain other business/infrastructure groups throughout the world. The 2003 Restructuring was targeted at reducing costs throughout the company.

During the first quarter of 2004, we commenced a new plan of restructuring, or the 2004 Restructuring, which was also intended to decrease costs and realize efficiencies by reducing workforce and resources throughout the company to align our cost structure with expected revenues.

A summary of restructuring and other charges (credits) by plan of restructuring for the three months ended October 2, 2004 is as follows:

A summary of restructuring and other charges (credits) by plan of restructuring for the nine months ended October 2, 2004 is as follows:

A summary of restructuring and other charges by plan of restructuring for the three months ended September 27, 2003 is as follows:

A summary of restructuring and other charges (credits) by plan of restructuring for the nine months ended September 27, 2003 is as follows:

Frequently, asset write-downs are based on significant estimates and assumptions, particularly regarding remaining useful life and utilization rates. We may incur other charges in the future if management determines that the useful life or utilization of certain long-lived assets has been reduced.

Closure and space reduction costs included payments required under leases less any applicable estimated sublease income after the properties were abandoned, lease buyout costs, and costs to maintain facilities during the abandonment period. To determine the lease loss, which is the loss after our cost recovery efforts from subleasing a building, certain assumptions were made related to the time period over which the relevant building would remain vacant and sublease terms, including sublease rates and contractual common area charges.

As of October 2, 2004, our best estimate of the lease loss related to all worldwide restructuring activities initiated since 2001 is estimated to be $34.2 million. This amount will be adjusted in the future based upon changes in the assumptions used to estimate the lease loss. The lease loss could range as high as $51.8 million if sublease rental rates decrease in applicable markets or if it takes longer than currently expected to find a suitable tenant to sublease the facilities. Since 2001, we have recorded facilities consolidation charges under the 2001 through 2004 Restructurings of $85.0 million related to reducing space or the closing of 34 sites, of which 24 have been vacated and ten have been downsized.

Because the restructuring charges and related benefits are derived from management’s estimates made during the formulation of the restructurings, based on then-currently available information, our restructuring activities may not achieve the benefits anticipated on the timetable or at the level contemplated. Demand for our products and services and, ultimately, our future financial performance, is difficult to predict with any degree of certainty. Accordingly, additional actions, including further restructuring of our operations, may be required in the future.

The following is further discussion of the activity under each restructuring plan:

2004 Restructuring – The 2004 Restructuring is expected to result in the termination of approximately 121 employees. Costs resulting from this restructuring included severance payments, severance-related benefits and outplacement services. All terminations and termination benefits associated with this restructuring were communicated to the affected employees prior to October 2, 2004, with all termination benefits expected to be paid by July 2, 2005.

We project annualized savings in employee salary and benefits costs of approximately $16.2 million resulting from employee terminations under the 2004 Restructuring.

2003 Restructuring – During the third quarter of 2004, we incurred $1.2 million of expense related to the 2003 Restructuring, comprised primarily of expenses incurred for facilities included in the 2003 Restructuring, but vacated during the third quarter of 2004 and, to a lesser extent, contract termination charges and expenses incurred to sublease facilities and storage and disposal charges associated with facilities vacated as part of the 2003 Restructuring. These expenses were partially offset by the reversal of a portion of the severance-related accrual for payroll taxes, benefits and outplacement services in excess of the remaining expected obligation.

We incurred a total expense of $2.1 million during the first nine months of 2004 related to the 2003 Restructuring, comprised primarily of expenses incurred for facilities included in the 2003 Restructuring, but vacated during the third quarter of 2004, and, to a lesser extent, contract termination charges and expenses incurred to sublease facilities and storage and disposal charges associated with facilities vacated as part of the 2003 Restructuring. These expenses were partially offset by the reversal of a portion of the severance-related accrual for payroll taxes, benefits and outplacement services in excess of the remaining expected obligation.

We expect to incur an additional $4 million to $6 million of future costs in connection with the 2003 Restructuring, primarily for facilities-related charges, which will be expensed as incurred. The actual amount of additional costs incurred could vary depending on changes in market conditions and the timing of these restructuring activities.

2002 Restructuring – During the third quarter of 2004, we reduced the expense related to the 2002 Restructuring by $0.6 million primarily due to an adjustment of the estimated lease loss related to a facility included in the 2002 Restructuring and the reversal of a portion of the severance and benefits accrual in excess of the remaining expected obligation.

2001 Restructuring – We did not record significant additional charges related to the 2001 Restructuring during the third quarter of 2004. Facilities-related charges recorded during the first nine months of 2004 of $0.5 million were primarily the result of changes in lease loss estimates and costs associated with facilities vacated as part of the 2001 Restructuring.

Upon consummation of our acquisition of Neolinear in April 2004, we immediately charged to expense $7.0 million representing acquired in-process technology that had not yet reached technological feasibility and had no alternative future use. The value assigned to acquired in-process technology was determined by identifying research projects in areas for which technological feasibility had not been established. The value was determined by estimating costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects and discounting the net cash flows back to their present value. The discount rate of 28%, which was assumed in this calculation, included a factor that reflects the uncertainty surrounding successful development of the acquired in-process technology. The in-process technology is expected to be commercially viable in December 2004. As of October 2, 2004, expenditures incurred to complete the in-process technology totaled $6.8 million and aggregate expenditures to complete the remaining in-process technology are expected to be approximately $0.5 million.

Upon consummation of the acquisition completed during the three months ended October 2, 2004, we immediately charged to expense $2.0 million representing acquired in-process technology that had not yet reached technological feasibility and had no alternative future use. The value assigned to acquired in-process

technology was determined by identifying research projects in areas for which technological feasibility had not been established. The value was determined by estimating costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects and discounting the net cash flows back to their present value. The discount rate of 30%, which was assumed in this calculation, included a factor that reflects the uncertainty surrounding successful development of the acquired in-process technology. The in-process technology is expected to be commercially viable in December 2004. As of October 2, 2004, expenditures incurred to complete the in-process technology totaled $0.2 million and aggregate expenditures to complete the remaining in-process technology are expected to be approximately $0.5 million.

The estimates presented above are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur. Additionally, these projects will require additional research and development after they have reached a state of technological and commercial feasibility.

Interest expense decreased $0.8 million in the three months ended October 2, 2004, as compared to the three months ended September 27, 2003, primarily due to a $1.1 million decrease in interest expense related to our now-terminated credit facilities, partially offset by a $0.3 million increase of amortization expense related to the costs associated with the issuance of our Zero Coupon Zero Yield Senior Convertible Notes, or the Notes, in August 2003.

Interest expense increased $1.1 million in the nine months ended October 2, 2004, as compared to the nine months ended September 27, 2003, primarily due to a $1.3 million increase in imputed interest on acquisition-related payments which occur over time and $1.7 million of amortization expense related to the costs associated with the issuance of our Notes, partially offset by a decrease of $1.9 million in interest expense related to our now-terminated credit facilities.

Other income (expense), net, for the three and nine months ended October 2, 2004 and September 27, 2003 is as follows:

In the three months ended October 2, 2004, Other loss of $1.4 million was comprised primarily of $1.1 million of impairment of investments and $0.3 million of Other loss, net. In the three months ended

In the nine months ended October 2, 2004, Other income of $2.6 million was comprised of $8.0 million of gains on the sale of short-term investments, partially offset by $3.0 million of impairment of investments, $0.8 million of losses on the sale of receivables and $1.6 million of Other loss, net. In the nine months ended September 27, 2003, Other loss of $7.9 million was comprised of $4.8 million of impairment of investments, $1.5 million of losses on the sales of receivables and $1.6 million of Other loss, net.

Equity in loss from investments, net, reflects our proportional share of the net losses of the investee companies for which we account for our investment using the equity method of accounting. Additional information about our investments for which we use the equity method of accounting can be found in Note 5 to our Condensed Consolidated Financial Statements.

The following table presents the provision (benefit) for income taxes and the effective tax rate for the three and nine months ended October 2, 2004 and September 27, 2003:

Our effective tax rate decreased for the three months ended October 2, 2004, compared to the three months ended September 27, 2003, due to an expected decrease in non-deductible stock compensation and an expected increase in tax benefits from foreign income taxed at a lower rate than the U.S. statutory rate. The provision for the three months ended October 2, 2004 includes an expected settlement with a tax authority of $0.5 million and has been treated as a discrete event allocable to the quarter.

Our effective tax rate reflects tax benefits derived from expected earnings outside the United States, which are generally taxed at rates lower than the U.S. statutory rate of 35% and which we intend to invest indefinitely outside of the United States. During the three months ended October 2, 2004, we changed our projected annual effective tax rate for the year ending January 1, 2005 to 32%. As of July 3, 2004, we projected this rate to be 24%. This change is primarily a result of projecting increased amounts of non-deductible expenses related to acquired in-process technology and decreased benefit from foreign income taxed at a lower rate than the U.S. statutory rate. The annual effective tax rate for the year ended January 3, 2004 was 42.5%. The projected annual effective tax rate for the year ending January 1, 2005 is lower primarily due to a projected decrease in non-deductible stock compensation, and a greater benefit from foreign income taxed at a lower rate than the U.S. statutory rate.

As of October 2, 2004 and based upon the tax laws in effect at that time, it was our intention to continue to indefinitely reinvest our undistributed foreign earnings and, accordingly, no deferred tax liability has been recorded in connection therewith. On October 22, 2004, the federal American Jobs Creation Act of 2004, or the Act, was signed into law. A key provision of the Act is a one-time incentive to repatriate foreign earnings at a reduced effective tax rate. A company must meet several requirements to qualify for the incentive, including the payment of an inter-company cash dividend, and a Board of Directors approved plan to reinvest the dividend in the United States. We are currently studying the impact of the repatriation provisions of the Act on our plans to indefinitely reinvest our foreign earnings. If, after taking into consideration these provisions, it becomes apparent that all or a portion of our undistributed foreign earnings will not be indefinitely reinvested, we will provide deferred taxes on those earnings in the period the determination is made. This will result in additional tax expense being recognized in the same period.

The IRS and other tax authorities regularly examine our income tax returns. In November 2003, the IRS completed its field examination of our federal income tax returns for the tax years 1997 through 1999 and issued a Revenue Agent’s Report, referred to as the RAR, in which the IRS proposes to assess an aggregate tax deficiency for the three-year period of approximately $143 million, plus interest, which interest will accrue until the matter is resolved. This interest is compounded daily at rates published by the IRS, which rates have been between four and nine percent since 1997, and adjust quarterly. The IRS may also make similar claims for years subsequent to 1999 in future examinations. The RAR is not a final Statutory Notice of Deficiency, and we have protested certain of the proposed adjustments with the IRS.

The most significant of the disputed adjustments relates to transfer pricing arrangements that we have with a foreign subsidiary. We believe that the proposed IRS adjustments are inconsistent with applicable tax laws, and that we have meritorious defenses to the proposed adjustments.

The IRS is currently examining our federal income tax returns for the tax years 2000 through 2002.

Significant judgment is required in determining our provision for income taxes. In determining the adequacy of our provision for income taxes, we have assessed the likelihood of adverse outcomes resulting from these examinations, including the current IRS examination and the IRS RAR for tax years 1997 through 1999. However, the ultimate outcome of tax examinations cannot be predicted with certainty, including the total amount payable or the timing of any such payments upon resolution of these issues. In addition, we cannot be certain that such amount will not be materially different than that which is reflected in our historical income tax provisions and accruals. Should the IRS or other tax authorities assess additional taxes as a result of a current or a future examination, we may be required to record charges to operations in future periods that could have a material adverse effect on our results of operations, financial position or cash flows in the period or periods recorded.

At October 2, 2004, our principal sources of liquidity consisted of $452.5 million of Cash and cash equivalents and Short-term investments, compared to $418.4 million at January 3, 2004. The primary sources of our cash for the nine months ended October 2, 2004 were customer payments under software licenses and from the sale or lease of our hardware products, payments for the provision of design and methodology services, proceeds from the sale of certain intellectual property, proceeds from the sale of receivables and proceeds from the exercise of stock options and common stock purchases under our employee stock purchase plans. In the first nine months of 2004, our primary uses of cash consisted of payroll costs, product, services and general and administrative expenses, purchases of treasury stock and cash paid in business acquisitions.

At October 2, 2004, we had net working capital of $400.8 million, as compared with $360.3 million at January 3, 2004. The increase in net working capital was primarily due to a $46.0 million increase in Cash and cash equivalents and Receivables, net. This increase was partially offset by a $5.0 million decrease in Short-term investments.

Net cash provided by operating activities increased $123.0 million, to $234.0 million, during the first nine months of 2004 as compared to $111.0 million in net cash provided by operating activities during the first nine months of 2003. The increase is primarily related to a larger reduction in Accounts payable and accrued liabilities in the first nine months of 2003 as compared to the first nine months of 2004, primarily due to larger payments of accrued severance and other accrued restructuring-related expenses in the first nine months of 2003 as compared to the first nine months of 2004. In addition, cash provided by operating activities increased due to greater collections of installment contract receivables in the first nine months of 2004 as compared to the first nine months of 2003.

We have entered into agreements whereby we may transfer qualifying accounts receivable to certain financing institutions on a non-recourse basis. These transfers are recorded as sales and accounted for in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” During the first nine months of 2004, we transferred accounts receivable totaling

Our primary investing activities consisted of business acquisitions and purchasing property, plant and equipment, which combined represented $162.0 million of cash used for investing activities in the first nine months of 2004, as compared to $195.9 million in the first nine months of 2003.

As part of our overall investment strategy, we are a limited partner in three venture capital funds, Telos Venture Partners, L.P., or Telos I, Telos Venture Partners II, L.P., or Telos II, and Telos Venture Partners III, L.P., or Telos III (Telos I, Telos II and Telos III are referred to collectively as Telos). We and certain of our deferred compensation trusts are the sole limited partners of Telos I and Telos III, and we are the sole limited partner of Telos II. The partnership agreements governing Telos I, Telos II and Telos III, which are substantially the same, require us to meet capital calls principally for the purpose of funding investments that are recommended by the applicable Telos general partner, and approved by the Telos advisory committee as being consistent with the partnership’s limitations and stated purposes. The Telos general partner, which is not affiliated with us, manages the partnerships and may be removed by us without cause. For all three partnerships, the advisory committee is comprised solely of the members of the Venture Committee of our Board of Directors, the current members of which are our Executive Chairman of the Board of Directors and two independent members of our Board of Directors. As of October 2, 2004, we had contributed $91.5 million to these partnerships and are contractually committed to contribute to them up to an additional $86.0 million. Our commitments expire concurrently with the termination date of each partnership, which, in the case of Telos I, is December 31, 2005, in the case of Telos II, is July 3, 2012, and, in the case of Telos III, is June 1, 2012. Our investments in the Telos partnerships are recorded in Other assets in the accompanying Condensed Consolidated Balance Sheets.

Net cash used for financing activities for the first nine months of 2004 was $30.5 million, as compared to net cash provided by financing activities of $120.3 million for the first nine months of 2003. The decrease in net cash provided by financing activities was primarily attributable to our issuance in 2003 of the Notes in the principal amount of $420.0 million, partially offset by the purchase of call options of $134.6 million and decreased purchases of our common stock of $116.8 million. In the first nine months of 2004, our primary use of cash for financing activities was $94.1 million for purchases of our common stock, which was partially offset by $65.8 million in proceeds we received from the issuance of our common stock. In the first nine months of 2003, our primary source of cash for financing activities was $420.0 million from the issuance of the Notes and $56.4 million from the sale of common stock warrants, partially offset by purchases of our common stock of $211.0 million, purchases of call options of $134.6 million and payments on credit facilities and capital leases, net of proceeds from credit facilities of $53.4 million.

As compared to January 3, 2004, Other long-term liabilities decreased $34.9 million to $292.5 million at October 2, 2004. The decrease was primarily attributable to a $19.5 million reduction in Other long-term liabilities that are now reflected as Accounts payable and accrued liabilities relating to indemnity holdbacks from purchase price payments for business acquisitions. The components of Other long-term liabilities are $44.3 million of deferred compensation, $26.8 million of accrued restructuring charges and $221.4 million relating to indemnity holdbacks from acquisitions, deferred payments relating to acquisitions and deferred tax liabilities.

We provide for U.S. income taxes on the earnings of our foreign subsidiaries unless these earnings are considered indefinitely invested outside of the United States. As of October 2, 2004 and based upon the tax laws in effect at that time, it was our intention to continue to indefinitely reinvest our undistributed foreign earnings.

On October 22, 2004, the federal American Jobs Creation Act of 2004, or the Act, was signed into law. A key provision of the Act is a one-time incentive to repatriate foreign earnings at a reduced effective tax rate. A company must meet several requirements to qualify for the incentive and we are currently studying the impact of the Act’s repatriation provisions on our plans to indefinitely reinvest our foreign earnings. If we determine that we will dividend all or a portion of our undistributed foreign earnings, we will potentially incur additional foreign and United States federal and state income taxes in the period the dividend is made. At January 3,

2004, the cumulative amount of earnings for which we have not provided a U.S. income tax accrual was approximately $450 million. The maximum dividend that may qualify for special treatment under the Act is the lower of approximately $550 million and the amount of our foreign earnings and profits at the time the dividend is made to one of our U.S. companies.

We received the RAR from the IRS in which the IRS proposes to assess an aggregate tax deficiency for the tax years 1997 through 1999 of approximately $143 million, plus interest, which interest will accrue until the matter is resolved. The RAR is not a final Statutory Notice of Deficiency, and we have filed a protest with the IRS to certain of the proposed adjustments. We are challenging these proposed adjustments vigorously. The IRS may also make similar claims for tax returns filed for years subsequent to 1999. While we are protesting certain of the proposed adjustments, we cannot predict with certainty the ultimate outcome of the tax examination, including the amount payable, or timing of such payments, which may materially impact our cash flows in the period or periods resolved.

We expect to incur an additional $4 million to $6 million of future costs in connection with our restructuring activities, primarily for facilities-related charges connected with the 2003 Restructuring, which will be expensed as incurred. We expect annualized cost reductions resulting from the 2004 Restructuring of approximately $16.2 million in employee salary and benefits costs, related to employee terminations under the restructuring plan.

In August 2003, we issued $420.0 million principal amount of Zero Coupon Zero Yield Senior Convertible Notes due 2023 to two initial purchasers in a private offering for resale to qualified institutional buyers pursuant to SEC Rule 144A. We received net proceeds of approximately $406.4 million, after transaction fees of approximately $13.6 million that were recorded in Other assets and are being amortized to interest expense using the straight-line method over five years, which is the duration of the first redemption period. We issued the Notes at par and the Notes bear no interest. The Notes are convertible into our common stock initially at a conversion price of $15.65 per share, which would result in an aggregate of 26.8 million shares issued upon conversion, subject to adjustment upon the occurrence of specified events. We may redeem for cash all or any part of the Notes on or after August 15, 2008 for 100.00% of the principal amount. The holders may require us to repurchase for cash all or any portion of their Notes on August 15, 2008 for 100.25% of the principal amount, on August 15, 2013 for 100.00% of the principal amount or on August 15, 2018 for 100.00% of the principal amount. The Notes do not contain any restrictive financial covenants.

In November 2003, we filed with the SEC a resale registration statement with respect to the Notes. This registration statement was declared effective by the SEC on April 29, 2004.

Concurrently with the issuance of the Notes, we entered into convertible notes hedge transactions whereby we have options to purchase up to 26.8 million shares of our common stock at a price of $15.65 per share. These options expire on August 15, 2008 and must be settled in net shares. The cost of the convertible notes hedge transactions to us was approximately $134.6 million.

In addition, we sold warrants to purchase up to 26.8 million shares of our common stock at a price of $23.08 per share. The warrants expire on various dates from February 2008 through May 2008 and must be settled in net shares. We received approximately $56.4 million in cash proceeds for the sales of these warrants.

In connection with our acquisitions completed prior to October 2, 2004, we may be obligated to pay up to an aggregate of $55.9 million in cash during the next 12 months if certain performance goals related to one or more of the following criteria are achieved in full: revenue, bookings, product development, product proliferation, and employee retention. In addition, we may be required to pay an additional $41.4 million in cash during the next four years if certain performance goals related to one or more of the following criteria are achieved in full: revenue, bookings, product development, product proliferation, and employee retention.

We expect that current cash and short-term investment balances and cash flow from operations will be sufficient to meet our working capital and other capital requirements for at least the next 12 months. Also, while we have no committed lines of credit, we believe our good credit and strong banking relationships will provide us with access to bank debt and opportunities to raise debt in the public markets if additional liquidity is needed.

In March 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95,” that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for share-based compensation transactions using the intrinsic method that we currently use and generally would require that such transactions be accounted for using a fair-value-based method and recognized as an expense in the consolidated statement of operations. The effective date of the proposed statement is for periods beginning after June 15, 2005. It is expected that the final statement will be issued before December 31, 2004. Should it be finalized in its current form, we expect it will have a significant impact on our Consolidated Statement of Operations as we will be required to expense the fair value of stock option grants and stock purchases under the employee stock purchase plans.

On September 30, 2004, the FASB reached a consensus on Emerging Issues Task Force Issue No. 04-08, “Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share”, or EITF 04-08. EITF 04-08 will require us to include in diluted earnings per share, on the “if-converted” method, the aggregate of approximately 26.8 million shares of our common stock into which the Notes may be converted, regardless of whether the conversion threshold stipulated in the Notes as a condition of conversion has been met. The adoption of EITF 04-08 will require us to restate previously reported diluted earnings per share for all periods in which the Notes were outstanding. We expect EITF 04-08 to become effective in the fourth quarter of 2004, which coincides with the expected effective date of SFAS No. 128R, “Earnings per Share, an amendment of FASB Statement No. 128”. The adoption of EITF 04-08 will result in an increase of approximately of 26.8 million in the number of fully diluted shares outstanding for earnings per share calculation purposes only. However, we do not expect a material impact on restated diluted earnings per share for any periods after the issuance of the Notes in August 2003.

On July 1, 2004 the FASB reached a consensus on Emerging Issues Task Force Issue No. 02-14, “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock”, or EITF 02-14. EITF 02-14 will require us to apply the equity method of accounting when we have the ability to exercise significant influence over the operating and financial policies of the investee only when we have an investment in common stock or in-substance common stock, as defined in EITF 02-14. EITF 02-14 will become effective in the fourth quarter of 2004. We expect that certain investments previously accounted for under the equity method of accounting will be accounted for under the cost method of accounting.

Our business faces many risks. Described below are what we believe to be the material risks that we face. If any of the events or circumstances described in the following risks actually occurs, our business, financial condition or results of operations could suffer.

We are subject to the cyclical nature of the integrated circuit and electronics systems industries, and any downturn may reduce our revenue.

Purchases of our products and services are dependent upon the commencement of new design projects by IC manufacturers and electronics systems companies. The IC industry is cyclical and is characterized by constant and rapid technological change, rapid product obsolescence and price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand.

The IC and electronics systems industries have experienced significant downturns, often connected with, or in anticipation of, maturing product cycles of both these industries’ and their customers’ products and a

Over the past several years, IC manufacturers and electronics systems companies have experienced a downturn in demand and production which has resulted in reduced research and development spending by many of our customers. Many of these companies appear to have experienced a gradual recovery in the second half of 2003 and the first three quarters of 2004, but they have continued to spend cautiously. Any economic downturn could harm our business, operating results and financial condition.

Our failure to respond quickly to technological developments could make our products uncompetitive and obsolete.

The industries in which we compete experience rapid technology developments, changes in industry standards, changes in customer requirements and frequent new product introductions and improvements. Currently, the industries we serve are experiencing several revolutionary trends:


	•	Migration to nanometer design: the size of features such as wires, transistors and contacts on ICs is shrinking due to advances in semiconductor manufacturing processes. Process feature sizes refer to the width of the transistors and the width and spacing of the interconnect on the IC. Feature size is normally identified by the headline transistor length, which is shrinking from 180 nanometers to 130 nanometers and smaller. This is commonly referred to in the semiconductor industry as the migration to nanometer design. It represents a major challenge for participants in the semiconductor industry, from IC design and design automation to design of manufacturing equipment and the manufacturing process itself. Shrinkage of transistor length to such infinitesimal proportions is challenging fundamental laws of physics and chemistry.
	•	The ability to design System-on-Chip, or SoC, ICs increases the complexity of managing a design that at the lowest level is represented by billions of shapes on the fabrication mask. In addition, SoCs typically incorporate microprocessors and digital signal processors that are programmed with software, requiring simultaneous design of the IC and the related software embedded on the IC.
	•	Increased capability of Field-Programmable Gate Array technologies creates an alternative to IC implementation for some electronics companies. This could reduce demand for Cadence’s IC implementation products and services.
	•	A growing number of low-cost design services businesses could reduce the need for some IC companies to invest in EDA products.
	•	The challenges of nanometer design are leading some customers to work with older, less risky manufacturing processes. This may reduce their need to upgrade their EDA products and design flows.

If we are unable to respond quickly and successfully to these developments and the evolution of these changes, we may lose our competitive position, and our products or technologies may become uncompetitive or obsolete. To compete successfully, we must develop or acquire new products and improve our existing products and processes on a schedule that keeps pace with technological developments in our industries. We must also be able to support a range of changing computer software, hardware platforms and customer preferences. We cannot guarantee that we will be successful in this effort.

We have experienced varied quarterly operating results, and our operating results for any particular fiscal period are affected by the timing of significant orders for our software products, fluctuations in customer preferences for license types and the timing of recognition of revenue under those license types.

We have experienced, and may continue to experience, varied quarterly operating results. In particular, we have experienced quarterly net losses for four of the past six quarters, and we may experience net losses in future periods. Various factors affect our quarterly operating results and some of them are not within our control. Our quarterly operating results are affected by the timing of significant orders for our software products because a significant number of licenses for our software products are in excess of $5.0 million. The

Our operating results are also affected by the mix of license types executed in any given period. We license software using three different license types: term, subscription and perpetual. Product revenue associated with term and perpetual licenses is generally recognized at the beginning of the license period, whereas product revenue associated with subscription licenses is recognized over multiple periods over the term of the license. Revenue may also be deferred under term and perpetual licenses until payments become due and payable from customers with nonlinear payment terms or as cash is collected from customers with lower credit ratings.

We continue to experience increasing customer preference for our subscription licenses and requests for more flexible payment terms. We expect revenue recognized from backlog to increase as a percentage of product revenue, on an annual basis, assuming that customers continue to prefer subscription licenses, or continue to request more flexible payment terms, both of which cause revenue to be recognized over time. In addition, revenue is impacted by the timing of license renewals, the extent to which contracts contain flexible payment terms and the mix of license types (i.e., perpetual, term or subscription) for existing customers, which changes could have the effect of accelerating or delaying the recognition of revenue from the timing of recognition under the original contract.

We plan operating expense levels primarily based on forecasted revenue levels. These expenses and the impact of long-term commitments are relatively fixed in the short term. A shortfall in revenue could lead to operating results below expectations because we may not be able to quickly reduce these fixed expenses in response to short-term business changes.

You should not view our historical results of operations as reliable indicators of our future performance. If revenue or operating results fall short of the levels expected by public market analysts and investors, the trading price of our common stock could decline dramatically.

Our future revenue is dependent in part upon our installed customer base continuing to license additional products, renew maintenance agreements and purchase additional services.

Our installed customer base has traditionally generated additional new license, service and maintenance revenues. In future periods, customers may not necessarily license additional products or contract for additional services or maintenance. Maintenance is generally renewable annually at a customer’s option, and there are no mandatory payment obligations or obligations to license additional software. If our customers decide not to renew their maintenance agreements or license additional products or contract for additional services, or if they reduce the scope of the maintenance agreements, our revenue could decrease, which could have an adverse effect on our results of operations.

We may not receive significant revenue from our current research and development efforts for several years, if at all.

Internally developing software products and integrating acquired software products into existing platforms is expensive, and these investments often require a long time to generate returns. Our strategy involves significant investments in software research and development and related product opportunities. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position. However, we cannot predict that we will receive significant revenue from these investments, if at all.

We have acquired and expect to acquire other companies and businesses and may not realize the expected benefits of these acquisitions.

We have acquired and expect to acquire other companies and businesses in the future. While we expect to carefully analyze all potential acquisitions before committing to the transaction, we cannot assure you that our management will be able to integrate and manage acquired products and businesses effectively or that the

acquisitions will result in long-term benefits to us or our stockholders. In addition, acquisitions involve a number of risks. If any of the following events occurs after we acquire another business, it could seriously harm our business, operating results and financial condition:


	•	Difficulties in combining previously separate businesses into a single unit;
	•	The substantial diversion of management’s attention from day-to-day business when evaluating and negotiating these transactions and then integrating an acquired business;
	•	The discovery, after completion of the acquisition, of liabilities assumed from the acquired business or of assets acquired that are not realizable;
	•	The failure to realize anticipated benefits such as cost savings and revenue enhancements;
	•	The failure to retain key employees of the acquired business;
	•	Difficulties related to assimilating the products of an acquired business in, for example, distribution, engineering and customer support areas;
	•	Unanticipated costs;
	•	Customer dissatisfaction with existing license agreements with Cadence which may preclude access to products acquired by Cadence after the effective date of the license; and
	•	Failure to understand and compete effectively in markets in which we have limited previous experience.

In a number of our acquisitions, we have agreed to make future cash or stock payments based on the performance of the businesses we acquired. The performance goals pursuant to which these future payments may be made generally relate to achievement by the acquired business of certain specified bookings, revenue, product proliferation, product development or employee retention goals during a specified period following completion of the applicable acquisition. Future acquisitions may involve issuances of stock as payment of the purchase price for the acquired business and also incentive stock or option grants to employees of the acquired businesses (which may be dilutive to existing stockholders), expenditure of substantial cash resources or the incurrence of material amounts of debt.

The specific performance goal levels and amounts and timing of contingent purchase price payments vary with each acquisition. In fiscal 2004 to date, we have recorded 1.1 million shares to former stockholders of acquired companies, as contingent earnout purchase price. In addition, in fiscal 2004 to date, we made cash payments of $14.5 million and accrued an additional $2.5 million of cash payments to former stockholders of acquired companies, as contingent earnout purchase price.

The additional goodwill and deferred stock compensation resulting from acquisitions related to the achievement of certain performance goals tied to one or more of the following criteria: revenue, bookings, product proliferation, product development and employee retention. The goodwill is not expected to be deductible for income tax purposes.

Future acquisitions may result in increased goodwill and other intangible assets, in addition to acquisition-related charges. These assets may eventually be written down to the extent they are deemed to be impaired, and any such write-downs would adversely affect our results.

Our failure to attract, train, motivate and retain key employees may make us less competitive in our industries and therefore harm our results of operations.

Our business depends on the efforts and abilities of our senior management, our research and development staff, and a number of other key management, sales, support, technical and services employees. The high cost of training new employees, not fully utilizing these employees, or losing trained employees to competing employers could reduce our gross margins and harm our business and operating results. Even in the

current economic climate, competition for highly skilled employees can be intense, particularly in geographic areas recognized as high technology centers such as the Silicon Valley area, where our principal offices are located, and the other locations where we maintain facilities. If economic conditions improve and job opportunities in the technology industry become more plentiful, we may experience increased employee attrition and increased competition for skilled employees. To attract, retain and motivate individuals with the requisite expertise, we may be required to grant large numbers of stock options or other stock-based incentive awards, which may be dilutive to existing stockholders. We may also be required to pay key employees significant base salaries and cash bonuses, which could harm our operating results. Additionally, if certain proposed accounting standards were adopted we would be required to record a charge to compensation expense for option grants which may affect our ability to provide equity compensation to employees.

In addition, regulations adopted by the NYSE and NASDAQ require stockholder approval for new stock option plans and significant amendments to existing plans, including increases in options, and prohibit NYSE and NASDAQ member organizations from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions. These regulations could make it more difficult for us to grant equity compensation to employees in the future. To the extent that these regulations make it more difficult or expensive to grant equity compensation to employees, we may incur increased compensation costs or find it difficult to attract, retain and motivate employees, which could materially and adversely affect our business.

The competition in our industries is substantial and we cannot assure you that we will be able to continue to successfully compete in our industries.

The EDA market and the commercial electronics design and methodology services industries are highly competitive. If we fail to compete successfully in these industries, it could seriously harm our business, operating results and financial condition. To compete in these industries, we must identify and develop or acquire innovative and cost competitive EDA products, integrate them into platforms and market them in a timely manner. We must also gain industry acceptance for our design and methodology services and offer better strategic concepts, technical solutions, prices and response time, or a combination of these factors, than those of other design companies and the internal design departments of electronics manufacturers. We cannot assure you that we will be able to compete successfully in these industries. Factors that could affect our ability to succeed include:


	•	The development by others of competitive EDA products or platforms and design and methodology services, which could result in a shift of customer preferences away from our products and services and significantly decrease revenue;
	•	Decisions by electronics manufacturers to perform design and methodology services internally, rather than purchase these services from outside vendors due to budget constraints or excess engineering capacity;
	•	The challenges of developing (or acquiring externally-developed) technology solutions which are adequate and competitive in meeting the requirements of next-generation design challenges;
	•	The significant number of current and potential competitors in the EDA industry and the low cost of entry;
	•	Intense competition to attract acquisition targets, which may make it more difficult for us to acquire companies at an acceptable price or at all; and
	•	The combination of or collaboration among many EDA companies to deliver more comprehensive offerings than they could individually.

We currently compete in the EDA market primarily with Synopsys, Inc., Mentor Graphics Corporation and Magma Design Automation, Inc. We also compete with numerous smaller EDA companies, with manufacturers of electronic devices that have developed or have the capability to develop their own EDA products, and with numerous electronics design and consulting companies. Manufacturers of electronic devices may be reluctant to purchase services from independent vendors such as us because they wish to promote their own internal design departments.

The intensely competitive markets in which we compete can put pressure on us to reduce our prices. If our competitors offer deep discounts on certain products in an effort to recapture or gain market segment share or to sell other software or hardware products, we may then need to lower prices or offer other favorable terms to compete successfully. Any such changes would be likely to reduce margins and can adversely affect operating results. Any broadly-based changes to our prices and pricing policies could cause sales and software license revenues to decline or be delayed as our sales force implements and our customers adjust to the new pricing policies. Some of our competitors may bundle products for promotional purposes or as a long-term pricing strategy or provide guarantees of prices and product implementations. These practices could, over time, significantly constrain the prices that we can charge for our products. If we cannot offset price reductions with a corresponding increase in the number of sales or with lower spending, then the reduced license revenues resulting from lower prices could have an adverse effect on our results of operations.

We rely on our proprietary technology as well as software and other intellectual property rights licensed to us by third parties, and we cannot assure you that the precautions taken to protect our rights will be adequate or that we will continue to be able to adequately secure such intellectual property rights from third parties.

Our success depends, in part, upon our proprietary technology. We generally rely on patents, copyrights, trademarks, trade secret laws, licenses and restrictive agreements to establish and protect our proprietary rights in technology and products. Despite precautions we may take to protect our intellectual property, we cannot assure you that third parties will not try to challenge, invalidate or circumvent these safeguards. We also cannot assure you that the rights granted under our patents or attendant to our other intellectual property will provide us with any competitive advantages, or that patents will be issued on any of our pending applications, or that future patents will be sufficiently broad to protect our technology. Furthermore, the laws of foreign countries may not protect our proprietary rights in those countries to the same extent as applicable law protects these rights in the United States. Many of our products include software or other intellectual property licensed from third parties. We may have to seek new or renew existing licenses for such software and other intellectual property in the future. Our design services business holds licenses to certain software and other intellectual property owned by third parties. Our failure to obtain, for our use, software or other intellectual property licenses or other intellectual property rights on favorable terms, or the need to engage in litigation over these licenses or rights, could seriously harm our business, operating results and financial condition.

Intellectual property infringement by or against us could result in our loss of key technology.

There are numerous patents in the EDA industry and new patents are being issued at a rapid rate. It is not always practicable 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, we may be forced to respond to or prosecute intellectual property infringement claims to protect our rights or defend a customer’s rights. These claims, regardless of merit, could consume valuable management time, result in costly litigation, or cause product shipment delays, all of which could seriously harm our business, operating results and financial condition. In settling these claims, we 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 favorable to us. Being forced to enter into a license agreement with unfavorable terms could seriously harm our business, operating results and financial condition. Any potential intellectual property litigation could force us to do one or more of the following:


	•	Pay damages, license fees or royalties to the party claiming infringement;
	•	Stop licensing products or providing services that use the challenged intellectual property;
	•	Obtain a license from the owner of the infringed intellectual property to sell or use the relevant technology, which license may not be available on reasonable terms, or at all; or
	•	Redesign the challenged technology, which could be time-consuming and costly.

If we were forced to take any of these actions, our business and results of operations may suffer.

We may not be able to effectively implement our restructuring activities, and our restructuring activities may not result in the expected benefits, which would negatively impact our future results of operations.

The EDA market and the commercial electronics design and methodology services industries are highly competitive and change quickly. We have responded to increased competition and changes in the industries in which we compete by restructuring our operations and reducing the size of our workforce. Despite our restructuring efforts over the last few years, we cannot assure you that we will achieve all of the operating expense reductions and improvements in operating margins and cash flows currently anticipated from these restructuring activities in the periods contemplated, or at all. Our inability to realize these benefits, and our failure to appropriately structure our business to meet market conditions, could negatively impact our results of operations.

As part of our recent restructuring activities, we have reduced the workforce in certain revenue-generating portions of our business, particularly in our services business. This reduction in staffing levels could require us to forego certain future strategic opportunities due to limited resources, which could negatively affect our long-term revenues.

In addition, these workforce reductions could result in a lack of focus and reduced productivity by remaining employees due to changes in responsibilities or concern about future prospects, which in turn may negatively affect our future revenues. Further, we believe our future success depends, in large part, on our ability to attract and retain highly skilled personnel. Our restructuring activities could negatively affect our ability to attract such personnel as a result of perceived risk of future workforce reductions.

We also cannot assure you that we will not be required to implement further restructuring activities or reductions in our workforce based on changes in the markets and industries in which we compete or that any future restructuring efforts will be successful.

The lengthy sales cycle of our products and services makes the timing of our revenue difficult to predict and may cause our operating results to fluctuate unexpectedly.

We have a lengthy sales cycle that generally extends at least three to six months. The length of the sales cycle may cause our revenue and operating results to vary unexpectedly from quarter to quarter. The complexity and expense associated with our business generally requires a lengthy customer education, evaluation and approval process. Consequently, we 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 us from pursuing other opportunities.

In addition, sales of our products and services may be delayed if customers delay approval or commencement of projects because of:


	•	The timing of customers’ competitive evaluation processes; or
	•	Customers’ budgetary constraints and budget cycles.

Lengthy sales cycles for acceleration and emulation hardware products subject us to a number of significant risks over which we have limited control, including insufficient, excess or obsolete inventory, variations in inventory valuation and fluctuations in quarterly operating results.

Also, because of the timing of large orders and our customers’ buying patterns, we may not learn of bookings shortfalls, revenue shortfalls, earnings shortfalls or other failures to meet market expectations until late in a fiscal quarter, which could cause even more immediate and serious harm to the trading price of our common stock.

The profitability of our services business depends on factors that are difficult to control, such as the high cost of our services employees, our cost of performing our fixed-price services contracts and the success of our design services business, which has historically suffered losses.

To be successful in our services business, we must overcome several factors that are difficult to control, including the following:


	•	Our cost of services employees is high and reduces our gross margin. Gross margin represents the difference between the amount of revenue from the sale of services and our cost of providing those services. We must pay high salaries to attract and retain professional services employees. This results in a lower gross margin than the gross margin in our software business. In addition, the high cost of training new services employees or not fully utilizing these employees can significantly lower gross margin. It is difficult to adjust staffing levels quickly to reflect customer demand for services; therefore, the services business has in the past and could continue to experience losses.
	•	A portion of services contracts consists of fixed-price contracts. Some of our customers pay a fixed price for services provided, regardless of the cost we must incur to perform the contract. If our cost in performing the services were to exceed the amount the customer has agreed to pay, we would experience a loss on the contract, which could harm our business, operating results and financial condition.
	•	We have historically suffered losses in our design services business. The market for electronics design services is sensitive to customer budgetary constraints and engineering capacity. Our design services business has historically suffered losses. If our design services business fails to increase its revenue to offset its expenses, the design services business will continue to experience losses. Our failure to succeed in the design services business may harm our business, operating results and financial condition.

Our international operations may seriously harm our financial condition because of the effect of foreign exchange rate fluctuations and other risks to our international business.

We have significant operations outside the United States. Our revenue from international operations as a percentage of total revenue was approximately 47% for the third quarter of 2004 and 44% for the third quarter of 2003. We expect that revenue from our international operations will continue to account for a significant portion of our total revenue. We also transact business in various foreign currencies. Recent economic and political uncertainty and the volatility of foreign currencies in certain regions, most notably the Japanese yen and the European Union euro, have had, and may in the future have, a seriously harmful effect on our revenue and operating results.

Fluctuations in the rate of exchange between the U.S. dollar and the currencies of other countries in which we conduct business could seriously harm our business, operating results and financial condition. For example, if there is an increase in the rate at which a foreign currency exchanges into U.S. dollars, it will take more of the foreign currency to equal the same amount of U.S. dollars than before the rate increase. If we price our products and services in the foreign currency, we will receive fewer U.S. dollars than we did before the rate increase went into effect. If we price our products and services in U.S. dollars, an increase in the exchange rate will result in an increase in the price for our products and services compared to those products of our competitors that are priced in local currency. This could result in our prices being uncompetitive in markets where business is transacted in the local currency.

Exposure to foreign currency transaction risk can arise when transactions are conducted in a currency different from the functional currency of one of our subsidiaries. A subsidiary’s functional currency is the currency in which it primarily conducts its operations, including product pricing, expenses and borrowings. Although we attempt to reduce the impact of foreign currency fluctuations, significant exchange rate movements may hurt our results of operations as expressed in U.S. dollars.


	•	The adoption and expansion of government trade restrictions;
	•	Limitations on repatriation of earnings;
	•	Limitations on the conversion of foreign currencies;
	•	Reduced protection of intellectual property rights in some countries;
	•	Recessions in foreign economies;
	•	Longer collection periods for receivables and greater difficulty in collecting accounts receivable;
	•	Difficulties in managing foreign operations;
	•	Political and economic instability;
	•	Unexpected changes in regulatory requirements;
	•	Tariffs and other trade barriers; and
	•	U.S. government licensing requirements for exports which may lengthen the sales cycle or restrict or prohibit the sale or licensing of certain products.

We have offices throughout the world, including key research facilities outside of the United States. Our operations are dependent upon the connectivity of our operations throughout the world. Activities that interfere with our international connectivity, such as computer “hacking” or the introduction of a virus into our computer systems, could significantly interfere with our business operations.

Our operating results could be adversely affected as a result of changes in our effective tax rates.


	•	Earnings being lower than anticipated in countries where we are taxed at lower statutory rates as compared to the U.S. statutory tax rate;
	•	An increase in expenses not deductible for tax purposes, including certain stock compensation, write-offs of acquired in-process technology and impairment of goodwill;
	•	Changes in the valuation of our deferred tax assets and liabilities;
	•	Changes in tax laws or the interpretation of such tax laws; or
	•	New accounting standards or interpretations of such standards.

Any significant change in our future effective tax rates could adversely impact our results of operations for future periods.

We have received an examination report from the Internal Revenue Service proposing a tax deficiency in certain of our tax returns, and the outcome of the examination or any future examinations involving similar claims may have a material adverse effect on our results of operations and cash flows.

The IRS and other tax authorities regularly examine our income tax returns. In November 2003, the IRS completed its field examination of our federal income tax returns for the tax years 1997 through 1999 and issued an RAR in which the IRS proposes to assess an aggregate tax deficiency for the three-year period of approximately $143 million, plus interest, which interest will accrue until the matter is resolved. This interest is compounded daily at rates published by the IRS, which rates have been between four and nine percent since 1997, and adjust quarterly. The IRS may also make similar claims for years subsequent to 1999 in future examinations. The RAR is not a final Statutory Notice of Deficiency, and we have filed a protest to certain of the proposed adjustments with the IRS.

The most significant of the disputed adjustments relates to transfer pricing arrangements that we have with a foreign subsidiary. We believe that the proposed IRS adjustments are inconsistent with the applicable tax laws, and that we have meritorious defenses to the proposed adjustments. We are challenging these proposed adjustments vigorously.

The IRS is currently examining our federal income tax returns for tax years 2000 through 2002.

Significant judgment is required in determining our provision for income taxes. In determining the adequacy of our provision for income taxes, we regularly assess the likelihood of adverse outcomes resulting

from these examinations, including the current IRS examination and the IRS RAR for the tax years 1997 through 1999. However, the ultimate outcome of tax examinations cannot be predicted with certainty, including the total amount payable or the timing of any such payments upon resolution of these issues. In addition, we cannot assure you that such amount will not be materially different than that which is reflected in our historical income tax provisions and accruals. Should the IRS or other tax authorities assess additional taxes as a result of a current or a future examination, we may be required to record charges to operations in future periods that could have a material impact on the results of operations, financial position or cash flows in the applicable period or periods recorded.

Forecasting our estimated annual effective tax rate is complex and subject to uncertainty, and material differences between forecasted and actual tax rates could have a material impact on our results of operations.

Forecasts of our income tax position and resultant effective tax rate are complex and subject to uncertainty because our income tax position for each year combines the effects of a mix of profits (losses) earned by us and our subsidiaries in tax jurisdictions with a broad range of income tax rates as well as benefits from available deferred tax assets and costs resulting from tax audits. To forecast our global tax rate, pre-tax profits and losses by jurisdiction are estimated and tax expense by jurisdiction is calculated. If the mix of profits and losses or effective tax rates by jurisdiction is different than those estimates, our actual tax rate could be materially different than forecasted, which could have a material impact on our results of operations.

Failure to obtain export licenses could harm our business by rendering us unable to ship products and transfer our technology outside of the United States.

We must comply with U.S. Department of Commerce regulations in shipping our software products and transferring our technology outside the United States and to foreign nationals. Although we have not had any significant difficulty complying with these regulations so far, any significant future difficulty in complying could harm our business, operating results and financial condition.

Proposed regulations related to equity compensation could cause us to recognize an additional expense, which would result in a reduction in our net income.

Errors or defects in our products and services could expose us to liability and harm our reputation.

Our customers use our products and services in designing and developing products that involve a high degree of technological complexity, each of which has its own specifications. Because of the complexity of the systems and products with which we work, some of our products and designs can be adequately tested only when put to full use in the marketplace. As a result, our customers or their end users may discover errors or


	•	Loss of current customers and loss of or delay in revenue and loss of market segment share;
	•	Failure to attract new customers or achieve market acceptance;
	•	Diversion of development resources to resolve the problem;
	•	Increased service costs; and
	•	Liability for damages.

If we become subject to unfair hiring claims, we could be prevented from hiring needed employees, incur liability for damages and incur substantial costs in defending ourselves.

Companies in our industry whose employees accept positions with competitors frequently claim that these competitors have engaged in unfair hiring practices or that the employment of these persons would involve the disclosure or use of trade secrets. These claims could prevent us from hiring employees or cause us to incur liability for damages. We could also incur substantial costs in defending ourselves or our employees against these claims, regardless of their merits. Defending ourselves from these claims could also divert the attention of our management from our operations.

Our business is subject to the risk of earthquakes, floods and other natural catastrophic events.

Our corporate headquarters, including certain of our research and development operations, and certain of our distribution facilities, are located in the Silicon Valley area of Northern California, which is a region known to experience seismic activity. In addition, several of our facilities, including our corporate headquarters, certain of our research and development operations, and certain of our distribution operations, are in areas of San Jose, California that have been identified by the Director of the Federal Emergency Management Agency, or FEMA, as being located in a special flood area. The areas at risk are identified as being in a one hundred year flood plain, using FEMA’s Flood Hazard Boundary Map or the Flood Insurance Rate Map. If significant seismic or flooding activity were to occur, our operations may be interrupted, which would adversely impact our business and results of operations.

We maintain research and other facilities in parts of the world that are not as politically stable as the United States, and as a result we may face a higher risk of business interruption from acts of war or terrorism than other businesses located only or primarily in the United States.

We maintain international research and other facilities, some of which are in parts of the world that are not as politically stable as the United States. Consequently, we may face a greater risk of business interruption as a result of terrorist acts or military conflicts than businesses located domestically. Furthermore, this potential harm is exacerbated given that damage to or disruptions at our international research and development facilities could have an adverse effect on our ability to develop new or improve existing products as compared to other businesses which may only have sales offices or other less critical operations abroad. We are not insured for losses or interruptions caused by acts of war or terrorism.

If we are unable to favorably assess the effectiveness of our internal control over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report on our assessment, our stock price could be adversely affected.

Under the Sarbanes-Oxley Act of 2002, or the Act, we are required to assess the effectiveness of our internal controls for financial reporting and assert that such internal controls are effective. Our independent auditors must evaluate management’s assessment concerning the effectiveness of our internal controls over financial reporting and render an opinion on our assessment and the effectiveness of our internal controls over financial reporting. To prepare for compliance with the Act, we have undertaken certain actions including the adoption of an internal plan, which includes a timeline and schedule of activities for the evaluation, testing and remediation, if necessary, of internal controls. These actions have resulted in and are likely to continue to result in increased expenses, and have required and are likely to continue to require significant efforts by

management and other employees. Although we believe that our efforts will enable us to provide the required report and enable our independent auditors to provide the required attestation as of our fiscal year end, we can give no assurance that such efforts will be completed in a timely manner and on a successful basis. If this were to occur, we may be unable to assert that the internal controls over financial reporting are effective, or our independent auditors may not be able to render the required attestation concerning our assessment and the effectiveness of the internal controls over financial reporting, which could adversely effect investor confidence and the market price of our common stock.

Our debt obligations expose us to risks that could adversely affect our business, operating results and financial condition, and could prevent us from fulfilling our obligations under such indebtedness.

We have a substantial level of debt. As of October 2, 2004, we had $420.0 million of outstanding indebtedness from the Notes that we issued in August 2003. The level of our indebtedness, among other things, could:


	•	make it difficult for us to satisfy our payment obligations on our debt as described below;
	•	make it difficult for us to incur additional debt or obtain any necessary financing in the future for working capital, capital expenditures, debt service, acquisitions or general corporate purposes;
	•	limit our flexibility in planning for or reacting to changes in our business;
	•	reduce funds available for use in our operations;
	•	make us more vulnerable in the event of a downturn in our business;
	•	make us more vulnerable in the event of an increase in interest rates if we must incur new debt to satisfy our obligations under the Notes; or
	•	place us at a possible competitive disadvantage relative to less leveraged competitors and competitors that have greater access to capital resources.

If we experience a decline in revenue due to any of the factors described in this section entitled “Factors That May Affect Future Results” or otherwise, we could have difficulty paying amounts due on our indebtedness. In the case of the Notes, although the Notes mature in 2023, the holders of the Notes may require us to repurchase their notes at an additional premium in 2008, which makes it probable that we will be required to repurchase the Notes in 2008 if the Notes are not otherwise converted into our common stock. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments, or if we fail to comply with the various requirements of our indebtedness, including the Notes, we would be in default, which would permit the holders of our indebtedness to accelerate the maturity of the indebtedness and could cause defaults under our other indebtedness. Any default under our indebtedness could have a material adverse effect on our business, operating results and financial condition.

We are not restricted under our outstanding indebtedness from incurring additional debt, including other senior indebtedness or secured indebtedness. In addition, our outstanding indebtedness does not restrict our ability to pay dividends, issue or repurchase stock or other securities or require us to achieve or maintain any minimum financial results relating to our financial position or results of operations. Our ability to recapitalize, incur additional debt and take a number of other actions that are not limited by the terms of our outstanding indebtedness could have the effect of diminishing our ability to make payments on such indebtedness when due. Although our outstanding indebtedness does not contain such financial and other restrictive covenants, future indebtedness could include such covenants. If we incur additional indebtedness or other liabilities, our ability to pay our obligations on our outstanding indebtedness could be adversely affected.

We may be unable to adequately service our indebtedness, which may result in defaults and other costs to us.

We may not have sufficient funds or may be unable to arrange for additional financing to pay the outstanding obligations due on our indebtedness. Any future borrowing arrangements or debt agreements to which we become a party may contain restrictions on or prohibitions against our repayment on our outstanding indebtedness. With respect to the Notes, at maturity, the entire outstanding principal amount of the Notes will

become due and payable. Holders may require us to repurchase for cash all or any portion of the Notes on August 15, 2008 for 100.25% of the principal amount, August 15, 2013 for 100.00% of the principal amount and August 15, 2018 for 100.00% of the principal amount. As a result, although the Notes mature in 2023, the holders may require us to repurchase the Notes at an additional premium in 2008, which makes it probable that we will be required to repurchase the Notes in 2008 if the Notes are not otherwise converted into our common stock. If we are prohibited from paying our outstanding indebtedness, we could try to obtain the consent of lenders under those arrangements, or we could attempt to refinance the borrowings that contain the restrictions. If we do not obtain the necessary consents or refinance the borrowings, we may be unable to satisfy our outstanding indebtedness. Any such failure would constitute an event of default under our indebtedness, which could, in turn, constitute a default under the terms of any other indebtedness then outstanding.

In addition, a material default on our indebtedness could suspend our eligibility to register securities using certain registration statement forms under SEC guidelines which permit incorporation by reference of substantial information regarding us, which could potentially hinder our ability to raise capital through the issuance of our securities and will increase the costs of such registration to us.

The price of our common stock may fluctuate significantly, which may make it difficult for stockholders to sell our common stock when desired or at attractive prices.

The market price of our common stock is subject to significant fluctuations in response to the factors set forth in this section entitled “Factors That May Affect Future Results” and other factors, many of which are beyond our control. Such fluctuations, as well as economic conditions generally, may adversely affect the market price of our common stock.

In addition, the stock markets in recent years have experienced extreme price and trading volume fluctuations that often have been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations may adversely affect the price of our common stock, regardless of our operating performance.

Conversion of the Notes will dilute the ownership interests of existing stockholders.

The terms of the Notes permit the holders to convert the Notes into shares of our common stock. The Notes are convertible into our common stock initially at a conversion price of $15.65 per share, which would result in an aggregate of approximately 26.8 million shares of our common stock issued upon conversion, subject to adjustment upon the occurrence of specified events. The conversion of some or all of the Notes will dilute the ownership interest of our existing stockholders. Any sales in the public market of the common stock issuable upon conversion could adversely affect prevailing market prices of our common stock. Prior to the conversion of the Notes, if the trading price of our common stock exceeds the conversion price of the Notes by 145.00% or more over specified periods, basic earnings per share will be diluted if and to the extent the convertible notes hedge instruments are not exercised. We may redeem for cash all or any part of the Notes on or after August 15, 2008 for 100.00% of the principal amount. The holders may require us to repurchase for cash all or any portion of their notes on August 15, 2008 for 100.25% of the principal amount, on August 15, 2013 for 100.00% of the principal amount, or on August 15, 2018 for 100.00% of the principal amount.

Each $1,000 of principal of the Notes is initially convertible into 63.879 shares of our common stock, subject to adjustment upon the occurrence of specified events. Holders of the Notes may convert their Notes prior to maturity only if: (1) the price of our common stock reaches $22.69 during periods of time specified by the Notes, (2) specified corporate transactions occur, (3) the Notes have been called for redemption or (4) the trading price of the Notes falls below a certain threshold. As a result, although the Notes mature in 2023, the holders may require us to repurchase their notes at an additional premium in 2008, which makes it probable that we will be required to repurchase the Notes in 2008 if the Notes are not otherwise converted into our common stock.

Although the conversion price is currently $15.65 per share, the convertible notes hedge and warrant transactions that we entered into in connection with the issuance of the Notes effectively increased the

conversion price of the Notes until 2008 to approximately $23.08 per share, which would result in an aggregate issuance upon conversion prior to August 15, 2008 of approximately 18.2 million shares of our common stock. We have entered into convertible notes hedge and warrant transactions to reduce the potential dilution from the conversion of the Notes, however we cannot guarantee that such convertible notes hedge and warrant instruments will fully mitigate the dilution. In addition, the existence of the Notes may encourage short selling by market participants because the conversion of the Notes could depress the price of our common stock.

Regulations related to certain features of contingently convertible debt will cause us to include the number of contingently issuable shares in our diluted earnings per share calculation, which will result in significantly lower diluted earnings per share.

We may, at the option of the noteholders and only in certain circumstances, be required to repurchase the Notes in shares of our common stock upon a significant change in our corporate ownership or structure, and issuance of shares to repurchase the notes would result in dilution to our existing stockholders.

Under the terms of the Notes, we may be required to repurchase the Notes following a significant change in our corporate ownership or structure, such as a change of control, prior to maturity of the Notes. Following a significant change in our corporate ownership or structure, in certain circumstances, we may choose to pay the repurchase price of the Notes in cash, shares of our common stock or a combination of cash and shares of our common stock. In the event we choose to pay all or any part of the repurchase price of notes in shares of our common stock, this would result in dilution to the holders of our common stock.

Convertible notes hedge and warrant transactions entered into in connection with the issuance of the Notes may affect the value of our common stock.

We entered into convertible notes hedge transactions with JP Morgan Chase Bank, an affiliate of one of the initial purchasers of the Notes, at the time of issuance of the Notes, with the objective of reducing the potential dilutive effect of issuing our common stock upon conversion of the Notes. We also entered into warrant transactions. In connection with our convertible notes hedge and warrant transactions, JP Morgan Chase Bank, or its affiliates purchased our common stock in secondary market transactions and entered into various over-the-counter derivative transactions with respect to our common stock. This entity or its affiliates is likely to modify its hedge positions from time to time prior to conversion or maturity of the Notes by purchasing and selling shares of our common stock, other of our securities or other instruments it may wish to use in connection with such hedging. The effect, if any, of any of these transactions and activities on the market price of our common stock or the Notes could adversely affect the value of our common stock and, as a result, the number of shares and the value of the common stock holders will receive upon conversion of the Notes. In addition, subject to movement in the trading price of our common stock, if the convertible notes hedge transactions settle in our favor, we could be exposed to credit risk related to the other party.

Rating agencies may provide unsolicited ratings on the Notes that could reduce the market value or liquidity of our common stock.

We have not requested a rating of the Notes from any rating agency and we do not anticipate that the Notes will be rated. However, if one or more rating agencies independently elects to rate the Notes and assigns the Notes a rating lower than the rating expected by investors, or reduces their rating in the future, the market price or liquidity of the Notes and our common stock could be harmed. A resulting decline in the market price of the Notes as compared to the price of our common stock may require us to repurchase the Notes.

Anti-takeover defenses in our governing documents and certain provisions under Delaware law could prevent an acquisition of our company or limit the price that investors might be willing to pay for our common stock.


	Our governing documents and certain provisions of the Delaware General Corporation Law that apply to us could make it difficult for another company to acquire control of our company. For example:


	•	Our certificate of incorporation allows our board of directors to issue, at any time and without stockholder approval, preferred stock with such terms as it may determine. No shares of preferred stock are currently outstanding. However, the rights of holders of any of our preferred stock that may be issued in the future may be superior to the rights of holders of our common stock.
	•	We have a rights plan, commonly known as a “poison pill,” which would make it difficult for someone to acquire our company without the approval of our board of directors.
	•	Section 203 of the Delaware General Corporation Law generally prohibits a Delaware corporation from engaging in any business combination with a person owning 15% or more of its voting stock, or who is affiliated with the corporation and owned 15% or more of its voting stock at any time within three years prior to the proposed business combination, for a period of three years from the date the person became a 15% owner, unless specified conditions are met.

All or any one of these factors could limit the price that certain investors would be willing to pay for shares of our common stock and could delay, prevent or allow our board of directors to resist an acquisition of our company, even if the proposed transaction were favored by a majority of our independent stockholders.

Our exposure to market risk for changes in interest rates relates primarily to our short-term investment portfolio. While we are exposed to interest rate fluctuations in many of the world’s leading industrialized countries, our interest income and expense is most sensitive to fluctuations in the general level of U.S. interest rates. In this regard, changes in U.S. interest rates affect the interest earned on our cash and cash equivalents, short-term and long-term investments and costs associated with foreign currency hedges.

We invest in high quality credit issuers and, by policy, limit the amount of our credit exposure to any one issuer. As part of our policy, our first priority is to reduce the risk of principal loss. Consequently, we seek to preserve our invested funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in only high quality credit securities that we believe to have low credit risk and by positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer or guarantor. The short-term interest-bearing portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity.

The table below presents the carrying value and related weighted average interest rates for our interest-bearing instruments. All highly liquid investments with a maturity of three months or less at the date of purchase are considered to be cash equivalents; investments with maturities between three and 12 months are considered to be short-term investments. Investments with maturities greater than 12 months are considered

Our operations include transactions in foreign currencies and, therefore, we benefit from a weaker dollar, and we are adversely affected by a stronger dollar relative to major currencies worldwide. The primary effect of foreign currency transactions on our results of operations from a weakening U.S. dollar is an increase in revenue offset by a smaller increase in expenses. Conversely, the primary effect of foreign currency transactions on our results of operations from a strengthening U.S. dollar is a reduction in revenue offset by a smaller reduction in expenses.

We enter into foreign currency forward exchange contracts with financial institutions to protect against currency exchange risks associated with existing assets and liabilities. A foreign currency forward exchange contract acts as a hedge by increasing in value when underlying asset exposures decrease in value or underlying liability exposures increase in value. Conversely, a foreign currency forward exchange contract decreases in value when underlying asset exposures increase in value or underlying liability exposures decrease in value. These forward contracts are not accounted for as hedges and, therefore, the unrealized gains and losses are recognized in Other income (expense), net, in advance of the actual foreign currency cash flows with the fair value of these forward contracts being recorded as accrued liabilities.

We do not use forward contracts for trading purposes. Our forward contracts generally have maturities of 180 days or less. Recognized gains and losses with respect to our current hedging activities will ultimately depend on how accurately we are able to match the amount of currency forward exchange contracts with underlying asset and liability exposures.

The table below provides information, as of October 2, 2004, about our forward foreign currency contracts. The information is provided in U.S. dollar equivalent amounts. The table presents the notional amounts, at contract exchange rates, and the weighted average contractual foreign currency exchange rates expressed as units of the foreign currency per U.S. dollar, which in some cases may not be the market convention for quoting on a particular currency. All of these forward contracts mature prior to December 17, 2004.

While we actively and continually manage our foreign currency risks, there can be no assurance that our foreign currency hedging activities will substantially offset the impact of fluctuations in currency exchange rates on our results of operations, cash flows and financial position.

In August 2003, we issued $420.0 million principal amount of the Notes to two initial purchasers in a private offering for resale to qualified institutional buyers pursuant to SEC Rule 144A, for which we received net proceeds of approximately $406.4 million after transaction fees of approximately $13.6 million. The Notes are convertible into our common stock initially at a conversion price of $15.65 per share, which would result in an aggregate of 26.8 million shares issued upon conversion, subject to adjustment upon the occurrence of specified events. We may redeem for cash all or any part of the Notes on or after August 15, 2008 for 100.00% of the principal amount. The holders may require us to repurchase for cash all or any portion of their Notes on August 15, 2008 for 100.25% of the principal amount, on August 15, 2013 for 100.00% of the principal amount or on August 15, 2018 for 100.00% of the principal amount. The Notes do not contain restrictive financial covenants.

Each $1,000 of principal of the Notes will initially be convertible into 63.8790 shares of our common stock, subject to adjustment upon the occurrence of specified events. Holders of the Notes may convert their Notes prior to maturity only if: (1) the price of our common stock reaches $22.69 during periods of time specified by the Notes, (2) specified corporate transactions occur, (3) the Notes have been called for redemption or (4) the trading price of the Notes falls below a certain threshold.

In addition, in the event of a significant change in our corporate ownership or structure, the holders may require us to repurchase all or any portion of their Notes for 100% of the principal amount.

Concurrently with the issuance of the Notes, we entered into convertible notes hedge transactions with JP Morgan Chase Bank, whereby we have options to purchase up to 26.8 million shares of our common stock at a price of $15.65 per share. These options expire on August 15, 2008 and must be settled in net shares. The cost of the convertible notes hedge transactions to us was approximately $134.6 million. As of October 2, 2004, the estimated fair value of the convertible notes hedge transactions was $99.1 million.

In addition, we sold to JP Morgan Chase Bank warrants to purchase up to 26.8 million shares of our common stock at a price of $23.08 per share. The warrants expire on various dates from February 2008 through May 2008 and must be settled in net shares. We received approximately $56.4 million in cash proceeds for the sales of these warrants. As of October 2, 2004, the estimated fair value of the warrants sold was $32.5 million.

We have a portfolio of equity investments that includes marketable equity securities and non-marketable equity securities. Our equity investments primarily are made in connection with our strategic investment program. Under our strategic investment program, from time to time we make cash investments in companies with distinctive technologies that are potentially strategically important to us.

As of October 2, 2004, the fair value of our portfolio of marketable equity securities was $28.9 million and $33.9 million at January 3, 2004. We do not engage in any hedging activities to reduce or eliminate equity price risk with respect to these equity investments. Accordingly, we could lose all or part of our investment portfolio of marketable equity securities if there is an adverse change in the market prices of the companies we invest in.

Our investments in non-marketable equity securities would be negatively affected by an adverse change in equity market prices, although the impact cannot be directly quantified. Such a change, or any negative change in the financial performance or prospects of the companies in which we have invested in non-marketable securities would harm the ability of these companies to raise additional capital and the likelihood of our being able to realize any gains or return of our investments through liquidity events such as initial public offerings, acquisitions and private sales. These types of investments involve a high degree of risk, and there can be no assurance that any company we invest in will grow or will be successful. Accordingly, we could lose all or part of our investment.

At October 2, 2004, our investments in non-marketable equity securities had a carrying amount of $48.2 million and $53.3 million at January 3, 2004. If we determine that an other-than-temporary decline in fair value exists for a non-marketable equity security, we write down the investment to its fair value and record the related write-down as an investment loss in our Condensed Consolidated Statements of Operations.

We carried out an evaluation required by Rule 13a-15 of the Securities Exchange Act of 1934 under the supervision and with the participation of our management, including the Chief Executive Officer, or CEO, and the Chief Financial Officer, or CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of October 2, 2004.

Disclosure controls and procedures are designed with the objective of ensuring that (i) information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms; and (ii) information is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal controls are procedures designed with the objective of providing reasonable assurance regarding the reliability of financial reporting and permitting the preparation of our financial statements in conformity with generally accepted accounting principles, including that our (A) transactions are properly authorized, recorded and reported and (B) assets are safeguarded against unauthorized or improper use.

The evaluation of our disclosure controls and procedures and internal controls included a review of our processes and implementation and the effect on the information generated for use in this Quarterly Report on Form 10-Q. In the course of this evaluation, we sought to identify any significant deficiencies or material weaknesses in our controls, to determine whether we had identified any acts of fraud involving personnel who have a significant role in our internal controls, and to confirm that any necessary corrective action, including process improvements, were being undertaken. This type of evaluation is done every fiscal quarter so that our conclusions concerning the effectiveness of these controls can be reported in our periodic reports filed with the SEC. Our internal controls are also evaluated on an ongoing basis by our internal auditors and by other

personnel in our Finance organization. The overall goals of these evaluation activities are to monitor our disclosure and internal controls and to make modifications as necessary. We intend to maintain these controls, modifying them as circumstances warrant.

The evaluation allowed us to make conclusions, as set forth below, regarding the state of our disclosure controls and procedures as of October 2, 2004. In connection with this evaluation, to improve the quality and timeliness of information available to management, we made certain changes in our internal controls over financial reporting in 2004, as described below.

As reported in our 2003 Annual Report, we restated our Consolidated Balance Sheet as of December 28, 2002 and the Consolidated Statements of Operations for 2002, and the Condensed Consolidated Statements of Operations for the first three quarters of 2003, to properly reflect the equity method of accounting for certain equity investments and for certain other adjustments.

During the first quarter of 2004, our independent auditors issued a letter to our Audit Committee related to the audit of our Consolidated Financial Statements for the year ended January 3, 2004 in which they noted certain matters involving our internal controls and operation that they considered to be “reportable conditions”, as defined under standards established by the American Institute of Certified Public Accountants. Reportable conditions are matters coming to the attention of our independent auditors that, in their judgment, relate to significant deficiencies in the design or operation of our internal controls that could adversely affect our ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements. The reportable conditions, which are less serious findings than findings of material weaknesses, were: the absence of appropriate controls relating to investments in non-marketable securities and the absence of appropriate documentation, review and approval of significant non-revenue related transactions, and the corresponding accounting entries originating from departments other than corporate accounting. As a result of these findings, our Audit Committee authorized and directed management to implement actions to address these deficiencies and to enhance the reliability and effectiveness of our control procedures.

To address the insufficiency of appropriate controls relating to investments in non-marketable securities, we implemented changes to our internal controls regarding reporting by Telos and our Mergers, Acquisitions and Alliances, or MA&A, group to our corporate accounting group regarding Cadence and Telos investments. These changes included the implementation of written reporting and review policies to ensure that our corporate accounting group receives and validates as complete and accurate, on a quarterly basis, all pertinent information relating to investments held directly by Cadence, as well as by Telos, so that we can properly account for our investments in non-marketable securities.

To address the absence of appropriate documentation, reviews and approvals of transactions, and accounting entries originating from departments other than corporate accounting, as of July 3, 2004, we had taken actions designed to enhance our internal controls, including adopting and implementing formal written policies and procedures to ensure appropriate communication between our corporate accounting group and other departments, including MA&A, Tax, Stock Administration and foreign locations, to facilitate the timely identification, documentation, review and approval of, and to ensure proper accounting for, significant non-revenue related and non-routine transactions. These policies and procedures were fully implemented prior to the completion of our second quarter 2004 accounting close process.

We believe that these efforts have addressed the significant deficiencies that affected or could have affected our internal controls. Based upon the foregoing, our CEO and CFO have concluded that our controls and procedures, after implementation of the aforementioned actions, are effective in meeting the above-stated objectives. We continue to improve and refine our internal controls. This process is ongoing, and we seek to foster an exemplary internal control environment. Our management, including our CEO and CFO, has concluded that, as of October 2, 2004, our disclosure controls and procedures are designed, and are effective, to give reasonable assurance that information we must disclose in reports filed with the SEC is properly recorded, processed and summarized, and then reported within the time periods specified in the rules and forms of the SEC.

Other than as summarized above, there have been no changes in our internal controls over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, our internal controls.

Despite management’s conclusions regarding the effectiveness of our controls and procedures, a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Our management, including our CEO and CFO, necessarily applied its judgment in assessing the benefits of controls relative to their costs. In particular, we have investments in certain unconsolidated entities, which investments are accounted for using either the cost basis or equity method of accounting. Because we do not control or manage these entities, our disclosure controls and procedures with respect to information we receive from such entities are often more limited than those we maintain with respect to our consolidated subsidiaries. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and may not be detected.

From time to time, we are involved in various disputes and litigation matters that arise in the ordinary course of business. These include disputes and lawsuits related to intellectual property, mergers and acquisitions, licensing, contract law, distribution arrangements and employee relations matters. Periodically, we review the status of each significant matter and assess its potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, we accrue a liability for the estimated loss at the low end of the range. Legal proceedings are subject to uncertainties, and the outcomes are difficult to predict. Because of such uncertainties, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to pending claims and litigation matters and may revise estimates.

While the outcome of these disputes and litigation matters cannot be predicted with any certainty, management does not believe that the outcome of any current matters will have a material adverse effect on our consolidated financial position or results of operations.

In August 2001, our Board of Directors authorized a program to repurchase shares of our common stock with a value of up to $500 million in the aggregate. The following table sets forth the repurchases we made during the three months ended October 2, 2004:

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


(Mark One)
	x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended October 2, 2004
OR
	o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-10606


Delaware		77-0148231
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)
2655 Seely Avenue, Building 5, San Jose, California		95134
(Address of Principal Executive Offices)		(Zip Code)
(408) 943-1234 Registrant’s Telephone Number, including Area Code


			Page

PART I.		FINANCIAL INFORMATION

	Item 1.	Financial Statements:
		Condensed Consolidated Balance Sheets: October 2, 2004 and January 3, 2004		3
		Condensed Consolidated Statements of Operations: Three and Nine Months Ended October 2, 2004 and September 27, 2003		4
		Condensed Consolidated Statements of Cash Flows: Nine Months Ended October 2, 2004 and September 27, 2003		5
		Notes to Condensed Consolidated Financial Statements		6

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		27

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		61

	Item 4.	Controls and Procedures		64

PART II.		OTHER INFORMATION

	Item 1.	Legal Proceedings		66

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		66

	Item 3.	Defaults Upon Senior Securities		67

	Item 4.	Submission of Matters to a Vote of Security Holders		67

	Item 5.	Other Information		67

	Item 6.	Exhibits		67

		Signatures		68
EXHIBIT 31.01
EXHIBIT 31.02
EXHIBIT 32.01
EXHIBIT 32.02


			October 2,			January 3,
			2004			2004

Current Assets:
	Cash and cash equivalents		$	423,557		$	384,525
	Short-term investments			28,943			33,898
	Receivables, net of allowance for doubtful accounts of $9,832 and $9,067, respectively			355,692			348,680
	Inventories			20,293			16,926
	Prepaid expenses and other			67,725			58,212

		Total current assets		896,210			842,241
Property, plant and equipment, net				394,723			403,847
Goodwill				988,919			922,797
Acquired intangibles, net				218,869			237,508
Installment contract receivables, net				85,986			121,627
Other assets				235,259			289,882

Total Assets			$	2,819,966		$	2,817,902

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
	Accounts payable and accrued liabilities		$	244,820		$	243,450
	Current portion of deferred revenue			250,559			238,478

		Total current liabilities		495,379			481,928

Long-Term Liabilities:
	Long-term portion of deferred revenue			18,019			16,287
	Convertible notes			420,000			420,000
	Other long-term liabilities			292,490			327,406

		Total long-term liabilities		730,509			763,693

Stockholders’ Equity:
	Common stock and capital in excess of par value			1,042,974			1,034,190
	Deferred stock compensation			(49,650	)		(48,856	)
	Retained earnings			581,033			566,354
	Accumulated other comprehensive income			19,721			20,593

		Total stockholders’ equity		1,594,078			1,572,281

Total Liabilities and Stockholders’ Equity			$	2,819,966		$	2,817,902



				Three Months Ended						Nine Months Ended

				October 2,			September 27,			October 2,			September 27,
				2004			2003			2004			2003

Revenue:
	Product			$	183,030		$	151,962		$	503,053		$	461,194
	Services				34,447			33,773			104,064			100,962
	Maintenance				84,104			83,025			247,267			246,237

			Total revenue		301,581			268,760			854,384			808,393

Costs and Expenses:
	Cost of product				25,033			15,418			58,590			49,663
	Cost of services				23,132			22,678			69,526			71,529
	Cost of maintenance				12,643			13,266			39,813			43,399
	Marketing and sales				76,736			80,758			238,131			246,993
	Research and development				85,300			84,179			263,541			257,677
	General and administrative				22,917			18,814			62,890			65,598
	Amortization of acquired intangibles				12,741			16,357			44,672			46,263
	Amortization of deferred stock compensation (A)				5,772			11,626			21,924			25,558
	Legal settlements				- - - -			(14,500	)		- - - -			(14,500	)
	Restructuring and other charges				1,036			62,874			9,400			64,226
	Write-off of acquired in-process
		technology			2,000			2,000			9,000			7,500

			Total costs and expenses		267,310			313,470			817,487			863,906

Income (loss) from operations					34,271			(44,710	)		36,897			(55,513	)
	Interest expense				(1,564	)		(2,392	)		(4,820	)		(3,706	)
	Other income (expense), net				(4,172	)		1,208			(10,016	)		(10,199	)

Income (loss) before provision (benefit) for income taxes					28,535			(45,894	)		22,061			(69,418	)
	Provision (benefit) for income taxes				8,904			(31,438	)		7,382			(36,620	)

Net income (loss)				$	19,631		$	(14,456	)	$	14,679		$	(32,798	)

Basic net income (loss) per share				$	0.07		$	(0.05	)	$	0.05		$	(0.12	)

Diluted net income (loss) per share				$	0.07		$	(0.05	)	$	0.05		$	(0.12	)

Weighted average common shares outstanding					270,509			266,755			271,514			267,605

Weighted average common and potential common shares outstanding – – assuming dilution					274,877			266,755			280,050			267,605


(A) Amortization of deferred stock compensation would be further classified as follows:
Cost of services				$	303		$	1,082		$	2,074		$	2,781
Marketing and sales					1,706			3,082			5,565			7,322
Research and development					3,567			6,850			11,444			13,451
General and administrative					196			612			2,841			2,004

				$	5,772		$	11,626		$	21,924		$	25,558



					Nine Months Ended

								Restated
					October 2,			September 27,
					2004			2003

Cash and Cash Equivalents at Beginning of Period					$	384,525		$	371,327

Cash Flows from Operating Activities:
	Net income (loss)					14,679			(32,798	)
	Adjustments to reconcile net income (loss) to net cash provided by operating activities:
		Depreciation and amortization				138,510			143,347
		Amortization of deferred stock compensation				21,924			25,558
		Equity in loss from investments, net				16,167			7,059
		Gain on sale of investments				(7,985	)		- - - -
		Write-off of investment securities				2,995			4,785
		Write-off of acquired in-process technology				9,000			7,500
		Non-cash restructuring and other charges				- - - -			19,035
		Proceeds from the sale of receivables				15,198			33,661
		Provisions for losses on trade accounts receivable and sales returns				2,168			16,598
		Other non-cash items				1,008			3,309
		Changes in operating assets and liabilities, net of effect of acquired businesses:
			Receivables			6,411			69,414
			Inventories			(3,367	)		(5,527	)
			Prepaid expenses and other			(4,470	)		(11,357	)
			Installment contract receivables			6,514			(74,949	)
			Other assets			9,022			20,842
			Accounts payable and accrued liabilities			(22,846	)		(74,741	)
			Deferred revenue			13,295			(19,668	)
			Other long-term liabilities			15,721			(21,102	)

				Net cash provided by operating activities		233,944			110,966

Cash Flows from Investing Activities:
	Proceeds from sale and maturities of short-term investments – – available-for-sale					3,557			- - - -
	Proceeds from the sale of long-term investments					6,942			- - - -
	Proceeds from sale of equipment					3,625			9,147
	Purchases of property, plant and equipment					(46,788	)		(54,998	)
	Purchases of software licenses					(757	)		(2,282	)
	Investment in venture capital partnerships and equity investments					(17,353	)		(34,341	)
	Cash paid in business combinations, net of cash acquired					(115,170	)		(140,854	)

				Net cash used for investing activities		(165,944	)		(223,328	)

Cash Flows from Financing Activities:
	Proceeds from credit facility					- - - -			45,000
	Principal payments on credit facility and capital leases					(354	)		(98,424	)
	Proceeds from issuance of convertible notes					- - - -			420,000
	Payment of convertible notes issuance costs					(1,920	)		(11,463	)
	Proceeds from sale of common stock warrants					- - - -			56,441
	Purchase of call options					- - - -			(134,637	)
	Proceeds from issuance of common stock					65,842			54,323
	Purchases of treasury stock					(94,103	)		(210,952	)

				Net cash provided by (used for) financing activities		(30,535	)		120,288

Effect of exchange rate changes						1,567			14,950

Increase in cash and cash equivalents						39,032			22,876

Cash and Cash Equivalents at End of Period					$	423,557		$	394,203


				(In thousands)
Current assets				$	13,383
Property, plant and equipment					288
Other assets					46
Acquired intangibles:
	Existing technology (five-year weighted-average useful life)				19,600
	Backlog (three-year weighted-average useful life)				1,700
	Patents (five-year weighted-average useful life)				4,700
	In-process technology				7,000
	Non-compete agreements (three-year weighted-average useful life)				1,200
	Trademarks (five-year weighted-average useful life)				1,400
Goodwill					38,319

		Total assets acquired			87,636

Current liabilities					1,762
Long-term liabilities					7,783

		Total liabilities assumed			9,545

			Net assets acquired	$	78,091


	Product			Services
	Segment			Segment		Total


	(In thousands)
Balance as of January 3, 2004	$	792,656		$	130,141	$	922,797
Goodwill resulting from acquisitions during the nine months ended October 2, 2004		44,350			- - - -		44,350
Additions due to earnouts		33,414			- - - -		33,414
Adjustments to deferred tax assets for prior acquisitions		(9,035	)		- - - -		(9,035	)
Other		(2,607	)		- - - -		(2,607	)

Balance as of October 2, 2004	$	858,778		$	130,141	$	988,919



	As of October 2, 2004							As of January 3, 2004

						Weighted							Weighted
						Average							Average
	Gross Carrying		Accumulated			Remaining		Gross Carrying		Accumulated			Remaining
	Amount		Amortization			Useful Life		Amount		Amortization			Useful Life


	(In thousands)							(In thousands)
Existing technology and backlog	$	584,107	$	(417,999	)		2.8 Years	$	528,857	$	(352,727	)		2.9 Years
Agreements and Relationships		42,446		(20,097	)		4.6 Years		41,046		(12,139	)		4.9 Years
Distribution Rights		30,100		(3,762	)		8.8 Years		30,100		(1,505	)		9.5 Years
Tradenames/ trademarks/patents		7,034		(2,960	)		3.4 Years		5,634		(1,758	)		3.3 Years

Total acquired intangibles	$	663,687	$	(444,818	)		3.7 Years	$	605,637	$	(368,129	)		3.9 Years


Estimated future amortization expense is as follows (in thousands):
	2004 – remaining period	$	23,785
	2005		84,606
	2006		47,415
	2007		27,704
	2008		15,231
	Thereafter		20,128

Total estimated amortization expense		$	218,869


NOTE 5.	MARKETABLE AND NON-MARKETABLE INVESTMENT SECURITIES


	Three months			Nine months
	ended			ended
	October 2, 2004			October 2, 2004


	(In thousands)
Net sales	$	7,422		$	26,740
Costs and expenses		(19,144	)		(71,754	)
Operating loss		(11,722	)		(45,014	)
Net loss		(10,342	)		(39,600	)


		Severance
		and			Asset-		Excess
		Benefits			Related		Facilities			Total


		(In thousands)
2004 Plan		$	405		$	- - - -	$	- - - -		$	405
2003 Plan			(400	)		290		1,319			1,209
2002 Plan			(231	)		32		(390	)		(589	)
2001 Plan			- - - -			- - - -		11			11

	Total	$	(226	)	$	322	$	940		$	1,036


		Deferred Stock
		Compensation

		(In thousands)
Balance as of January 3, 2004		$	(48,856	)
	Amortization of deferred stock compensation		21,924
	Warrants and stock options		(1,117	)
	Restricted stock related to acquisitions		(4,131	)
	Restricted stock related to incentive stock awards		(20,992	)
	Forfeitures		3,522

Balance as of October 2, 2004		$	(49,650	)



		For the Three Months Ended October 2, 2004

												Consolidated
		Product			Services		Maintenance		Other			Total


		(In thousands)
Revenue		$	183,030		$	34,447	$	84,104	$	- - - -		$	301,581
Cost of revenue			25,033			23,132		12,643		- - - -			60,808

	Gross margin		157,997			11,315		71,461		- - - -			240,773
Operating expenses and amortization of deferred stock compensation			- - - -			- - - -		- - - -		(203,466	)		(203,466	)
Restructuring and other charges			- - - -			- - - -		- - - -		(1,036	)		(1,036	)
Write-off of acquired in-process technology			(2,000	)		- - - -		- - - -		- - - -			(2,000	)
Interest expense and Other income (expense), net			- - - -			- - - -		- - - -		(5,736	)		(5,736	)

Segment income (loss) from operations		$	155,997		$	11,315	$	71,461	$	(210,238	)	$	28,535


NOTE 1.	BASIS OF PRESENTATION


	Restatement


NOTE 2.	STOCK-BASED COMPENSATION


NOTE 3.	ACQUISITIONS



		For the Three Months Ended September 27, 2003 – Restated

												Consolidated
		Product			Services		Maintenance		Other			Total


		(In thousands)
Revenue		$	151,962		$	33,773	$	83,025	$	- - - -		$	268,760
Cost of revenue			15,418			22,678		13,266		- - - -			51,362

	Gross margin		136,544			11,095		69,759		- - - -			217,398
Operating expenses and amortization of deferred stock compensation			- - - -			- - - -		- - - -		(211,734	)		(211,734	)
Legal settlements			- - - -			- - - -		- - - -		14,500			14,500
Restructuring and other charges			- - - -			- - - -		- - - -		(62,874	)		(62,874	)
Write-off of acquired in-process technology			(2,000	)		- - - -		- - - -		- - - -			(2,000	)
Interest expense and Other income (expense), net			- - - -			- - - -		- - - -		(1,184	)		(1,184	)

Segment income (loss) from operations		$	134,544		$	11,095	$	69,759	$	(261,292	)	$	(45,894	)



		For the Nine Months Ended October 2, 2004

												Consolidated
		Product			Services		Maintenance		Other			Total


		(In thousands)
Revenue		$	503,053		$	104,064	$	247,267	$	- - - -		$	854,384
Cost of revenue			58,590			69,526		39,813		- - - -			167,929

	Gross margin		444,463			34,538		207,454		- - - -			686,455
Operating expenses and amortization of deferred stock compensation			- - - -			- - - -		- - - -		(631,158	)		(631,158	)
Restructuring and other charges			- - - -			- - - -		- - - -		(9,400	)		(9,400	)
Write-off of acquired in-process technology			(9,000	)		- - - -		- - - -		- - - -			(9,000	)
Interest expense and Other income (expense), net			- - - -			- - - -		- - - -		(14,836	)		(14,836	)

Segment income (loss) from operations		$	435,463		$	34,538	$	207,454	$	(655,394	)	$	22,061



		For the Nine Months Ended September 27, 2003 – Restated

												Consolidated
		Product			Services		Maintenance		Other			Total


		(In thousands)
Revenue		$	461,194		$	100,962	$	246,237	$	- - - -		$	808,393
Cost of revenue			49,663			71,529		43,399		- - - -			164,591

	Gross margin		411,531			29,433		202,838		- - - -			643,802
Operating expenses and amortization of deferred stock compensation			- - - -			- - - -		- - - -		(642,089	)		(642,089	)
Legal settlements										14,500			14,500
Restructuring and other charges										(64,226	)		(64,226	)
Write-off of acquired in-process technology			(7,500	)		- - - -		- - - -		- - - -			(7,500	)
Interest expense and Other income (expense), net			- - - -			- - - -		- - - -		(13,905	)		(13,905	)

Segment income (loss) from operations		$	404,031		$	29,433	$	202,838	$	(705,720	)	$	(69,418	)



				For the				For the
				Three Months Ended				Nine Months Ended

						Restated				Restated
				October 2,		September 27,		October 2,		September 27,
				2004		2003		2004		2003


				(In thousands)				(In thousands)
North America:
	United States			$	159,343	$	150,475	$	451,023	$	432,776
	Other				8,287		5,650		20,596		17,183

		Total North America			167,630		156,125		471,619		449,959

Europe				$	62,129	$	52,073	$	157,871	$	138,524


Japan and Asia:
	Japan				44,325		35,340		144,025		148,380
	Asia				27,497		25,222		80,869		71,530

		Total Japan and Asia			71,822		60,562		224,894		219,910

			Total	$	301,581	$	268,760	$	854,384	$	808,393



				As of

				October 2,		January 3,
				2004		2004


				(In thousands)
North America:
	United States			$	1,470,867	$	1,457,982
	Other				3,290		3,401

		Total North America			1,474,157		1,461,383

Europe					84,419		87,793

Japan and Asia:
	Japan				34,196		35,085
	Asia				12,708		12,656

		Total Japan and Asia			46,904		47,741

			Total	$	1,605,480	$	1,596,917


	*Valuation of long-lived and intangible assets, including goodwill*



		Three Months Ended

		October 2,	July 3,	April 3,	January 3,	September 27,
		2004	2004	2004	2004	2003

Functional Verification		18%	20%	20%	20%	18%
Digital IC Design		24%	21%	25%	20%	27%
Custom IC Design		27%	24%	27%	27%	27%
Design for Manufacturing		12%	9%	6%	13%	7%
System Interconnect		8%	9%	10%	10%	8%
Services and other		11%	17%	12%	10%	13%

	Total	100%	100%	100%	100%	100%


*Item 3.*	*Quantitative and Qualitative Disclosures About Market Risk*


				Carrying		Average
				Value		Interest Rate

				(In millions)
Interest-Bearing Instruments:
	Commercial Paper – fixed rate			$	182.3		1.76%
	Cash equivalents – variable rate				134.3		1.81%
	Cash – variable rate				86.5		0.78%

		Total interest-bearing instruments			403.1		1.57%
		Total non-interest bearing cash			20.5

			Total cash and cash equivalents	$	423.6


				Weighted
				Average
		Notional		Contract
		Principal		Rate

		(In millions)
Forward Contracts:
	Japanese yen	$	111.7		109.33
	Euro		26.9		0.81
	British pound sterling		12.8		0.56
	Hong Kong dollars		11.5		7.79
	Canadian dollars		10.0		1.29
	Other		4.9		- - - -

			177.8
	Estimated fair value	$	1.7


						Total Number of		Maximum Dollar
		Total				Shares Purchased as		Value of Shares that
		Number of		Average		Part of Publicly		May Yet Be
		Shares		Price		Announced		Purchased Under
		Purchased		Per Share		Repurchase Program		Repurchase Program

								(In millions)
Period:
July 4, 2004 – August 7, 2004			- - - -	$	- - - -		- - - -	$	147.2
August 8, 2004 – September 4, 2004			2,001,600		12.12		2,001,600	$	122.9
September 5, 2004 – October 2, 2004			- - - -		- - - -		- - - -	$	122.9

	Total		2,001,600	$	12.12		2,001,600


Exhibit
Number			Exhibit Title

	31	.01	Certification of the Registrant’s Chief Executive Officer, Michael J. Fister, pursuant to Rule 13a-14 of the Securities Exchange Act of 1934.
	31	.02	Certification of the Registrant’s Chief Financial Officer, William Porter, pursuant to Rule 13a-14 of the Securities Exchange Act of 1934.
	32	.01	Certification of the Registrant’s Chief Executive Officer, Michael J. Fister, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	32	.02	Certification of the Registrant’s Chief Financial Officer, William Porter, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


DATE: November 9, 2004		By: /s/ Michael J. Fister

		Michael J. Fister President, Chief Executive Officer and Director

DATE: November 9, 2004		By: /s/ William Porter

		William Porter Senior Vice President and Chief Financial Officer