UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(MARK ONE)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JANUARY 31, 2005
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: 0-19807

 

SYNOPSYS, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE		56-1546236
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

 

 

 

Indicate by check mark whether the registrant (l) 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 ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes ý  No o

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

145,129,608 shares of Common Stock as of March 5, 2005

 

SYNOPSYS, INC.

QUARTERLY REPORT ON FORM 10-Q

JANUARY 31, 2005

 

TABLE OF CONTENTS

 

		Page
PART I.	FINANCIAL INFORMATION	1
ITEM 1.	FINANCIAL STATEMENTS	1
	UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS	1
	UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS	2
	UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	3
	NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	4
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	11
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	29
ITEM 4.	CONTROLS AND PROCEDURES	31
PART II.	OTHER INFORMATION	31
ITEM 1.	LEGAL PROCEEDINGS	31
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	32
ITEM 5.	OTHER INFORMATION	32
ITEM 6.	EXHIBITS	35
SIGNATURES		37

 

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

SYNOPSYS, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

		JANUARY 31, 2005			OCTOBER 31, 2004
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	376,367		$	346,709
Short-term investments		206,136			232,320
Total cash, cash equivalents and short-term investments		582,503			579,029
Accounts receivable, net of allowances of $7,185 and $7,113, respectively		108,028			132,258
Deferred income taxes		127,629			125,601
Income taxes receivable		46,522			46,583
Prepaid expenses and other current assets		27,710			29,562
Total current assets		892,392			913,033
Property and equipment, net		173,532			178,155
Long-term investments		11,472			12,831
Goodwill		667,880			593,706
Intangible assets, net		187,940			198,069
Long-term deferred income taxes		155,517			146,360
Other assets		56,389			50,033
Total assets		$	2,145,122		$	2,092,187
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities		$	166,532		$	184,146
Accrued income taxes		196,517			188,096
Deferred revenue		482,192			368,913
Total current liabilities		845,241			741,155
Deferred compensation and other liabilities		58,534			51,794
Long-term deferred revenue		31,016			34,189
Stockholders’ equity:
Common stock, $0.01 par value; 400,000 shares authorized; 145,206 and 147,378 shares outstanding, respectively		1,451			1,474
Additional paid-in capital		1,241,531			1,240,568
Retained earnings		186,945			202,146
Treasury stock, at cost; 11,931, and 9,759 shares, respectively		(212,778		)	(175,762		)
Deferred stock compensation		(1,975		)	(2,732		)
Accumulated other comprehensive loss		(4,843		)	(645		)
Total stockholders’ equity		1,210,331			1,265,049
Total liabilities and stockholders’ equity		$	2,145,122		$	2,092,187

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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SYNOPSYS, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

 

		THREE MONTHS ENDED JANUARY 31,
		2005			2004
Revenue:
Time-based license		$	186,284		$	170,598
Upfront license		10,798			59,490
Maintenance and service		44,222			55,176
Total revenue		241,304			285,264
Cost of revenue:
License		24,847			20,331
Maintenance and service		17,029			15,551
Amortization of intangible assets and deferred stock compensation		28,099			25,240
Total cost of revenue		69,975			61,122
Gross margin		171,329			224,142
Operating expenses:
Research and development		72,917			70,337
Sales and marketing		83,990			70,746
General and administrative		24,223			29,137
In-process research and development		5,700			—
Amortization of intangible assets and deferred stock compensation		8,852			9,244
Total operating expenses		195,682			179,464
Operating income (loss)		(24,353		)	44,678
Other income (expense), net		5,199			(1,069		)
Income (loss) before provision (benefit) for income taxes		(19,154		)	43,609
Provision (benefit) for income taxes		(4,829		)	11,457
Net income (loss)		$	(14,325	)	$	32,152
Basic earnings (loss) per share:
Net income (loss) per share		$	(0.10	)	$	0.21
Weighted-average common shares outstanding		146,060			156,316
Diluted earnings (loss) per share:
Net income (loss) per share		$	(0.10	)	$	0.19
Weighted-average common shares and dilutive stock options outstanding		146,060			165,864

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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SYNOPSYS, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

		THREE MONTHS ENDED JANUARY 31,
		2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$	(14,325	)	$	32,152
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Amortization and depreciation		50,482			48,230
In-process research and development		5,700			—
Deferred income taxes		(7,205		)	—
Write-down of long-term investments		1,568			1,401
Provision for (reduction to) allowance for doubtful accounts		(720		)	2,000
Net change in unrecognized gains and losses on foreign exchange contracts		(4,458		)	(3,633		)
Gain on sale of short— and long-term investments		30			(37		)
Net changes in operating assets and liabilities:
Accounts receivable		31,480			4,595
Income taxes receivable		61			653
Prepaid expenses and other current assets		2,544			(10,117		)
Other assets		(6,127		)	(9,502		)
Accounts payable and accrued liabilities		(32,909		)	(54,736		)
Accrued income taxes		2,062			(22,220		)
Deferred revenue		107,129			13,615
Deferred compensation and other liabilities		6,763			8,918
Net cash provided by operating activities		142,075			11,319
CASH FLOWS FROM INVESTING ACTIVITIES:
Cash paid for acquisitions, net of cash received		(91,293		)	—
Proceeds from sales and maturities of short-term investments		97,114			124,474
Purchases of short-term investments		(71,538		)	(155,529		)
Purchases of long-term investments		—			(1,000		)
Purchases of property and equipment		(6,330		)	(14,980		)
Capitalization of software development costs		(738		)	(685		)
Net cash used in investing activities		(72,785		)	(47,720		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuances of common stock		2,268			86,135
Purchases of treasury stock		(40,160		)	(160,937		)
Net cash used in financing activities		(37,892		)	(74,802		)
Effect of exchange rate changes on cash and cash equivalents		(1,740		)	(377		)
Net increase (decrease) in cash and cash equivalents		29,658			(111,580		)
Cash and cash equivalents, beginning of period		346,709			524,308
Cash and cash equivalents, end of period		$	376,367		$	412,728

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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SYNOPSYS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.               BASIS OF PRESENTATION

 

Synopsys, Inc. (Synopsys or the Company) has prepared the accompanying unaudited condensed consolidated financial statements pursuant to the Securities and Exchange Commission’s (the Commission) rules and regulations. Pursuant to these rules and regulations, the Company has condensed or omitted certain information and footnote disclosures it normally includes in its annual consolidated financial statements prepared in accordance with generally accepted accounting principles (GAAP). In management’s opinion, the Company has made all adjustments (consisting only of normal, recurring adjustments, except as otherwise indicated) necessary to fairly present its financial position, results of operations and cash flows. The Company’s interim period operating results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and notes thereto in Synopsys’ Annual Report on Form 10-K for the fiscal year ended October 31, 2004 on file with the Commission.

 

To prepare financial statements in conformity with GAAP, management must make estimates and assumptions that affect the amounts reported in the unaudited condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

 

Synopsys’ fiscal year and first fiscal quarter ended on the Saturday nearest October 31 and January 31, respectively. Fiscal 2005 and 2004 are both 52-week years. For ease of presentation, the unaudited condensed consolidated financial statements and accompanying notes refer to the applicable calendar month end.

 

In the first quarter of fiscal 2005, the Company revised its methodology for allocating and reporting costs of revenue. We have reclassified cost of revenue for the first quarter of fiscal 2004 to conform to the fiscal 2005 allocation methodology and presentation.

 

2.                       BUSINESS COMBINATIONS

 

Acquisition of ISE Integrated Systems Engineering AG (ISE)

 

The Company acquired ISE on November 2, 2004.

 

Reasons for the Acquisition.  ISE’s Technology Computer Aided Design (TCAD) software provides process simulation and device and circuit simulation, helping semiconductor manufacturers shorten the time to design and test chips prior to actual manufacturing.  In approving the merger agreement, Synopsys’ Board considered a number of factors, including its opinions that (i) the merger of ISE’s TCAD organization with Synopsys’ own TCAD business would permit the introduction of a consolidated TCAD platform that addresses the challenges posed by future technologies while maintaining continuity with existing software, and (ii) the merger would enable Synopsys to help further reduce its customers’ costs and manufacturing risks as they create smaller, faster and more power-efficient chips.  The results of operations of ISE are included in the accompanying unaudited condensed consolidated statement of operations since the date of the acquisition. The Company does not consider the acquisition of ISE to be material to its results of operations, and therefore is not presenting pro forma statements of operations for the three-month periods ended January 31, 2005 and 2004.

 

Purchase Price. The Company paid $100.0 million in cash on November 2, 2004. The total purchase consideration consisted of:

 

 

           Under the acquisition agreement, the Company has also agreed to pay up to $20 million over three years to certain former shareholders of ISE now employed by Synopsys based upon achievement of certain sales and employee retention milestones. Any amounts payable under this arrangement will be accrued as compensation expense when, and if, it is probable that such amounts have been earned.

 

Acquisition-related costs of $2.9 million consist primarily of legal, tax and accounting fees of $1.3 million, approximately $1.1 million of estimated facilities closure costs, and other directly related charges.  As of January 31, 2005, the Company had paid $1.3

 

4

 

million of the acquisition-related costs, of which $0.2 million relates to facilities closure costs.  The holdback to secure representations and warranties  is payable in November 2005.

 

The Company has allocated the total purchase consideration to the assets and liabilities acquired, including identifiable intangible assets, based on their respective fair values at the acquisition date, resulting in goodwill of approximately $74.2 million. The following table summarizes the preliminary allocation of the purchase price to the fair value of the assets and liabilities acquired.

 

 

Goodwill and Intangible Assets. Goodwill, representing the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired in the merger, will not be amortized and is not deductible for tax purposes. The purchase price allocated to identifiable intangible assets is as follows:

 

 

Amortization of the core/developed technology is included in cost of revenue in the statement of operations for the three months ended January 31, 2005.  The Company included amortization of other intangible assets in operating expenses in its statement of operations for the three months ended January 31, 2005.

 

3.                       GOODWILL AND INTANGIBLE ASSETS

 

The Company’s aggregate goodwill as of January 31, 2005 consisted of the following:

 

		(in thousands)
Balance at October 31, 2004		$	593,706
ISE goodwill		74,205
Other adjustments		(31		)
Balance at January 31, 2005		$	667,880

 

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Intangible assets as of January 31, 2005 consisted of the following:

 

 

Total amortization expense related to intangible assets is set forth in the table below:

 

 

The following table presents the estimated future amortization of intangible assets:

 

 

4.                       STOCK REPURCHASE PROGRAM

 

The Company is authorized to purchase up to $500 million of its common stock under a stock repurchase program previously established by the Company’s Board of Directors (Board) and replenished up to the $500 million maximum in December 2004.  During the three months ended January 31, 2005, the Company repurchased approximately 2.3 million shares at an average price of $17.11 per share, for a total of $40.2 million. During the three months ended January 31, 2004, the Company repurchased approximately 4.6 million shares at an average price of $35.13 per share, for a total of $160.9 million.  As of January 31, 2005, $484.8 million remained available for repurchases under the program.

 

5.                       CREDIT FACILITY

 

In April 2004, Synopsys entered into a three-year, $250.0 million senior unsecured revolving credit facility. This facility contains financial covenants requiring that the Company maintain a minimum leverage ratio and specified levels of cash, as well as other non-financial covenants. The facility terminates on April 28, 2007. Borrowings under the facility bear interest at the greater of the administrative agent’s prime rate or the federal funds rate plus 0.50%; however, the Company has the option to pay interest based on the outstanding amount at eurodollar rates plus a spread between 0.80% and 1.125% based on a pricing grid tied to a financial covenant. In addition, commitment fees are payable on the facility at rates between 0.20% and 0.25% per annum based on a pricing

 

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grid tied to a financial covenant. As of January 31, 2005, the Company had no outstanding borrowings under this credit facility and was in compliance with all covenants.

 

6.                       COMPREHENSIVE INCOME

 

The following table sets forth the components of comprehensive income (loss), net of tax:

 

 

		THREE MONTHS ENDED JANUARY 31,
		2005			2004
		(in thousands)
Net income (loss)		$	(14,325	)	$	32,152
Unrealized gains (loss) on investments, net of tax of ($85) and $8, respectively		(133		)	13
Correction of error in accounting for certain hedging transactions, net of tax of ($1,150) and $0, respectively(1)		(1,808		)	—
Unrecognized (losses) gains on currency contracts, net of tax of $125 and ($198), respectively		564			(306		)
Reclassification adjustment for recognized gains (losses) on currency contracts, net of tax of ($851) and ($1,529), respectively		(1,338		)	(2,363		)
Foreign currency translation adjustment		(1,483		)	1,220
Total comprehensive income (loss)		$	(18,523	)	$	30,716

(1)    See Note 11 for further explanation.

 

7.                       EARNINGS (LOSS) PER SHARE

 

The Company computes basic earnings per share using the weighted-average number of common shares outstanding during the period. The Company computes diluted earnings per share using the weighted-average number of common shares and dilutive stock options outstanding under the treasury stock method.

 

The table below reconciles the weighted-average common shares used to calculate basic net income per share to the weighted-average common shares used to calculate diluted net income per share.

 

		THREE MONTHS ENDED JANUARY 31,
		2005		2004
		(in thousands)
Weighted-average common shares for basic net income (loss) per share		146,060		156,316
Weighted-average dilutive stock options outstanding under the treasury stock method		—		9,548
Weighted-average common shares for diluted net income (loss) per share		146,060		165,864

 

The effect of dilutive stock options outstanding excludes approximately 41.4 million and 0.8 million stock options for the three months ended January 31, 2005 and 2004, respectively, which were anti-dilutive for net income (loss) per share calculations. No stock options were considered dilutive for the three months ended January 31, 2005 due to the net loss for such period.

 

8.                       STOCK-BASED COMPENSATION

 

           As permitted by Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, the Company has elected to use the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, to measure compensation expense for stock-based awards to employees. Accordingly, the Company generally recognizes no compensation expense with respect to stock-based awards to employees as awards are issued with exercise prices equal to the fair value of the common stock on the grant date. The Company reports pro forma information regarding net income and earnings per share as if the Company had accounted for employee stock awards under the fair value method as required by SFAS No. 123, as amended by Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation—Transition and Disclosure. The fair value of these stock-based awards to employees was estimated using the Black-Scholes option pricing model, assuming no expected dividends.  The weighted-average expected life, risk-free interest rate and volatility for the three months ended January 31, 2005 and 2004 are comparable to those for the fiscal year ended October 31, 2004.

 

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The Company’s unaudited pro forma net income and earnings per share data under SFAS 123 are as follows:

 

		THREE MONTHS ENDED JANUARY 31,
		2005			2004
		(in thousands, except per share amounts)
Net income (loss), as reported		$	(14,325	)	$	32,152
Stock-based employee compensation included in net income		577			1,141
Stock-based employee compensation expense determined under the fair value method for all awards, net of tax		(20,288		)	(22,164		)
Pro forma net income (loss) under SFAS 123		$	(34,036	)	$	11,129
Earnings (loss) per share—basic
As reported under APB 25		$	(0.10	)	$	0.21
Pro forma under SFAS 123		$	(0.23	)	$	0.07
Earnings (loss) per share—diluted
As reported under APB 25		$	(0.10	)	$	0.19
Pro forma under SFAS 123		$	(0.23	)	$	0.07

 

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123R) which Synopsys will be required to follow beginning in its fourth quarter of fiscal 2005. SFAS 123R will result in the recognition of substantial compensation expense relating to our employee stock options and employee stock purchase plans. The Company currently uses the intrinsic value method to measure compensation expense for stock-based awards to its employees. As noted above, the Company generally does not recognize any compensation related to stock option grants the Company issues under its stock option plans or related to the discounts the Company provides under its employee stock purchase plans. Under the new rules, the Company is required to adopt a fair-value-based method for measuring the compensation expense related to employee stock awards; this will lead to substantial additional compensation expense and therefore will have a material adverse effect on the Company’s reported results of operations. The table above provides the pro forma net income (loss) and earnings (loss) per share as if the Company had used a fair-value-based method similar to one of the methods permitted under SFAS 123R to measure the compensation expense for employee stock awards during the three-month periods ended January 31, 2005 and 2004.

 

9.               SEGMENT DISCLOSURE

 

Statement of Financial Accounting Standards No. 131 (SFAS 131), Disclosures about Segments of an Enterprise and Related Information, requires disclosures of certain information regarding operating segments, products and services, geographic areas of operation and major customers. SFAS 131 reporting is based upon the “management approach.” Under this method, management organizes the Company’s operating segments for which separate financial information is (i) available and (ii) evaluated regularly by the Chief Operating Decision Maker (CODM) in deciding how to allocate resources and in assessing performance. Synopsys’ CODMs are the Company’s Chief Executive Officer and Chief Operating Officer.

 

The Company provides software, intellectual property and consulting services to the semiconductor and electronics industries. In making operating decisions, the CODMs primarily consider consolidated financial information, accompanied by disaggregated information about revenues by geographic region and product platform. The CODMs have determined that the Company operates in a single segment.

 

Revenue and property and equipment, net, related to operations in the United States and other geographic areas were:

 

		THREE MONTHS ENDED JANUARY 31,
		2005			2004
		(in thousands)
Revenue:
United States		$	131,670		$	160,128
Europe		36,716			48,238
Japan		46,037			38,604
Asia-Pacific		26,881			38,294
Consolidated		$	241,304		$	285,264

 

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		JANUARY 31, 2005			OCTOBER 31, 2004
		(in thousands)
Property and equipment, net:
United States		$	148,835		$	153,604
Other		24,697			24,551
Consolidated		$	173,532		$	178,155

 

Geographic revenue data for multi-region, multi-product transactions reflect internal allocations and is therefore subject to certain assumptions and to the Company’s methodology.

 

For management reporting purposes, the Company organizes its products and services into five distinct groups: Galaxy Design Platform, Discovery Verification Platform, Intellectual Property, Design for Manufacturing and Professional Service & Other. The Company includes revenue from companies or products it has acquired during the periods covered from the acquisition date through the end of the relevant periods. For presentation purposes, the Company allocates software maintenance revenue to the products to which those support services relate.

 

		THREE MONTHS ENDED JANUARY 31
		2005			2004
		(in thousands)
Revenue:
Galaxy Design Platform		$	142,529		$	179,394
Discovery Verification Platform		52,129			58,795
Intellectual Property		15,345			17,528
Design for Manufacturing		23,458			20,749
Professional Service & Other		7,843			8,798
Consolidated		$	241,304		$	285,264

 

10.                 RELATED PARTY TRANSACTIONS

 

Revenue derived from Intel Corporation and its subsidiaries in the aggregate accounted for approximately 13.0% of the Company’s total revenue for the three months ended January 31, 2005, and 10.6% of the Company’s total revenue for the three months ended January 31, 2004. Andy D. Bryant, Intel Corporation’s Executive Vice President and Chief Financial and Enterprise Services Officer, also serves on the Company’s Board of Directors. Management believes all transactions between the two parties were carried out on an arm’s length basis.

 

11.         OTHER INCOME (EXPENSE)

 

The following table presents a summary of other income (expense) components:

		THREE MONTHS ENDED JANUARY 31,
		2005			2004
		(in thousands)
Interest income		$	1,793		$	1,467
Gain (loss) on sale of investments, net of investment write-downs		(1,255		)	(1,360		)
Foreign currency exchange gain		2,233			117
Correction of an error in accounting for certain hedging transactions		2,958			—
Other		(530		)	(1,293		)
Total		$	5,199		$	(1,069	)

 

In the first quarter of fiscal 2005, the Company reevaluated its interpretation of certain provisions of Statement of Financial Accounting Standards No. 133, Accounting for Derivatives and Hedging (SFAS 133), resulting in the discovery of an error in the application of the standard to certain prior year foreign currency hedge transactions. The effect of the error was not material in any prior period and did not impact the economics of the Company’s hedging program. To correct the error, the Company has reclassified the remaining $3.0 million related to the disallowed hedges from accumulated other comprehensive loss to other income in the three months ended January 31, 2005.

 

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12.  CONTINGENCIES

 

On August 25, 2004, a class action complaint entitled Kanekal v. Synopsys, Inc., et al., No. C-04-3580, was filed in federal district court for the Northern District of California against Synopsys and certain of our officers alleging violations of the Exchange Act. The complaint purports to be a class action lawsuit brought on behalf of persons who acquired Synopsys stock during the period December 3, 2003 through August 18, 2004. The complaint alleges that the individual defendants caused Synopsys to make false and misleading statements about Synopsys’ business, forecasts and financial performance, and that certain Synopsys officers or employees sold portions of their stock holdings while in the possession of material, adverse,  non-public information. The complaint does not specify the amount of damages sought. In November 2004, the Court appointed a lead plaintiff in the case.  In January 2005, the lead plaintiff, the Wu Group, filed an amendment complaint.  Discovery has not commenced in the case and no trial date has been established. While management intends to defend against these federal securities claims vigorously, and Synopsys does not believe that this lawsuit will have a material effect on Synopsys’ financial position, results of operations or cash flows, there can be no assurance as to the ultimate disposition of this lawsuit. No amount has been accrued as a loss is not considered probable or estimable.

 

13. PROPOSED BUSINESS COMBINATION TRANSACTION

 

On November 30, 2004, Synopsys signed a merger agreement to acquire Nassda Corporation in an all-cash transaction for a purchase price of $7.00 per share. The aggregate consideration is approximately $192 million. At September 30, 2004, Nassda reported cash, cash equivalents and short-term investments of $101.4 million. The transaction is subject to customary regulatory approvals and other closing conditions. In addition, the approval of Nassda’s stockholders holding a majority of the outstanding shares of Nassda common stock and approval of the holders of a majority of the outstanding shares of Nassda common stock casting votes affirmatively or negatively on the merger agreement (excluding Nassda’s officers and directors, the individual defendants and the related parties of the individual defendants) is required for Nassda and Synopsys to complete the proposed merger. Certain directors, officers and employees of Nassda who own in the aggregate approximately 60% of Nassda’s outstanding common shares have agreed to vote in favor of the adoption and approval of the merger agreement. Upon the closing of the acquisition, the Nassda officers,  directors and employees who are defendants in litigation between Synopsys and Nassda will make settlement payments to Synopsys in the aggregate amount of approximately $61 million.

 

On January 10, 2005, Synopsys announced that the Federal Trade Commission had requested additional information and documentary material in connection with its review of the transaction. Synopsys is currently responding to such request and currently expects the transaction to close during its third fiscal quarter.

 

On December 1, 2004, a class action complaint entitled Robert Israel v. Nassda Corporation, et. al., No. 4705695, was filed in the Court of Chancery of the State of Delaware naming Nassda, its directors and Synopsys as defendants.  The complaint purports to be a class action lawsuit brought on behalf of shareholders of Nassda, other than the defendant directors and their affiliates, who allegedly would be injured or threatened with injury if the proposed acquisition of Nassda by Synopsys proceeded forward on the terms announced. The purported class action seeks to enjoin the transaction, or alternatively, damages. The complaint does not specify the amount of damages sought. Synopsys believes the claims in this purported class action are without merit, and intends to defend against them vigorously.

 

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

 

The following discussion of our financial condition and results of operations should be read together with our unaudited condensed consolidated financial statements and the related notes thereto contained in Item 1 of this report. This discussion contains forward-looking statements. Our actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties,  including the risk factors set forth in this discussion, especially under the caption “Factors that May Affect Future Results,” and elsewhere in this Form 10-Q. The words “may,” “will,” “could,” “would,” “anticipate,”  “expect,” “intend,” “believe,” “continue,” or the negatives of such terms,  or other comparable terminology and similar expressions identify these forward-looking statements. The information included herein is as of the filing date of this Form 10-Q with the Securities and Exchange Commission  (SEC) and future events or circumstances could differ significantly from these forward-looking statements. Accordingly, we caution readers not to place undue reliance on such statements.

 

           Synopsys is a world leader in electronic design automation (EDA) software for semiconductor design. We deliver technology-leading semiconductor design and verification software platforms and integrated circuit (IC) manufacturing software products to the global electronics market, enabling the development and production of complex systems-on-chips (SoCs). We also provide intellectual property (IP) and professional design services to simplify the design process and accelerate time-to-market for our customers.

 

           Business Environment

 

           We generate substantially all of our revenue from the semiconductor and electronics industries. Our customers typically fund purchases of our software and services out of their research and development (R&D) budgets. As a result, our customers’ business outlook and willingness to invest in new, and increasingly complex, chip designs heavily influence our business.

 

           Beginning in late calendar 2000, the semiconductor industry experienced its steepest and longest downturn of the past 20 years. Semiconductor industry sales dropped approximately 46% from late 2000 to early 2002 and then recovered slowly into 2003. Throughout this period, our customers took many steps to reduce their expenses, including constraining R&D expenditures, reducing the number of design engineers they employed, cutting back on their design starts, purchasing from fewer suppliers, and requiring more favorable pricing, payment and license terms from those suppliers, as well as pursuing consolidation within their own industry. Further, during this downturn, many semiconductor design companies failed or were acquired and the pace of investment in new companies declined.

 

           The Semiconductor Industry Association reported semiconductor industry growth of approximately 18% in 2003 and 29% in 2004. Historically, growth in semiconductor sales has been followed by growth in semiconductor R&D spending, which in turn has led to growth in EDA expenditures. We estimate R&D spending among large semiconductor companies increased approximately 10% from 2003 to 2004. However, the relationship of R&D spending and EDA spending is not precise, and in the past there has been a lag of several quarters between an upturn in semiconductor industry sales and EDA spending growth. By the end of our third fiscal quarter of 2004, however, it became clear that EDA spending growth was not tracking the upturn in the semiconductor industry.

 

           We believe EDA spending has not tracked the industry’s recovery for a number of reasons. First, in light of the severity of the 2000-2002 downturn, we believe customers’ intense focus on expense reduction continued even after the downturn ended, and that, as a result, they now generally approach spending more conservatively. Second, the consumer electronics market, where product price is a primary competitive factor, has been a key driver of the semiconductor industry’s recovery.  This factor has further increased pressure on our customers to control costs, including by limiting their EDA spending.

 

           In addition to these broader trends, we believe our customers turned more cautious about their own business outlook in mid-calendar 2004 due to a number of factors, including lack of visibility into their own future results, unexpected inventory buildup in the semiconductor supply chain and concerns about the industry’s growth prospects in 2005.  These developments materially and adversely affected both our bookings and revenue for the third quarter and full-year fiscal 2004.  Our orders for fiscal 2004 were $956 million, down from $1.37 billion in fiscal 2003, and our revenue, particularly impacted by our customers' increasing unwillingness to agree to the shorter payment terms we require to recognize upfront revenue, was $1.09 billion in fiscal 2004 compared to $1.18 billion in fiscal 2003.

 

           Following the third quarter of fiscal 2004, we re-evaluated customer demand for upfront licenses. Recognizing our customers’ increased preference for conserving cash by paying for licenses over time rather than upfront, effective in the fourth quarter of fiscal 2004 we shifted our target license mix to consist almost entirely of time-based licenses, in which customers typically pay the license fee ratably over the term of the license. As a result, and consistent with our goal of booking substantially all of our licenses as time-based licenses,  upfront licenses constituted approximately 7% of our license orders in the fourth quarter of fiscal 2004, and approximately 3% of our license orders in the first quarter of fiscal 2005, compared to an average of approximately 24% since our original introduction of time-based licenses in August 2000.

 

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           This shift to predominantly time-based licenses negatively impacted revenue, earnings and cash flow from operations in the fourth quarter of fiscal 2004 and revenue and earnings in the first quarter of fiscal year 2005.  In addition, we expect revenue, earnings and cash flow from operations for the second and third quarters and full-year fiscal 2005 under our new model to be below the comparable periods in fiscal 2004 under the old, higher upfront model. However, we believe this model shift meets our customers’ needs, improves the predictability of our business and helps preserve the value of our technology by reducing the need to book a given license or licenses at the end of a quarter in order to generate current quarter revenue.

 

           We continue to believe that, over the long-term, growth in EDA spending will continue to depend on growth in semiconductor R&D spending and on continued growth in the overall semiconductor market. The Semiconductor Industry Association has forecasted flat semiconductor revenues in 2005 and modest growth in 2006. With this measured industry outlook, we believe EDA customers will continue to spend with caution and to focus intently on cost controls, contributing to a similarly flat environment for spending on EDA products. Accordingly, and with our license model shift and our expectation of a relatively low level of major customer license renewals in fiscal 2005 based on scheduled renewal dates, we expect our revenue, earnings and cash flow from operations for fiscal 2005 to be below fiscal 2004.

 

           Synopsys is under no obligation (and expressly disclaims any such obligation) to update or alter any of the information contained in this Overview, whether as a result of new information, future events or otherwise.

 

Product Developments for the Three Months Ended January 31, 2005

 

During the first quarter of fiscal 2005, we announced or introduced a number of new products and related developments, including:

 

•                                        Successful achievement of the 100^th tape out of a 90-nanometer IC by customers using our Galaxy Physical products, an industry first.

 

•                                        Availability of the industry’s first Verification Intellectual Property (VIP) suite for the AMBA^TM 3 AXI protocol, the de facto standard interface used in hundreds of embedded processor-based designs, improving designers’ verification efficiency.

 

•                                        Expanded support for the Galaxy^TM Design and Discovery^TM Verification platforms when running on industry-leading processor platforms.

 

•                                        Collaboration with leading EDA and semiconductor companies to deliver a comprehensive low-power, energy-efficient processor solution.

 

Financial Performance for the Three Months Ended January 31, 2005

 

•                                                 Our book-to-bill ratio in the first quarter was approximately 1.8 to 1, compared to between 0.5 and 0.6 to 1 in the first quarter of fiscal 2004, driven by a major North American customer renewal during the quarter and healthy orders activity in the Asia-Pacific region.

 

•                                                 Revenue was $241.3 million, down 15% from $285.3 million for the three months ended January 31, 2004, primarily due to the shift to an almost completely ratable license model during the fourth quarter of fiscal 2004, which significantly reduced both upfront license fees and maintenance revenue.

 

•                                                 Upfront license revenue declined 82% from $59.5 million in the first quarter of fiscal 2004 to $10.8 million in the current quarter, primarily due to the license model shift we commenced in the fourth quarter of fiscal 2004. Time-based license revenue increased 9% from $170.6 million in the first quarter of fiscal 2004 to $186.3 million in the current quarter, primarily reflecting recognition of revenue on time-based orders booked in prior periods. We believe our new, more ratable license model will provide a more predictable license revenue stream.

 

•                                                 For the quarter, we derived approximately 5% of our software revenue from upfront licenses and 95% from time-based licenses, versus approximately 26% and 74%, respectively, for the first quarter of fiscal 2004, reflecting the shift from upfront licenses to time-based licenses in the fourth quarter of fiscal 2004. Also as a result of this shift, during the first quarter, approximately 91% of our revenue was derived from backlog attributable to prior period time-based license bookings.

 

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•                                                 Maintenance revenue declined by 20% from $45.2 million in the first quarter of fiscal 2004 to $36.2 million, driven by the lower level of upfront orders under the new license model (which led to a lower level of new maintenance orders since maintenance is included with the license fee in time-based licenses and not reported separately) and by non-renewal of maintenance by certain existing perpetual license customers.

 

         •                                                Professional service and other revenue, at $8.0 million, decreased 20% from $10.0 million for the first quarter of fiscal 2004 due to the timing of formal customer acceptance of performance milestones under ongoing contracts.

 

•                                               Net loss was $(14.3) million compared to net income of $32.2 million in the first quarter of fiscal 2004, primarily due to  decreased upfront revenue resulting from our license model transition, higher cost of revenue to support increased field support headcount, increased sales commission expense driven by higher shipments and the in-process research and development charge relating to the acquisition of ISE Integrated Systems Engineering AG (ISE), partially offset by an increase in other income.

 

                •                                               Cash provided by operations was $142.1 million compared to $11.3 million for the first quarter fiscal 2004, driven primarily by strong cash collections on time-based licenses booked during the quarter.

 

        •                                                 We repurchased 2.3 million shares of our common stock in the first quarter for approximately $40.2 million.

 

Acquisitions in the Three Months Ended January 31, 2005

 

On November 2, 2004, we completed our acquisition of ISE, enhancing our TCAD software offerings.  The results of operations of ISE are included in our unaudited condensed consolidated statement of operations since the acquisition date. 

 

Also on November 2, 2004, we announced the acquisition of certain assets of LEDA Design, a developer of mixed-signal intellectual property (IP), which will help Synopsys meet increasing customer demand for IP solutions.

 

Critical Accounting Policies

 

           We base the discussion and analysis of our financial condition and results of operations upon our audited consolidated financial statements, which we prepare in accordance with accounting principles generally accepted in the United States of America. In preparing these financial statements, we must make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates based on historical experience and various other assumptions we believe are reasonable under the circumstances. Our actual results may differ from these estimates.

 

           The accounting policies that most frequently require us to make estimates and judgments, and therefore are critical to understanding our results of operations, are:

 

•               Revenue recognition;

 

•               Valuation of intangible assets and goodwill;

 

•               Income taxes; and

 

•               Allowance for doubtful accounts.

 

Revenue Recognition.  We have designed and implemented revenue recognition policies in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended.

 

           With respect to software sales, we utilize three license types:

 

•               Technology Subscription Licenses (TSLs) are for a finite term, on average approximately three years, and generally provide the customer limited rights to receive, or to exchange certain quantities of licensed software for, unspecified future technology. Maintenance is bundled for the term of the license and not purchased separately.

 

•               Term Licenses are also for a finite term, usually three years, but do not provide the customer any rights to receive, or to exchange licensed software for, unspecified future technology. Customers purchase maintenance separately for the first year and may renew annually for the balance of the term. The annual maintenance fee is typically calculated as a percentage of the net license fee.

 

•               Perpetual Licenses, which continue as long as the customer renews maintenance, plus an additional 20 years. Perpetual licenses do not provide the customer any rights to receive, or to exchange licensed software for, unspecified future technology. Customers purchase maintenance separately for the first year and may renew annually. The annual maintenance

 

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fee for purchases under $2 million is typically calculated as a percentage of the list price of the licensed software. For purchases over $2 million, the annual maintenance fee is typically calculated as a percentage of the net license fee.

 

           Our customers often renew their TSLs and term licenses with us prior to, and sometimes well before, expiration of the original license. In a renewal transaction, we may either replace the pre-existing arrangement with an entirely new arrangement or maintain two agreements. Where we replace the existing agreement, we often supersede the original arrangement and thereafter deliver software and recognize revenue based upon the type of license reflected in the new agreement. Where we maintain two agreements, we recognize revenue on the new incremental agreement based upon the new license type purchased. If we grant extended payment terms (as discussed below), we recognize license revenue as payments become due and payable.

 

           Customers occasionally convert their existing TSLs to perpetual licenses, paying an incremental fee which we recognize upon contract signing in accordance with AICPA Technical Practice Aid (TPA) 5100.73, assuming all other revenue recognition criteria have been met. In some situations, the contract converting the TSL to a perpetual license is modified to such an extent that a new arrangement exists. The changes to the contract may include increases or decreases in the total technology under license, changes in payment terms, changes in license terms and other pertinent factors. In these situations, we account for the entire arrangement fee as a new sale and recognize revenue when all other revenue recognition criteria have been met.

 

           We report revenue in three categories: upfront license, time-based license and maintenance and service.

 

           Upfront license revenue includes:

 

•               Perpetual licenses. We recognize the perpetual license fee in full if, upon shipment of the software, payment terms require the customer to pay a substantial portion of the perpetual license fee within one year from shipment and all other revenue recognition criteria are met.

 

•               Upfront term licenses. We recognize term license fees in full if, upon shipment of the software, payment terms require the customer to pay a substantial portion of the term license fee within one year from shipment and all other revenue recognition criteria are met.

 

           Time-Based License (TBL) revenue includes:

 

•               Technology Subscription Licenses. We typically recognize revenue from TSL license fees (which include bundled maintenance) ratably over the term of the license period. However, where we offer extended payment terms (i.e., where a substantial portion of the arrangement fee is due after one year from shipment), we recognize revenue from TSLs in an amount equal to the lesser of the ratable portion of the entire fee or customer installments as they become due and payable.

 

•               Term and Perpetual Licenses with Extended Payment Terms. For term licenses and perpetual where less than a substantial portion of the term license fee is due within one year from shipment, we recognize revenue as customer installments become due and payable.

 

           Maintenance and service revenue includes:

 

•               Maintenance Fees Associated with Perpetual and Term Licenses. We generally recognize revenue from maintenance associated with perpetual and term licenses ratably over the maintenance term.

 

•               Professional Service Fees. We generally recognize revenue from consulting and training services as services are performed and accepted.

 

           We allocate revenue on software transactions (referred to as “arrangements”) involving multiple elements to each element based on the respective fair values of the elements. Our determination of fair value of each element is based on vendor-specific objective evidence (VSOE). We limit our assessment of VSOE for each element to the price charged when the same element is sold separately.

 

           We have analyzed all of the elements included in our multiple-element arrangements and determined that we have sufficient VSOE to allocate revenue to the maintenance components of our perpetual and term license products and to consulting. Accordingly, assuming all other revenue recognition criteria are met, we recognize revenue from perpetual and term licenses upon delivery using the residual method in accordance with SOP 98-9, recognize revenue from maintenance ratably over the maintenance term and recognize consulting revenues as the related services are performed.

 

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           We make significant judgments related to revenue recognition. Specifically, in connection with each transaction involving our products, we must evaluate whether (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) our fee is fixed or determinable, and (iv) collectibility is probable. We apply these criteria as discussed below.

 

•               Persuasive Evidence of an Arrangement Exists. Our customary practice is to have a written contract, signed by both the customer and us, or a purchase order from those customers that have previously negotiated a standard end-user license arrangement or volume purchase agreement with us prior to recognizing revenue on an arrangement.

 

•               Delivery Has Occurred. We deliver software to our customers physically or electronically. For physical deliveries, our standard transfer terms are typically FOB shipping point. For electronic deliveries, delivery occurs when we provide the customer access codes or “keys” that allow the customer to take immediate possession of software.

 

•               The Fee is Fixed or Determinable. Our determination that an arrangement fee is fixed or determinable depends principally on the arrangement’s payment terms. Our standard payment terms require that 75% or more of the arrangement fee be paid within one year. Where these terms apply, we regard the fee as fixed or determinable, and we recognize revenue upon delivery (assuming all other revenue recognition criteria are met). If the payment terms do not meet this standard, we do not consider the fee to be fixed or determinable and generally recognize revenue when customer installments are due and payable. In the case of a TSL, we recognize revenue ratably even if the fee is fixed or determinable, due to application of other revenue accounting guidelines relating to maintenance services and arrangements that include rights to unspecified future technology.

 

•               Collectibility is Probable. To recognize revenue, we must judge collectibility of the arrangement fees, which we do on a customer-by-customer basis pursuant to our credit review policy. We typically sell to customers with whom we have a history of successful collection. For a new customer, we evaluate the customer’s financial position and ability to pay and typically assign a credit limit based on that review. We increase the credit limit only after we have established a successful collection history with the customer. If we determine at any time that collectibility is not probable based upon our credit review process or the customer’s payment history, we recognize revenue on a cash-collected basis.

 

Description of Other Critical Accounting Policies. Other than our revenue recognition policy, which is summarized above, our critical accounting policies reflecting these estimates and judgments are described in Part II, Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the fiscal year ended October 31, 2004, filed with the SEC on January 12, 2005. We have not changed those policies since such date. Investors should therefore read this Item 2 in conjunction with such description.

 

Results of Operations

 

Revenue Background

 

           We generate our revenue from the sale of software licenses, maintenance and professional services. Under the accounting rules and policies applicable to different kinds of licenses, orders we receive for software licenses and services turn into revenue on our income statement at varying rates. In general, orders for software licenses turn to revenue either at the time the license is shipped (an “upfront license”), or ratably over the term of the license (a “time-based license, or “TBL”; substantially all of our time-based licenses are technology subscription licenses, or “TSLs”). Maintenance orders generally turn to revenue ratably over the maintenance period, and professional service orders generally turn to revenue upon completion and acceptance of contractually agreed upon milestones. A more complete description of our revenue recognition policies can be found above under Critical Accounting Policies.

 

           Our revenue in any fiscal quarter is equal to the sum of our upfront license revenue, time-based license revenue, maintenance revenue and professional service revenue. Upfront license revenue generally depends on the volume of upfront license orders shipped during the quarter. Time-based license revenue in any quarter is derived almost entirely from TSL orders received and delivered in prior quarters; since our TSL orders generally yield revenue ratably over a typical term of three years, a TSL order contributes at most one-twelfth of its aggregate booking value into revenue in the quarter it is booked. Maintenance revenue in any quarter is similarly derived largely from maintenance orders received in prior quarters since our maintenance orders generally yield revenue ratably over a typical term of one year. Finally, Professional Service revenue is also derived almost entirely from orders received in prior quarters, since we recognize revenue from professional services when those services are rendered and accepted, not when they are booked. Any order or portion thereof that does not turn to revenue in the quarter in which it is received is added to our backlog and generally recognized in future periods.

 

           Given the different revenue impacts of upfront licenses compared to TSLs, in any given fiscal quarter our license revenue is very sensitive to the mix of upfront and time-based licenses delivered during the quarter. A TSL order results in significantly lower current-period revenue than an equal-sized order for an upfront license. Conversely, a TSL order will result in higher revenue recognized in future periods than an equal-sized order for an upfront license. For example, on a $120,000 order for an upfront license, we recognize $120,000

 

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of revenue in the quarter the product is shipped and no revenue in future quarters. On a $120,000 order for a three-year TSL shipped on the last day of the quarter, we recognize no revenue in the quarter the product is shipped and $10,000 in each of the twelve succeeding quarters. TSLs also shift maintenance revenue to time-based license revenue since maintenance is included in TSLs.

 

           License Order Mix

 

           The percentage of upfront licenses we book is driven by a number of factors, including the level of overall license orders, customer demand, preferred customer payment terms and requested customer ship dates. Beginning in August 2000, when we adopted TSLs, we maintained a target license mix of approximately 75% TSLs and 25% upfront licenses, based on our expectations of total orders and our assessment of the demand for upfront licenses. As a result of reduced customer demand for upfront licenses in fiscal 2004 as described above in “Business Environment,” we shifted to an almost completely time-based license model. Our actual license order mix for the last nine fiscal quarters is set forth below.

 

		Q1- 2005		Q4- 2004		Q3- 2004		Q2- 2004		Q1- 2004		Q4- 2003		Q3- 2003		Q2- 2003		Q1- 2003
Upfront licenses		3	%	7	%	20	%	42	%	57	%	33	%	21	%	26	%	15	%
Time-based license		97	%	93	%	80	%	58	%	43	%	67	%	79	%	74	%	85	%

 

           Our upfront term and time-based license agreements sometimes provide the right to re-mix a portion of the software initially subject to the license for other Synopsys products. The customer’s re-mix of product, when so provided in the specific license arrangement, does not alter the timing of recognition of the license fees paid by the customer. However, because in such cases the customer need not obtain a new license and pay an additional license fee for the use of the additional products, the use of these arrangements could result in reduced revenue compared to licensing the individual products separately.

 

           Total Revenue

 

Three Months Ended January 31,						$			%
2005			2004			Change			Change
(dollars in millions)
$	241.3		$	285.3		$	(44.0	)	(15	)%

 

 

            The decrease in total revenue for the current quarter compared to the comparable quarter in fiscal 2004 was due primarily to our shift to an almost completely ratable license model in the fourth quarter of fiscal 2004, which significantly reduced both upfront license fees and maintenance revenue in the current quarter. As a result of this shift, we expect total reported revenue under the more ratable model for the second and third quarters and full fiscal year 2005 to be below the comparable periods in fiscal 2004.

 

           Time-Based License Revenue

 

		January 31,						$			%
		2005			2004			Change			Change
		(dollars in millions)
Three months ended		$	186.3		$	170.6		$	15.7		9	%
Percentage of total revenue		77		%	60		%

 

           The increase in time-based license revenue in the three months ended January 31, 2005 compared to the same period during fiscal 2004 was primarily due to our ratable license model under which orders booked in prior quarters contribute to revenue in subsequent periods. Although total bookings during fiscal 2004 (a main driver of time-based revenue in the three months ended January 31, 2005) were below total bookings in fiscal 2003, deferred revenue from orders booked in prior periods caused the increase in time-based revenue for the quarter. The increase in the percentage of total revenue comprised of time-based revenue rose as a result of the increase in time-based revenue in the quarter and the decrease in total revenue for the quarter compared to the same period in fiscal 2004.

 

           With our shift in the fourth quarter of fiscal 2004 to an almost completely ratable license model, we expect an additional phase-in period during which our time-based license revenue should continue to increase in both dollar terms and as a percentage of total revenue, even if the overall level of TBL orders does not grow, and could increase even if the overall level of TBL orders in any period declines. Over the long term, as we complete this further transition, we expect time-based license revenue to more closely track time-based license orders trends.

 

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           Upfront License Revenue

 

		January 31,						$			%
		2005			2004			Change			Change
		(dollars in millions)
Three months ended		$	10.8		$	59.5		$	(48.7	)	(82	)%
Percentage of total revenue		5		%	21		%

 

                The decrease in upfront license revenue for the three months ended January 31, 2005 compared to the same period in fiscal 2004 was primarily due to the shift to a higher ratable license mix in the fourth quarter of fiscal 2004 and to the fact that Synopsys booked a substantially higher-than-average percentage of its orders as upfront licenses in the prior year period.  The percentage of total revenue comprised of upfront licenses fell significantly for the same reasons. Finally, as a result of the license model shift, we expect upfront revenue in fiscal 2005 to continue to be significantly below prior periods in fiscal 2004 in both dollar terms and as a percentage of total revenue.

Unfilled upfront license orders were approximately $6.6 million at January 31, 2005 compared to $8.0 million as of January 31, 2004. Unfilled upfront license orders represent non-cancelable license orders that have been received from our customers for the license of our software products but were not shipped as of the end of the applicable fiscal period. We generally ship our software products within 10 days after acceptance of customer orders. In certain cases, we have limited discretion over the timing of product shipments, which can affect the timing of revenue recognition for software license orders. In those cases, we consider a number of factors, including: the delivery dates requested by customers; the effect of the related license revenue on our business plan; the amount of upfront software license orders received in the quarter; the amount of upfront software license orders shipped in the quarter; the degree to which upfront software license orders received are concentrated at the end of a quarter; and our operational capacity to fulfill upfront software license orders at the end of a quarter.

 

           Maintenance and Service Revenue

 

		January 31, 2005			January 31, 2004			$			%
								Change			Change
		(dollars in millions)
Three months ended
Maintenance revenue		$	36.2		$	45.2		$	(9.0	)	(20	)%
Professional service and other revenue		8.0			10.0			(2.0		)	(20	)%
Total service revenue		$	44.2		$	55.2		$	(11.0	)	(20	)%
Percentage of total revenue		18		%	19		%

 

           Our maintenance revenue declined due to (i) the continued shift towards TSLs, which include maintenance with the license fee and thus contribute no separately recognized maintenance fees, (ii) non-renewal of maintenance by certain customers and, (iii) to a lesser extent, the pricing of maintenance on perpetual license transactions above $2 million, which is substantially lower than the rates on standard perpetual licenses. With our license model shift, we expect more of our maintenance revenue to be included in our overall TSL revenue, and therefore for our separately recognized maintenance revenue to continue to decline. In addition, some customers may choose in the future not to renew maintenance on perpetual licenses for economic or other factors, which would have an adverse effect on future maintenance revenue.

 

           Professional service and other revenue decreased approximately 20% during the three months ended January 31, 2005 compared to the same period during fiscal 2004 due primarily to the timing of formal customer acceptance of performance milestones under ongoing projects. Because recognition of professional service revenue depends upon completion of contract milestones, customer schedules and other contract terms, professional service revenue is likely to fluctuate from quarter to quarter. We expect capacity constraints, which have constrained our professional service revenue growth in the past, to continue to limit professional service bookings growth during the remainder of fiscal 2005.

 

           Total maintenance and service revenue as a percentage of total revenue was relatively stable compared to the three months ended January 31, 2004 due to the fact that total maintenance and service revenue decreased by a similar percentage as the decrease in total revenue for the quarter.

 

                Revenue—Product Groups. For management reporting purposes, we organize our products and services into five groups: Galaxy Design Platform, Discovery Verification Platform, Intellectual Property (IP), Design for Manufacturing and Professional Service & Other.

 

Galaxy Design Platform. Our Galaxy Design Platform includes our logic synthesis, physical synthesis, physical design, timing analysis, signal integrity analysis and physical verification products, as well as certain analog and mixed-signal tools. Our

 

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principal products in this category are the Design Compiler^® synthesis product, Physical Compiler^® physical synthesis tool, Module CompilerÔ data path design product, Power CompilerÔ power management product, DFT CompilerÔ design for test tool, JupiterXTÔ design planning product, Apollo^™ and Astro^™ place and route products, PrimeTime^®/PrimeTime^® SI timing analysis products, Tetra Max^® test pattern generation product family, Star RXCTÔ extraction product and Hercules^™ physical verification tool, as well as our MilkywayÔ common design data repository.  We believe physical design and design analysis products will account for an increasing share of Galaxy Design Platform revenue relative to our logic synthesis products as customers recognize the importance of using physical level design and analysis tools to address challenges particular to small geometry designs.

 

Discovery Verification Platform. Our Discovery^™ Verification Platform includes our verification and simulation products. Our principal products in this category are the VCS^® functional verification product, System Studio™ system level design product, Vera^® testbench generator, LEDA™ design rule checker, Formality^® formal verification solution, Magellan^™ hybrid formal verification product, NanoSim^® simulation and analysis product,  HSPICE^® circuit simulator and our reusable verification IP. The Discovery Platform also includes Discovery AMS, a subset of our verification technologies optimized to perform verification on analog and mixed-signal designs.

 

Intellectual Property (IP). Our IP solutions include our DesignWare^® Foundation Library of basic chip elements, DesignWare Verification Library of chip function models and DesignWare Cores, pre-designed and pre-verified digital and mixed-signal design blocks that implement many of the most important industry standards, including USB (1.1, 2.0 and On-the-Go), PCI (PCI, PCI-X and PCI-Express) and JPEG.

 

Design for Manufacturing (DFM). Our Design for Manufacturing products and technologies address the mask-making and yield enhancement challenges of very small geometry ICs and include our TCAD device modeling products, Proteus™/InPhase optical proximity correction products, phase-shift masking technologies, SiVL^® layout verification product, CATS^® mask qualification product and Virtual Stepper^® mask qualification product.

 

Professional Service & Other. Our Professional Services group provides consulting services, including design methodology assistance, specialized systems design services, turnkey design and training.

 

The following table summarizes the revenue attributable to these groups as a percentage of total revenue for the last eight quarters. We include revenue from companies or products we have acquired during the periods covered from the acquisition date through the end of the relevant periods. For presentation purposes, we allocate software maintenance revenue, which represented approximately 15% of our total revenue for the three months ended January 31, 2005 and 2004, to the products to which those support services related.

 

		Q1 2005		Q4- 2004		Q3- 2004		Q2- 2004		Q1- 2004		Q4- 2003		Q3- 2003		Q2- 2003
Galaxy Design Platform		59	%	60	%	61	%	64	%	63	%	62	%	64	%	70	%
Discovery Verification Platform		22		21		21		20		21		22		20		19
IP		6		6		7		6		6		7		8		5
Design for Manufacturing		10		9		7		7		7		5		5		4
Professional Service & Other		3		4		4		3		3		4		3		2
Total		100	%	100	%	100	%	100	%	100	%	100	%	100	%	100	%

 

           The respective revenue contributions from our different groups have been relatively stable over the eight-quarter period shown in the table above. This stability is principally due to the fact that most of our customers purchase multiple products from us, and do so under TSLs, for which revenue is recognized ratably over the term of the license. Accordingly, significant changes in revenue contribution from different groups have been driven primarily by one-time events, such as acquisitions, or by the mix of upfront versus time-based orders received for certain products during a given quarter.

 

           For example, our Galaxy Design Platform revenue as a percentage of total revenue was higher in the second quarter of fiscal 2003 due to a number of large perpetual licenses with our Japanese customers, many of which included a disproportionate amount of products from the Galaxy Design Platform, yielding significant upfront revenue contributions from that product group for that quarter. Similarly, the percentage of revenue from our IP products rose significantly in the third quarter of fiscal 2003 as a result of increased sales of upfront IP licenses during that quarter.

 

           While we expect our TSL licensing model will continue to lessen quarter-to-quarter variations in revenue in the near-term, we believe our IP and Design for Manufacturing products will, over time, account for increasing percentages of total revenue as a result of our customers’ greater acceptance of and reliance upon pre-designed, pre-verified IP components and tools and technologies needed for

 

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the manufacture of very small geometry ICs, as illustrated by the increase in DFM revenue share from the fourth quarter of fiscal 2004 to the first quarter of fiscal 2005.

 

Factors Affecting Cost of Revenues and Operating Expenses

 

Temporary Shutdown of Operations.  During the three months ended January 31, 2005 and January 31, 2004, we temporarily shut down operations in North America for four days and three days, respectively, as a cost-saving measure, resulting in savings as follows:

		THREE MONTHS ENDED JANUARY 31,
		2005			2004
		(in thousands)
Cost of revenue		$	856		$	604
Research and development		1,889			1,372
Sales and marketing		1,169			871
General and administrative		514			423
Total		$	4,428		$	3,270

 

Functional Allocation of Operating Expenses

 

Historically, we allocate certain human resource programs, information technology and facility expenses among our functional income statement categories based on headcount within the functional area. Annually, or upon a significant change in headcount (as in the case of a workforce reduction or realignment) and other factors, management reviews the allocation methodology and the expenses included in the allocation pool. Management conducted such a review with respect to the workforce realignment effective in fiscal 2004. The resulting expense allocations may contribute significantly to fluctuations in individual operating expenses from period to period.

 

Cost of Revenue

 

		JANUARY 31,						DOLLAR			%
		2005			2004			CHANGE			CHANGE
		(dollars in millions)
Three months ended
Cost of license revenue		$	24.9		$	20.3		$	4.6		23	%
Cost of maintenance and service revenue		17.0			15.6			1.4			9	%
Amortization of intangible assets and deferred stock compensation		28.1			25.2			2.9			12	%
Total		$	70.0		$	61.1		$	8.9		14	%
Percentage of total revenue		29		%	21		%

 

 

We divide cost of revenue into three categories: cost of license revenue, cost of maintenance and service revenue and amortization costs.  In the three months ended January 31, 2005, we revised our methodology for allocating and reporting costs of revenue externally to better align costs of revenue with the appropriate revenue categories.  Cost of revenue for the three months ended January 31, 2004 has been reclassified to conform to the new allocation methodology.  Expenses directly associated with providing consulting and training have been segregated from costs of revenue associated with internal functions which provide license delivery and post-customer contract support services.  These group costs are then allocated by management between cost of license revenue and cost of maintenance and service revenue based on revenue reported during the quarter.  In general, our total costs of revenue are relatively fixed and do not fluctuate significantly with changes in revenue or license mix.

 

Cost of license revenue.  Cost of license revenue includes costs associated with the sale and licensing of our software products, both ratable and upfront.  Cost of license revenue includes the allocated cost of employee salary and benefits providing services for software delivery, software production costs, product packaging, amortization of capitalized software development costs related to Synopsys products, documentation and royalties payable to third party vendors.

 

Cost of maintenance and service revenue.  Cost of maintenance and service revenue includes employee salary and benefits for consulting professionals and associated costs to maintain the related infrastructure necessary to manage a services and training organization. Further, cost of maintenance and service revenue includes allocated costs of employee salary and benefits providing customer services, such as hot-line and on-site support, production employees and documentation of maintenance updates.

 

Amortization costs.  See “Amortization of Intangible Assets and Deferred Stock Compensation” below for information regarding the amount of amortization charged to cost of revenue for the relevant periods.

 

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