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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2004

For the transition period from                      to                     

Commission file number: 000-31545

SYNPLICITY, INC.

(Exact name of registrant as specified in its charter)

600 West California Avenue, Sunnyvale, CA 94086

(Address of Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code: (408) 215-6000

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 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 Securities Exchange Act of 1934, as amended). Yes x No ¨

As of August 2, 2004, the registrant had 26,089,483 shares of common stock outstanding.

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SYNPLICITY, INC.

INDEX

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PART I - FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

SYNPLICITY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

The accompanying notes are an integral part of the condensed consolidated financial statements.

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SYNPLICITY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

The accompanying notes are an integral part of the condensed consolidated financial statements.

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SYNPLICITY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of the condensed consolidated financial statements.

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SYNPLICITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1. Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of Synplicity, Inc. and its wholly owned subsidiaries. Intercompany balances and transactions have been eliminated in consolidation. The balance sheet at June 30, 2004 and the statements of operations for the three and six months ended June 30, 2004 and 2003 and the statements of cash flows for the six months ended June 30, 2004 and 2003 are unaudited. In the opinion of management, these condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) that are necessary for a fair presentation of the results for and as of the periods shown. The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States. However, certain information or footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The results of operations for such periods are not necessarily indicative of the results expected for 2004 or for any future period. The condensed consolidated balance sheet information as of December 31, 2003 is derived from audited financial statements as of that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. These financial statements should be read in conjunction with the financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission.

Foreign Currency Translation

The functional currency of our foreign subsidiaries is the U.S. dollar, with the exception of our Japanese subsidiary for which the yen is its functional currency. For our foreign subsidiaries for which the U.S. dollar is the functional currency, assets and liabilities denominated in foreign currencies are translated at the month-end exchange rate, except for non-monetary assets and liabilities such as property and equipment, which are translated at historical rates. Revenue and expenses are translated at the average exchange rate for the period, except for expenses related to those balance sheet items that are translated using historical rates. Adjustments resulting from these translations are included in our results of operations. For our Japanese subsidiary, assets and liabilities are denominated in yen and translated at the month-end exchange rate, and equity balances are translated at historical rates. Revenue and expenses are translated at the average exchange rate for the period. Adjustments resulting from these translations are included in shareholders’ equity.

Revenue Recognition

For each sale of a perpetual license, the first year of maintenance is generally sold with the license. We defer the recognition of license and maintenance revenue until:

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Once all of the above conditions have been met, license revenue is recognized based upon the residual method after all elements other than maintenance have been delivered in accordance with AICPA Statement of Position 98-9, Modification of SOP No. 97-2 with Respect to Certain Transactions. Maintenance revenue is recognized ratably over the maintenance period since customers under maintenance agreements receive unspecified product updates, electronic, internet-based technical support and telephone support throughout their maintenance period, which is typically one year. The majority of our customers also purchase maintenance renewals annually, which, depending on the product, we offer at either 15% or 20% of the list price of the specific product license, and which establishes vendor specific objective evidence (“VSOE”) of the fair value of maintenance.

We also offer two-year and three-year term licenses for certain products under which the customer can purchase the first year of maintenance with the license and can renew maintenance in each of the following one or two years. Revenue from term licenses is recognized in the same manner as revenue from perpetual licenses as VSOE of the fair value of maintenance is established by the maintenance renewal pricing.

We assess whether the fee is fixed or determinable for sales with non-standard payment terms by evaluating our history of collections from these customers and/or their current financial standing. In no case will we deem a fee to be fixed or determinable where the fee is due after the expiration of the license or more than 12 months after delivery. We make judgments as to whether collection of the fee is probable based on the analysis provided by our credit review procedures. Revenue on arrangements to end-user customers that have met all of the revenue recognition criteria except probability of collection is recognized as collection becomes reasonably assured, which is generally as payments are received.

Revenue on sales to distributors is considered to have met the probability of collection criterion when the distributor has resold the product to an end user and either we have received payment for the product or we assess that we have a substantial and sustained history of collections from the distributor.

We also sell time-based licenses to use our software products for specified periods of time. Time-based licenses include maintenance services for the duration of their respective terms. Revenue from time-based licenses is allocated between license and maintenance revenue in similar proportion to perpetual license transactions, and recognized ratably over the period of the license as we do not have VSOE of the fair value of maintenance for time-based licenses since it is not priced or offered separately. In addition, we have provided a version of one of our products to certain field programmable gate array (“FPGA”) manufacturers for distribution to their customers. As part of these agreements we have certain maintenance and support obligations to the FPGA manufacturers. Revenue on these arrangements is also allocated to license and maintenance revenue and recognized ratably over the period of each arrangement, as we do not have VSOE of fair value of maintenance for these arrangements since it is not priced or offered separately.

We have entered into agreements with semiconductor manufacturers LSI Logic Corporation and NEC Electronics Corporation to customize our ASIC synthesis or physical synthesis tools for certain of their products. When licenses are being purchased as part of the agreement, once the contract has been signed, delivery of the customized product has occurred, collection of the fee is probable and we have no remaining obligations, we recognize revenue from both the development and license fees ratably over the period of the licenses since we do not have VSOE of fair value of the licenses. When licenses are not being purchased as part of the agreement, once the contract has been signed, we recognize revenue from the development fees on a percentage of completion basis. Revenue recognized from these arrangements represents less than 10% of total revenue and is recorded in license revenue.

Goodwill and Intangible Assets

In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), goodwill is not amortized but is tested for impairment using a fair value approach. Goodwill is tested for impairment annually during the fourth quarter as well as whenever indicators of impairment exist. In accordance with the provisions of Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), long-lived assets, including intangible assets and property and equipment, are reviewed for impairment whenever events or

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changes in circumstances indicate that their carrying amount may not be recoverable. Recoverability of a long lived asset other than goodwill is measured by comparison of its carrying amount to the expected future undiscounted cash flows that the asset is expected to generate. An impairment charge is recorded if the carrying amount of the asset exceeds the sum of the expected undiscounted cash flows. Any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets. Significant management judgment is required in forecasting future operating results and cash flows and, should different conditions prevail or judgments be made, material write-downs of net intangible assets and/or goodwill could occur. Our intangible assets are being amortized using the straight-line method over the estimated useful life of five years.

Stock-Based Compensation

As permitted by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock Based Compensation-Transition and Disclosure, we have elected the disclosure-only alternative under SFAS 123 and have elected to account for employee stock based compensation in accordance with the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”). Under APB 25, when the exercise price of our employee stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized.

Any deferred stock compensation calculated according to APB 25 is amortized over the vesting period of the individual option, generally four years, using the graded vesting method. The graded vesting method provides for vesting of portions for the overall awards at interim dates and results in greater stock-based compensation expense in earlier years than the straight-line vesting method.

Pro forma information regarding net income (loss) has been determined as if we had accounted for our employee stock options under the fair value method prescribed by SFAS 123 (in thousands, except per share data):

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Guarantees

We generally warrant that the program portion of our software will perform substantially in accordance with certain specifications for a period of 90 days. Our liability for a breach of this warranty is either a return of the license and maintenance fees or providing a fix, patch, work-around or replacement of the software.

We provide standard warranties against and indemnification for the potential infringement of third party intellectual property rights to our customers relating to the use of our products. We also have indemnification agreements with members of our board of directors and certain officers and employees under which we may be required to indemnify such persons for liabilities arising out of their duties to us. Our bylaws also provide for indemnification to directors, officers and employees. The terms of such obligations vary. Generally, the maximum obligation is the amount permitted by law.

Historically, costs related to these guarantees have not been significant and we are unable to estimate the potential impact of these guarantees on our future results of operations. No liabilities were recorded for these guarantees on our balance sheet as of June 30, 2004.

Segment Information

We operate in one segment, the development and licensing of software products that are used in the design and verification of semiconductors. We market and sell our products throughout North America, principally the United States, as well as in Europe, Japan and the rest of Asia.

Note 2. Financial Instruments

Available-for-sale securities consisted of the following at June 30, 2004 (in thousands):

Note 3. Net Income (Loss) Per Share

Basic net income (loss) per share has been computed using the weighted-average number of shares of common stock outstanding during the period, less the weighted-average number of shares of common stock that are subject to repurchase. Diluted net income (loss) per share includes the impact of shares of common stock subject to repurchase and options to purchase common stock, if dilutive (using the treasury stock method).

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The following table presents the calculation of basic and diluted net income (loss) per share (in thousands, except per share data):

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Note 5. Stock Repurchase Program

In May 2004, our Board of Directors authorized a stock repurchase program of up to one million shares of our common stock over a 12 month period. Shares will be repurchased in the open market at times and prices we consider appropriate. The timing of purchases and the exact number of shares to be purchased will depend on market conditions. In accordance with our insider trading policy, we are restricted from repurchasing shares when we are in possession of material inside information and when our trading window closes. From May 2004 to June 30, 2004, we repurchased a total of 38,534 shares at an average price of $6.09 per share. Repurchased shares of our common stock are no longer deemed outstanding.

Note 6. Intangible Assets and Goodwill

The following summarizes our intangible assets as of June 30, 2004 (in thousands):

The following summarizes our actual and estimated amortization expense related to the above intangible assets (in thousands):

To date, we have not recognized any impairment losses on goodwill.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are forward-looking statements. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. These risks and other factors include those listed under “Factors Affecting Future Operating Results” and elsewhere in this Quarterly Report on Form 10-Q. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of these terms or other comparable terminology. Forward-looking statements include, but are not limited to: the statements under “2nd Quarter 2004 Financial Highlights” regarding our future results of operations; the statements under “Critical Accounting Policies and Estimates” regarding the condensed consolidated financial statements included in this Quarterly Report, the recognition of future revenue from the sale of licenses and additional allowances for doubtful accounts; the statements under “Three and Six Months Ended June 30, 2004 and 2003—Cost of revenue” regarding the cost of maintenance revenue; the statements under “Three and Six Months Ended June 30, 2004 and 2003—Operating expenses” regarding future operating expenses; the statements under “Liquidity and Capital Resources” concerning the sufficiency of our available resources to meet cash requirements and the factors which will determine our future cash requirements; and the statements in “Factors Affecting Future Operating Results.” These statements are only predictions. Actual events or results may differ materially. In evaluating these statements, you should specifically consider various factors, including the risks outlined under “Factors Affecting Future Operating Results.” These factors may cause our actual results to differ materially from any forward-looking statement.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform our prior statements to actual results.

You should read the following discussion and analysis in conjunction with our condensed consolidated financial statements and the related notes thereto included in this Quarterly Report on Form 10-Q.

Overview

We operate in one segment, the development and licensing of software products that are used in the design and verification of semiconductors. We market and sell our products throughout North America, principally the United States, as well as in Europe, Japan and other parts of Asia. Our revenue from sales outside North America represented approximately 41% and 42% of our total revenue in the three and six months ended June 30, 2004 respectively, and 41% and 30% of our total revenue in 2003 and 2002, respectively.

Our products include:

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We primarily sell perpetual licenses to use our software products and related maintenance services, and therefore our revenue consists of license and maintenance revenue. Maintenance services include unspecified product updates and electronic, internet-based technical support and telephone support. Historically, we have generated the majority of our total revenue from licenses. We also sell time-based licenses to use our software products, which have represented a growing proportion of total license revenue. Time-based licenses include maintenance services for the duration of their respective terms.

2^nd Quarter 2004 Financial Highlights

In the second quarter of 2004, business conditions in North America were still impacted by the economic downturn in the technology industry, but improved modestly with an increasing number of startups and more companies with available budgets to spend on our tools. Sales in Japan and Europe were solid with increases over both the second quarter of 2003 and the first quarter of 2004, while sales growth in Asia was hindered due to reorganization within our Asia sales force. Maintenance revenue increased over the same quarter last year due to higher maintenance renewal rates this quarter compared to last year and our increased level of business. We also continued to have customers return to active maintenance. We continued to make progress in the cell-based and Structured or Platform ASIC (“Structured ASIC”) markets as bookings for our ASIC synthesis products grew over the same quarter in the prior year. Operating expenses increased from the second quarter of 2003 as we removed cost control measures that were in place in 2003, hired additional employees and incurred higher costs associated with corporate governance compliance. We believe our future results of operations will be dependent on improvement in the North American economy as well as the FPGA business, continued growth in our ASIC synthesis business and continued improvement in our maintenance renewal rate. Financial highlights for the quarter are as follows:

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, and we evaluate these estimates on an on-going basis. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

For each sale of a perpetual license, the first year of maintenance is generally sold with the license. We defer the recognition of license and maintenance revenue until:

Once all of the above conditions have been met, license revenue is recognized based upon the residual method after all elements other than maintenance have been delivered in accordance with AICPA Statement of Position 98-9, Modification of SOP No. 97-2 with Respect to Certain Transactions. Maintenance revenue is recognized ratably over the maintenance period since customers under maintenance agreements receive unspecified product updates and electronic, internet-based technical support and telephone support throughout their maintenance period, which is typically one year. The majority of our customers also purchase maintenance renewals annually, which, depending on the product, we offer at either 15% or 20% of the list price of the specific perpetual product license, and which establishes vendor specific objective evidence (“VSOE”) of the fair value of maintenance.

We also offer two-year and three-year term licenses for certain products under which the customer can purchase the first year of maintenance with the license and can renew maintenance in each of the following one or two years. Revenue from term licenses is recognized in the same manner as revenue from perpetual licenses as the VSOE of fair value of maintenance is established by the maintenance renewal pricing.

We assess whether the fee is fixed or determinable for sales with non-standard payment terms by evaluating our history of collections from these customers and/or their current financial standing. In no case will we deem a fee to be fixed or determinable where the fee is due after the expiration of the license or more than 12 months after delivery. We make judgments as to whether collection of the fee is probable based on the analysis provided by our credit review procedures. Revenue on arrangements to end-user customers that have met all of the revenue recognition criteria except probability of collection is recognized as collection becomes reasonably assured, which is generally as payments are received.

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Revenue on sales to distributors is considered to have met the probability of collection criterion when the distributor has resold the product to an end user and either we have received payment for the product or we assess that we have a substantial and sustained history of collections from the distributor.

We also sell time-based licenses to use our software products for specified periods of time. Time-based licenses include maintenance services for the duration of their respective terms. Revenue from time-based licenses is allocated between license and maintenance revenue in similar proportion to perpetual license transactions, and recognized ratably over the period of the license as we do not have VSOE of the fair value of maintenance since it is not priced or offered separately. In addition, we have provided a version of one of our products to certain FPGA manufacturers for distribution to their customers. As part of these agreements we have certain maintenance and support obligations to the FPGA manufacturers. Revenue on these arrangements is also allocated to license and maintenance revenue and recognized ratably over the period of each arrangement, as we do not have VSOE of the fair value of maintenance since it is not priced or offered separately.

We have entered into agreements with semiconductor manufacturers LSI Logic Corporation and NEC Electronics to customize our ASIC synthesis or physical synthesis tools for certain of their products. When licenses are being purchased as part of the agreement, once the contract has been signed, delivery of the customized product has occurred, collection of the fee is probable and we have no remaining obligations, we recognize revenue from both the development and license fees ratably over the period of the licenses since we do not have VSOE of fair value of the licenses. When licenses are not being purchased as part of the agreement, once the contract has been signed, we recognize revenue from the development fees on a percentage of completion basis. Revenue recognized from these arrangements represents less than 10% of total revenue and is recorded in license revenue.

Goodwill and Intangible Assets

Goodwill is not amortized but is tested for impairment using a fair value approach. Goodwill is tested for impairment annually during the fourth quarter as well as whenever indicators of impairment exist. Long-lived assets, including intangible assets, are reviewed whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Recoverability of a long lived asset other than goodwill is measured by comparison of its carrying amount to the expected future undiscounted cash flows (without interest charges) that the asset is expected to generate. An impairment charge is recorded if the carrying amount of the asset exceeds the sum of the expected undiscounted cash flows. Any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets. Significant management judgment is required in forecasting future operating results and cash flows and, should different conditions prevail or judgments be made, material write-downs of net intangible assets and/or goodwill could occur. In addition, determining the useful life for an intangible asset is a matter of judgment and has an impact on the amount of amortization expense recorded in any given period. Different assumptions about the useful life of an intangible asset would result in more or less amortization expense being recorded in a given period. Our intangible assets are being amortized using the straight-line method over the estimated useful life of five years.

Allowance for Doubtful Accounts

We maintain and update quarterly an allowance for doubtful accounts for estimated losses resulting from the failure of our customers to make required payments. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make payments, additional allowances may be required.

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Valuation Allowance for Deferred Tax Assets

We evaluate the need for a valuation allowance for deferred tax assets in accordance with the requirements of Statement of Financial Accounting Standards No. 109 (“SFAS 109”) and such evaluations require judgment. Our last evaluation was for the year ending December 31, 2003 based on the cumulative pre-tax losses we had sustained in the three years ended December 31, 2003. Based on that evaluation, a valuation allowance in the amount equal to our net deferred tax assets was recorded.

Results of Operations

The following table sets forth the results of our operations expressed as a percent of total revenue. Our historical operating results are not necessarily indicative of the results for any future period.

Three and Six Months Ended June 30, 2004 and 2003

Total revenue

Total revenue increased by 16% to $14.2 million for the three months ended June 30, 2004 from $12.2 million for the three months ended June 30, 2003. Total revenue increased by 17% to $27.7 million for the six months ended June 30, 2004 from $23.8 million for the six months ended June 30, 2003.

License revenue. License revenue increased by 15% to $8.1 million for the three months ended June 30, 2004 from $7.0 million for the three months ended June 30, 2003. License revenue increased by 15% to $15.5 million for the six months ended June 30, 2004 from $13.4 million for the six months ended June 30, 2003. These increases were due to higher license revenue in Japan and North America. Additionally, revenue recognized from our development agreements for the Structured ASIC market was higher than the same period last year.

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Maintenance revenue. Maintenance revenue increased by 19% to $6.2 million for the three months ended June 30, 2004 from $5.2 million for the three months ended June 30, 2003. Maintenance revenue increased by 18% to $12.3 million for the six months ended June 30, 2004 from $10.4 million for the six months ended June 30, 2003. This increase was attributable to higher maintenance renewal rates compared to the prior year, our increased level of business and back-maintenance charges for customers returning to active maintenance.

Cost of revenue

Cost of license revenue. Cost of license revenue includes product packaging, software documentation and other costs associated with shipping, royalties due from us to third parties and engineering costs directly associated with our development agreement with NEC for which revenue is being recognized on a percentage of completion basis. Cost of license revenue increased by 56% to $156,000 for the three months ended June 30, 2004 from $100,000 for the three months ended June 30, 2003. Cost of license revenue increased by 130% to $359,000 for the six months ended June 30, 2004 from $156,000 for the six months ended June 30, 2003. As a percent of license revenue, cost of license revenue increased to 2% for the three and six months ended June 30, 2004 from 1% for the three and six months ended June 30, 2003. These increases were primarily due to engineering costs associated with the NEC agreement incurred in the three and six months ended June 30, 2004.

Cost of maintenance revenue. Cost of maintenance revenue consists primarily of personnel and other expenses related to providing maintenance support to our customers. Cost of maintenance revenue increased 16% to $607,000 for the three months ended June 30, 2004 from $525,000 for the three months ended June 30, 2003. Cost of maintenance revenue increased 14% to $1.2 million for the six months ended June 30, 2004 from $1.0 million for the six months ended June 30, 2003. These increases were primarily due to higher compensation expense from additional employees as well as the removal of salary reductions that were in place in 2003. As a percent of maintenance revenue, cost of maintenance revenue remained at 10% for the three months and six months ended June 30, 2004 and 2003.

Amortization of intangible assets. Amortization of intangible assets of $222,000 and $445,000 in the three and six months ended June 30, 2004, respectively, reflects the amortization of acquired intangible assets over a five-year useful life. Amortization of intangible assets amounted to $223,000 and $441,000 in the three and six months ended June 30, 2003, respectively.

Operating expenses

Research and development. Research and development expenses increased 12% to $5.8 million for the three months ended June 30, 2004 from $5.2 million for the three months ended June 30, 2003. Research and development expenses increased 9% to $11.4 million for the six months ended June 30, 2004 from $10.4 million for the six months ended June 30, 2003. These increases were primarily due to additional employees and the removal of salary reductions. We expect that research and development expenses will continue to increase during the remainder of 2004 as we hire additional employees and adjust compensation levels. As a percent of total revenue, research and development expenses decreased to 41% for the three months ended June 30, 2004 from 42% for the same period in 2003. As a percent of total revenue, research and development expenses decreased to 41% for the six months ended June 30, 2004 from 44% for the same period in 2003 due to higher revenue.

Sales and marketing. Sales and marketing expenses increased 2% to $5.6 million for the three months ended June 30, 2004 from $5.5 million for the three months ended June 30, 2003. Sales and marketing expenses increased 6% to $11.0 million for the six months ended June 30, 2004 from $10.4 million for the six months ended June 30, 2003. These increases were mainly due to removal of salary reductions, higher commission expense and costs associated with a tradeshow in the second quarter of 2004. We expect that sales and marketing expenses will continue to increase slightly during the remainder of 2004 due to higher commission expense, hiring of additional employees and adjustments to compensation levels. As a percent of total revenue, sales and marketing decreased to 40% for the three months ended June 30, 2004 from 45% for the three months ended June 30, 2003. As a percent of total revenue, sales and marketing expenses decreased to 40% for the six months ended June 30, 2004 from 44% for the six months ended June 30, 2003, mainly due to higher revenue.

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General and administrative. General and administrative expenses increased 4% to $1.33 million for the three months ended June 30, 2004 from $1.27 million for the three months ended June 30, 2003. General and administrative expenses increased 3% to $2.5 million for the six months ended June 30, 2004 from $2.4 million for the six months ended June 30, 2003. These increases were mainly due to the removal of salary reductions as well as higher costs associated with corporate governance compliance and additional employees, partially offset by the recovery of certain bad debt allowances. We expect that general and administrative expenses will continue to increase during the remainder of 2004 due to higher corporate governance compliance costs and adjustments to compensation levels. As a percent of total revenue, general and administrative expenses decreased to 9% for the three and six months ended June 30, 2004 from 10% for the three and six months ended June 30, 2003.

Stock-based compensation. Stock-based compensation was $57,000 for the three months ended June 30, 2004 and $130,000 for the three months ended June 30, 2003. Stock-based compensation was $119,000 for the six months ended June 30, 2004 and $269,000 for the six months ended June 30, 2003. The remaining deferred stock compensation at June 30, 2004 is expected to be amortized as follows: $67,000 for the six months ending December 31, 2004, $69,000 for the year ending December 31, 2005 and $19,000 for the year ending December 31, 2006. The amount of stock-based compensation expense to be recorded in future periods could decrease if options for which accrued but unvested compensation has been recorded are forfeited.

Other income, net

Other income, net decreased to $132,000 for the three months ended June 30, 2004 compared to $215,000 for the same period in 2003. Other income, net decreased to $255,000 for the six months ended June 30, 2004 compared to $355,000 for the same period in 2003. These decreases were primarily due to interest received on full payment of a note from one of our officers in 2003.

Income Tax

We recorded income tax provisions of $101,000, $202,000, $130,000 and $260,000 for the three and six months ended June 30, 2004 and 2003, respectively, which relate primarily to estimated foreign taxes calculated on year to date income.

Liquidity and Capital Resources

As of June 30, 2004, we had cash and cash equivalents of $9.1 million, short-term investments of $37.1 million, long-term investment of $2.1 million and working capital of $33.9 million. Net cash provided by operating activities decreased to $3.1 million for the six months ended June 30, 2004 from $3.3 million for the same period in 2003 primarily due to higher accounts receivable at June 30, 2004.

Net cash provided by investing activities was $932,000 for the six months ended June 30, 2004 compared to $6.1 million used for investing activities for the same period in 2003. For the six months ended June 30, 2004 cash provided by investing activities was from maturities of short-term investments offset by purchase of short-term investments and purchase of computer, equipment and software. Cash used in investing activities for the six months ended June 30, 2003 was for the purchase of short-term investments, as well as the purchase of computers, equipment and software, partially offset by maturities and/or sales of short-term investments.

Net cash provided by financing activities was $688,000 for the six months ended June 30, 2004 compared to $537,000 used in financing activities for the same period in 2003. Net cash provided by financing activities for the six months ended June 30, 2004 was primarily from the sale of common stock to employees, partially offset by repurchases of common stock. Net cash used in financing activities for the six months ended June 30, 2003 was primarily for repurchases of common stock under our stock repurchase program, partially offset by the sale of common stock to employees and receipt of cash in full repayment of a note from one of our officers. The note to our officer was issued in September 1998 and our current policy is not to enter into such agreements with our officers.

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Our future liquidity and capital requirements will depend on numerous factors, including:

We believe that our cash and investments of $48.4 million as of June 30, 2004 will be sufficient to meet our operating and capital requirements through at least the next 12 months. However, it is possible that we may require additional financing within this period. We intend to continue to invest in the development of new products and enhancements to our existing products. In addition, even if we have sufficient funds to meet our anticipated cash needs in the next 12 months, we may need to raise additional funds beyond this time. We may be required to raise those funds through public or private financings, strategic relationships or other arrangements. We cannot assure that such funding, if needed, will be available on terms attractive to us, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. If we fail to raise capital when needed, our failure could have a negative impact on our profitability and our ability to pursue our business strategy.

Factors Affecting Future Operating Results

Our sales and operating results have been, and may continue to be, negatively impacted by the adverse economic conditions in the United States

We have experienced negative effects from the economic downturn in the United States and in those markets with a heavier reliance on the networking and communications industry. Many of our customers continue to tightly control spending and have reduced or delayed purchase orders. These conditions have negatively affected the demand and revenue for our products and have created longer sales cycles. Additionally, in an effort to reduce spending, customers have been seeking time-based agreements which cause us to recognize revenue ratably, thus reducing near-term revenue. Although we have begun to see signs of modest improvement in the United States economy on our business, this downturn could continue or worsen, and may further extend to other geographic regions. A continuation or worsening of current economic conditions in the United States, particularly in the networking and communications industry, or extension of such conditions to other geographic regions or industries, would continue to adversely affect our business.

We have a history of losses and may experience losses in the future, which could result in the market price of our common stock declining

We had a net loss of $377,000 in 2003 and have had significant net losses in the past, including net losses of $3.3 million in 2002 and $2.6 million in 2000. We expect to continue to incur significant levels of operating expenses. If revenue does not increase or declines, we may not be able to control our costs in order to achieve profitability. If we are not profitable, the market price of our common stock may decline, perhaps substantially. Our expenses may increase in the next 12 months as we:

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Any failure to significantly increase our new product bookings and revenue as we implement our product and distribution strategies would also harm our ability to achieve or maintain profitability and could negatively impact the market price of our common stock.

The Structured ASIC market is new and our future growth and profitability are dependent on its development

A new breed of ASIC devices called Structured ASICs is emerging. In 2003 we introduced the first custom architecture-specific synthesis tool for NEC Electronics’ new Structured ASIC device as well as our first physical synthesis product for LSI Logic’s new Platform ASIC device. In addition, we are currently working on customizing our physical synthesis product for NEC’s Structured ASIC device. We are investing significant resources in customizing our Synplify ASIC and Amplify ASIC Physical Optimizer products for this emerging market. Failure of the Structured ASIC market to develop, or our failure to penetrate that market, would have a material adverse affect on our revenue and operating results.

We have relied and expect to continue to rely on sales of our Synplify, Synplify Pro and HDL Analyst products for a substantial portion of our license revenue, and a decline in sales of these products could cause our license revenue to decline

Historically, we have derived a significant majority of our revenue from sales of our Synplify, Synplify Pro and HDL Analyst products. License revenue for our Synplify, Synplify Pro and HDL Analyst products accounted for 73%, 81% and 82% of our total license revenue in 2003, 2002 and 2001, respectively. We expect that revenue from these products will continue to account for a majority of our license revenue for at least the next 12 months. License revenue of our Synplify, Synplify Pro and HDL Analyst products in dollars decreased in 2003 from 2002 and may continue to decrease. Any factors which continue to adversely affect the pricing of, or demand for, our Synplify, Synplify Pro and HDL Analyst products could cause our license revenue to decline and our business to suffer. Factors that may affect sales of our Synplify, Synplify Pro and HDL Analyst products, some of which are beyond our control, include the following:

Our revenue could decline substantially if our existing customers do not continue to purchase additional licenses or maintenance from us, or if existing agreements with FPGA manufacturers are canceled

We rely on sales of additional licenses to our existing customers, as well as annual maintenance renewals for our products. Additional license sales to our existing customers represented 78%, 73% and 75% of

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our license sales in 2003, 2002 and 2001, respectively. If we fail to sell additional licenses for our products to our existing customers, we would experience a material decline in revenue. Even if we are successful in selling our products to new customers, the level of our revenue could be harmed if our existing customers do not continue to purchase a substantial number of additional licenses from us or fail to renew their maintenance. Our success in generating revenue from existing customers is dependent on maintaining our relationships with those customers as well as increased need for and usage of our products by those customers. Additionally, we experienced lower rates of maintenance renewal during 2003 and 2002 compared to prior years including, but not limited to, the effects of customers’ inability to renew maintenance on some or all of their licenses due to business conditions or budget restrictions. We have recently begun to see improvement in our maintenance renewal rates. However, if we were to again experience pressure on maintenance renewal rates, our maintenance revenue could stop growing or decline.

We have agreements with certain FPGA manufacturers to resell a version of our Synplify product. Some of these agreements allow for cancellation with a notice period. Revenue recognized from these agreements generated 7%, 7% and 5% of our revenue in 2003, 2002 and 2001, respectively. If these agreements were canceled or not renewed, our revenue could decline.

We may not succeed in developing, marketing and selling new commercially acceptable logic synthesis, physical synthesis and verification products, and our operating results may decline as a result

We intend to develop additional logic synthesis, physical synthesis and verification products that leverage our core capabilities. We also intend to develop new features for our existing products. In addition, in 2003 we entered into agreements with semiconductor manufacturers to develop customized tools for certain of their products. Developing new and customized products and new features for existing products that meet the needs of electronic product designers requires significant investments in research and development. If we fail to introduce new products, customized products or enhanced versions of existing products that are commercially acceptable in a timely and cost-effective manner, our business could be negatively affected. Growing competition, technological changes that negatively affect the demand for FPGAs and ASICs and our inexperience in selling our products to customers that design ASICs could also adversely affect our revenue. If we fail to successfully identify, develop, market and sell new commercially acceptable products and enhance our current products, our operating results will decline. Our future growth and profitability will depend in large part on our ability to gain market acceptance of our products outside of our Synplify, Synplify Pro and HDL Analyst products, especially our ASIC products including Structured ASICs. We cannot be certain that our newer products, our entry into the ASIC logic synthesis product market or other new markets, or our acquired products, will be successful. If customers do not widely adopt such products, our operating results could decline.

Our quarterly operating results and stock price may fluctuate because our ability to accurately forecast our quarterly sales is limited, our costs are relatively fixed in the short term and we expect our business to be affected by seasonality

Our ability to accurately forecast quarterly sales is limited, which makes it difficult to predict the quarterly revenue that we will recognize. In addition, the time required to initiate and complete a sale for our FPGA products is relatively short, and our ability to foresee and react to changes in customer demand for our products may be limited and therefore inaccurate. Most of our costs are for personnel and facilities, which are relatively fixed in the short term. If we have a shortfall in revenue in relation to our expectations, we may be unable to reduce our expenses quickly to avoid lower quarterly operating results. Consequently, our quarterly operating results could fluctuate, and the fluctuations could adversely affect the market price of our common stock. In addition, in the past we have experienced fluctuations in the sale of licenses for our products due to seasonality. For example, sales may decline during the summer months, particularly in European markets, and we have experienced and anticipate we will continue to experience relatively lower product bookings in our first quarter due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers and the economic incentives for our sales force. These factors may lead to fluctuations in our quarterly operating results.

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If we experience an increase in the length of our sales cycle, our quarterly operating results could become more unpredictable and our stock price may decline as a result

We experience sales cycles, or the time between an initial customer contact and completion of a sale, of generally two weeks to several months for our FPGA products, depending on the product. When the current economic downturn began, we experienced an increase in the length of our sales cycle which has since stabilized. If we experience such an increase in the length of our sales cycle again, our quarterly operating results could suffer and our stock price could decline as a result. The sales cycles for our Certify, Synplify ASIC, Amplify ASIC and Fortify products are substantially longer than those of our FPGA products, which could result in additional unpredictability of our quarterly revenue. Additionally, since we have limited experience selling our new Amplify ASIC product, its sales cycle could be longer than we expect and could add to the unpredictability in our revenue from quarter to quarter. Lastly, for all of our products, customers often purchase a small number of licenses and then sometimes incrementally increase the number of licenses over time. If customers were to implement enterprise-wide evaluation programs or purchase products for the entire organization at one time, our sales cycle could lengthen and our revenue could be more unpredictable from quarter to quarter.

Our near-term revenue could decline as a result of increases in sales of time-based licenses

We have seen an increase in the number and dollar amount of time-based license agreements. Time-based license revenue accounted for approximately 27% of our total license revenue in the six months ended June 30, 2004 and 29% and 23% of our total license revenue in 2003 and 2002, respectively. This trend may continue since customers may prefer time-based licenses over perpetual licenses for our newer, higher-priced products and customers who previously purchased perpetual licenses may choose to convert to time-based licenses. Time-based license agreements generally have terms from one to three years and we recognize revenue from them ratably over the term of the agreements. Increases in time-based licenses could affect our near-term revenue growth due to the delayed timing of revenue recognition for such licenses. If our average selling price of time-based licenses decreases, or if customers do not renew such licenses, our revenue could also decline. Any decline in our revenue, or lack of significant growth in our revenue, could result in a decrease in our stock price because our revenue may fail to meet the expectations of investment analysts and others.

We depend on our marketing, product development and sales relationships with leading FPGA manufacturers, and if these relationships suffer, we may have difficulty introducing and selling our FPGA synthesis products and our revenue could decline

We believe that our success in maintaining acceptance in the FPGA market depends in part on our ability to maintain or further develop our strategic marketing, product development and sales relationships with leading FPGA manufacturers, including Altera and Xilinx. We believe our relationships with leading FPGA manufacturers are important in validating our technology, facilitating broad market acceptance of our FPGA synthesis products and enhancing our sales, marketing and distribution capabilities. For example, we attempt to coordinate our product offerings with future releases of Altera’s and Xilinx’s FPGA components and software. If we are unable to maintain and enhance our existing relationships with Altera and Xilinx and develop a similar relationship with other major FPGA vendors, we may have difficulty selling our FPGA synthesis products or we may not be able to introduce products on a timely basis that capitalize on new FPGA component characteristics or software feature enhancements.