Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the fiscal year ended January 31, 2005

or

For the transition period from             to             

Commission file number 0-21342

WIND RIVER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

500 Wind River Way, Alameda, California 94501

(Address of principal executive offices, including zip code)

(510) 748-4100

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $.001 per share

(Title of Class)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

The aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant, computed by reference to the closing price on the NASDAQ National Market on July 31, 2004, the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $709,933,246. For purposes of this disclosure, shares of common stock held by persons who hold more than 5% of the outstanding shares of common stock and shares held by officers and directors of the registrant have been excluded because such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of April 11, 2005, there were 83,921,239 shares of the Registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Certain information called for by Part III of this Form 10-K is incorporated by reference to the definitive proxy statement for the Registrant’s 2005 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission not later than 120 days after January 31, 2005.

Table of Contents

WIND RIVER SYSTEMS, INC.

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

2

Table of Contents

Unless stated otherwise, references in this report to “Wind River,” “we,” “our,” “us” or “the Company” refer to Wind River Systems, Inc., a Delaware corporation, and its consolidated subsidiaries.

Wind River, VxWorks, Tornado and Wind are registered trademarks of Wind River Systems, Inc., and Wind River Systems is the trademark of Wind River Systems, Inc. All other names mentioned are trademarks, registered trademarks or service marks of their respective companies or organizations.

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. When used in this Annual Report on Form 10-K, the words “could,” “may,” “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan” and similar expressions as they relate to our management or to Wind River are intended to identify these forward-looking statements. These forward-looking statements address our expected business, results of operations, future financial position, business strategy, including our adoption of Linux, and our shift to an enterprise licensing model, our ability to increase our revenues, our financing plans and capital requirements, forecasted trends relating to our services or the markets in which we operate and similar matters and include statements based on current expectations, estimates, forecasts and projections about the economies and markets in which we operate and our beliefs and assumptions regarding these economies and markets. This information and such statements are subject to important risks, uncertainties and assumptions, which are difficult to predict. The results or events predicted in these statements may differ materially from actual results or events. Factors that could cause or contribute to such differences include, but are not limited to, a decline in the rate of adoption of our enterprise license model, the impact of timing of our reported revenues based on our enterprise license model, adoption of our open source strategy, accounting changes regarding option expensing, demand for our customers’ products, competitive products and pricing, potential slow downs in customer sales, intellectual property disputes, litigation and other factors discussed under the caption “Factors That May Affect Future Results” under Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

These forward-looking statements speak only as of the date this Annual Report on Form 10-K was filed and of information currently and actually known. We do not intend to update these forward-looking statements to reflect events or circumstances that occur after the filing of this Annual Report on Form 10-K or to reflect the occurrence or effect of anticipated events, except as required by law.

3

Table of Contents

PART I

Background

Technology is transforming the way people live. Intelligent connected devices are becoming pervasive in our daily lives, and the functionality of these devices is expanding rapidly. This new functionality is forcing a significant increase in the complexity of software and development tools necessary to develop and run these devices. Device manufacturers today are faced with the challenge of managing this increasing software complexity while controlling costs and delivering relevant products to market on time. The need to optimize the way device software is developed and run increasingly is driving manufacturers to choose between buying and building the software that runs their products.

Device Software Optimization

Wind River is a global leader in Device Software Optimization (DSO). Our software is used to develop and run devices better, faster, at lower cost and more reliably. Our software and development tools are used to optimize the functionality of devices as diverse as digital imaging products, automobile braking systems, Internet routers, avionics control panels and factory automation equipment. Wind River offers customers DSO solutions to enhance product performance, standardize designs across projects and throughout the enterprise, reduce research and development costs, and shorten product development cycles.

We simplify our customers’ process of programming for these devices by providing integrated software development and runtime platforms targeted to specific markets, as well as off-the-shelf device software, programming tools and hardware. To date, Wind River Platforms integrate our proprietary operating systems software with tools and middleware to meet the requirements of specific industries. Our off-the-shelf software includes operating systems and middleware applications, such as networking and security protocols that offer additional capabilities beyond those in the operating systems. Our software programming tools help customers design, develop, integrate and test their own applications for these devices. We also offer a range of hardware reference designs that customers can incorporate into their products or use as a development environment.

To complement our broad range of software products and hardware reference designs, our professional services team provides comprehensive design engineering services and technical support. We also provide training and worldwide maintenance and support for our products.

Wind River was incorporated in California in February 1983 and reincorporated in Delaware in April 1993. Our principal executive offices are located at 500 Wind River Way, Alameda, California 94501, and the telephone number at that location is (510) 748-4100. Our Internet website is http://www.windriver.com.

Device Software Systems

Device software systems are incorporated into a larger device and are used to control, monitor or assist the operation of that device. As a result, device software systems are designed to provide an immediate, predictable response to an unpredictable sequence of external events. To succeed in today’s increasingly competitive environment, manufacturers using device software systems must bring complex applications for new products to market rapidly and economically. Developing device software applications has evolved from a relatively modest programming task to a complex engineering effort. As more powerful microprocessors have become available and have decreased in price, these device software systems are being used in a wider range of applications and digital appliances and are facilitating the development of entirely new classes of products. Consequently, software with a higher degree of sophistication is required to develop these more complex applications, often including an integrated platform that provides developers many more features, higher performance and greater productivity than were necessary or feasible for programming prior generations of microprocessors.

4

Table of Contents

Products and Services

Our products and services help customers create complex device software applications more quickly, more economically, and with less risk than creating such applications using internally developed or less well-integrated software, systems and tools. Our product family is comprised of development platforms for device software, development suites and individual tools, device software components, hardware and professional services.

Our value proposition is to offer integrated, end-to-end, enterprise-wide device software development solutions, based on open standards and supported worldwide by a trusted vendor—that is, to offer customers a viable “buy” option.

Wind River Platforms

The cornerstone of our product offering is our Wind River Platforms, which we typically license using an enterprise license model. Wind River Platforms bundle an integrated development suite, one or more operating systems and industry-specific middleware consisting of various protocols and interfaces into market specific platforms. With the enterprise license model, we license these market specific platforms under subscription-based development licenses. In the majority of cases, these subscription licenses also include downstream production rights under which customers pay an aggregated per unit fee for the right to produce their products incorporating our intellectual property. (See “—Licensing Models” below for more information about the enterprise license model.)

Our Wind River Platforms are comprised of:

Our Wind River Platforms are:

5

Table of Contents

Integrated Development Suite

Wind River Workbench is our end-to-end integrated development suite. It combines a common look and feel with development tools across environments, operating systems, cores, hosts and programming languages. Based on the Eclipse 3.0 framework, Workbench enables ease of integration with hundreds of third-party plug-ins. It allows companies to standardize development tools and processes across projects and teams, optimizing device software development, enhancing test capabilities and significantly shortening the time-to-market.

Off-the-Shelf Software, Development Tools and Hardware

Our Workbench development suite products may be licensed individually, without purchase of a Wind River Platform. We also provide a line of stand-alone development tools that customers can use with their own proprietary systems or with other third-party operating systems.

We offer optional extensions and middleware for our operating systems, which provide additional capabilities to developers, such as networking, connectivity, security protocols and device management. Our middleware products act as an interface between the operating system software and application-specific software. Customers may license and incorporate these extensions and middleware into the underlying operating system to provide features required for their specific applications. As applications become more complex, especially for Web-enabled products, prepackaged middleware solutions such as those we offer have become more widely used to simplify development.

Our product family also includes a range of hardware reference designs and hardware bring-up tools that help our customers design and implement software solutions. Through the use of these hardware products, customers can incorporate portions of the reference design into their products or use the entire design as a development platform before custom boards are available. This allows software programming to be tested for operability and functionality, and to be corrected for errors early in the design cycle, thereby advancing overall product development, improving product quality and accelerating time-to-market.

Open Source Strategy

An important part of our strategy is to add open source products and support to our device software optimization offerings. This strategy has two elements. First, our integrated development suite, Wind River

6

Table of Contents

Workbench, incorporates Eclipse technology, an open source technology tools framework. Allowing developers access to hundreds of open source, proprietary and third-party tools within a single, robust development environment, Workbench lets us offer our customers the best tools available and frees us to invest our resources in developing new technologies, not developing and maintaining proprietary alternatives to existing products.

The second part of our strategy is to offer a new suite of products and services that support the Linux operating system. We intend to offer additional development tools that can be used with the Linux operating system, as well as with our proprietary system, VxWorks. We also intend to expand our professional services to provide support to customers building devices based on Linux, introducing new platform products which include Linux reference file systems and entering into partnerships with other commercial Linux providers. Pursuant to this strategy, we joined the Open Source Development Labs (OSDL), a Linux consortium, the Consumer Electronics Linux Forum (CELF), an industry group focused on the advancement of Linux as a platform for consumer electronic devices, as well as the Eclipse Consortium. (See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Our Future Results or the Market Price of Our Stock—We have adopted an open source strategy that may not be successful or may expose us to additional risks” for a distribution of some of the risks related to this strategy.)

Wind River is a Strategic Developer Member of Eclipse, an open source consortium supporting the Eclipse technology. Additionally, we released an implementation of TIPC, a protocol that facilitates communication between devices running different operating systems. Finally, we are committed to working closely with industry partners including IBM and Intel to encourage broad adoption of industry standards in the DSO space.

Professional Services

To complement our broad range of software and hardware products, we provide comprehensive design services and technical support. These services help customers complete a product specification, design critical drivers, ports or interfaces, and/or provide a complete design for the customer’s product or application. These design services are offered on either a time-and-materials or fixed-price basis and can encompass a broad range of services, including fully project-managed custom hardware development, software development and product integration. We offer training through partners who provide a series of formal technical courses designed to teach developers the basics of device software development and how to use our tools, operating systems and middleware effectively. We also provide worldwide maintenance and support for our products.

Licensing Models

We license our software using two primary licensing models, subscription-based enterprise licensing and project-based perpetual licensing. Our Wind River Platforms and Workbench Integrated Development Suite are primarily licensed under enterprise licensing.

Our subscription-based enterprise license model was first introduced in November 2002. This model includes subscription-based development licenses that are typically one year in duration, although some licenses extend to periods greater than one year. Subscription enterprise licenses eliminate the more traditional “project” and “site” restrictions on the use of our products. At the end of the subscription period, the customer’s right to develop using Wind River Platforms or tools expires unless renewed. Most enterprise licenses (i) have an initial duration of one year, with annual renewals, (ii) include payment terms for the full cost of the annual subscription within 30-60 days after entering into the enterprise license agreement, (iii) include production license reporting once a customer makes a commercial release of a device that incorporates our products, and (iv) may include a number of service credits for field engineering support. During fiscal 2005, certain customers have entered into multi-year strategic agreements with us. These agreements have generally included payment terms for the full cost of the multi-year subscription within 30-90 days after entering into the enterprise licensing agreement.

In February 2004, we introduced a variation on this model that includes a higher priced per-seat subscription without a separate per-unit production license fee, allowing our customers to choose between the “shared

7

Table of Contents

success” model that includes production license fees or a pure “per-seat” subscription model without a separate production license fee. To date, the majority of subscription licenses continue to include per-unit production licenses fees, which aggregate volumes across the enterprise to create incentives for broader adoption. However, we believe that offering certain variations of our enterprise licensing models allow our customers to have greater flexibility in meeting their business needs.

We also license our software under project-based perpetual licenses. Under this model, our customers pay an up-front, development license fee together with an annual maintenance fee that is based on a fixed percentage of the total licensing fees. For device software products, the customer typically also pays a per-unit, per-project production-license fee based on the number of copies of our operating system software that is included in each final manufactured device. The terms of the perpetual license for our software restrict the customer’s use to a specific project, such as a line of printers or digital camera and, as a result, any software licenses or prepaid production license fees can generally only be used on that specific project.

We anticipate that we will continue using both our enterprise licensing and perpetual licensing models. However, the proportion of our business sold under the enterprise license model which is subscription-based is increasing and we expect that this trend will continue. We believe that the enterprise licensing model allows us to:

Under our perpetual license model, we sell our products at the specific project level and are dealing primarily with the engineers leading and making decisions for individual projects. The strategy for our Wind River Platform products is to seek enterprise wide adoption. As a result, the customer’s decision to adopt our products under the enterprise licensing model is now more strategic; leading to longer sales lead times and ultimately more complex and time consuming negotiations. Our success is therefore dependent upon our ability to first educate our current and potential customers of the value associated with our Wind River Platform products and services and, secondly, our ability to negotiate and close such transactions with these customers on terms which are mutually agreeable.

Due to the fact that a significant portion of our business is sold under the enterprise licensing model, our reported revenue in a quarter does not necessarily reflect the entire level of our business activity. Under the enterprise license model, revenue is recognized ratably over the subscription period. By contrast, under applicable accounting rules, a perpetual license requires the majority of license revenue to be recognized in the quarter in which the products are delivered and a much smaller amount relating to the fair value of maintenance being deferred and recognized subsequently over the maintenance period. Therefore, an order for an enterprise license will result in lower current quarter revenue than an equal-sized order for a perpetual license, but will result in a faster growth in deferred revenue. We expect customers to continue to transition from perpetual licensing to the enterprise licensing in the coming fiscal year. Depending on the rate at which customers transition from our perpetual model to our enterprise license model, our reported revenue may continue to be impacted in the short-term.

Strategic Alliances

We believe that having many strategic relationships with semiconductor manufacturers, circuit board manufacturers, system manufacturers, other software companies and our customers is important to our future success in the DSO marketplace. These relationships help us penetrate our market segments, drive innovation and

8

Table of Contents

standards across the industry and better serve our customers’ overall needs. In addition, we offer certain corporate programs, including the Wind River Partner Program, which are designed to support the development of global alliances and foster a community of third-party partners by making it easy for these companies to access our technology, integrate value-added products and jointly market these solutions with us.

We have strategic relationships with many of the major semiconductor and system manufacturers, including ARM Holdings plc, Broadcom Corporation, Freescale Semiconductor, Inc., Hitachi, Inc., IBM Corporation, Intel Corporation, MIPS Technologies, Inc., NEC Corporation, Philips Electronics N.V., Texas Instruments Incorporated, Toshiba Corporation, Radisys Corporation and Xilinx, Inc. We have ported our technologies to their semiconductors and circuit board level products, allowing us to leverage their sales channels to give our products broader market exposure. Our gross research and development expenses were offset by $1.2 million, $2.8 million and $3.6 million in fiscal years 2005, 2004 and 2003, respectively, in funding from programs with these customers. In addition to our strategic relationships with semiconductor companies, we have entered into joint engineering programs with other key customers. Our gross research and development expenses in fiscal years 2005, 2004 and 2003 were offset by $2.6 million, $669,000 and $911,000, respectively, in funding from these programs.

We also have developed an ecosystem of smaller software companies that integrate with our platform products to provide additional value-added capabilities. This includes companies who provide additional development tools which integrate and plug-in to our Tornado and Workbench development suites, along with companies that provide complementary protocols, middleware and other technology that integrate with our VxWorks and Linux operating systems. From time to time we may elect to re-sell or recommend products from these companies through our worldwide sales channel. Occasionally, this may lead us to acquire these products or the company itself. A recent example is our acquisition of certain assets of Real-Time Innovations. For many years Wind River sold development tools from Real-Time Innovations through the Wind River worldwide sales channel. In the fourth quarter of fiscal year 2005, we acquired the ScopeTools division of Real-Time Innovations, a move that, among other items, enables us to optimize the integration of these tools with our Workbench development suite.

In February 2004 we announced a strategic relationship with Red Hat, Inc., a leading provider of open source Linux platforms. Today, as a result of this alliance, we now support Red Hat Enterprise Linux (RHEL) as our preferred Linux development host with our Wind River Workbench and development tools. We continue to work with Red Hat to promote standardization and interoperability across the DSO and Enterprise marketplaces.

Customers

Our products have been deployed by a broad range of organizations, including companies in the following industries: networking (both data and voice), consumer electronics, aerospace and defense, industrial and automotive. Our customers include end-users, distributors, original equipment manufacturers, system integrators and value-added resellers.

Our top ten customers by revenue for fiscal year 2005 were: Alcatel, Lockheed Martin Corporation, Motorola, Inc., Nortel Networks Corporation, Northrop Grumman Corporation, Philips Electronics N.V., Raytheon Company, Roper Industries, Inc., Siemens AG, and The Walt Disney Company. No single customer accounted for more than 10% of our revenue in any of the fiscal years ended January 31, 2005, 2004 or 2003.

Marketing, Sales and Distribution

We market our products and services in North America, Europe (including the Middle East and Africa, “EMEA”), Japan and the Asia Pacific region, primarily through our own direct sales organization, which consists of salespersons, field application engineers and support staff. Our direct sales force presents Wind River and our products for licensing to prospective customers, while application engineers provide technical pre-sale and post-

9

Table of Contents

sale support. As of January 31, 2005, we had 150 sales employees located throughout North America, 100 sales employees throughout EMEA, 48 sales employees in Japan and 32 sales employees in the Asia Pacific region. As of January 31, 2005, we had 62 employees in marketing, 89 employees in professional services and 87 employees in customer support.

Revenues from sales to customers outside of North America represented $106.8 million, $89.6 million and $103.6 million, or approximately 45%, 44% and 42% of total revenue, in fiscal years 2005, 2004 and 2003, respectively. (See Note 15, “Segment and Geographic Information” in the Notes to Consolidated Financial Statements for further information about our international sales. See also Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Results—Our significant international business activities subject us to increased costs and economic risks” for further discussion of the risks associated with our international operations generally.)

Prices for international customers for our Wind River Platforms are generally quoted in United States Dollars, Euros, United Kingdom Sterling or Japanese Yen and are set globally. Prices for international customers for our perpetual licenses are generally quoted in local currencies or United States Dollars and are based on the United States price list adjusted to reflect the higher cost of doing business outside the United States. International customers are normally invoiced in the currency in which they are quoted. (See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for a discussion of the foreign currency fluctuation risks we face.)

We have experienced, and expect to continue to experience, seasonality resulting primarily from customer buying patterns and product development cycles. We have generally experienced the strongest demand for our products in the fourth quarter of each fiscal year and the weakest demand in the first quarter of each fiscal year. The continued transition to our enterprise license model may also impact the manner in which seasonality affects quarterly trends in our revenue. (See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for more information about the impact of our transition to an enterprise license model. See also, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Our Future Results or the Market Price of Our Stock—Numerous factors may cause our total revenues and operating results to fluctuate significantly from period to period. These fluctuations increase the difficulty of financial planning and forecasting and may result in decreases in our available cash and declines in the market price of our stock.”)

Competition

The DSO industry is highly competitive and fragmented. Wind River’s primary competition comes from internal research and development departments of companies that develop device systems in-house. In many cases, companies that develop device systems in-house have already made significant investments of time and effort in developing their own internal systems. Historically, the process of shifting to a commercial standard has been viewed as difficult, and was a decision typically made at the project level. More recently, a number of in-house departments have begun to use open-source software, such as the Linux operating system, as the first strategic step toward standardization. Today, the increasing software complexity associated with devices is forcing a strategic shift as many companies are making build versus buy decisions to optimize their own device software development. The buy option, we believe, becomes increasingly attractive.

We also compete with commercial Linux distributors such as MontaVista Software, Inc., LynuxWorks.com, TimeSys Corporation, Metrowerks (a subsidiary of Freescale Seminconductor, Inc.), and others, and Enterprise Linux vendors such as SuSe Linux, Red Hat and others. As there continues to be increased adoption of Linux in markets such as telecommunications and data communications, we believe there will be more standardization of the development cycle based on open source technologies, an initiative that is being driven by the OSDL Corporation specification and standardization for Carrier Grade Linux. This offers equipment manufacturers high availability of open system architecture for core and edge applications. However, our competitive position could

10

Table of Contents

be affected as other embedded software solution vendors move to the middle ground and find new ways to be more open, leveling the playing field with Linux, availability of source code, ability to create and maintain IP ownership, and the ability to compete on price with reduced upfront and production licensing options.

We also compete with independent software vendors, including Microsoft Corporation, Mentor Graphics, ENEA OSE Systems AB, LynxWorks, Green Hills Software, Inc., and QNX Software Systems, Ltd. (recently acquired by Harman International), as well as a number of other vendors that address one or more segments of the device system design process. Some of the companies that develop device systems in-house and some of these independent software vendors, such as Microsoft Corporation, may have significantly greater financial, technical, marketing, sales and other resources and significantly greater name recognition than we do.

We also believe that critical competitive factors in the industry are based on the way customers and potential customers manage their process of software development. Key drivers to software development include managing limited internal resources, controlling costs, minimizing development time and limiting risks. Therefore, reliability, performance, price, product availability, architecture support and customer support may also represent competitive forces affecting our industry. We compete favorably with respect to each of these factors. (See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Our Future Results or the Market Price of Our Stock—We face intense competition in the DSO industry, which could decrease demand for our products or cause us to reduce our prices,” for a further description of factors that may impact our competitive position.)

Product Development and Engineering

We believe that our success will continue to depend primarily on our ability to maintain and enhance our current product line, develop new products, maintain technological competitiveness and meet an ever-expanding range of customer and market requirements. As of January 31, 2005, our product development and engineering group included 382 full-time employees.

During fiscal 2005, 2004 and 2003, product development and engineering expenses were $59.2 million, $56.7 million and $74.0 million, respectively, excluding capitalized software development costs. During the fiscal years ended January 31, 2005, 2004 and 2003, we incurred product and development and engineering expenses that qualified for capitalization of $1.5 million, none and $969,000, respectively. (See “—Strategic Alliances” above for information on research and development funded by third parties.)

Proprietary Rights

Our success is heavily dependent upon our proprietary technology. To protect our proprietary rights, we rely on a combination of patent, copyright, trade secret and trademark laws. As a part of our regular business processes, we generally enter into nondisclosure agreements with employees, consultants, distributors, customers and corporate partners, as appropriate, and thereby limit access to and distribution of our software, documentation and other proprietary information. Furthermore, our licensing agreements provide for protection of our intellectual property both in terms of source code handling and underlying intellectual property ownership of modifications to the Wind River code. (See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Our Future Results or the Market Price of Our Stock—The rights we rely upon to protect the intellectual property underlying our products may not be adequate, which could enable third parties to use our technology and reduce our ability to compete.”)

As we progress with our open source strategy, we may increasingly rely on third party open source products that have been developed and made available for licensing under open source license terms. Certain open source licenses, such as the GNU General Public License that applies to Linux, generally permit anyone to copy, modify and distribute the software, subject only to the restriction that any resulting or derivative work that is made available to the public be licensed under those same terms instead of under our standard license terms. Therefore,

11

Table of Contents

as we incorporate our open source strategy into our product development, although we will retain the copyrights to the code that we develop ourselves, our most valuable intellectual property with respect to derivative works from these licenses will be our collection of trademarks. (See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Factors That May Affect Our Future Results or the Market Price of Our Stock—We have adopted an open source strategy that may not be successful or may expose us to additional risks.”)

Wind River is a registered trademark in the United States and other countries worldwide. We have used, registered, and/or applied to register specific trademarks and service marks to distinguish many of our products, technologies and services from those of our competitors in the U.S. and in foreign countries and jurisdictions. We enforce our trademark, service mark and trade name rights in the U.S. and abroad.

We have filed and obtained a number of patents and patent applications in the United States and abroad that relate to various aspects of our products and technology. As of January 31, 2005, we held 23 issued patents in the United States, none of which have expired. The expiration dates of these patents range from 2015 to 2021. While we believe that patent protection of our products is important, any patents obtained may not provide substantial protection or be of commercial benefit to us. It is also possible that their validity will be challenged.

Manufacturing

Our manufacturing operations consist of assembling, packaging and shipping the software products and documentation needed to fulfill each order. Outside vendors provide tape and CD duplication, printing of documentation and manufacturing of packaging materials. We also manufacture and assemble our hardware development tools at our facility in Canton, Massachusetts and at certain subcontractor facilities.

Employees

As of January 31, 2005, we had 1,112 employees, including 392 in sales and marketing, 184 in professional services and support activities, 382 in product development and engineering and 154 in management, operations, finance and administration. Of these employees, 801 were located in North America and 311 were located outside of North America. None of our employees in North America is represented by a labor union or is subject to a collective bargaining agreement. We have never experienced a work stoppage.

Our employees are vital to our success, and our key management, engineering, sales and other employees are difficult to replace. We generally do not have employment contracts with our key employees or maintain key person life insurance on any of our employees. If we are unable to attract, assimilate, retain or motivate highly qualified technical and sales employees in the future through competitive compensation and employment policies, our ability to develop and introduce competitive new products in a timely manner may suffer.

Executive Officers of the Registrant

The names of our executive officers, their ages as of April 11, 2005 and their positions are shown below:

12

Table of Contents

Mr. Klein has been a director of Wind River since July 2003 and in January 2004 became the Chairman of the Board, President and Chief Executive Officer of Wind River. Prior to joining Wind River, Mr. Klein was with Mercury Interactive Corporation, a software company focused on business technology optimization, where he served as Chief Operating Officer from January 2000 until December 2003. He also served at Mercury Interactive as a director from July 2000 until December 2003 and held management positions there from 1992 through 1999 including President of North American Operations and Vice President of North American Sales. Mr. Klein serves on the Board of Directors of Tumbleweed Communications Corp., a provider of messaging solutions and is a director on the board of a privately-held company. Mr. Klein holds a B.S. degree in electrical engineering and biomedical engineering from the University of Southern California.

Mr. Zellner joined Wind River in September 2000 as Vice President of Finance, Chief Financial Officer and Secretary and currently serves as Senior Vice President of Finance and Administration, Chief Financial Officer and Secretary. From 1991 to 2000, Mr. Zellner was at Applied Materials, Inc., a semiconductor equipment manufacturer, where he last served as a Senior Director of Finance. Prior to joining Applied Materials, from 1979 to 1991, he served in various financial roles at Unisys Corporation, a computer systems and information management company. Mr. Zellner has completed the Stanford Executive Program at Stanford University Graduate School of Business and holds an M.B.A and a B.B.A. in accounting from Florida Atlantic University.

Mr. Bruggeman joined Wind River in February 2004 and currently serves as Vice President of Worldwide Marketing and Chief Marketing Officer. Prior to joining Wind River, Mr. Bruggeman was Vice President of Marketing at Mercury Interactive, a software company focused on business technology optimization, from May 2002 until January 2004. Prior to joining Mercury Interactive, Mr. Bruggeman was Executive Vice President at Alventive, Inc., a provider of web-based collaboration software, from February 1999 to May 2001 and Vice President of Marketing and Business Development at America On-Line, Inc., an internet service provider, from February 1997 to January 1999. Mr. Bruggeman earned a B.S. degree in Statistics and Computer Science from San Jose State University and a M.S. degree in Mathematics from the University of Connecticut.

Mr. Galvin joined Wind River in January 2004 as Vice President, Strategy and Corporate Development. Prior to joining Wind River, Mr. Galvin was Managing Director and Global Sector Coordinator for software and services research at JP Morgan Chase, an investment banking firm, from January 2001 to April 2003. Mr. Galvin began his career at Hambrecht & Quist in 1993, became a Managing Director in 1999, and remained at the firm through its merger with Chase Manhattan and then JP Morgan. Mr. Galvin earned a B.A. degree with honors in Comparative and Regional Studies (Latin America) from the University of California, Berkeley.

Mr. Morrison is Vice President of Engineering at Wind River and has previously held other management positions at Wind River including Vice President and General Manager of several different business units. Mr. Morrison joined Wind River as part of its acquisition of Integrated Systems, Inc. (ISI) in February 2000. Mr. Morrison spent fourteen years with ISI, in various positions where he last served as a Vice President and General Manager of the design automation solutions business unit from March 1999 through February 2000. Mr. Morrison earned his Bachelor of Applied Science degree in Engineering from the University of Toronto, as well as his masters degree at the Massachusetts Institute of Technology, specializing in control systems.

Mr. Wheaton joined Wind River in July 2003 as Vice President of Worldwide Sales and is currently Vice President of Worldwide Field Operations. Mr. Wheaton had previously served as Senior Vice President of Sales for Wind River from March 1992 to September 1998. From September 1998 until June 2003, Mr. Wheaton was a private investor. Before joining Wind River in 1992, Mr. Wheaton was employed at ShareBase Corporation, a relational database hardware and software company, first as Vice President of Domestic Sales and then as Vice President of Worldwide Marketing. From 1988 to 1989, he served as the western regional manager of Powersoft Corporation, a computer software company. Mr. Wheaton holds a B.S. degree in automotive engineering from Western Michigan University.

13

Table of Contents

Financial Information About Segments and Geographic Areas

For financial information about segments and geographic areas, see Note 15, “Segment and Geographic Information,” in Notes to Consolidated Financial Statements filed as part of this Annual Report.

Available Information

We file our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 with the SEC electronically. The public may read or copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is http://www.sec.gov.

You may obtain a free copy of our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports on the day of filing with the SEC on or through our website at http://www.windriver.com or by contacting the Investor Relations Department at our corporate offices by calling (866) 296-5361. We are not incorporating by reference in this Annual Report on Form 10-K any information from our website.

We own our corporate headquarters in Alameda, California. The campus provides approximately 273,000 square feet of office space. We also lease a number of sales, services, customer training, manufacturing, and research and development offices in North America, EMEA, Japan and the Asia Pacific region. We recently sold our Sunnyvale, California facility. (See Note 4 “Certain Balance Sheet Components” in Notes to Consolidated Financial Statements for further information.)

From time to time, we are subject to legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of patents and other intellectual property rights. Management believes the outcome of our outstanding legal proceedings, claims and litigation will not have a material adverse effect on our business, results of operations, cash flows or financial condition. However, such matters involve complex questions of fact and law and could involve significant costs and the diversion of resources to defend. Additionally, the results of litigation are inherently uncertain, and an adverse outcome is at least reasonably possible.

On June 7, 2004, we filed a complaint against Green Hills Software, Inc. (Green Hills), a direct competitor, in the Superior Court of California, County of Alameda. The subsequently amended complaint requested in excess of $25,000 in damages due to breach by Green Hills of a cooperative marketing and technology agreement entered into between the parties in October 1992. On January 18, 2005, Green Hills filed a complaint against us in the United States District Court for the Central District of California alleging, among other things, that we violated antitrust and unfair competition laws by allegedly refusing to license our VxWorks product to Green Hills and refusing to market VxWorks separately from the integrated development environment (IDE) for VxWorks. Green Hills requested an award for damages and injunctive relief on these matters. No opinion has yet been issued following a hearing held on April 11, 2005 in response to Wind River’s motion to dismiss and Green Hills’ motion for preliminary injunction regarding trademark issues. These related lawsuits are still in the preliminary stages, and it is not possible for us to quantify the extent of potential liability to Green Hills, if any, resulting from the Green Hills lawsuit. We do not believe that the lawsuit brought by Green Hills against us has any merit and intend to defend the action vigorously.

Not applicable.

14

Table of Contents

PART II

Our common stock is traded on The NASDAQ National Market under the symbol WIND. As of April 11, 2005, there were approximately 708 stockholders of record of our common stock. The following table sets forth the low and high sales prices on the NASDAQ National Market for the quarters indicated:

We have not paid cash dividends on our common stock to date. Our loan facility with Wells Fargo Bank prohibits us from declaring or paying any dividend or distribution either in cash, stock or any other property on our common stock without the prior written consent of the lender. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Commitments” for more information on our loan facility. We presently intend to retain all of our earnings for use in our business and, therefore, do not anticipate paying dividends on our common stock within the foreseeable future.

Equity Compensation Plan Information

The following table sets forth information about our common stock that may be issued upon the exercise of options, warrants and rights under our existing equity compensation plans as of January 31, 2005. The table does not include information with respect to shares subject to outstanding options granted under equity compensation plans assumed by Wind River in connection with acquisitions of the companies that originally granted those options. Footnote (1) to the table sets forth the total number of shares of our common stock issuable upon the exercise of those assumed options as of January 31, 2005, and the weighted average exercise price of those options. No additional options may be granted under those assumed plans.

15

Table of Contents

The equity compensation plans not approved by security holders generally have the same features as those approved by security holders. For further details regarding Wind River’s equity compensation plans, see Note 12, “Stock-Based Compensation Plans” in Notes to Consolidated Financial Statements filed as part of this Annual Report.

The selected consolidated financial data presented below should be read in conjunction with the more detailed Consolidated Financial Statements presented in Item 8 of this Annual Report on Form 10-K.

16

Table of Contents

Executive Operating and Financial Summary

Wind River is a global leader in Device Software Optimization (DSO). Our software is used to develop and run devices better, faster, at a lower cost and more reliably. Our software and development tools are used to optimize the functionality of devices as diverse as digital imaging products, automobile braking systems, Internet routers, avionics control panels and factory automation equipment. Wind River offers customers DSO solutions to enhance product performance, standardize designs across projects and throughout the enterprise, reduce research and development costs and shorten product development cycles.

How We Earn Our Revenues

We earn our revenues from the license and sale of our products and from providing services related to our products. Our software products are licensed to our customers for their development use under either a subscription license or a perpetual license which assists them in the overall development process of their devices. Customers who purchase a subscription license, also referred to as an enterprise license, are charged per term (e.g. an annual fee), renewable at the election of the customer. Customers who purchase a perpetual license are generally charged a one-time, up-front fee. Once development is completed, whether under a subscription license or a perpetual license, we also generally charge our customers a production license fee for every copy of our product included in the final, manufactured device. Customers either report their usage on a quarterly basis or purchase a block of production licenses in advance of use. We also earn revenue for support and maintenance services for our products, which includes telephone support and provision of updates. For products licensed under a perpetual license, support and maintenance may be purchased for a separate fee. For products licensed under a subscription license, support and maintenance is included in the per-term fee, and includes upgrades. In addition, we also charge customers for other services related to our products, such as training and professional services. Our training services are generally purchased for a fixed fee, while our professional services are available on both a time-and-materials and fixed price contract basis. Our professional services are designed to assist our customers with the design and development of a completed device or application.

Our product revenues are comprised of revenues from perpetual licenses, the revenues that we receive for all production licenses, whether related to development under a perpetual license or a subscription license, and hardware revenues. Our subscription revenues are derived from revenues from our subscription licenses, which includes support and maintenance provided to these customers. Our services revenues are derived from our training and professional services revenues, as well as revenues for support and maintenance of our products under perpetual licenses.

Our Licensing Models

We license our software using two primary licensing models, subscription-based enterprise licensing and project-based perpetual licensing. Our Wind River Platforms and Workbench Integrated Development Suite are primarily licensed under enterprise licensing.

Our subscription-based enterprise license model was first introduced in November 2002. This model includes subscription-based development licenses that are typically one year in duration, although some licenses extend to periods greater than one year. Subscription enterprise licenses eliminate the more traditional “project” and “site” restrictions on the use of our products. At the end of the subscription period, the customer’s right to develop using Wind River Platforms or tools expires unless renewed. Most enterprise licenses (i) have an initial duration of one year, with annual renewals, (ii) include payment terms for the full cost of the annual subscription within 30-60 days after entering into the enterprise license agreement, (iii) include production license reporting once a customer makes a commercial release of a device that incorporates our products, and (iv) may include a

17

Table of Contents

number of service credits for field engineering support. During fiscal 2005, some customers have entered into multi-year strategic agreements with us. These agreements have generally included payment terms for the full cost of the multi-year subscription within 30-90 days after entering into the enterprise licensing agreement.

In February 2004, we introduced a variation on this model that includes a higher priced per-seat subscription without a separate per-unit production license fee, allowing our customers to choose between the “shared success” model that includes production license fees or a pure “per-seat” subscription model without a separate production license fee. To date, the majority of subscription licenses continue to include per-unit production licenses fees, which aggregate volumes across the enterprise to create incentives for broader adoption. However, we believe that offering certain variations of our enterprise licensing models allows our customers to have greater flexibility in meeting their business needs.

We also license our software under project-based perpetual licenses. Under this model, our customers pay an up-front, development license fee together with an annual maintenance fee that is based on a fixed percentage of the total licensing fees. For device software products, the customer typically also pays a per-unit, per-project production-license fee based on the number of copies of our operating system software that are included in final manufactured devices. The terms of the perpetual license for our software restrict the customer’s use to a specific project, such as a line of printers or digital camera and, as a result, any software licenses or prepaid production license fees can generally only be used on that specific project.

Under our perpetual license model, we sell our products at the specific project level and are dealing primarily with the engineers leading and making decisions for individual projects. The strategy for our Wind River Platform products is to seek enterprise wide adoption. As a result, the customer’s decision to adopt our products is now more strategic leading to longer sales lead times and ultimately more complex and time consuming negotiations. Our success is therefore dependent upon our ability to first educate our current and potential customers of the value associated with our Wind River Platform products and services and, secondly, our ability to negotiate and close such transactions with these customers on terms which are mutually agreeable.

Due to the fact that a significant portion of our business is sold under the enterprise licensing model, our reported revenue in a given quarter does not necessarily reflect our level of business activity. Under the enterprise license model, revenue is recognized ratably over the subscription period. By contrast, under applicable accounting rules, a perpetual license requires the majority of license revenue to be recognized in the quarter in which the products are delivered and a much smaller amount relating to the fair value of maintenance being deferred and recognized subsequently over the maintenance period. Therefore, an order for an enterprise license will result in lower current-quarter revenue than an equal-sized order for a perpetual license, but will result in increased deferred revenue compared to the perpetual license. We expect customers to continue to transition from perpetual licensing to the enterprise licensing in the coming fiscal year. Depending on the rate at which customers transition from our perpetual model to our enterprise license model, our reported revenue may continue to be impacted in the short term.

Recent Operating Results

During fiscal 2005, we returned to profitability and positive cash flow from operations, following our focus on growth in revenue and deferred revenue and our focus on cost containment. Growth in revenue and deferred revenue was primarily driven by an increase in our enterprise licensing business arising from additional focus on our DSO strategy and an improvement in the overall economy and production license revenues which more than offset decreases in revenue from our perpetual license sales and maintenance. We also repaid our $40.0 million term loan in the second quarter of fiscal 2005 and repurchased $75.0 million of our Convertible Subordinated Note in January 2005. (See Note 8 “Convertible Subordinated Notes and Other Borrowings” in Notes to Consolidated Financial Statements for further information).

Our total revenues were $235.4 million fiscal 2005 compared to $204.1 million in fiscal 2004, an increase of $31.3 million or 15% and decreased $45.0 million or 18% in fiscal 2004 compared to revenues of $249.1 million

18

Table of Contents

in fiscal 2003. Our net income was $8.2 million or a net income of $0.09 per fully diluted share in fiscal 2005. Our net loss was $24.6 million and $106.9 million, or a net loss of $0.31 per fully diluted share and $1.35 per fully diluted share, in fiscal 2004 and 2003, respectively.

Our total deferred revenue has increased to $77.1 million at January 31, 2005 from $39.1 million at January 31, 2004, primarily as a result of continued increases in sales of Wind River Platforms and other enterprise license based products. Of the total deferred revenue balance at January 31, 2005, $11.5 million relates to deferred revenue classified as long term. This deferred revenue relates to the portion of multi-year contracts that is due to be recognized as revenue in a time period greater than one year from the balance sheet date.

We generated cash flow from operations of $40.4 million in fiscal 2005 compared to cash used in operations of $9.0 million and $38.2 million in fiscal 2004 and 2003, respectively.

Acquisition

On January 21, 2005, we acquired the assets and certain obligations of the ScopeTools business unit of Real-Time Innovations, Inc (“RTI”). Total consideration for the transaction was $10.1 million, comprising $9.1 million in cash, 40,977 shares of our common stock with a fair value of $494,000, $283,000 in acquisition costs and $251,000 in assumed maintenance support costs. We determined that $735,000 of the amount paid to RTI as part of the purchase consideration related to royalty payments due RTI under a pre-existing distributor arrangement whereby we licensed the software of the ScopeTools business. This amount was calculated in accordance with the terms of pre-existing arrangement and has been recognized as cost of revenue and deducted from the purchase consideration. The 40,977 shares and $507,000 in cash were placed in escrow for a period of 12 months to indemnify us in case we incur certain liabilities in connection with the transaction.

In accordance with the purchase method of accounting as prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 141 “Business Combinations” (“SFAS No. 141”), we allocated the total consideration to the intangible assets and tangible liabilities acquired, based on their estimated fair values. In performing the purchase price allocation of acquired intangible assets, we considered its intention for future use of the assets, analyses of historical financial performance and estimates of future performance of the ScopeTools business unit, among other factors. We used the income valuation approach in determining fair value using discount rates ranging from 19% to 36%. Of the purchase price, $2.5 million was allocated to intangible assets and $7.6 million was allocated to goodwill. The intangible assets consist of existing technology of $1.7 million, core technology of $400,000, maintenance agreements of $300,000 and non-competition agreements of $100,000 and are being amortized over periods of two to seven years. The goodwill of $7.6 million represents our assigned value for the long-term potential of the integration of the ScopeTools business unit into our overall product strategy. The ScopeTools business unit’s results of operations, which are not material to us, have been included in our results since the date of acquisition.

Critical Accounting Policies and Estimates

General

Management’s discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which were prepared in accordance with accounting principles generally accepted in the United States, or GAAP. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Note 2, “Summary of Significant Accounting Policies” in Notes to Consolidated Financial Statements describes our significant accounting policies which are reviewed by us on a regular basis and which are also reviewed by senior management with the Audit Committee of our Board of Directors.

An accounting policy is deemed by us to be critical if it requires an accounting estimate to be made based on assumptions about matters that are uncertain at the time the estimate is made, and if different estimates that

19

Table of Contents

reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the financial statements. The policies and estimates that we believe are most critical to an understanding of our financial results and condition and that require a higher degree of judgment and complexity are:

Revenue Recognition

We recognize revenues from three sources: (1) product revenues, (2) service revenues and (3) subscription revenues, net of sales returns and other allowances. Product revenues consist of revenues from production licenses (sometimes referred to as royalties), and fees for stand-alone software and software programming tools sold under our perpetual licensing model and from sales of our hardware. Service revenues are derived from fees from professional services, which include design and development fees, software maintenance contracts, and customer training and consulting. Subscription revenues consist primarily of revenues from the licensing of products and services under our enterprise licensing model, including items such as development tools, an operating system, various protocols and interfaces and maintenance and support services such as installation and training, which are licensed over a limited period of time, typically 12 months. Agreements generally do not allow the right of return or sales price adjustments.

We recognize revenues in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended (“SOP 97-2”), SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (“SOP 81-1”), and Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition” (“SAB 104”). We recognize revenues when persuasive evidence of an arrangement exists, delivery has occurred, the vendor’s fee is fixed or determinable and vendor-specific objective evidence (“VSOE”) exists for all undelivered elements of the arrangement and collection is determined to be probable. These four criteria are further defined as follows:

Persuasive evidence of an arrangement exists. It is our customary practice to have non-cancelable contracts and generally a customer purchase order prior to recognizing revenues on an arrangement.

Delivery has occurred. Product revenues for software and hardware are recognized at the time of shipment or upon the delivery of a product master, with standard transfer terms of FOB shipping point. If undelivered products or services exist that are essential to the functionality of the delivered product in an arrangement, delivery is not considered to have occurred. If only non-essential products or services are undelivered and if evidence of fair value of all undelivered elements exists, then revenue is recognized using the residual method. Under the residual method, the recognition of fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue.

We recognize revenues from time-based and subscription-based licenses ratably over the term of the agreement.

Our enterprise license model agreements require that we deliver unspecified future updates and upgrades within the same product family during the subscription term. Accordingly, fees from our enterprise license agreements are recognized ratably over their term.

20

Table of Contents

Sales to original equipment manufacturers, system integrators and value-added resellers are recognized at the time the risk of loss has transferred. Sales to distributors are generally recognized upon receipt of production reports related to the sale of product to an end-user.

Professional service revenues are separately priced, are generally available from a number of suppliers, and are typically not essential to the functionality of our software products. Revenues from these services are recognized separately from the license fee because the arrangements qualify as “service transactions” as defined by SOP 97-2. Generally, revenue from time-and-materials consulting contracts are recognized as services are performed.

Contract accounting is utilized for service revenues from fixed-price contracts and those requiring significant software modification, development or customization. In such instances, the arrangement fee is accounted for in accordance with SOP 81-1, whereby the arrangement fee is recognized, generally using the percentage-of-completion method measured on labor input costs. If increases in projected costs-to-complete are sufficient to create a loss contract, the entire estimated loss is charged to operations in the period the loss first becomes known. The complexity of the estimation process and judgments related to the assumptions, risks and uncertainties inherent with the application of the percentage-of-completion method of accounting affect the amounts of revenue and related expenses reported in our Consolidated Financial Statements. A number of internal and external factors can affect our estimates, including labor rates, utilization, changes to specification and testing requirements and collectibility of unbilled receivables.

Service revenues from software maintenance, support and update fees are recognized ratably over the contract period, typically 12 months. Service revenues from training and consulting are recognized when the services are provided.

The vendor’s fee is fixed or determinable. At the time of each transaction, we assess whether the fee associated with a revenue transaction is fixed or determinable based on the payment terms associated with the transaction. For product and subscription revenues, if a significant portion of a fee is due after our standard payment terms, which are generally no greater than 90 days from invoice date, we account for the fee as not being fixed or determinable. In these cases, revenue is recognized as the fees become due.

Collection is probable. We assess probability of collection based on a number of factors, including our past transaction history with the customer and the credit-worthiness of the customer. New customers and certain existing customers are subject to a credit review process that evaluates each customer’s financial position and ultimately its ability to pay according to the original terms of the arrangement. Based on our review process, if it is determined from the outset of an arrangement that collection of the resulting receivable is not probable, then revenue is recognized on a cash-collected basis.

Vendor Specific Objective Evidence (“VSOE”). We establish VSOE for subscription transactions and maintenance services by reference to substantive stated future renewal rates included in contracts or the amounts charged on similar transactions. We establish VSOE for professional services time-and-materials contracts by reference to standard hourly rates charged for services. We have not yet established VSOE for professional services fixed-price contracts. Where such services are sold in conjunction with other products, significant management judgment is required to determine appropriate revenue recognition.

Significant management judgments and estimates are made in connection with the revenues recognized in any accounting period. We must assess whether the fee associated with a revenue transaction is fixed or determinable, whether VSOE exists for all elements of a transaction and the related revenue recognition impact of this, whether or not collection is probable and, for fixed-price contracts, make estimates of costs to complete. Material differences could result in the amount and timing of revenues for any period if management were to make different judgments or utilize different estimates.

Deferred revenues. Deferred subscription revenues represent customer billings made in advance for software licensed over a subscription period. Subscription periods vary from annual to multi-year and are classified as such. Deferred service revenues include pre-payments for software consulting and other product

21

Table of Contents

services, including software licenses transactions that are not segmentable from consulting services. Revenue for these services is recognized as the services are performed. Deferred maintenance and service revenues represent customer payments made in advance for annual support contracts. Maintenance is typically billed on a per annum basis in advance and revenue is recognized ratably over the maintenance period.

Estimating sales returns and other allowances, and allowance for doubtful accounts

We record estimated reductions in revenue for potential returns of products by customers and other allowances. As a result, management must make estimates of potential future product returns and other allowances related to current period product revenue. In making such estimates, management analyzes historical returns, current economic trends and changes in customer demand and acceptance of our products. If management were to make different judgments or utilize different estimates, material differences in the amount of our reported revenue could result. The provision for sales returns and other allowances was $2.7 million and $4.1 million at January 31, 2005 and 2004, respectively. The decrease relates to an improvement in our historical rate of returns and allowances.

Similarly, management makes estimates of the non-collectibility of accounts receivables, specifically analyzing accounts receivable and historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms, when evaluating the adequacy of the allowance for doubtful accounts. In addition to the identification of individual specific doubtful accounts receivable, we provide allowances for other accounts receivable based on our historical experience. If management were to make different judgments or utilize different estimates, material differences in the amount of our reported operating expenses could result. The allowance for doubtful accounts was $2.0 million and $2.7 million at January 31, 2005 and 2004, respectively. See Note 2, “Summary of Significant Accounting Policies” in Notes to Consolidated Financial Statements for a summary of activities during the years reported.

Valuation of long-lived assets, including goodwill and purchased intangibles

Goodwill and purchased intangibles. Intangible assets resulting from the acquisitions of entities accounted for using the purchase method of accounting are estimated by management based on the fair value of assets received. These include acquired customer base, technological know-how, trademarks and goodwill. Intangible assets are amortized over the estimated useful lives ranging from one year to seven years on a straight-line basis. Intangible assets acquired subsequent to June 30, 2001 have been accounted for in accordance with the provisions of SFAS No. 141 and have been amortized in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). For all other intangible assets, we adopted the provisions of SFAS No. 142 on February 1, 2002, which requires that goodwill no longer be amortized, but continue to be evaluated for impairment. Significant management judgment is involved in assessing the fair value of goodwill and purchased intangible assets received. The primary methods used to determine the fair value of assets received is the income approach, under which we must make assumptions as to the future cash flows of the acquired entity or assets, the appropriate discount rate to use to present value the cash flows and the anticipated life of the acquired assets, and the market approach, under which we compare the value of our reporting unit to publicly-traded companies in similar lines of business. If we made different judgments, material differences in the amount of fair value assigned to purchased intangibles and goodwill could arise.

We review goodwill for impairment annually in the second quarter of each fiscal year and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable in accordance with SFAS No. 142. We currently operate as one reportable segment. The primary methods used to determine the fair value of goodwill for impairment purposes were the income and market approaches. Goodwill was $92.0 million and $84.4 million and purchased intangibles were $2.5 million and $2.2 million at January 31, 2005 and 2004, respectively.

Impairment of long-lived assets. We evaluate the recoverability of our long-lived assets such as property and equipment and intangible assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal

22

Table of Contents

of Long-Lived Assets” (“SFAS No. 144”). SFAS No. 144 requires the recognition of the impairment of long-lived assets when circumstances indicate an impairment has occurred and in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets. Accordingly, we evaluate asset recoverability when an event occurs that may impair recoverability of the asset. We determine the recoverability of the carrying amount of each asset by reviewing the following factors: the undiscounted value of expected operating cash flows in relation to its net capital investments, the estimated useful or contractual life of the asset, the contract or product supporting the asset. In the case of purchased intangibles and capitalized software development costs, we periodically review the recoverability of the asset’s value by evaluating its products with respect to technological advances, competitive products and the needs of its customers. Substantially all of our long-lived assets, including goodwill, are located in North America.

The impairment charge for goodwill, purchased intangibles and other long-lived assets is assessed based upon estimated discounted cash flows over the remaining useful life of the goodwill, purchased intangibles or long-lived assets using an appropriate discount rate that incorporates our cost of capital and the risk profile of the associated investment. The assumptions supporting the cash flows, including the discount rates, are determined using our best estimates as of the date of the impairment review. These estimates are highly subjective and require significant management judgment as these estimates require us to make assumptions regarding future operating results, which are inherently difficult to predict. If these estimates or their related assumptions change in the future, we may be required to record additional impairment charges for these assets not previously recorded. For details about the impairment charges we recorded during fiscal 2004 and 2003, see “—Results of Operations—Years Ended January 31, 2005, 2004 and 2003—Impairment of Goodwill and Purchased Intangibles” below.

Restructuring Charges.

In fiscal 2005, 2004 and 2003, restructuring charges consist of costs associated with restructuring programs implemented by us and costs associated with the settlement of litigation and related remediation efforts. We account for the individual components of the restructuring activities as discussed further below.

In June 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”). SFAS No. 146 supersedes Emerging Issues Task Force (“EITF”) Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs To Exit an Activity (Including Certain Costs Associated with a Restructuring)” (“EITF 94-3”), and EITF Issue No. 88-10 “Costs Associated with Lease Modification or Termination” (“EITF 88-10”). We adopted SFAS No. 146 effective January 1, 2003; therefore, our 2004 and 2005 restructuring activities were accounted for in accordance with SFAS No. 146. The adoption of SFAS No. 146 did not impact our restructuring obligations recognized in connection with our restructuring activities initiated in fiscal 2003, as these obligations continue to be accounted for in accordance with EITF 94-3 and EITF 88-10 and other applicable pre-existing guidance.

The following is a summary of the accounting principles used to record and measure our 2005, 2004 and 2003 restructuring activities and associated obligations:

2005 and 2004 Restructurings. The expenses incurred in connection with our fiscal 2005 and 2004 restructuring are comprised principally of severance and associated employee termination costs related to the reduction of our workforce, an office closure and for employee litigation as a result of previous restructurings. The employee litigation relates to alleged wrongful termination. These activities have been accounted for primarily in accordance with SFAS No. 146. SFAS No. 146 requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is incurred, as opposed to when management commits to an exit plan. SFAS No. 146 also requires that: (i) liabilities associated with exit and disposal activities be measured at fair value; (ii) one-time termination benefits be expensed at the date the entity notifies the employee, unless the employee must provide future service, in which case the benefits are expensed ratably over the future service period; and (iii) costs to terminate a contract (specifically an operating lease) before the end of its term be

23

Table of Contents

recognized when the entity terminated the contract in accordance with the contract terms. The employee litigation charges were accounted for in accordance with SFAS No.5, “Accounting for Contingencies”.

A small portion of our restructuring costs for fiscal 2005 and 2004 have been accounted for in accordance with SFAS No. 112 “Employers’ Accounting for Postemployment Benefits, an Amendment of FASB Statements No. 5 and 43,” (“SFAS No. 112”). We applied SFAS No. 112 to a small number of international employees where we have historically provided termination benefits based on local statutory regulations. Accordingly, we record the liability related to these termination costs when we determine that they are both probable and estimable, which is generally when: (i) we approve a termination plan that commits us to such plan and establishes the benefits the employees will receive upon termination; (ii) the plan specifically identifies the number of employees to be terminated, their locations and their job classifications; and (iii) the period of time to implement the plan does not indicate changes to the plan are likely.

2003 Restructuring. Restructuring obligations incurred prior to the adoption of SFAS No. 146 in fiscal 2003 were accounted for and continue to be accounted for in accordance with EITF 94-3, SAB 100 “Restructuring and Impairment Charges” (“SAB 100”) and EITF 88-10. The expenses incurred in connection with our 2003 restructuring are comprised primarily of: (i) severance and associated employee termination costs related to the reduction of our workforce; (ii) consolidation of excess facilities; and (iii) impairment costs associated with certain other assets. We accounted for the individual components of the 2003 restructuring as follows:

Severance and associated employee termination costs. In accordance with EITF 94-3 and SAB 100, we recorded the liability related to these termination costs when the following conditions had been met: (i) management with the appropriate level of authority approves a termination plan that commits us to such plan and establishes the benefits the employees will receive upon termination; (ii) the benefit arrangement is communicated to the employees in sufficient detail to enable the employees to determine the termination benefits; (iii) the plan specifically identifies the number of employees to be terminated, their locations and their job classifications; and (iv) the period of time to implement the plan does not indicate changes to the plan are likely. The termination costs recorded by us are not associated with, nor do they benefit, continuing activities.

Consolidation of excess facilities. We accounted for the costs associated with the consolidation of excess facilities in accordance with EITF 88-10, and accordingly, we recorded the costs associated with excess facilities when the related leased property had no substantive future use or benefit to us. Our estimated excess facility costs represent the remaining lease payments and estimated costs less estimated proceeds from subleasing certain facilities. The estimated proceeds from subleasing these facilities are based on current comparable rates for leases in the respective markets.

Impairment costs associated with certain other assets. During fiscal 2003, we recorded a charge of $3.5 million related to certain other assets, primarily assets associated with certain products that management decided to discontinue as a result of its restructuring programs.

We review the status of restructuring activities on a quarterly basis and, if appropriate, record changes to restructuring obligations as part of operating expenses based on management’s most current estimates. Restructuring charges in fiscal 2005, 2004 and 2003 were $2.7 million, $2.2 million and $32.7 million, respectively.

Inherent in the estimation of the costs related to our restructuring efforts are assessments related to the most likely expected outcome of the significant actions to accomplish the restructuring. In determining our restructuring charges, the majority of estimates made by management related to our charges for excess facilities. In determining the charge for excess facilities, we were required to estimate future sublease income, negotiated lease settlement costs, future net operating expenses of the facilities, and brokerage commissions, among other expenses. These estimates, along with other estimates made by management in connection with our restructuring, may vary significantly depending, in part, on factors that may be beyond our control. Specifically, these estimates will depend on our success in negotiating with lessors, the time periods required to locate and contract

24

Table of Contents

suitable subleases and the market rates at the time of such subleases. Adjustments to our reserve for the consolidation of excess facilities will be required if actual lease exit costs or sublease income differ from amounts currently expected. We review the status of our restructuring activities on a quarterly basis and, if appropriate, record changes to our restructuring obligations as part of operating expenses based on management’s most current estimates.

Accounting for Income Taxes

Significant management judgment is required in determining our provision for income taxes, income tax liabilities, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. Judgment is applied to estimate taxable income by jurisdiction and our ability to utilize any unexpired credits and/or net operating losses. We are subject to income tax audits in all of the jurisdictions in which we operate and, as a result, must also assess exposures to any potential issues arising from current or future audits of current and prior years tax returns. Accordingly, we must assess such potential exposure and, where necessary, provide a reserve to cover any expected loss. To the extent that we establish a reserve, our provision for income taxes would be increased. If we ultimately determine that payment of these amounts is unnecessary, we reverse the liability and recognize a tax benefit during the period in which we determine that the liability is no longer necessary. We record an additional charge in our provision for taxes in the period in which we determine that the recorded tax liability is less than we expect the ultimate assessment to be. During the year ended January 31, 2005, we realized a benefit of $1.0 million arising from the final assessment of a foreign tax audit. Our tax rate may also vary based on our results and the mix of income or loss amongst the domestic and foreign tax jurisdictions in which we operate.

Deferred income taxes are recorded in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”) and are determined based on the differences between financial reporting and the tax basis of assets and liabilities using the tax rates and laws in effect when the differences are expected to reverse. SFAS No. 109 provides for the recognition of deferred tax assets if the realization of such assets is more likely than not to occur. We have recorded a valuation allowance due to uncertainties related to our ability to utilize our deferred tax assets, in all jurisdictions apart from Germany, primarily relating to certain net operating losses carried forward and foreign tax credits, before they expire. This determination has been made based on available evidence, including our historical levels of taxable income. Should we determine that we would be able to realize our deferred tax assets in the foreseeable future, an adjustment to our deferred tax assets would cause a material increase to income in the period such determination was made. Significant management judgment is required in determining the period in which the reversal of a valuation allowance should occur. Factors that we must consider in making this determination include historical levels and future forecasts of taxable income among other items. The valuation allowance at January 31, 2005 and 2004 was $76.6 million and $74.2 million, respectively. Management continues to evaluate the realizability of our deferred tax assets and related valuation allowances.

Stock-based Compensation

SFAS No. 123, “Accounting for Stock-Based Compensation,” currently encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. We have continued to account for stock-based employee compensation using the intrinsic value method. Under that method, compensation cost for stock options granted to employees is measured as the excess, if any, of the quoted market price of our stock at the date of the grant over the amount an employee must pay to acquire the stock. However, as of February 1, 2006, we will be required to apply FASB Statement 123R, Share-Based Payment, which will require us to measure compensation cost for all share-based payments at fair value.

Litigation Contingencies

We are involved from time to time in various proceedings, lawsuits and claims involving our customers, products, intellectual property, stockholders and employees, among other things. Quarterly, we review the status

25

Table of Contents

of each significant matter and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be reasonably estimated, we accrue a liability for the estimated loss. Significant judgment is required in both the determination of probability and the determination as to whether an exposure is reasonably estimable. Because of uncertainties related to these matters, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to our pending claims and litigation and may revise our estimates. Such revisions in the estimates of the potential liabilities could have a material impact on our consolidated results of operations or financial position.

Results of Operations for the Years Ended January 31, 2005, 2004 and 2003

Revenues

We recognize revenues from three sources: (1) product revenues, (2) service revenues and (3) subscription revenues, net of sales returns and other allowances. Product revenues consist of revenues from production licenses (sometimes referred to as royalties), and fees for stand-alone software and software programming tools sold under our perpetual licensing model and from sales of our hardware. Service revenues are derived from fees from professional services, which include design and development fees, software maintenance contracts, and customer training and consulting. Subscription revenues consist of revenues from the licensing of products and services under our enterprise licensing model including items such as development tools, an operating system, various protocols and interfaces and maintenance and support services such as installation and training, which are licensed over a limited period of time, typically 12 months.

Total revenues increased 15% in fiscal 2005 compared to fiscal 2004 and decreased 18% in fiscal 2004 compared to 2003.

The increase in total revenues in fiscal 2005 compared to 2004 was primarily due to higher customer demand for our software and hardware, improvements in production license revenues and increased investments in device software optimization solutions as a result of an improvement in the overall economy. See “—Factors That May Affect Our Future Results or the Market Price of Our Stock”.

The decrease in total revenues in fiscal 2004 compared to 2003 was due to lower customer demand for hardware and software products, including revenues from production licenses, which are generally tied to the number of devices deployed by our customers. This lower customer demand was mainly a result of the continuing economic downturn in the high-technology sector, which started during fiscal 2002 and continued through fiscal 2004.

Our product and service revenues, in particular maintenance revenues, have also been affected as the result of the transition of some of our customers to our Wind River Platforms. Fees from the Wind River Platforms are recorded as subscription revenue ratably over the license term, which is typically one year. In contrast under our perpetual model, a significant percentage of the transaction fee is recognized in the quarter the transaction is completed. While this has impacted, and will continue to impact, our revenues in the short term as customers transition to the Wind River Platforms, our deferred revenues have increased to $77.1 million at January 31, 2005 from $39.1 million at January 31, 2004, primarily as a result of the transition of business to our Wind River Platforms.

26

Table of Contents

Product Revenues.

Product revenues are comprised of perpetual license revenues, including hardware revenues, and production license revenues from perpetual and subscription licensing. The table below sets forth information for such components.

Perpetual license revenues declined 11% in fiscal 2005 compared to fiscal 2004 and declined 37% in fiscal 2004 compared to fiscal 2003. Perpetual license revenues have decreased as a percentage of revenue in fiscal 2005 and 2004 compared to fiscal 2003 due to the transition to our Wind River Platforms, which are accounted for as subscription revenues. We expect perpetual licenses and hardware revenues to continue to decline as the transition to our Wind River Platforms continues.

Production license revenues increased 22% in fiscal 2005 compared to fiscal 2004 and declined 15% in fiscal 2004 compared to fiscal 2003. This increase in fiscal 2005 was primarily due to our customers manufacturing more embedded devices that include our technology, especially in the digital consumer and networking segments, improvement in our execution in the area of customer compliance and reporting and improvement in our customers’ own quarterly reporting processes.

Subscription Revenues. Subscription revenues were $49.0 million in fiscal 2005 compared to $19.1 million in fiscal 2004, an increase of 156%. The significant increase in fiscal 2005 in subscription revenues resulted from the continued transition of a number of our customers from our traditional perpetual licensing model to our Wind River Platforms under the enterprise license model and increasing business activity levels. We expect that subscription revenues will continue to increase both in absolute dollars and as a percentage of revenue in the future. Fiscal 2004 was the first full fiscal year in which we sold our Wind River Platform products under the enterprise license model. The transition of customers to enterprise license model will continue to affect the level of our overall revenues because we recognize fees under this business model ratably as opposed to our perpetual model where a significant proportion of the fee is recognized at the time the transaction is completed.

Service Revenues.

Service revenues are derived from fees for professional services, which include design and development fees, software maintenance contracts, customer training and consulting.

Maintenance revenues declined 15% in fiscal 2005 compared to fiscal 2004, and declined 12% in fiscal 2004 compared to fiscal 2003. The decline in fiscal 2005 is primarily due to the continued transition of our customers to our Wind River Platforms, which include maintenance as a part of the subscription fee. We expect

27

Table of Contents

maintenance revenues will continue to decline as our customers’ transition to our Wind River Platforms continues. Other service revenues increased 7% in fiscal 2005 compared to fiscal 2004 and declined 32% in fiscal 2004 compared to fiscal 2003. The increase in fiscal 2005 was due to an increase in professional service revenues. In addition to the impact from the general economic environment, other service revenues were also impacted in fiscal 2004 due to a disruption in services backlog arising from a reorganization of our sales force. During fiscal year 2005 and 2004, we generated $6.0 million and $8.0 million in revenue from fixed-price services contracts accounted for under the percentage-of-completion method of accounting, respectively. The majority of other service revenues are related to time-and-materials services contracts, which are recognized as the related services are performed.

Revenues by Geography

Revenues from international sales increased 19% to $106.8 million in fiscal 2005 from $89.6 million in fiscal 2004 and decreased 14% from $103.6 million in fiscal 2003. The increase is due to a 16% increase in revenues from EMEA, a 22% increase in revenues from Japan, and a 24% increase in revenues from Asia Pacific, between fiscal 2005 and 2004. The decrease in fiscal 2004 compared to fiscal 2003 was due to a 16% decrease in revenues from EMEA, a 4% decrease in revenues from Japan, and a 20% decrease in revenues from Asia Pacific, between fiscal 2004 and 2003. International revenues increased as a percentage of revenues between fiscal 2005 and 2004 primarily due to international revenues increasing at a faster rate than North American revenues. International revenues increased in absolute dollars primarily due to increases in subscription revenues and production license revenues in all international geographies. The impact of foreign exchange rate movements did not have a significant impact on international revenues during fiscal 2005. The decrease in international revenues between fiscal 2004 and 2003 resulted primarily from the same macroeconomic factors that have impacted our business in North America and have caused our customers to reduce their research and development spending and purchase fewer of our products and services. Our international revenues have also been affected as the result of the transition of some of our customers to our Wind River Platforms, in which revenue is recognized ratably as opposed to being recognized immediately under our perpetual license model. International revenues accounted for 45%, 44% and 42% of total revenues in fiscal 2005, 2004 and 2003, respectively. We expect international sales to continue to represent a significant portion of our revenues, although the actual percentage may fluctuate from period to period. Our international sales are generally denominated in United States Dollars, Euro, United Kingdom Sterling or Japanese Yen.

28

Table of Contents

Deferred Revenues

Our deferred revenues consist of the following:

During fiscal 2005, we began offering subscription and maintenance periods greater than twelve months and, accordingly, began to record long-term deferred revenues which represents the portion of multi-year contracts that are due to be recognized as revenue in a time period greater than one year from the balance sheet date. The growth in subscription deferred revenues results from the continued transition from our traditional perpetual licensing model to our Wind River Platforms enterprise license model and increasing business activity levels. The growth in deferred revenues for subscriptions during fiscal 2005 corresponds to the 156% increase in subscription revenue. The growth in deferred revenues for maintenance and other during fiscal 2005 corresponds to the growth in our software consulting services revenue.

Cost of Revenues

The general decline in overall costs of products and services was due to lower fixed costs such as employee costs, consulting cost and manufacturing and distribution costs arising from our restructuring activities during fiscal 2005, 2004 and 2003 and also cost of product and cost of services have decreased in absolute dollars in fiscal 2005 compared to fiscal 2004, due to the transition to our Wind River Platforms, which are accounted for as cost of subscription.

Cost of Product. Product-related costs consist primarily of salaries and benefits for production employees, other direct production costs, amortization of capitalized software development costs, royalty payments to third parties for the use of their software, and shipping costs. Cost of products decreased by 40%, or $3.9 million, in fiscal 2005 compared to fiscal 2004 and by 48%, or $8.8 million, in fiscal 2004 compared to fiscal 2003. The

29

Table of Contents

decline in product-related costs in absolute dollars in fiscal 2005, 2004 and 2003 was primarily due to lower direct production costs due to the allocation of costs to subscription. Direct production costs were $2.7 million, $5.8 million and $11.0 million in fiscal 2005, 2004 and 2003, respectively. Amortization of capitalized software development costs in fiscal 2005, 2004 and 2003 amounted to $105,000, $381,000 and $952,000, respectively, and third-party royalty costs for fiscal 2005, 2004 and 2003 were $2.5 million, $3.0 million and $5.7 million, respectively. The decline in product-related costs as a percentage of product revenues in the fiscal 2005 compared to fiscal 2004 was related to the increased allocation to subscription and increased production license revenues that have only marginal cost of product. The decline in product-related costs as a percentage of product revenues in fiscal 2004 compared to fiscal 2003 was related to the decline in production costs resulting from our restructuring activities taken in fiscal 2003 and 2002. Product-related cost of revenues may be affected in the future by costs of distribution related to the introduction of new products, royalty costs for use of third-party software in our products and by the amortization of capitalized software development costs.

Cost of Subscription. Subscription-related costs of revenues consists primarily of subscription-related costs, including salaries and benefits for production employees, other direct production costs, amortization of capitalized software development costs, royalty payments to third parties for the use of their software, shipping costs and costs of providing subscription-related maintenance and support services. Cost of subscriptions increased 111%, or $5.9 million, in fiscal 2005 compared to fiscal 2004 and $4.9 million, in fiscal 2004 compared to fiscal 2003. Subscription-related production costs were $4.5 million, $1.4 million and $211,000 during fiscal 2005, 2004 and 2003, respectively. Subscription-related maintenance and support services costs were $6.8 million, $3.4 million and $163,000 during fiscal 2005, 2004 and 2003, respectively. The increase in absolute dollars in subscription costs in fiscal 2005 as compared to fiscal 2004 was primarily due to the higher allocation of maintenance and support services costs and higher production costs and as a result of the related increase in subscription revenue. The increase in absolute dollars in subscription costs in fiscal 2004 as compared to fiscal 2003 was due to fiscal 2004 being the first full year in which we sold our Wind River Platforms under the enterprise license model. The decrease in cost of subscription revenues as a percentage of subscription revenues in fiscal 2005 compared to fiscal 2004 was due to fixed costs, such as production and maintenance salaries, being absorbed by a higher revenue base. The increase in cost of subscription revenues as a percentage of subscription revenues in fiscal 2004 compared to fiscal 2003 was due to the fact that our Wind River Platforms include a higher mixture of services costs which traditionally carry a proportionally lower gross margin. We expect costs of subscriptions to continue to fluctuate as a percentage of subscription revenue based on the level of sales of our Wind River Platforms and the continued transition of existing customers from our perpetual based licensing to the enterprise license model. Cost of subscriptions may be affected in the future by the direct production costs, amortization of capitalized software development costs, costs of distribution, royalty costs for use of third party software in our products, and the costs of providing subscription-related maintenance and support services.

Cost of Services. Service-related cost of revenues consist primarily of personnel related costs associated with providing services, including consulting services, to customers and the infrastructure to manage a services organization, as well as costs to recruit, develop and retain services professionals. Cost of services decreased by 9%, or $3.4 million, in fiscal 2005 compared to fiscal 2004 and by 28%, or $14.4 million, in fiscal 2004 compared to fiscal 2003. The decrease in absolute dollars of service costs in fiscal 2005 compared to fiscal 2004 and in fiscal 2004 compared to fiscal 2003, was primarily due to reduced use of outside consultants and a reduction of full-time employees as part of the restructuring programs implemented beginning fiscal 2003 and through fiscal 2005. We realized overall cost reductions of $3.9 million and $9.6 million in professional service costs relating primarily to internal payroll and external contractor costs, savings of $146,000 and $2.7 million in training costs, and increased costs of $586,000 and savings of $2.1 million in maintenance costs in fiscal 2005 compared to fiscal 2004, and fiscal 2004 compared to fiscal 2003, respectively. In addition, cost of service revenues decreased as a percentage of services revenue in fiscal 2005 compared to fiscal 2004 and fiscal 2003 due in part to the transition to our Wind River Platforms which are accounted for as costs of subscriptions. We expect cost of services to continue to fluctuate as a percentage of service revenue based on our ability to fully utilize our professional services organization.

30

Table of Contents

Amortization of Purchased Intangibles. Amortization of purchased intangibles relates to amortization of completed technology acquired through purchase transactions. The decreases in amortization in fiscal 2005 compared to fiscal 2004 and fiscal 2004 compared to fiscal 2003 were due to a lower amortizable base of purchased intangible assets. In January 2005, we acquired the assets and obligations of the ScopeTools business unit of Real-Time Innovations, Inc. and recorded $2.1 million in completed technology which is expected be amortized to cost of revenue over a four year period.

Operating Expenses

We allocate the total costs for information technology, facilities and fixed asset depreciation to each of the functional areas based on worldwide headcount data. Information technology allocated costs includes salaries, employee-related costs, outside consulting costs for projects, communication costs, hardware and software maintenance contracts costs and depreciation expense for fixed assets. Facilities allocated costs include facility rent for the corporate offices as well as shared function offices, property taxes, depreciation expenses for office furniture and other department operating costs. Fixed asset depreciation allocated costs includes straight-line depreciation expense on buildings, leasehold improvements, computer equipment, software, furniture and office equipment.

The general decline in both absolute dollars and as a percentage of revenue in selling and marketing, product development and engineering and general and administrative costs as shown below, for fiscal years 2004 and 2003, and to a lesser extent 2005, was due in a large part to the restructuring programs and cost control measures we implemented over the past few years, which led to decreased overall costs, primarily payroll related expenses, consulting expenses, general operating expenses, such as travel costs and reduced depreciation expenses arising from reduced capital expenditures. In fiscal 2005 compared to fiscal 2004, revenues increased at a faster rate than selling and marketing and product development and engineering costs causing the decrease in these costs as a percentage of revenue.

Selling and Marketing. Selling and marketing expenses consist primarily of product and other marketing related expenses, compensation related expenses, sales commissions, facility costs and travel costs.

The increase in selling and marketing expenses in fiscal 2005 compared to fiscal 2004 was 6% or $4.9 million. This increase was attributable to higher salaries and related fringe benefit costs of $3.5 million due to an increased investment in the sales organization, higher sales commissions of $2.0 million, due to an increase in revenue and higher distributor commissions of $729,000, due to increased use of distributor and sales agents and higher advertising and marketing costs of $718,000. The increases were offset by a reduction in depreciation expense of $1.2 million, due to a lower depreciable base of short-lived fixed assets and $2.0 million due to a decrease in rent and other facility costs. The decrease in selling and marketing expenses from fiscal 2004 to fiscal 2003 was 29% or $35.3 million. The decrease was attributable to lower sales commission expenses as a result of decreased sales volume and decreased expenditures due to the restructuring programs implemented during fiscal 2004 and 2003. In addition, salaries and related fringe benefits costs decreased by $10.2 million, sales commission costs decreased by $6.6 million, travel expenses decreased by $2.9 million, consulting expenses decreased by $2.3 million, depreciation expenses decreased $4.2 million and rent and utilities decreased by $2.9 million, in fiscal 2004 compared to fiscal 2003. We expect an increase in selling and marketing expenses in absolute dollars in both the short- and long-term as we continue to focus on long-term growth in the areas of sales and marketing personnel and marketing and advertising programs.

31

Table of Contents

Product Development and Engineering Expenses. Product development and engineering expenses consist primarily of payroll related expenses, facility costs and consulting fees for our product research and development organization.

The increase in product development and engineering expenses in fiscal 2005 compared to fiscal 2004 was 5% or $2.6 million. This increase was primarily attributable to higher salaries and fringe benefits of $3.5 million, the addition of an engineering incentive program totaling $1.1 million and an increase in consulting and outside costs of $922,000. These increases were offset by a decrease in depreciation expense of $1.7 million due to a lower base of depreciable assets and savings in several other areas. Additionally, in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” we capitalized $1.5 million of product development expenses in fiscal 2005 in connection with the release of VxWorks 6.0 and Workbench 2.2, both of which were major product releases for us. The related costs will be amortized over the next two years as a component of cost of revenues. The decrease in product development and engineering expenses in fiscal 2004 compared to fiscal 2003 was 23% or $17.3 million. The decrease in absolute dollars of product development and engineering expenses in fiscal 2004 compared to fiscal 2003 was primarily due to cost-control measures relating to our restructuring programs. Salaries and fringe benefits costs decreased by $11.6 million in fiscal 2004 compared to fiscal 2003. In addition, depreciation expense decreased $2.1 million in fiscal 2004 compared to fiscal 2003 due to a lower depreciable base of our short-lived fixed assets. We received $3.8 million in fiscal 2005, $3.5 million in fiscal 2004 and $4.5 million in fiscal 2003, respectively, of third party funded research and development which offset a portion of our gross research and development expenses. In the short-term, dollars received for funded research and development accounted for as an offset to gross product development and engineering expenses may vary depending on the timing and nature of work performed under these programs. In the long-term, we expect the dollars received for funded research and development to be reduced significantly as our programs wind down. We expect that product development and engineering expenses in absolute dollars will not increase significantly in the short-term.

General and Administrative Expenses. General and administrative expenses consist primarily of compensation related expenses, facilities related expenses and external fees for professional services, such as legal and accounting.

The decrease in general and administrative expenses in fiscal 2005 compared to fiscal 2004 was 18% or $4.7 million and was primarily a result of general cost saving initiatives realized from restructuring activities in fiscal 2005 and from previous restructurings. We realized $5.6 million in payroll-related cost reductions in fiscal 2005 compared to fiscal 2004. This decrease was offset by an increase of $878,000 in attestation services, primarily due to the additional requirements of the Sarbanes-Oxley Act of 2002, and tax services. The decrease in general and administrative expenses in fiscal 2004 compared to fiscal 2003 was 23% or $7.6 million primarily due to cost-control measures relating to our restructuring programs implemented in fiscal 2004 and fiscal 2003. Due to these restructuring plans, we realized $4.3 million in payroll-related cost reductions and realized $2.9 million in legal and accounting costs, primarily as a result of lower legal costs resulting from our restructuring plans, and from having incurred $800,000 of legal costs in fiscal 2003 relating to an employee litigation matter. The decrease in costs in fiscal 2004 was offset by $1.4 million in stock compensation charges associated with the

32

Table of Contents

separation of our former Chief Executive Officer, Thomas St. Dennis. We believe that general and administrative expenses will not increase significantly in the short-term. However, we do expect an increase in absolute dollars in the long-term, as we invest in worldwide staff and infrastructure in the areas of information systems and finance and administration.

Goodwill. We performed our annual test for goodwill impairment as required by SFAS No. 142 as of June 30, 2004. We currently operate in one reportable segment, which is also the only reporting unit for the purposes of SFAS 142. The primary methods used to determine the fair values for SFAS 142 impairment purposes were the income and market approach. The income approach provides an estimation of the fair value of a reporting unit based on the discounted cash flows derived from the reporting unit’s estimated remaining life plus any residual value. The market approach indicates the fair value of a reporting unit based upon a comparison to publicly-traded companies in similar lines of business. The assumptions supporting the income approach, including the discount rate, which was assumed to be 17%, were determined using our best estimates as of the date of the impairment review. We completed our evaluation under both methods and concluded that goodwill was not impaired as the fair value of the reporting unit exceeded its carrying value, including goodwill.

Amortization of Other Intangibles

The decrease in amortization of other intangibles for fiscal 2005 and 2004 compared to 2003 was due to a lower amortizable base of other intangible assets. In January 2005, we acquired the assets and obligations of the ScopeTools business unit of Real-Time Innovations, Inc. and recorded $400,000 in intangible assets, other than goodwill which are expected to be amortized to operating expenses over a two to seven year period.

Impairment of Purchased Intangibles

There was no goodwill or purchased intangibles impairment for fiscal 2005. During the second quarters of fiscal 2004 and 2003 and during the fourth quarter of fiscal 2003, we identified possible impairments of goodwill and certain purchased technologies relating to previous acquisitions. The impairments were based on a change in the long-term strategic plan for these purchased technologies following a deterioration in the business climate and changes in sales and cash flow forecasts.

In anticipation of continued customer spending and as part of our strategic plans, we acquired businesses to complement and extend our product offerings. Since these acquisitions were made, many companies in the high technology and software industries had experienced significant decreases in capital funding and customer spending and, as a result, had curtailed research and development activities. Therefore, revenues associated with these businesses did not meet the original expectations at the time of acquisition.

33

Table of Contents

Accordingly, we compared the undiscounted cash flows associated with such acquired business and long-lived assets with the respective carrying amounts and determined that an impairment of certain of these assets existed. As a result, we recorded aggregate impairment charges of $1.4 million and $4.3 million of purchased technologies during fiscal 2004 and 2003, respectively. The impaired amount was measured as the amount by which the carrying amount exceeded the present value of the estimated future cash flows as follows:

The impairment review of these assets was determined based upon the estimated discounted cash flows over the remaining useful life of the goodwill and purchased intangibles, using discount rates ranging from 17% to 30% for fiscal 2003. No discount rate was applied in fiscal 2004 due to the short-term nature of remaining cash flows. The assumptions supporting the cash flows, including the discount rates, were determined using our best estimate as of the date of the impairment review. The impairment charge for those assets held for disposal also included the expected proceeds of disposition. As of January 31, 2005 and 2004, we had net book values of goodwill of $92.0 million and $84.4 million, respectively, and net book values of purchased intangibles of $2.5 million and $2.2 million, respectively. All identifiable intangible assets, other than goodwill, will continue to be amortized in accordance with SFAS No. 142. See Note 3, “Goodwill and Purchased Intangibles” in Notes to the Consolidated Financial Statements.

Restructuring and Other Charges. Restructuring and other charges consist of costs associated with restructuring programs, a settlement with our former chief executive officer and a settlement of litigation and related remediation efforts.

Restructuring Charges. We recorded net restructuring charges of $2.7 million, $2.2 million and $32.7 million in fiscal 2005, 2004 and 2003, respectively, which in each case were classified as operating expenses.

As a result of decisions undertaken by us regarding the cost structure of our business, beginning in fiscal 2002, we implemented restructuring plans that were designed to align our anticipated revenues more closely with our cost structure. Our restructuring plans have been based on certain assumptions regarding the cost structure of our business and the nature and severity of prior industry adjustments and general economic trends, and involved the implementation of a number of initiatives, including headcount reductions, facilities closures, and other cost-control measures such as employing a program of office closure days and reducing discretionary spending on items such as consulting and travel. As a result of the headcount reductions, we eliminated an aggregate of 58 employee positions in fiscal 2005, 70 employee positions in fiscal 2004 and 591 employee positions in fiscal 2003. Our restructuring program for fiscal 2003 was initiated prior to our adoption of SFAS No. 146 and has been accounted for in accordance with the provisions of SAB 100, EITF 94-3 and EITF 88-10. Our restructuring programs for fiscal 2005 and 2004 have been accounted for in accordance with SFAS No. 146 and SFAS No. 112. For a further discussion of factors that may affect the success of the restructuring program, see “—Factors That May Affect Our Future Results or the Market Price of Our Stock—Our restructuring plans may not enable us to achieve profitability in a difficult economic environment or achieve our business objectives.”

34

Table of Contents

As of January 31, 2005, our total restructuring liabilities related to our restructuring plans for fiscal 2005, 2004 and 2003 were approximately $1.4 million. The following table summarizes our restructuring liabilities as of January 31, 2005, 2004 and 2003:

The worldwide workforce reductions implemented during fiscal 2003 were substantially completed during the first half of fiscal 2004. The workforce reductions implemented in fiscal 2004 were substantially completed by the end of the third quarter of fiscal 2005. The workforce reductions implemented in fiscal 2005 will be substantially completed by the end of the first quarter of fiscal 2006.

During fiscal 2005, we undertook further limited restructurings in the areas of professional services, sales and marketing which involved a headcount reduction of 58 employees. We also incurred charges associated with restructurings from fiscal 2004. In addition, we incurred charges associated with vacating an office in Canada and charges associated with employee litigation as a result of previous restructurings. Also, in fiscal 2005, we revised estimates for actual experience in the amount of $446,000 in employee-related items, which includes outplacement fees, COBRA fees and employer related taxes and $92,000 related to a buy-out of the Canadian office. All charges have been calculated in accordance with the provisions of SFAS No. 146, SFAS No. 112 and SAB 100.

The workforce reductions in fiscal 2004 and 2003 affected all business functions, including sales and marketing, professional services, product development and engineering, and finance and administration and impacted employees from our operations in North America, EMEA and Japan. We also reduced the number of contractors and temporary workers used by us as a result of the fiscal 2003 restructuring program. In addition, we revised estimates for actual usage in the amount of $560,000 and $1.1 million in fiscal 2004 and fiscal 2003, respectively, primarily associated with workforce reductions related to outplacement fees and COBRA fees.

We recorded a net restructuring charge of $3.5 million during fiscal 2003, relating to the consolidation of certain excess facilities primarily in the United States, Japan and Europe. The consolidation of excess facilities

35

Table of Contents

includes the closure of certain leased corporate facilities and sales offices that related to business activities that were restructured. The estimated excess facility costs represent the remaining lease payments and estimated costs less estimated proceeds from sub-leasing certain facilities. The estimated proceeds from sub-leasing these facilities are based on current comparable rates for leases in the respective markets. If rental rates for our leased facilities continue to decrease in these markets or it takes longer than expected to find a suitable tenant to sublease these facilities, the actual loss could exceed this estimate. Amounts accrued due to the consolidation of excess facilities as a result of the fiscal 2003 restructuring programs will be paid through fiscal 2006. Equipment disposed of or removed from operations as a result of the workforce reduction resulted in non-cash charges of $206,000 in fiscal 2003 and consisted primarily of computer equipment.

During fiscal 2003, we recorded a restructuring charge of $3.5 million for other items primarily relating to research and development activities that management decided to discontinue as a result of our restructuring activities.

Other Charges. During fiscal 2005, we recorded a reversal of $66,000 of other charges related to the settlement of litigation previously accrued for in fiscal 2003. During fiscal 2004, we recorded a charge of $766,000 associated with a settlement of our former Chief Executive Officer, Thomas St. Dennis. The charge primarily related to compensation for tax liabilities arising from the settlement of a stockholder loan that Mr. St. Dennis held with the company. (See Note 7, “Management Changes” in Notes to Consolidated Financial Statements for further information.) During fiscal 2003, we recorded a charge of $3.7 million relating to the settlement of litigation with a third party and related remediation efforts.

Gain on Sale of Asset

In fiscal 2005, we sold our Sunnyvale facility and realized a gain of $2.0 million. We had no similar sales in fiscal 2004 or 2003.

Other Income (Expense)