MAGMA DESIGN AUTOMATION INC - FORM 10-Q - September 9, 2011

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________________________ 
FORM 10-Q
 _____________________________________________ 
(Mark One)
S
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended July 31, 2011
or
£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                  to                 .
Commission File No.: 0-33213
_______________________________________________ 
MAGMA DESIGN AUTOMATION, INC.
(Exact name of registrant as specified in its charter)
_______________________________________________
Delaware
 
77-0454924
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
1650 Technology Drive,
San Jose, California 95110
(Address of principal executive offices)
Telephone: (408) 565-7500
(Registrant’s telephone number, including area code)
___________________________________________ 
Indicate by check mark whether the registrant (l) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days.    Yes  S No  £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  S    No  £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large Accelerated Filer  £
 
Accelerated Filer  x
Non-accelerated Filer  £    (Do not check if a smaller reporting company)
 
Smaller reporting company  £
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes £   No  S
The number of shares outstanding of the registrant’s Common Stock, par value $0.0001, as of September 8, was 68,449,383.

MAGMA DESIGN AUTOMATION, INC.
FORM 10-Q
QUARTERLY PERIOD ENDED JULY 31, 2011
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


1

PART 1: FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

MAGMA DESIGN AUTOMATION, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
 
 
July 31,
2011
 
May 1,
2011
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
51,101

 
$
47,088

Accounts receivable, net including receivables from related parties of $190 and $2,181 at July 31, 2011 and May 1, 2011, respectively
14,450

 
35,530

Prepaid expenses and other current assets
5,343

 
3,915

Total current assets
70,894

 
86,533

Property and equipment, net
5,977

 
6,066

Intangible assets, net
2,953

 
3,691

Goodwill
7,415

 
7,415

Other assets
2,870

 
2,767

Total assets
$
90,109

 
$
106,472

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
2,954

 
$
3,697

Accrued expenses
9,697

 
14,160

Current portion of term debt
3,750

 
3,750

Current portion of other long-term liabilities
1,234

 
1,199

Deferred revenue
20,975

 
34,390

Total current liabilities
38,610

 
57,196

Convertible notes, net of debt premium of $134 and $145 at July 31, 2011 and May 1, 2011, respectively
3,384

 
3,395

Long-term portion of term debt
18,250

 
19,188

Long-term tax liabilities
1,746

 
1,703

Other long-term liabilities
1,154

 
1,270

Total liabilities
63,144

 
82,752

Commitments and contingencies (Note 12)

 

Stockholders' equity:
 
 
 
Common stock
7

 
7

Additional paid-in capital
450,566

 
447,328

Accumulated deficit
(387,188
)
 
(387,087
)
Treasury stock at cost
(32,615
)
 
(32,615
)
Accumulated other comprehensive loss
(3,805
)
 
(3,913
)
Total stockholders' equity
26,965

 
23,720

Total liabilities and stockholders' equity
$
90,109

 
$
106,472


See accompanying notes to unaudited condensed consolidated financial statements.


2

MAGMA DESIGN AUTOMATION, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
 
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
Revenue*:
 
 
 
Licenses
$
26,557

 
$
24,305

Services
8,749

 
8,251

Total revenue
35,306

 
32,556

Cost of revenue*:
 
 
 
Licenses
619

 
936

Services
4,000

 
3,806

Total cost of revenue
4,619

 
4,742

Gross profit
30,687

 
27,814

Operating expenses:
 
 
 
Research and development
12,785

 
12,259

Sales and marketing
10,410

 
10,567

General and administrative
6,171

 
4,690

Amortization of intangible assets
202

 
256

Restructuring charges
726

 
(14
)
Total operating expenses
30,294

 
27,758

Operating income
393

 
56

Other income (expense):
 
 
 
Interest income
14

 
29

Interest expense
(482
)
 
(806
)
Valuation gain, net
—

 
38

Loss on extinguishment of debt
—

 
(2,093
)
Other income (expense), net
394

 
(151
)
Other expense, net
(74
)
 
(2,983
)
Net income (loss) before income taxes
319

 
(2,927
)
Provision for income taxes
420

 
331

Net loss
$
(101
)
 
$
(3,258
)
Net loss per share, basic and diluted
$
0.00

 
$
(0.06
)
Shares used in per share calculation, basic and diluted
67,785

 
52,563



* Revenue and cost of revenue for the three months ended August 1, 2010 have been adjusted to conform with the presentation for the three months ended July 31, 2011. See Note 1 for further discussion.


See accompanying notes to unaudited condensed consolidated financial statements


3

MAGMA DESIGN AUTOMATION, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
Cash flows from operating activities:
 
 
 
Net loss
$
(101
)
 
$
(3,258
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation
984

 
1,298

Amortization of intangible assets
739

 
1,081

Provision for doubtful accounts
—

 
148

Amortization of debt discount and debt issuance costs
63

 
354

Amortization of debt premium
(12
)
 
(247
)
Loss on extinguishment of convertible notes
—

 
2,093

Gain on purchased put option
—

 
(38
)
Loss/(Gain) on strategic equity investments
(482
)
 
34

Stock-based compensation
2,226

 
2,984

Restructuring charges
726

 
(14
)
Other non-cash items
(31
)
 
53

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
21,314

 
5,101

Prepaid expenses and other assets
(1,575
)
 
504

Accounts payable
(1,301
)
 
(256
)
Accrued expenses
(5,067
)
 
(4,392
)
Deferred revenue
(13,562
)
 
(4,002
)
Other long-term liabilities
80

 
(56
)
Net cash provided by operating activities
4,001

 
1,387

Cash flows from investing activities:
 
 
 
Cash paid for business acquisitions
—

 
(596
)
Purchase of property and equipment
(150
)
 
(359
)
Proceeds from maturities and sale of investments
—

 
16,875

(Purchase)/Sale of strategic investments
518

 
(275
)
Net cash provided by investing activities
368

 
15,645

Cash flows from financing activities:
 
 
 
Repayment of lease obligations
(489
)
 
(495
)
Repayment of secured credit line
—

 
(11,162
)
Repayment of convertible notes due 2010
—

 
(23,250
)
Repurchase of convertible notes due 2014
—

 
(4,839
)
Repayment of term debt
(938
)
 
—

Proceeds from issuance of common stock, net
2,069

 
793

Repurchase of common stock for retirement
—

 
(1,960
)
Retirement of restricted stock
(1,036
)
 
(578
)
Net cash used in financing activities
(394
)
 
(41,491
)
Effect of foreign currency translation changes on cash and cash equivalents
38

 
1

Net change in cash and cash equivalents
4,013

 
(24,458
)
Cash and cash equivalents, beginning of period
47,088

 
57,518

Cash and cash equivalents, end of period
$
51,101

 
$
33,060

Supplemental disclosure of cash flow information
 
 
 
Non-cash investing financing activities:
 
 
 
Purchase of equipment under capital leases
$
369

 
$
221


See accompanying notes to unaudited condensed consolidated financial statements.


4

MAGMA DESIGN AUTOMATION, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 1.    Basis of Presentation
The accompanying unaudited condensed consolidated financial statements included herein have been prepared by Magma Design Automation, Inc. (“Magma” or the “Company”) pursuant to the rules and regulations of the United States Securities and Exchange Commission (“SEC”) for interim period financial reporting. Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to these rules and regulations. However, management believes that the disclosures are adequate to ensure that the information presented is not misleading. The condensed consolidated financial statements reflect, in the opinion of management, all adjustments necessary to present a fair statement of results and financial position for the interim periods presented. The operating results for any interim period are not necessarily indicative of the results that may be expected for the entire fiscal year ending April 29, 2012. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended May 1, 2011, as amended. The accompanying unaudited condensed consolidated balance sheet at May 1, 2011 is derived from audited consolidated financial statements at that date.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Management periodically evaluates such estimates and assumptions for continued reasonableness. Appropriate adjustments, if any, to the estimates used are made prospectively based upon such periodic evaluation. Actual results could differ from those estimates.
Principles of Consolidation
The consolidated financial statements of Magma include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Accounts denominated in foreign-currencies have been translated from their functional currency to the U.S. dollar.
Reclassifications
Certain immaterial amounts on the statement of cash flows for the three months ended August 1, 2010, have been reclassified to conform to the three months ended July 31, 2011 presentation.
Reclassification of Revenue and Cost of Revenue
Beginning with the first quarter of fiscal 2012, revenue and cost of revenue is reported in Magma's condensed consolidated statements of operations in two categories: licenses and services. Previously, revenue and cost of revenue were reported in three categories: licenses, bundled licenses and services, and services. Magma management has concluded that the results of the bundled licenses and services category of revenue do not indicate a material trend in the historical or future performance of the Company's operations. Bundled licenses and services revenue and cost of revenue are divided into their component parts and included with either licenses or services. The Company allocates the established vendor specific objective evidence ("VSOE") for services included in bundled licenses contracts to the services revenue category in the condensed consolidated statement of operations. Presentation of prior period revenue and cost of revenue has been adjusted to conform to the current period.
This change for financial reporting purposes conforms to the presentation of revenue and cost of revenue for management reporting and analysis purposes in Magma's Management's Discussion and Analysis of Financial Condition and Results of Operations since the third quarter of fiscal 2009. Previously, for financial reporting purposes, bundled licenses and services revenue was presented as a category of revenue to reflect Magma's revenue recognition policy. The Company offers various contractual terms in designing license agreements to accommodate customer preferences, which are unrelated to product performance and service requirements, order volume, or pricing. The contractual terms that result in the recognition of bundled licenses and services revenue are subject to customer preferences and have historically been inconsistently elected by customers. Moreover, revenue from existing long term contracts shifted between revenue categories, with no change in the aggregate revenues recognized from such contracts. Because customers can choose to purchase the same products in either bundled or unbundled arrangements, under the former presentation, customer choices in any quarter created the appearance of volatility that did not reflect the underlying substance. Separating the bundled contracts into their respective components of licenses and services will more clearly reflect the results of revenues by removing the distorting effects of changing customer preferences. Finally, the former presentation and disclosure was inconsistent with the presentation practice of Magma's main competitors, which inhibited comparability, relevance and usefulness to users of the financial statements for the purposes of making investment decisions. Therefore, management has concluded that the bundled license and service revenue category does not indicate a material trend in the Company's historical or future performance.


Recently issued accounting pronouncements
 In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-05, “Comprehensive Income (Topic 220)—Presentation of Comprehensive Income” (“ASU 2011-05”), to require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of equity. ASU 2011-05 is effective for interim and annual periods beginning after December 15, 2011 and should be applied retrospectively. Magma does not expect the adoption of ASU 2011-05 to have a significant effect on its consolidated financial statements.    
 In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs,” which amends ASC 820, “Fair Value Measurement,” (“ASU 2011-04”). The amended guidance changes the wording used to describe many requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. Additionally, the amendments clarify FASB’s intent about the application of existing fair value measurement requirements. The guidance provided in ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011 and is applied prospectively. Magma does not expect the adoption of these provisions to have a significant effect on its consolidated financial statements.
Note 2.    Fair Value Option
During the second quarter of fiscal 2009, the Company elected fair value accounting for the purchased put option recorded in connection with the Auction Rate Securities (“ARS”) settlement agreement signed with UBS Financial Services, Inc. (“UBS”) (see Note 3 “Fair Value of Financial Instruments”). This election was made in order to mitigate volatility in earnings caused by accounting for the purchased put option and underlying ARS under different methods. Fair value accounting led to a gain of $38,000 on the exercise of the purchased put option for the three months ended August 1, 2010, which is included in “Valuation gain, net” in the Company's condensed consolidated statement of operations.
Note 3.    Fair Value of Financial Instruments
The Company measures assets and liabilities carried at fair value. These assets and liabilities are classified and disclosed in one of the following three levels:
•Level 1: Quoted market prices in active markets for identical assets or liabilities.
•Level 2: Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and
•Level 3: Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
The following table is a reconciliation of financial assets measured at fair value using significant unobservable inputs (Level 3) during the three months ended July 31, 2011 and August 1, 2010 (in thousands):
 
 
Three months ended
 
 
July 31,
2011
 
August 1,
2010
Beginning balance
  
$
—

 
$
16,837

Net sales and settlements
 
—

 
(16,875
)
Gain on put option
 
—

 
38

Ending balance
 
$
—

 
$
—











Cash and cash equivalents are included in the consolidated balance sheets as follows (in thousands):
 
 
Cost
Gross
Realized
Gains
Gross Realized Losses
Estimated Fair Value
July 31, 2011
  
 
 
 
Cash and cash equivalents
  
 
 
 
Cash (U.S. and international)
$
51,101

—

—

$
51,101

 
  
 
 
 
May 1, 2011
  
 
 
 
Cash and cash equivalents
  
 
 
 
Cash (U.S. and international)
$
47,088

—

—

$
47,088


Note 4.    Basic and Diluted Net Loss
The Company computes net loss per share by dividing net loss (numerator) by the weighted average number of common shares outstanding (denominator) during the period. Diluted net loss per share is impacted by equity instruments considered to be potential common shares, if dilutive, computed using the “treasury stock” method of accounting. Potentially dilutive common shares outstanding include shares issuable under the Company’s stock-based compensation plans such as stock options, restricted stock and restricted stock units, and under the Company's employee stock purchase plan, as well as shares issuable upon conversion of redeemable convertible notes.
A summary of weighted average shares used in basic and diluted net loss per share is as follows (in thousands):
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
Numerator
 
 
 
     Net loss
$
(101
)
 
$
(3,258
)
Denominator
 
 
 
     Weighted-average common shares for basic net loss
67,785

 
52,563

     Dilutive effect of common shares equivalents from stock-based compensation plans
—

 
—

     Weighted-average common shares for diluted net loss per share
67,785

 
52,563

 
 
 
 
Net loss per share- basic
$(0.00)

 
$(0.06)

Net loss per share- diluted
$(0.00)

 
$(0.06)

Certain shares issuable under stock options, restricted stock, restricted stock units and the employee stock purchase plan were excluded from the computation of diluted net loss per share in periods when their effect was anti-dilutive either because the Company incurred a net loss for the period, the exercise price of the options was greater than the average market price of the common stock during the period, or the effect was anti-dilutive as a result of applying the “treasury stock” method. In addition, certain common shares issuable upon conversion of convertible notes were excluded from the computation of diluted net loss per share because their effect was anti-dilutive as a result of applying the “if converted” method.
A summary of the potential common shares excluded from diluted net loss per share is as follows (in thousands):
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
Shares of common stock issuable under Company’s stock-based compensation plans
8,587

 
11,506

Shares of common stock issuable upon conversion of convertible notes
1,806

 
16,346



Note 5.    Balance Sheet Components
Significant components of certain balance sheet items were as follows (in thousands):
 
 
July 31,
2011
 
May 1,
2011
Accounts receivable, net:
 
 
 
Trade accounts receivable, including receivables from related parties of $190 and $2,181 at July 31, 2011 and May 1, 2010, respectively
$
8,514

 
$
26,750

Unbilled receivables
5,936

 
8,939

Gross accounts receivable
14,450

 
35,689

Allowance for doubtful accounts
—

 
(159
)
Total accounts receivable, net
$
14,450

 
$
35,530

Accrued expenses:
 
 
 
Accrued sales commissions
$
862

 
$
1,160

Accrued bonuses
96

 
4,013

Other payroll and related accruals
6,053

 
5,219

Acquisition accrual
60

 
60

Accrued professional fees
743

 
368

Income taxes payable
199

 
326

Restructuring accrual
84

 
769

Other
1,600

 
2,245

Total accrued expenses
$
9,697

 
$
14,160

Note 6.    Accumulated Other Comprehensive Loss
Accumulated other comprehensive loss consisted of the following (in thousands):
 
July 31,
2011
 
May 1,
2011
Foreign currency translation adjustments
$
3,805

 
$
3,913

Note 7.    Acquisitions
The Company did not make any acquisitions during the three months ended July 31, 2011.
Acquisition-related earnouts and purchase of licensed technology
For a number of Magma’s previously completed acquisitions, the Company agreed to pay contingent consideration to former stockholders of the acquired companies based on the acquired businesses’ achievement of certain technology or financial milestones. The following table summarizes the amounts of goodwill and intangible assets recorded by the Company for contingent consideration paid or payable to former stockholders of the acquired companies and in connection with the purchase of licensed technology (in thousands):
 
Three Months Ended
 
July 31,
2011
 
May 1,
2011
Goodwill:
 
 
 
Sabio Labs, Inc.
$
—

 
$
322

Total goodwill
—

 
322

Intangible assets:
 
 
 
Licensed Technology
—

 
370

Total intangible assets
—

 
370

Total earnout consideration
$
—

 
$
692

As of July 31, 2011, there were no outstanding earnouts on any of the previously acquired companies.
Note 8.    Goodwill and Intangible Assets
The following table summarizes the components of goodwill, other intangible assets and related accumulated amortization balances, which were recorded as a result of business combinations and asset purchases (in thousands):
 
 
 
July 31, 2011
 
May 1, 2011
 
Average
Life
(months)
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
Goodwill
 
 
$
7,415

 
$
—

 
$
7,415

 
$
7,415

 
$
—

 
$
7,415

Other intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
Developed technology
43

 
$
115,496

 
$
(114,481
)
 
$
1,015

 
$
115,496

 
$
(114,237
)
 
$
1,259

Licensed technology
40

 
42,356

 
(41,824
)
 
532

 
42,356

 
(41,480
)
 
876

Customer relationship or base
70

 
5,575

 
(4,635
)
 
940

 
5,575

 
(4,505
)
 
1,070

Acquired customer contracts
33

 
1,390

 
(1,090
)
 
300

 
1,390

 
(1,089
)
 
301

Trademark
67

 
900

 
(734
)
 
166

 
900

 
(715
)
 
185

Total
 
 
$
165,717

 
$
(162,764
)
 
$
2,953

 
$
165,717

 
$
(162,026
)
 
$
3,691

During the three months ended July 31, 2011, the Company did not have any purchase price adjustments related to acquired businesses.
Goodwill is reviewed annually or whenever events or circumstances occur which indicate that goodwill might be impaired. The Company uses a two-step approach to determining whether and by how much goodwill has been impaired. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment. In estimating the fair value of the Company, the Company made estimates and judgments about future revenues and cash flows for its reporting unit.
To determine the fair value of a reporting unit, the Company uses a market approach. Under the market approach, the fair value of the reporting unit is based on quoted market prices and the number of shares outstanding of the Company's common stock. The first step requires a comparison of the fair value of the Company (reporting unit) to its net book value. If the fair value is greater than net book value, no impairment is deemed to have occurred. If the fair value is less, then the second step must be performed to determine the amount, if any, of actual impairment. The Company uses the income method for the second step. The income method is based on a discounted future cash flow approach that uses estimates including the following for the reporting unit: revenue, based on assumed market growth rates and its assumed market share; estimated costs; and appropriate discount rates based on the particular business's weighted average cost of capital. The Company's estimates of market segment growth, market segment share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates it uses to manage the underlying business. The Company's business consists of both established and emerging technologies and its forecasts for emerging technologies are based upon internal estimates and external sources rather than historical information.
During fiscal 2011, the Company conducted its annual goodwill impairment test at December 31, 2010, using the market approach for the first step. At December 31, 2010, the Company determined that the fair value of its reporting unit is greater than the book value of the net assets of the reporting unit and therefore concluded there is no impairment of goodwill.
During the three months ended July 31, 2011, there were no triggering events that would indicate an impairment and cause the Company to conduct an impairment test.
The Company has included the amortization expense on intangible assets that relate to products sold in cost of revenue, while the remaining amortization is shown as a separate line item on the Company’s condensed consolidated statements of operations. The amortization expense related to intangible assets was as follows (in thousands):
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
Amortization of intangible assets included in:
 
 
 
Cost of revenue
$
537

 
$
825

Operating expenses
202

 
256

Total
$
739

 
$
1,081

As of July 31, 2011, the estimated future amortization expense of intangible assets in the table above was as follows (in thousands):
 
Fiscal Year
Estimated
Amortization
Expense
2012 (remaining nine months)
$
1,358

2013
1,135

2014
295

2015
119

2016 and thereafter
46

 
$
2,953

Note 9.    Convertible Notes, Current and Long-Term
The Company’s 2% Convertible Senior Notes due 2010 (the “2010 Notes”) matured on May 15, 2010. These notes bore interest at 2% per annum, with interest payable on May 15 and November 15 of each year since 2007. During the first quarter of fiscal 2011, the Company paid the remaining principal balance and the outstanding interest on the 2010 Notes of approximately $23.2 million.
On September 11, 2009, the Company completed an exchange offer pursuant to which an aggregate principal amount of $26.7 million of its 2010 Notes were exchanged for $26.7 million aggregate principal amount of newly issued 6% Convertible Senior Notes due 2014 (the “2014 Notes”). Because the terms of the 2014 Notes were substantially different from the 2010 Notes, the exchange offer was treated as an extinguishment of the $26.7 million principal amount of the 2010 Notes. The Company initially recorded the 2014 Notes at fair value of $28.5 million, including a debt premium of $1.8 million. The debt premium is being amortized to interest expense over the term of the 2014 Notes. A total of $1.9 million of underwriting and legal fees related to the 2014 Notes offering was capitalized upon issuance and is being amortized over the term of the 2014 Notes using the effective interest method.
The 2014 Notes mature on May 15, 2014 and bear interest at 6% per annum, with interest payable on May 15 and November 15 of each year, commencing May 15, 2010. The 2014 Notes are convertible into shares of the Company’s common stock at an initial conversion price of $1.80 per share, for an aggregate of approximately 14.8 million shares. Upon conversion, the holders of the 2014 Notes will receive shares of common stock of the Company. Except in limited specific circumstances related to a change in control, holders will not receive a cash settlement; therefore, the Company is not required to separately account for the liability and equity components on the 2014 Notes. The 2014 Notes are unsecured senior indebtedness of Magma, which rank equally in right of payment to Magma’s credit facility with Wells Fargo Capital Finance, LLC (see Note 10 “Term Loan and Revolving Loans”). The 2014 Notes are effectively subordinated in right of payment to the Wells Fargo credit facility to the extent of the security interest held by Wells Fargo Bank in the assets of the Company. After May 15, 2013, the Company has the option to redeem the 2014 Notes for cash in an amount equal to 100% of the aggregate outstanding principal amount at the time of such redemption.
During the first quarter of fiscal 2011, the Company repurchased an aggregate principal amount of $2.75 million of the 2014 Notes for $4.8 million in cash. A loss on extinguishment of the 2014 Notes of $2.1 million is accounted for in the condensed consolidated statements of operations as “Loss on extinguishment of debt”.
During the second quarter of fiscal 2011, the Company engaged in separately negotiated transactions with certain holders of its 2014 Notes to convert outstanding 2014 Notes to common stock. Pursuant to those transactions, the holders converted an aggregate principal amount of $20.7 million of the 2014 Notes into 11.5 million shares of the Company’s common stock. The 2014 Notes were converted at $1.80 per share per the initial indenture agreement at issuance. On conversion of the notes, the Company incurred $2.3 million in inducement fees, which were accounted for in the condensed statements of operations.
As of July 31, 2011, approximately $3.25 million of the 2014 Notes remained outstanding and are convertible into approximately 1.8 million shares of our common stock.
The following table summarizes the Company’s carrying values and market-based fair values of these financial instruments as of July 31, 2011 and May 1, 2011 (in thousands):
 
Carrying
Value
 
Estimated
Fair Value
July 31, 2011
 
 
 
Convertible senior notes due 2014
$
3,250

 
$
14,114

May 1, 2011
 
 
 
Convertible senior notes due 2014
$
3,250

 
$
12,065

Note 10.    Term Loan and Revolving Loans
On March 19, 2010, the Company entered into a new four year credit facility with Wells Fargo Capital Finance, LLC, (as amended, the “New Credit Facility”), which replaced the Company’s $15.0 million secured revolving line of credit facility with Wells Fargo Bank, N.A. (the “Credit Facility”). The New Credit Facility provides for a revolving loan not to exceed $15.0 million and a term loan of $15.0 million (“Term Loan A”). The New Credit Facility is secured by a first priority interest in all of the Company’s assets. The Term Loan A repayments are in equal quarterly installments of $0.6 million, beginning October 31, 2010.
The Company subsequently executed three amendments in order to clarify certain administrative and operational aspects of the New Credit Facility. The amendments were executed in June 2010, July 2010 and September 2010, respectively, and did not materially alter the terms and conditions of the New Credit Facility. In October 2010, the Company executed a fourth amendment, which expanded the New Credit Facility with an additional term loan of $10.0 million (“Term Loan B”) and extended the maturity date to October 2014. The repayments of Term Loan B principal amounts are in equal installments of $0.4 million beginning April 30, 2011.
Under the terms of the New Credit Facility, outstanding borrowings and letter of credit liabilities may not, at any time, exceed the greater of $40.0 million or 50% of all “post-contract support” revenues and “time based license fee” revenues for the preceding twelve-month period. These requirements could, but to date have not, limit the Company’s borrowing availability.
The revolving loan and Term Loan A bear interest at either a LIBOR Rate or a Base Rate, at management’s election, in each case determined as follows (plus a margin of 4.5%): (A) if at a LIBOR Rate, at a per annum rate equal to the LIBOR Rate of the greater of (i) 1.00% per annum and (ii) the one, two or three month LIBOR rate quoted by Bloomberg and (B) if at the Base Rate, the greatest of (i) the Federal Funds Rate plus 0.5%, (ii) the three month LIBOR Rate plus 1.0% and (iii) the Wells Fargo prime rate. Term Loan B bears interest at either a LIBOR Rate or a Base Rate, at management’s election, in each case determined as follows (plus a margin of 3.00%): (A) if at a LIBOR Rate, at a per annum rate equal to the LIBOR Rate of the greater of (i) 1.00% per annum and (ii) the one, two or three month LIBOR rate quoted by Bloomberg and (B) if at the Base Rate the greatest of (i) the Federal Funds Rate plus 0.5%, (ii) the three month LIBOR Rate plus 1.0% and (iii) the Wells Fargo prime rate. In addition, the Company is required to pay fees of 0.5% per annum on the unused amount of the New Credit Facility, and 2.5% per annum for each letter of credit issued and quarterly administrative fees of $10,000.
The Company is required to pay interest and fees monthly, with the outstanding principal amount plus all accrued but unpaid interest and fees payable in full at the maturity date of October 29, 2014.
The New Credit Facility, contains covenants that limit the Company’s ability to create liens, merge, consolidate, dispose of assets, incur indebtedness and guarantees, repurchase or redeem capital stock and indebtedness, make certain investments, acquisitions and capital expenditures, enter into certain transactions with affiliates or change the nature of the Company’s business. Events of default under the New Credit Facility include, but are not limited to, payment defaults, covenant defaults, breaches of representations and warranties, cross defaults to certain other material agreements and indebtedness, bankruptcy and other insolvency events, actual or asserted invalidity of security interests or loan documents, and certain change of control events.
The New Credit Facility, also restricts the Company’s ability to pay dividends or make other distributions on the Company’s stock and requires that the Company comply with certain financial covenants. As of July 31, 2011, the Company had borrowed $25.0 million of term debt and repaid $3.0 million in total, including $2.3 million on Term Loan A and $0.7 million on Term Loan B. As of July 31, 2011, the unused amount of revolving loan under the New Credit Facility, was $13.3 million. As of July 31, 2011, the Company was in compliance with the financial covenants contained in the New Credit Facility.
Note 11.    Restructuring charges
During the first quarter of fiscal 2012, the Company announced "SiliconOne", a major restructuring of its global go-to-market strategy. The direction of product strategy to differentiated integrated vertical solutions requires the sales teams to be able to present multiple-product platforms that integrate with customer design flows, rather than selling individual products, a strategy which the Company has relied upon since its founding. Because substantially different skill sets, along with changes to the structure and scope of the sales and marketing departments are required to support the implementation of the new strategy, the Company initiated a restructuring plan in the first quarter of fiscal 2012 ("FY 2012 Restructuring Plan").
The FY 2012 Restructuring Plan: (i) was approved and controlled by senior management; (ii) materially changed the manner in which the Company conducts its business; (iii) identified the number of positions and functions that were to be substantially modified, relocated or terminated; and (iv) identified the expected completion date for the changes required by the SiliconOne initiative. The Company determined that certain employees did not possess the capabilities and background necessary to support the SiliconOne initiative. As a result, some of these employees were terminated and paid severance during the first quarter of fiscal 2012, resulting in a charge of $0.8 million to restructuring expense in connection with the FY 2012 Restructuring Plan. No other type of restructuring charge related to the FY 2012 Restructuring Plan was recorded during the first quarter of fiscal 2012.
In connection with the FY 2012 Restructuring Plan, the Company expects to incur additional severance and relocation costs during the second quarter of fiscal 2012. An accrual for additional costs has not been recorded because liabilities had not been incurred, and the costs were not reasonably estimable at the end of the first quarter of fiscal 2012. Each severance and relocation arrangement under the FY 2012 Restructuring Plan is individually negotiated, and therefore the liability is not known until the offer is accepted by each employee. The FY 2012 Restructuring Plan is expected to be complete by the end of the second quarter of fiscal 2012.
In fiscal 2009, the Company initiated a restructuring plan (“FY 2009 Restructuring Plan”) designed to improve its cost structure and to better align its resources and improve operating efficiencies. In connection with the FY 2009 Restructuring Plan, the Company recorded a restructuring charge of $(0.1) million for the first quarter of fiscal 2012 related to a change in estimate for purchased software that was initially recorded at $0.7 million in the third quarter of fiscal 2011. The purchased software refers to the Company's legacy customer relationship management tool ("CRM tool"), which the Company was contractually obligated to license through January 30, 2012 (the third quarter of fiscal 2012). During the first quarter of fiscal 2012, the Company negotiated a $0.1 million reduction in the final annual license fee payable to the vendor of the CRM tool. Accordingly, the Company reduced $0.1 million of restructuring expense in the first quarter of fiscal 2012, the period the negotiations were completed. No other restructuring charges were recorded in connection with the FY 2009 Restructuring Plan during the first quarter of fiscal 2012.
The restructuring liability activity was as follows (in thousands):
 
Severance
 
Facilities and
Other
 
Net
Liability
Balance at May 1, 2011
$
228

 
$
541

 
$
769

Restructuring provision
826

 
(100
)
 
726

Cash payments
(1,029
)
 
(382
)
 
(1,411
)
Balance at July 31, 2011
$
25

 
$
59

 
$
84

Note 12.    Contingencies
The Company is subject to various legal proceedings and disputes that arise in the ordinary course of business from time to time. The number and significance of these legal proceedings and disputes may increase as the Company’s size changes. Any claims against the Company, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. As a result, these legal proceedings and disputes could harm the Company’s business and have an adverse effect on its consolidated financial statements. However, the results of any litigation or dispute are inherently uncertain and, as of July 31, 2011, no estimate could be made of the loss or range of loss, if any, from such litigation matters and disputes. Liabilities are recorded when a loss is probable and the amount can be reasonably estimated. No accrued legal settlement liabilities are recorded on the condensed consolidated balance sheet as of July 31, 2011 or May 1, 2011. Litigation settlement and legal fees are expensed in the period in which they are incurred.
In Genesis Insurance Company v. Magma Design Automation, et al., Case No. 06-5526-JW, filed on September 8, 2006 in the United States District Court for the Northern District of California, Genesis seeks a declaration of its rights and obligations under an excess directors and officers liability policy for defense and settlement costs arising out of the securities class action against the Company, as well as a related derivative lawsuit. Genesis seeks a return of $5.0 million it paid towards the settlement of the securities class action and derivative lawsuits from the Company or from another of the Company’s excess directors and officers liability insurers, National Union.
The Company contends that either Genesis or National Union owes the settlement amounts, but not the Company. The trial court granted summary judgment for the Company and National Union, finding that Genesis owed the settlement amount. Genesis appealed to the Ninth Circuit Court of Appeals, and the Company cross-appealed. On July 12, 2010, the Court of Appeals reversed, ruling that Genesis does not owe the settlement amount under its policy, and remanded the case to the trial court for further proceedings. On December 20, 2010, the trial ruled on various cross-motions that National Union owes the settlement amount to Genesis. The court entered a judgment in favor of Genesis and the Company on March 2, 2011, requiring that National Union pay $5.0 million plus prejudgment interest to Genesis. National Union appealed the trial court's judgment to the Ninth Circuit Court of Appeals. The opening brief of National Union is due by October 3, 2011. While there can be no assurance as to the ultimate disposition of the litigation, the Company does not believe that its resolution will have a material adverse effect on the Company's financial position, results of operations or cash flows.
Indemnification Obligations
The Company enters into standard license agreements in the ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify its customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to the Company’s products. These indemnification obligations do not have a specific term. The Company’s normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification the Company may be required to provide may exceed the amount received from the customer. The Company estimates the fair value of its indemnification obligations to be insignificant, based upon its historical experience concerning product and patent infringement claims. Accordingly, the Company has no liabilities recorded for indemnification under these agreements as of July 31, 2011.
The Company has agreements whereby its officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a directors’ and officers’ liability insurance policy that reduces its exposure and enables the Company to recover a portion of future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is insignificant. Accordingly, no liabilities have been recorded for these agreements as of July 31, 2011.
In connection with certain of the Company’s business acquisitions, the Company has also agreed to assume, or cause its subsidiaries to assume, the indemnification obligations of the acquired companies to their respective officers and directors. No liabilities have been recorded for these agreements as of July 31, 2011.
Warranties
The Company offers certain customers a warranty that its products will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, the Company has no liabilities recorded for these warranties as of July 31, 2011. The Company assesses the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the future.
Note 13.    Repurchase and Retirement of Common Stock
Effective January 31, 2011, the Company’s Board of Directors approved an increase in the Company’s stock buy-back program, authorizing the Company to purchase up to $30.0 million of its common stock, an increase in $10.0 million over the original authorization of $20.0 million announced in fiscal 2008.
During the first quarter of fiscal 2011, the Company used approximately $2.0 million to repurchase approximately 638,375 shares of its common stock in the open market. The repurchase prices ranged from $2.82 to $3.37 per share. The repurchased shares were retired immediately subsequent to the purchase.
The Company did not repurchase any shares of its common stock during the first quarter of fiscal 2012.
Note 14.    Stock-Based Compensation
The stock-based compensation recognized in the consolidated statements of operations was as follows (in thousands):
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
Cost of revenue
$
109

 
$
271

Research and development expense
872

 
1,235

Sales and marketing expense
651

 
725

General and administrative expense
594

 
753

Total stock-based compensation expense
$
2,226

 
$
2,984

The Company has adopted several stock incentive plans providing stock-based awards to employees, directors, advisors and consultants, including stock options, restricted stock and restricted stock units. The Company also has an Employee Stock Purchase Plan (“ESPP”), which enables employees to purchase shares of the Company’s common stock. Stock-based compensation expense by type of award was as follows (in thousands):
 
Three Months Ended
 
July 31,
2011

 
August 1,
2010

Stock options
$
407

 
$
665

Restricted stock and restricted stock units
1,147

 
1,264

Employee stock purchase plan
672

 
1,055

Total stock-based compensation expense
$
2,226

 
$
2,984

Stock Options and Employee Stock Purchase Plan
The Company uses the Black-Scholes option pricing model to determine the fair value of its stock options and ESPP awards. The Black-Scholes option pricing model incorporates various highly subjective assumptions, including expected future stock price volatility and expected terms of instruments. The Company established the expected term for employee options and awards, as well as forfeiture rates, based on the historical settlement experience, while giving consideration to vesting schedules and to options that have life cycles less than the contractual terms. Assumptions for option exercises and pre-vesting terminations of options were stratified for employee groups with sufficiently distinct behavior patterns. For fiscal 2011, expected future stock price volatility was developed based on the average of the Company's historical daily stock price volatility and average implied volatility. For fiscal 2012, expected future stock price volatility was developed based on the average of the Company's historical daily stock price volatility. Due to significant changes in the Company's capital structure during fiscal 2011 and the lack of comparable traded option activity, management believes using historical daily stock price volatility exclusively for fiscal 2012 is a better basis for estimating future stock price volatility. The risk-free interest rate for the period within the expected life of the option is based on the yield of United States Treasury notes at the time of grant. The expected dividend yield used in the calculation is zero as the Company has not historically paid dividends.
The assumptions used in the Black-Scholes model and the weighted average grant date fair values per share were as follows:
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
Stock options:
 
 
 
Expected life (years)
3.85

 
3.97

Volatility
75
%
 
71
%
Risk-free interest rate
0.66%-1.00%

 
 1.20%-1.53%

Expected dividend yield
—
%
 
—
%
Weighted average grant date fair value
$
3.98

 
$
1.70

ESPP awards:
 
 
 
Expected life (years)
1.13

 
1.13

Volatility
65
%
 
71
%
Risk-free interest rate
0.20
%
 
0.43
%
Expected dividend yield
—
%
 
—
%
Weighted average grant date fair value
$
2.87

 
$
1.38

As of July 31, 2011, there was approximately $2.8 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to stock option grants, which will be recognized over the remaining weighted average vesting period of approximately 2.45 years.
As of July 31, 2011, the Company had $3.7 million of total unrecognized compensation expense, net of estimated forfeitures, related to the ESPP, which will be recognized over the remaining weighted average vesting period of approximately 1.13 years. Cash received from the purchase of shares under the ESPP was $1.3 million and $0.7 million for the three months ended July 31, 2011 and August 1, 2010, respectively.
Restricted Stock and Restricted Stock Units
Restricted stock and restricted stock units were granted to employees at par value under the Company’s stock incentive plans and performance plans, or assumed in connection with an acquisition. In general, restricted stock and restricted stock unit awards vest over two to four years and are subject to the employees’ continuing service to the Company.
The cost of restricted stock and restricted stock unit awards is determined using the fair value of the Company’s common stock on the date of the grant, and compensation expense is recognized over the vesting period, which is generally two to four years.
As of July 31, 2011, the Company had $4.8 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to restricted stock awards, which will be recognized over the remaining weighted average vesting period of approximately 1.62 years.
Note 15.    Income Taxes
The Company estimates its annual effective tax rate at the end of each fiscal quarter. The Company's estimate takes into account estimations of annual pre-tax income, the geographic mix of pre-tax income and the Company's interpretations of tax laws. The following table presents the provision for income taxes and the effective tax rates.
 
Three months ended
 
July 31,
2011

 
August 1,
2010

Income (loss) before income taxes
$
319

 
$
(2,927
)
Provision for income tax
$
420

 
$
331

Effective tax rate
131.6
%
 
11.3
%
The provision for income taxes was $0.4 million and $0.3 million for the three months ended July 31, 2011 and August 1, 2010, respectively. The effective tax rates were 131.6% and 11.3% for the three months ended July 31, 2011 and August 1, 2010, respectively. The tax provision increase for the quarter ended July 31, 2011 is due to higher foreign withholding tax payments than the year-ago quarter ended August 1, 2010. As the Company is in a full valuation allowance position in the U.S., the Company does not receive any tax benefit from making these foreign withholding tax payments. The fluctuation in the effective tax rate is primarily driven by taxes on earnings from its foreign subsidiaries. The Company's foreign subsidiaries are generally always profitable due to the cost plus arrangements with the U.S. parent entity, thus taxable income is forecasted to be incurred for its foreign operations regardless of consolidated results. The level of taxes on foreign earnings, combined with the change in the Company's consolidated operating results from a loss for the quarter ended August 1, 2010 ($2.9 million) to a profit for the quarter ended July 31, 2011 ($0.3 million) drove the increase in the effective tax rate.
The Company’s fiscal 2012 effective tax rate for the three months ended July 31, 2011 differs from the combined federal and state statutory rate primarily due to changes in its U.S. valuation allowance, state taxes, foreign income taxed at other than U.S. rates, stock compensation expense, research and development credits and foreign withholding taxes.
Note 16.    Segment Information
The Company reports segment information using the “management approach.” Under this approach, operating segments are identified in substantially the same manner as they are reported internally and used by the Company’s chief operating decision maker (“CODM”) for purposes of evaluating performance and allocating resources. Based on this approach, the Company has one reportable segment as the CODM reviews financial information on a basis consistent with that presented in the consolidated financial statements.
Revenue from North America, Europe, Japan and the Asia-Pacific region, which includes India, South Korea, Taiwan, Hong Kong and the People’s Republic of China, was as follows (in thousands, except for percentages shown):
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
North America*
$
23,307

 
$
17,917

Europe
4,800

 
1,983

Japan
1,997

 
5,819

Asia-Pacific (excluding Japan)
5,202

 
6,837

 
$
35,306

 
$
32,556

 
 
 
 
 
July 31,
2011
 
August 1,
2010
North America*
66
%
 
55
%
Europe
13
%
 
6
%
Japan
6
%
 
18
%
Asia-Pacific (excluding Japan)
15
%
 
21
%
 
100
%
 
100
%
*
Substantially all of the Company’s North America revenue related to the United States for all periods presented.
For the three months ended July 31, 2011 and August 1, 2010, the Company had one customer that represented 18% and 14% of total revenue, respectively.
Note 17.    Related Party Transactions
The Company leases a facility, which is used as its data center, from one of its customers. The lease expires in fiscal 2014. During the three months ended July 31, 2011 and August 1, 2010, the Company recorded $0.2 million of rent expense each quarter related to this lease and recognized $1.1 million and $1.7 million from the sale of software licenses to this customer.
A member of the Company's Board of Directors during the first quarter of fiscal 2012 also serves as a Board member for a customer of Magma. Magma recognized revenue from the sale of software licenses to this customer representing 1% of revenue during the three months ended July 31, 2011.


5

ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS    
This Management's Discussion and Analysis of Financial Condition and Results of Operations section should be read in conjunction with our condensed consolidated financial statements and results appearing elsewhere in this Quarterly Report on Form 10-Q and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K, for the fiscal year ended May 1, 2011, as amended . Throughout this section, and elsewhere in this Form 10-Q, we make forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Any statements that do not relate to historical or current facts or matters are forward-looking statements. You can often identify these and other forward-looking statements by terms such as “becoming,” “may,” “will,” “should,” “predicts,” “potential,” “continue,” “anticipates,” “believes,” “estimates,” “seeks,” “expects,” “plans,” “intends,” the negative of such terms or other comparable terminology, or the use of future tense. Statements concerning current conditions may also be forward-looking if they imply a continuation of current conditions. These forward-looking statements include, but are not limited to:
•
our belief that our current facilities are adequate to support our current and near-term operations
•
our expectations about future revenue , including the product sources of such future revenue, and our belief that revenue fluctuations are a result of timing of customer purchases of service
•
our expectation that we will attain a certain level of cash flow from license sales, maintenance agreements, consulting contracts, customer contracts, acquired workforce and acquired developed technologies and patents
•
our expectation that our sales cycle will lengthen
•
our expectation that we will generally continue to depend upon a relatively small number of customers for a substantial portion of our revenue
•
our belief that growth rates in the semiconductor market have began to recover
•
our expectation that we will retain future earnings, if any, to fund the development and growth of our business
•
our expectations concerning our backlog orders
•
our belief that we have sufficient capital resources to fund our anticipated operating and working capital requirements, capital investments and debt service
•
our expected capital expenditures during fiscal 2012 and their expected purposes, and our expected sources of such capital expenditures
•
our belief that our acquisitions will enable us to compete successfully in the EDA industry and our expectation that we will be able to make acquisitions in the future
•
our expectation that we will be able to continue to use earnout arrangements to consummate our acquisitions and our belief that these arrangements will not complicate integration efforts
•
our stock price volatility
Although we believe that the expectations reflected in the forward-looking statements contained herein are reasonable, and we have based these expectations on our beliefs and assumptions, such expectations may prove to be incorrect. Our actual results of operations and financial performance could differ significantly from those expressed in or implied by our forward-looking statements. These statements involve certain known and unknown risks and uncertainties. Factors that could cause or contribute to such differences include, but are not limited to, the risks discussed under the heading “Risk Factors” or included elsewhere in this Quarterly Report on Form 10-Q, and in our Annual Report on Form 10-K, for the fiscal year ended May 1, 2011, as amended. We do not intend, and undertake no obligation, to update any of our forward-looking statements after the date of this Quarterly Report on Form 10-Q to reflect actual results or future events or circumstances.
Overview
We provide electronic design automation (“EDA”) software products and related services. Our software enables chip designers to reduce the time it takes to design and produce complex integrated circuits used in the communications, computing, consumer electronics, networking and semiconductor industries. Our products are used in all major phases of the chip development cycle, from initial design through physical implementation. Our focus is on software used to design the most technologically advanced integrated circuits, specifically those with minimum feature sizes of 0.65 nanometers and smaller, including the newest 28-nanometer process node.
As an EDA software provider, we generate substantially all of our revenue from the semiconductor and electronics industries.

6

Our customers typically fund purchases of our software and services out of their research and development (“R&D”) budgets. As a result, our revenue is heavily influenced by our customers’ long-term business outlook and willingness to invest in new chip designs.
The semiconductor industry is highly volatile and cost-sensitive. Our customers focus on controlling costs and reducing risk, lowering R&D expenditures, decreasing design starts, purchasing from fewer suppliers, and requiring more favorable pricing and payment terms from suppliers. In addition, intense competition among suppliers of EDA products has resulted in pricing pressure on EDA products.
To support our customers, we have focused on providing technologically advanced products to address each step in the integrated circuit design process, as well as integrating these products into broad platforms, and expanding our product offerings. Our goal is to be the EDA technology supplier of choice for our customers as they pursue longer-term, broader and more flexible relationships with fewer suppliers.
During the first quarter of fiscal 2012, we recognized revenue of $35.3 million, an increase of 8% from the first quarter of fiscal 2011. License revenue for each of the quarters ended July 31, 2011 and August 1, 2010 accounted for approximately 75% of total revenue.
Global Markets
Recent market and economic conditions have been challenging, with tighter credit conditions and continued slow global economic growth through fiscal 2011 and the first quarter of fiscal 2012. Continued concerns about the global financial and banking system, systemic impact of inflation (or deflation), energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market and a declining real estate market in the U.S. have contributed to increased market volatility and diminished expectations for the global economy generally.
As a result of these market conditions, the availability and cost of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the financial markets has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. If these market conditions decline, they may limit our or our customer's ability to access the capital markets to meet liquidity needs, resulting in an adverse effect on our financial condition and results of operations. However, growth rates in the semiconductor industry have recently began to recover.
Critical Accounting Policies and Estimates
In preparing our condensed consolidated financial statements, we make estimates, assumptions and judgments that can have a significant impact on our revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the most significant potential impact on our financial statements. For that reason and due to the estimation processes involved in each, we consider these to be our critical accounting policies.
Revenue recognition
We recognize revenue on software arrangements involving multiple elements (such as software products, upgrades, enhancements, maintenance, installation and training) to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on evidence that is specific to us. If evidence of fair value does not exist for each element of a license arrangement and maintenance is the only undelivered element, then all revenue for the license arrangement is recognized over the term of the agreement. If evidence of fair value does exist for the elements that have not been delivered, but does not exist for one or more delivered elements, then revenue is recognized using the residual method, under which recognition of revenue for the undelivered elements is deferred and the residual license fee is immediately recognized as revenue for the elements delivered.
Our revenue recognition policy is detailed in Note 1 to the Consolidated Financial Statements included in our Annual Report on Form 10-K, for the fiscal year ended May 1, 2011, as amended. Management has made significant judgments related to revenue recognition. Specifically, in connection with each transaction involving our products (referred to as an “arrangement” in the accounting literature), we must evaluate whether our fee is “fixed or determinable” and assess whether “collectability is probable.” These judgments are discussed below.
The fee is fixed or determinable. With respect to each arrangement, we must make a judgment as to whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, then revenue is recognized upon delivery of the software (assuming other revenue recognition criteria are met). If the fee is not fixed or determinable, then the revenue is recognized when customer installments are due and payable.
In order for an arrangement to be considered to have fixed or determinable fees, 100% of the license, services and initial post contract support fee is to be paid within one year or less from the order date. We have a history of collecting fees on such

7

arrangements according to contractual terms. Arrangements with payment terms extending beyond twelve months are considered not to be fixed or determinable.
Collectability is probable. In order to recognize revenue, we must make a judgment about the collectability of the arrangement fee. Our judgment of the collectability is applied on a customer-by-customer basis pursuant to our credit review policy. We typically sell to customers for which there is a history of successful collection. New customers are subjected to a credit review process, which evaluates the customers’ financial positions and ability to pay. If it is determined from the outset of an arrangement that collectability is not probable based upon our credit review process, revenue is recognized on a cash receipts basis (as each payment is collected).
Licenses and services revenue
We derive licenses revenue primarily from licenses of our design and implementation software and, to a lesser extent, from licenses of our analysis and verification products. We license our products under time-based and perpetual licenses whereby license revenue is recognized after the execution of a license agreement and the delivery of the product to the customer, provided that there are no uncertainties surrounding the product acceptance, fees are fixed or determinable, collection is probable and there are no remaining obligations other than maintenance.
For perpetual licenses and time-based license arrangements, where maintenance is included for the first period of the license term, with maintenance thereafter renewable by the customer at the substantive rates stated in their agreements with us, the stated rate for maintenance renewal is vendor-specific objective evidence (“VSOE”) of the fair value of maintenance in these arrangements. For these arrangements, license revenue is recognized using the residual method in the period in which the license agreement is executed assuming all other revenue recognition criteria are met. Where an arrangement involves extended payment terms, revenue recognized using the residual method is limited to amounts due and payable.
We provide design methodology assistance and specialized services relating to generalized turnkey design services. We have an established VSOE of fair value for consulting and training services. Therefore, revenue from such services is recognized when such services are performed. Our consulting services generally are not essential to the functionality of the software. Our software products are fully functional upon delivery and implementation does not require any significant modification or alteration. Services to our customers often include assistance with product adoption and integration and specialized design methodology assistance. Customers typically purchase these professional services to facilitate the adoption of our technology and dedicate personnel to participate in the services being performed, but they may also decide to use their own resources or appoint other professional service organizations to provide these services. Software products are billed separately and independently from consulting services, which are generally billed on a time-and-materials or milestone-achieved basis. We generally recognize revenue from consulting services as the services are performed.
For transactions that include maintenance for the entire license term, we have no VSOE of fair value of maintenance. Therefore, we recognize license revenue ratably over the maintenance period. If an arrangement involves extended payment terms—that is, where payment for less than 100% of the arrangement fee is due within one year of the contract date—we recognize revenue to the extent of the lesser of the amount due and payable or the ratable portion. Where consulting and training services are included in arrangements that include time-based licenses and post contract support (“PCS”) where VSOE of PCS has not been established, the Company recognizes the entire arrangement fee ratably over the PCS service period, beginning with the delivery of the software, provided that all other revenue recognition criteria are met. We allocate these arrangements to licenses and services revenue based upon established VSOE of services revenue in the condensed consolidated statements of operations.
If we were to change any of these assumptions or judgments, it could cause a material increase or decrease in the amount of revenue that we report in a particular period. Amounts invoiced relating to arrangements where revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized over time as the applicable revenue recognition criteria are satisfied.
Services revenue
We derive services revenue primarily from consulting and training for our software products and from maintenance fees for our products. Most of our license agreements include maintenance, generally for a one-year period, renewable annually. Services revenue from maintenance arrangements is recognized on a straight-line basis over the maintenance term. Because we have VSOE of fair value for consulting and training services, revenue is recognized as these services are performed or completed. Our consulting and training services are generally not essential to the functionality of the software. Our products are fully functional upon delivery of the product. Additional factors considered in determining whether the revenue should be accounted for separately include, but are not limited to: degree of risk, availability of services from other vendors, timing of payments and impact of milestones or acceptance criteria on our ability to recognize the software license fee.
Change in Revenue Reporting
For the first quarter of fiscal 2012, we reported revenue and cost of revenue in the condensed consolidated statements of

8

operations in two categories: licenses revenue and services revenue. Previously, revenue and cost of revenue were reported in three categories: licenses, bundled licenses and services, and services. We concluded that the results of the bundled licenses and services category of revenue do not indicate a material trend in the historical or future performance of our operations. Bundled licenses and services revenue and cost of revenue are divided into their component parts and included with either licenses or services. We allocated the established VSOE of services revenue included in bundled licenses revenue to services revenue in the condensed consolidated statement of operations. Presentation of prior period revenue and cost of revenue has been adjusted to conform to the current period.
This change for financial reporting purposes conforms to the presentation of revenue and cost of revenue for management reporting and analysis purposes in our Management's Discussion and Analysis of Financial Conditions and Results of Operations since the third quarter of fiscal 2009. Bundled licenses and services revenue was presented as a category of revenue due to our revenue recognition accounting policy. We offer various contractual terms to our customers in designing license agreements to accommodate customer preferences, which are unrelated to product performance and service requirements, order volume, or pricing. The contractual terms that result in the recognition of bundled licenses and services revenue are subject to customer preferences and have historically been inconsistently elected by customers. Moreover, revenue from existing long term-contracts frequently shifts between revenue categories, with no change in the aggregate revenues recognized from such contracts. Because customers can choose to purchase the same products as either bundled or unbundled, under the former presentation, customer choices in any quarter can create the appearance of revenue volatility that does not reflect the underlying substance. Separating the bundled contracts into their respective components of licenses and services will more clearly reflect the results of revenues by removing the distorting effects of changing customer preferences. We also noted the former presentation and disclosure was inconsistent with industry practice of our main competitors, which inhibits comparability, relevance and usefulness to users of the financial statements for purposes of making investment decisions.
Stock-based compensation
Stock-based compensation expense is measured at the grant date, based on the fair value of the award, and is recognized as expense, net of estimated forfeitures, over the vesting period of the award.
Determining the fair value of stock-based awards at the grant date requires the input of various highly subjective assumptions, including expected future stock price volatility, expected term of instruments and expected forfeiture rates. We established the expected term for employee options and awards, as well as forfeiture rates, based on the historical settlement experience, while giving consideration to vesting schedules and to options that have estimated life cycles less than the contractual terms. Assumptions for option exercises and pre-vesting terminations of options were stratified for employee groups with sufficiently distinct behavior patterns. For fiscal 2011, expected future stock price volatility was developed based on the average of our historical daily stock price volatility and average implied volatility. For fiscal 2012, expected future stock price volatility was developed based on the average of our historical daily stock price volatility. Due to significant changes in our capital structure during fiscal 2011 and the lack of comparable traded option activity, management believes using historical daily stock price volatility exclusively for fiscal 2012 is a better basis for estimating future stock price volatility. These input factors are subjective and are determined using management’s judgment. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially affected.
Unbilled accounts receivable
Unbilled accounts receivable represents revenue that has been recognized in advance of being invoiced to the customer. In all cases, the revenue and unbilled receivables are for contracts that are non-cancelable, in which there are no contingencies and where the customer has taken delivery of both the software and the encryption key required to operate the software. We typically generate invoices 45 days in advance of contractual due dates, and we invoice the entire amount of the unbilled accounts receivable within one year from the contract inception.
Allowances for doubtful accounts
We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We regularly review the adequacy of our accounts receivable allowance after considering the size of the accounts receivable balance, each customer’s expected ability to pay and our collection history with each customer. We review significant invoices that are past due to determine if an allowance is appropriate using the factors described above. We also monitor our accounts receivable for concentration in any one customer, industry or geographic region.
The allowance for doubtful accounts represents our best estimate, but changes in circumstances relating to accounts receivable may result in a requirement for additional allowances in the future. If actual losses are significantly greater than the allowance we have established, that would increase our sales and marketing expenses and reported net loss. Conversely, if actual credit losses are significantly less than our allowance, this would decrease our sales and marketing expenses and our reported net income would increase.
As of July 31, 2011, two of our customers each accounted for more than 10% of total receivables. We did not have an

9

allowance for doubtful accounts at July 31, 2011.
Accounting for asset purchases and business combinations
We are required to allocate the purchase price of acquired assets and business combinations to the tangible and intangible assets acquired, liabilities assumed, and in-process research and development based on their estimated fair values. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.
Critical estimates in valuing certain of the intangible assets include, but are not limited to, future expected cash flows from license sales, maintenance agreements, consulting contracts, customer contracts, acquired workforce and acquired developed technologies and patents; expected costs to develop the in-process research and development into commercially viable products and estimated cash flows from the projects when completed; the acquired company’s brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined company’s product portfolio; and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable.
Other estimates associated with the accounting for business combinations may change as additional information becomes available regarding the assets acquired and liabilities assumed resulting in changes in the purchase price allocation.
Goodwill impairment
We test goodwill for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests in certain circumstances. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of the reporting units. We have determined that we have one reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for the reporting units. Any impairment loss recorded in the future could have a material adverse impact on our financial condition and results of operations.
We use a two-step approach to determining whether and by how much goodwill has been impaired. The first step requires a comparison of the fair value of the Company (single reporting unit) to its net book value. If the fair value is greater, then no impairment is deemed to have occurred. If the fair value is less, then the second step must be performed to determine the amount, if any, of actual impairment. To determine the fair value, our review process includes the income method and is based on a discounted future cash flow approach that uses estimates including the following for the reporting unit: revenue, based on assumed market growth rates and its assumed market share; estimated costs; and appropriate discount rates based on the particular business’s weighted average cost of capital. Our estimate of market segment growth, market segment share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we use to manage the underlying business. Our business consists of both established and emerging technologies and our forecasts for emerging technologies are based upon internal estimates and external sources rather than historical information. We also considered our market capitalization on the dates of the Company’s impairment tests in determining the fair value of the business.
During fiscal 2011, we conducted our annual goodwill impairment test at December 31, 2010 using the market approach. Under the market approach, the fair value of the reporting unit is based on quoted market prices and the number of shares outstanding of our common stock. At December 31, 2010, we determined that the fair value of the Company was greater than the net book value of the net assets of the reporting unit including goodwill and therefore concluded there was no impairment of goodwill.
During the three months ended July 31, 2011, there were no triggering events that would indicate an impairment and cause us to conduct an impairment test.
Valuation of intangibles and long-lived assets
Our intangible assets include acquired intangibles, excluding goodwill. Acquired intangibles with definite lives are amortized on a straight-line basis over the remaining estimated economic life of the underlying products and technologies (original lives assigned are one to six years). For assets to be held and used, we initiate our review whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. Recoverability of an asset is measured by comparison of its carrying amount to the expected future undiscounted cash flows that the asset is expected to generate. If it is determined that an asset is not recoverable, an impairment loss is recorded in the amount by which the carrying amount of the asset exceeds its fair value. Based on our review, no impairment is indicated.
Income taxes
Significant judgment is required in determining our provision for income taxes. In the ordinary course of business, there are many transactions and calculations where the ultimate tax outcome is uncertain. The amount of income taxes we pay could be

10

subject to audits by federal, state, and foreign tax authorities, which could result in proposed assessments. Although we believe that our estimates are reasonable, no assurance can be given that the final outcome of these tax matters will not be different from what was reflected in our historical income tax provisions.
Deferred tax assets and liabilities result primarily from temporary timing differences between book and tax valuation of assets and liabilities, as well as federal and state net operating loss and credit carryforwards. We assess the likelihood that our net deferred tax assets will be recovered from future taxable income and, to the extent we believe that the recovery is not likely, we establish a valuation allowance. We consider all available positive and negative evidence, including our past operating results, the existence of cumulative losses in the most recent fiscal years, future taxable income, and ongoing prudent and feasible tax planning strategies, in assessing the amount of the valuation allowance.
As of July 31, 2011, we believe it is more likely than not, that all or some portion of the deferred tax assets will not be realized; and accordingly, a valuation allowance against our U.S. net deferred tax assets is required. We will continue to evaluate the realizability of the deferred tax assets on a quarterly basis. Future reversals or increases to our valuation allowance could have a significant impact on our future earnings.
Strategic investments in privately-held companies
Our strategic equity investments consist of preferred stock and convertible notes that are convertible into preferred or common stock of several privately-held companies. The carrying value of our portfolio of strategic equity investments totaled $0.5 million at July 31, 2011. Our ability to recover our investments in private, non-marketable equity securities and convertible notes and to earn a return on these investments is primarily dependent on how successfully these companies are able to execute on their business plans and how well their products are accepted, as well as their ability to obtain additional capital funding to continue operations.
Under our accounting policy, the carrying value of a non-marketable investment is the amount paid for the investment unless it has been determined to be other than temporarily impaired, in which case we write the investment down to its estimated fair value. For equity investments where our ownership interest is between 20% to 50%, or where we can exercise significant influence on the investee’s operating or financial decisions, we record our share of net equity income (loss) of the investee based on our proportionate ownership.
We review all of our investments periodically for impairment; however, for non-marketable equity securities, the fair value analysis requires significant judgment. This analysis includes assessment of each investee’s financial condition, the business outlook for its products and technology, its projected results and cash flows, the likelihood of obtaining subsequent rounds of financing and the impact of any relevant contractual equity preferences held by us or others. If an investee obtains additional funding at a valuation lower than our carrying amount, we presume that the investment is other than temporarily impaired, unless specific facts and circumstances indicate otherwise, such as when we hold contractual rights that give us a preference over the rights of other investors. As the equity markets have experienced volatility over the past few years, we have experienced substantial impairments in our portfolio of non-marketable equity securities. If equity market conditions do not improve, as companies within our portfolio attempt to raise additional funds, the funds may not be available to them, or they may receive lower valuations, with more onerous investment terms than in previous financings, and the investments will likely become impaired. However, we are not able to determine at the present time which specific investments are likely to be impaired in the future, or the extent or timing of individual impairments. We recorded write-downs related to these non-marketable equity investments of $36,000 and $34,000 for the three months ended July 31, 2011 and August 1, 2010, respectively for our proportionate share in the net losses of the investee companies.
The investments are included in other long-term assets in the consolidated balance sheets. The carrying value of the Company’s strategic investments was as follows (in thousands):
 
July 31,
2011
 
May 1,
2011
Non-Marketable Securities - Application of Equity Method
$
496

 
$
531

Total
$
496

 
$
531

During the fourth quarter of fiscal 2010, Synopsys, Inc. purchased 100% of the outstanding stock of Zerosoft, Inc., for $24.0 million in cash and future contingent cash payments. Our 35% ownership interest in Zerosoft, Inc. at the time of the sale resulted in $4.7 million in cash at closing and $4.3 million in contingent proceeds. The contingent proceeds consisted of a holdback amount equal to 10% of the initial consideration to be held in escrow and released for payment 15 months from the date of the agreement to secure the indemnification obligations of the sellers, and earnout consideration based upon the achievement of certain annual product performance improvement milestones for the three years subsequent to the sale agreement. The proceeds (net of expenses) of $4.6 million offset against the net book value of the investment of $1.4 million on the date of sale of the investment resulted in a net gain of $3.2 million, which was recorded in the statement of operations in other income.The holdback amount and earnout consideration are gain contingencies each representing incremental income and will be recognized if and when all contingencies are resolved.

11

During the first quarter of fiscal 2012, we received contingent proceeds of $0.5 million that were held in escrow. The proceeds have been recorded in other income in the condensed consolidated statement of operations.
Results of Operations
Revenue
Revenue is comprised of licenses and services revenue. Licenses revenue consists of fees for time-based or perpetual licenses of our software products. Services revenue consists of fees for services, such as customer training, consulting and PCS associated with licenses. We recognize revenue based on the specific terms and conditions of the license contracts with our customers for our products and services as described above under the caption “Critical Accounting Policies and Estimates.”
Licenses revenue
Licenses revenue is divided into the following categories:
•
Ratable
•
Due & Payable
•
Up-Front
•
Cash Receipts
We use these classifications of revenue to provide greater insight into the reporting and monitoring of trends in the components of our revenue and to assist us in managing our business. The characterization of an individual contract may change over time. For example, a contract originally characterized as Ratable may be redefined as Cash Receipts if that customer has difficulty in making payments in a timely fashion. In cases where a contract has been re-characterized for management’s discussion and analysis purposes, prior periods are not restated to reflect that change.
Ratable. For time-based licenses that include maintenance or services where VSOE is not established, we recognize license revenue ratably over the contract term, or as customer payments become due and payable, if less. In our statements of operations the revenue for these arrangements are allocated to their component parts, and included in either license or service revenue based on arrangements where VSOE for maintenance and services has been established. We refer to these licenses generally as “Ratable” and we generally refer to all time-based licenses recognized on a ratable basis as “Long-Term,” independent of the actual length of term of the license.
Due & Payable. For time-based licenses that include maintenance or services where VSOE is established and the payment terms extend greater than one year from the arrangement effective date, we recognize license revenue on a due and payable basis. For management reporting and analysis purposes, we refer to this type of license generally as “Due & Payable.”
Up-Front. For time-based and perpetual licenses that include maintenance or services where VSOE is established, we recognize license revenue upon shipment if the payment terms require the customer to pay 100% of the license fee and the initial period of PCS is within one year from the agreement date. In all of these cases, the contracts are non-cancelable, and the customer has taken delivery of both the software and the encryption key required to operate the software. For management reporting and analysis purposes, we refer to this type of license generally as “Up-Front,” where the license is either perpetual or time-based.
Cash Receipts. We recognize revenue from customers who have not met our predetermined credit criteria as we receive cash payments from these customers to the extent that revenue has otherwise been earned. For management reporting and analysis purposes, we refer to this type of license revenue as “Cash Receipts.”
Our licenses revenue in any given quarter depends upon the mix and volume of perpetual or short-term licenses ordered during the quarter and the amount of long-term ratable, due & payable, and cash receipts license revenue recognized during the quarter. In general, we refer to license revenue recognized from perpetual or time-based licenses during the current period as “Up-Front” revenue for management reporting and analysis purposes. All other types of revenue are generally referred to as revenue from backlog, such as licenses revenue recognized during the current period from perpetual or time-based licenses from contracts entered into in prior periods. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of short-term licenses. The precise mix of orders fluctuates substantially from period to period and affects the revenue we recognize in the period. If we achieve our target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we have more-than-expected long-term licenses) or may exceed them (if we have more-than-expected short-term or perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets as described in the risk factors in Part II, Item 1A of this Quarterly Report on Form 10-Q.
Services revenue
Services revenue is primarily from consulting and training for our software products and from maintenance fees for our

12

products. Most of our license agreements include maintenance, generally for a one-year period, renewable annually. Services revenue from maintenance arrangements is recognized ratably over the maintenance term. Because we have VSOE of fair value for consulting and training services, revenue is recognized as these services are performed or completed.
Revenue, cost of revenue and gross profit
The table below sets forth the fluctuations in revenue, cost of revenue and gross profit data by category as defined for management reporting and analysis purposes for the three months ended July 31, 2011 and August 1, 2010 (in thousands, except for percentage data):
Three Months Ended:
July 31,
2011
 
% of
Revenue
 
August 1,
2010
 
% of
Revenue
 
Dollar
Change
 
% Change
Revenue
 
 
 
 
 
 
 
 
 
 
 
Licenses revenue
 
 
 
 
 
 
 
 
 
 
 
Ratable
$
5,696

 
16
%
 
$
6,017

 
18
%
 
$
(321
)
 
(5
)%
Due & Payable
15,111

 
43
%
 
12,240

 
38
%
 
2,871

 
23
 %
Up-Front*
2,527

 
7
%
 
3,210

 
10
%
 
(683
)
 
(21
)%
Cash Receipts
3,223

 
9
%
 
2,838

 
9
%
 
385

 
14
 %
Total Licenses revenue
26,557

 
75
%
 
24,305

 
75
%
 
2,252

 
9
 %
Services revenue
8,749

 
25
%
 
8,251

 
25
%
 
498

 
6
 %
Total Revenue
35,306

 
100
%
 
32,556

 
100
%
 
2,750

 
8
 %
Cost of Revenue
 
 
 
 
 
 
 
 
 
 
 
License
619

 
2
%
 
936

 
3
%
 
(317
)
 
(34
)%
Services
4,000

 
11
%
 
3,806

 
12
%
 
194

 
5
 %
Total cost of sales
4,619

 
13
%
 
4,742

 
15
%
 
(123
)
 
(3
)%
Gross Profit
$
30,687

 
87
%
 
$
27,814

 
85
%
 
$
2,873

 
10
 %
*
Includes $0.8 million, or 2%, and $2.1 million, or 7%, of total revenue from new contracts for the three months ended July 31, 2011 and August 1, 2010, respectively.
We market our products and related services to customers in four geographic regions: North America (Domestic), Europe (including Europe, the Middle East and Africa), Japan, and Asia-Pacific (including India, South Korea, Taiwan, Hong Kong and the People’s Republic of China). Internationally, we market our products and services primarily through our subsidiaries and various distributors. Revenue is attributed to geographic areas based on the country in which the customer is domiciled. The table below sets forth geographic distribution of revenue data for the three months ended July 31, 2011 and August 1, 2010 (in thousands, except for percentage data):
Three Months Ended:
July 31,
2011
 
% of
Revenue
 
August 1, 2010
 
% of
Revenue
 
Dollar Change
 
%
Change
North America
$
23,307

 
66
%
 
$
17,917

 
55
%
 
$
5,390

 
30
 %
International:
 
 
 
 
 
 
 
 
 
 
 
Europe
4,800

 
13
%
 
1,983

 
6
%
 
2,817

 
142
 %
Japan
1,997

 
6
%
 
5,819

 
18
%
 
(3,822
)
 
(66
)%
Asia-Pacific (excluding Japan)
5,202

 
15
%
 
6,837

 
21
%
 
(1,635
)
 
(24
)%
Total international
11,999

 
34
%
 
14,639

 
45
%
 
(2,640
)
 
(18
)%
Total revenue
$
35,306

 
100
%
 
$
32,556

 
100
%
 
$
2,750

 
8
 %
Revenue
Revenue for the three months ended July 31, 2011 and August 1, 2010 was $35.3 million and $32.6 million, respectively, an increase of 8%.
Licenses revenue increased by 9% in the three months ended July 31, 2011 as compared to the three months ended August 1, 2010. The increase in the license revenue was due to enhanced versions of several existing products gaining initial market acceptance, combined with some improvement in economic conditions in the semiconductor industry, which resulted in an increase

13

in customer spending compared to license revenue for the three months ended August 1, 2010.
•
Ratable and Due & Payable revenue combined increased by $2.6 million, or 14%, for the three months ended July 31, 2011, as compared to the three months ended August 1, 2010. The increase as a percentage of total revenue is the result of the mix and volume of revenue from backlog from long-term Ratable and Due & Payable contracts recognized during the quarter compared to Up-Front revenue. The mix and volume of contracts is primarily driven by customer requirements and is within our expected target of revenue from backlog.
•
Up-Front revenue decreased $0.7 million, or 21%, in the three months ended July 31, 2011, as compared to the three months ended August 1, 2010. Up-front revenue as a percentage of total revenue decreased by 3% for the three months ended July 31, 2011, as compared to the three months ended August 1, 2010. The decrease as a percent of total revenue is the result of the mix and volume of Up-Front revenue recognized during the quarter compared to revenue from backlog from long-term Ratable and Due & Payable contracts. The mix and volume of Up-Front contracts is primarily driven by customer requirements and included $0.8 million, or 2%, of total revenue for the three months ended July 31, 2011, from new contracts entered into in the quarter, and is within our target of 10% or less of total revenue.
•
Cash Receipts revenue increased during the three months ended July 31, 2011 by $0.4 million as compared to the three months ended August 1, 2010. The increase is due to additional customers classified as cash receipts as a result of a continued concern for the financial condition of some of our customers.
Services revenue increased by $0.5 million during the three months ended July 31, 2011, as compared to the three months ended August 1, 2010. We believe the fluctuations were a result of the timing of customer’s purchase of services.
North America revenue increased by $5.4 million during the three months ended July 31, 2011, as compared to the three months ended August 1, 2010. The increase in the domestic revenue is due to the improvement in economic conditions in the semiconductor industry which resulted in an increase in customer spending.
The increase in the domestic revenue is due to the improvement in economic conditions in the semiconductor industry, which resulted in an increase in customer spending.
International revenue decreased by $2.6 million during the three months ended July 31, 2011, as compared to the three months ended August 1, 2010. The decrease in international revenue was mainly due to a $3.8 million decrease in the revenue from Japan. The revenue from Japan decreased due to consolidations in the semi-conductor industry, involving certain of our customers, which was a result of global competition and efforts to improve efficiency and eliminate overlap.
One customer accounted for 10% or more of total revenue for each of the fiscal quarters ended July 31, 2011 and August 1, 2010.
Cost of Revenue
Cost of licenses revenue primarily consists of amortization of acquired developed technology and other intangible assets that are fixed in nature, variable expenses such as royalties, and allocated outside sales representative expenses.
Cost of licenses revenue decreased by $0.3 million, or 34%, during the three months ended July 31, 2011, compared to the three months ended August 1, 2010, primarily due to the full amortization of significant intangible assets from prior acquisitions.
Cost of services revenue primarily consists of personnel and related costs to provide product support, training and consulting services. Cost of services revenue also includes stock-based compensation expenses and asset depreciation.
Cost of services revenue increased by $0.2 million, or 5% for the three months ended July 31, 2011, as compared to the three months ended August 1, 2010. The increase was primarily due to an increase of $0.2 million in consulting costs.
Operating expenses
The table below sets forth operating expense data for the three months ended July 31, 2011 and August 1, 2010 (in thousands, except for percentage data):

14

Three Months Ended:
July 31,
2011
 
% of
Revenue
 
August 1,
2010
 
% of
Revenue
 
Dollar
Change
 
%
Change
Operating Expenses
 
 
 
 
 
 
 
 
 
 
 
Research and development
$
12,785

 
36
%
 
$
12,259

 
38
 %
 
$
526

 
4
 %
Sales and marketing
10,410

 
29
%
 
10,567

 
32
 %
 
(157
)
 
(1
)%
General and administrative
6,171

 
17
%
 
4,690

 
14
 %
 
1,481

 
32
 %
Amortization of intangible assets
202

 
1
%
 
256

 
1
 %
 
(54
)
 
(21
)%
Restructuring charges
726

 
2
%
 
(14
)
 
—
 %
 
740

 
(5,286
)%
Total operating expenses
$
30,294

 
85
%
 
$
27,758

 
85
 %
 
$
2,536

 
9
 %
Research and development expense increased by $0.5 million, or 4%, in the three months ended July 31, 2011 as compared to the three months ended August 1, 2010. The increase was primarily due to an increase in payroll related expense by $0.8 million as a result of merit increases implemented at the beginning of fiscal 2012. The increase was also attributable to an increase of $0.1 million in travel and entertainment and consulting expenses. This increase was offset by a decrease of $0.4 million related to stock based compensation expenses.
Sales and marketing expense decreased by $0.2 million, or 1%, in the three months ended July 31, 2011 as compared to the three months ended August 1, 2010. The decrease was primarily due to the decrease in allocation of the application engineer costs by $0.2 million, decrease of $0.2 million in common expenses, such as information technology and facility related expenses. The decrease was also attributable to a decrease in the consulting and travel and entertainment costs by $0.3 million. The above decreases were offset by an increase in the payroll related costs by $0.5 million as a result of merit increases implemented at the beginning of the fiscal 2012.
General and administrative expense increased by $1.5 million, or 32%, in the three months ended July 31, 2011, as compared to three months ended August 1, 2010. The increase was mainly due to the $1.9 million in the legal and administrative costs incurred due to an investigation conducted by the Audit Committee of the Board of Directors of whistleblower allegations related to business expense reimbursements, executive and other employee compensation, and restructuring costs. The investigation was concluded in the first quarter of fiscal 2012. The increase was offset by a decrease in consulting expenses of $0.2 million and a decrease in deferred stock compensation expense of $0.2 million.
Amortization of intangible assets decreased by $0.1 million, or 21%, during the three months ended July 31, 2011, as compared to three months ended August 1, 2010, primarily due to several existing developed technologies and patents having been fully amortized prior to or during the three months ended July 31, 2011.
The intangible assets amortized include licensed technology, customer relationship or base, patents, customer contracts and trademarks that were identified in the purchase price allocation for each business combination and asset purchase transaction.
Restructuring charges increased by $0.7 million, for the three months ended July 31, 2011, respectively, as compared to the three months ended August 1, 2010.
During the first quarter of fiscal 2012, we announced "SiliconOne", a major restructuring of our global go-to market strategy. The direction in product strategy to differentiated integrated vertical solutions requires the sales teams to be able to present multiple-product platform solutions that integrate with customer design flows, rather than selling individual products; a strategy which we have relied upon since our founding. Because substantially different skill sets along with changes to the structure and scope of the sales and marketing departments, are required to support the implementation of the new go-to-market strategy, we initiated a restructuring plan in the first quarter of fiscal 2012 ("FY 2012 Restructuring Plan").
The FY 2012 Restructuring Plan: (i) was approved and controlled by senior management; (ii) materially changed the manner in which we conduct our business; (iii) identified the number of positions and functions that were to be substantially modified, relocated or terminated; and (iv) identified the expected completion date for the changes required by the SiliconOne initiative. We determined that certain employees did not possess the capabilities and background necessary to ensure the success of the SiliconOne initiative. As a result, some of these employees were terminated and paid severance during the first quarter of fiscal 2012, resulting in a charge of $0.8 million to restructuring expense in connection with the FY 2012 Restructuring Plan. No other type of restructuring charge related to the FY 2012 Restructuring Plan was recorded during the first quarter of fiscal 2012.
In connection with the FY 2012 Restructuring Plan, we expect to incur additional severance and relocation costs during the second quarter of fiscal 2012. An accrual for additional costs has not been recorded because liabilities had not been incurred and the costs were not reasonably estimable at the end of the first quarter of fiscal 2012. Each severance and relocation arrangement under the FY 2012 Restructuring Plan is individually negotiated, and therefore the liability is not known until the offer is accepted by each employee. The FY 2012 Restructuring Plan is expected to be complete by the end of the second quarter of fiscal 2012.

15

In fiscal 2009, we initiated a restructuring plan (“FY 2009 Restructuring Plan”) designed to improve our cost structure and to better align our resources and improve operating efficiencies. In connection with the FY 2009 Restructuring Plan, we recorded a restructuring charge of $(0.1) million for the first quarter of fiscal 2012 related to a change in estimate for purchased software that was initially recorded at $0.7 million in the third quarter of fiscal 2011. The purchased software refers to the our legacy customer relationship management tool ("CRM tool"), which we were contractually obligated to license through January 30, 2012 (the third quarter of fiscal 2012). During the first quarter of fiscal 2012, we negotiated a $0.1 million reduction in the final annual license fee due to the vendor of the CRM tool. Accordingly, we reduced $0.1 million of restructuring expense in the first quarter of fiscal 2012, the period the negotiations were completed. No other restructuring charges were recorded in connection with the FY 2009 Restructuring Plan during the first quarter of fiscal 2012.
Other items
The table below sets forth other data for the three months ended July 31, 2011 and August 1, 2010 (in thousands, except for percentage data):
Three Months Ended:
July 31,
2011
 
% of
Revenue
 
August 1,
2010
 
% of
Revenue
 
Dollar
Change
 
%
Change
Operating income, net
 
 
 
 
 
 
 
 
 
 
 
Interest income
$
14

 
—
 %
 
$
29

 
—
 %
 
$
(15
)
 
(52
)%
Interest expense
(482
)
 
(1
)%
 
(806
)
 
(2
)%
 
324

 
(40
)%
Valuation gain, net
—

 
—
 %
 
38

 
—
 %
 
(38
)
 
(100
)%
Loss on extinguishment of debt
—

 
—
 %
 
(2,093
)
 
(6
)%
 
2,093

 
(100
)%
Other income (expense), net
394

 
1
 %
 
(151
)
 
—
 %
 
545

 
(361
)%
Total other expense, net
$
(74
)
 
—
 %
 
$
(2,983
)
 
(8
)%
 
$
2,909

 
(98
)%
Provision for income taxes
$
420

 
(1
)%
 
$
331

 
(1
)%
 
$
89

 
27
 %
Interest income decreased by 52% in the three months ended July 31, 2011, compared to the three months ended August 1, 2010, primarily due to the lower interest rates on investments in money market funds.
Interest expense primarily represents amortization of debt premium and issuance costs in connection with our 2014 Notes and interest on our term debt and line of credit facility.
The interest expense and amortization of debt discount/premium decreased by $0.3 million for the three months ended July 31, 2011, as compared to the three months ended August 1, 2010. During fiscal 2011, we repurchased $2.75 million of the 2014 Notes and converted $20.7 million of the 2014 Notes into common stock. The decrease in the principal amount of 2014 Notes resulted in decrease in the interest expense by $0.4 million. The decrease was offset by an increase in interest expense of $0.1 million due to additional term debt of $10.0 million in fiscal 2011 from Wells Fargo Capital, LLC.
Valuation gain, net represented a net gain of $38,000 in the three months ended August 1, 2010. See the discussion in Note 2 “Fair Value Option,” included in our condensed consolidated financial statements.
Loss on extinguishment of debt represents loss incurred on the repurchase of $2.75 million of aggregate principal amount of the 2014 Notes for $4.8 million during the first quarter of fiscal 2011.
Other income (expense), net for the three months ended July 31, 2011 increased by $0.5 million as compared to the three months ended August 1, 2010. The increase was primarily due to the receipt of contingent proceeds of $0.5 million that were held in escrow on the sale of our investment in Zerosoft, Inc. to Synopsys.
Provision for income taxes along with our effective tax rates for the periods presented follows:
 
Three months ended
 
July 31,
2011

 
August 1,
2010

Income (loss) before income taxes
$
319

 
$
(2,927
)
Provision for income tax
$
420

 
$
331

Effective tax rate
131.6
%
 
11.3
%
The provision for income taxes was $0.4 million and $0.3 million for the three months ended July 31, 2011 and August 1, 2010, respectively. The effective tax rates were 131.6% and 11.3% for the three months ended July 31, 2011 and August 1, 2010,

16

respectively. The tax provision increase for the quarter ended July 31, 2011 is due to higher foreign withholding tax payments than the year-ago quarter ended August 1, 2010. As we are in a full valuation allowance position in the U.S., we did not receive any tax benefit from making these foreign withholding tax payments. The fluctuation in the effective tax rate is primarily driven by taxes on earnings from our foreign subsidiaries. Our foreign subsidiaries are generally always profitable due to the cost plus arrangements with the U.S. parent entity, thus taxable income is forecasted to be incurred for our foreign operations regardless of consolidated results. The level of taxes on foreign earnings, combined with the change in the our consolidated operating results from a loss for the quarter ended August 1, 2010 ($2.9 million) to a profit for the quarter ended July 31, 2011 ($0.3 million) drove the increase in the effective tax rate.
Our fiscal 2012 effective tax rate for the three months ended July 31, 2011 differs from the combined federal and state statutory rate primarily due to changes in our U.S. valuation allowance, state taxes, foreign income taxed at other than U.S. rates, stock compensation expense, research and development credits and foreign withholding taxes.
We are in a net deferred tax asset position for which a full valuation allowance has been recorded against our U.S. net deferred tax assets. We will continue to provide a valuation allowance against our U.S. net deferred tax assets until it becomes more likely than not that the deferred tax assets are realizable. We will continue to evaluate the realizability of the deferred tax assets on a quarterly basis.
We are subject to income taxes in the United States and in numerous foreign jurisdictions and in the ordinary course of business, there are many transactions and calculations where the ultimate tax determination is uncertain. The statute of limitations for adjustments to our historic tax obligations will vary from jurisdiction to jurisdiction. Our larger jurisdictions provide a statute of limitations ranging from three to six years. In the U.S., the statute of limitations remains open for fiscal years 2004 and forward. At July 31, 2011, we do not anticipate that our total unrecognized tax benefits will significantly change due to any settlement of examination or expiration of statute of limitations within the next twelve months. In addition, we do not believe that the ultimate settlement of these obligations will materially affect our liquidity.
Liquidity and Capital Resources
The table below sets forth certain cash and cash equivalents as of July 31, 2011 and May 1, 2011, and cash flow data for the three months ended July 31, 2011 and August 1, 2010 (in thousands):
 
July 31,
2011
 
May 1,
2011
Cash and cash equivalents
$
51,101

 
$
47,088

 
 
 
 
 
Three Months Ended
 
July 31,
2011
 
August 1,
2010
Net cash provided by operating activities
$
4,001

 
$
1,387

Net cash provided by investing activities
$
368

 
$
15,645

Net cash used in financing activities
$
(394
)
 
$
(41,491
)
Our cash and cash equivalents were approximately $51.1 million on July 31, 2011, an increase of $4.0 million, or 9%, from cash and cash equivalents of $47.1 million at May 1, 2011. The increase is primarily due to the increase in cash provided by operating and investing activities of $4.0 million and $0.4 million, respectively, offset by cash used in financing activities of $0.4 million.
We hold our cash and cash equivalents in the United States and in foreign accounts, primarily in Japan, the Netherlands and India. As of July 31, 2011, we held an aggregate of $43.2 million in cash and cash equivalents in the United States and an aggregate of $7.9 million in foreign accounts. If required for our operations in the United States, most of the cash held abroad could be repatriated to the U.S. but, under current law, would be subject to U.S. federal income taxes (subject to an adjustment for foreign tax credits). We do not anticipate a need to repatriate these funds for use in our U.S. operations. During fiscal 2011, we repatriated earnings from certain foreign subsidiaries, and will continue to evaluate opportunities for earnings repatriation from foreign operations if favorable circumstances warrant.
Net cash provided by operating activities
Net cash provided by operating activities increased by $2.6 million, or 188%, in the three months ended July 31, 2011 compared to the three months ended August 1, 2010 due to an increase in cash from customers of $6.5 million due to better cash collections, offset by an increase in cash paid on prepaid and other assets of $2.1 million, and increase in cash used by accounts payable and accrued liabilities of $1.7 million.
Net cash provided by investing activities

17

Net cash provided by investing activities decreased by $15.3 million, or 98%, for the three months ended July 31, 2011 compared to the three months ended August 1, 2010. During the first quarter of fiscal 2011, the cash inflow was mainly due to the receipt of $16.9 million cash received on maturity of Auction Rate Securities, whereas during the first quarter ended July 31, 2011, we did not receive any cash on sale of investment. The above decrease was offset by increase in purchase (sale) of strategic investments, net by $0.8 million, decrease in cash paid on purchase of property and equipment by $0.3 million and a decrease in cash paid on business/asset acquisitions by $0.6 million.
Net cash used in financing activities
Net cash used in financing activities decreased $41.1 million, or 99%, in the three months ended July 31, 2011, compared to the three months ended August 1, 2010. During the three months ended August 1, 2010, we paid $23.2 million in aggregate principal amount of the 2010 Notes; we also used $11.2 million to repay the UBS secured credit line. In addition, we purchased 2014 Notes with an aggregate principal value of $2.75 million for $4.8 million, and purchased common stock on the open market for $2.0 million.
Capital resources
Cash and cash equivalents available for use aggregated a total of $51.1 million at July 31, 2011.
We believe that our existing cash and cash equivalents, our available borrowing and our operating cash flows will be sufficient to repay the current portion of the quarterly Term Loan A (as defined below) and Term Loan B (as defined below) installments of $0.6 million and $0.4 million per quarter, respectively, and to meet our anticipated operating and working capital requirements and fund our capital investments in the ordinary course of business for at least the next 12 months.
We generated positive cash flow of $4.0 million from operations in the first fiscal quarter of 2012. Our ability to fund our cash needs over the short and long term will depend on our ability to continue to generate cash from operations, which is subject to general economic and financial market conditions, competition, maintaining our existing credit facility and other factors. If we are unable to generate sufficient cash from operations for these purposes, we may be required to access the capital and credit markets for additional liquidity, and we cannot guarantee that we will be able to do so on satisfactory terms or at all. In particular, continued concerns about the global financial and banking systems, systemic impact of inflation (or deflation), energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market and a declining real estate market in the U.S. have contributed to continued uncertainty for the global economy generally. If these market conditions continue, the availability and cost of credit may be adversely affected and we may be unable, or limited in our ability, to access the capital markets to meet our liquidity needs, resulting in an adverse impact on our financial position and results of operations.
Revolving Loans and Term Debt
On March 19, 2010, we entered into a new four year credit facility with Wells Fargo Capital Finance, LLC. (as amended the “New Credit Facility”), which replaced our previous $15.0 million secured revolving line of credit facility with Wells Fargo Bank, N.A (the “Credit Facility”). The New Credit Facility provides for a revolving loan not to exceed $15.0 million and a term loan of $15.0 million (“Term Loan A”). The New Credit Facility is secured by a first priority interest in all of our assets. The Term Loan A repayments are in equal quarterly installments of $0.6 million, beginning October 31, 2010.
We subsequently executed three amendments in order to clarify certain administrative and operational aspects of the New Credit Facility. The amendments were executed in June 2010, July 2010 and September 2010, respectively, and did not materially alter the terms and conditions of the New Credit Facility. In October 2010, we executed a fourth amendment, which expanded the New Credit Facility with an additional term loan of $10.0 million (“Term Loan B”) and extended the maturity date to October 2014. The repayments of Term Loan B principal amounts are in equal installments of $0.4 million beginning April 30, 2011.
Under the terms of the New Credit Facility, outstanding borrowings and letter of credit liabilities may not, at any time, exceed the greater of $40.0 million or 50% of all “post-contract support” revenues and “time based license fee” revenues for the preceding twelve-month period. These requirements could, but to date have not, limited our borrowing availability.
The revolving loan and Term Loan A bear interest at either a LIBOR Rate or a Base Rate, at management’s election, in each case determined as follows (plus a margin of 4.5%): (A) if at a LIBOR Rate, at a per annum rate equal to the LIBOR Rate of the greater of (i) 1.00% per annum and (ii) the one, two or three month LIBOR rate quoted by Bloomberg and (B) if at the Base Rate, the greatest of (i) the Federal Funds Rate plus 0.5%, (ii) the three month LIBOR Rate plus 1.0% and (iii) the Wells Fargo prime rate. Term Loan B bears interest at either a LIBOR Rate or a Base Rate, at management’s election, in each case determined as follows (plus a margin of 3%): (A) if at a LIBOR Rate, at a per annum rate equal to the LIBOR Rate of the greater of (i) 1.00% per annum or (ii) the one, two or three month LIBOR rate quoted by Bloomberg and (B) if at the Base Rate the greatest of (i) the Federal Funds Rate plus 0.5%, (ii) the three month LIBOR Rate plus 1.0% and (iii) the Wells Fargo prime rate. In addition, we are required to pay fees of 0.5% per annum on the unused amount of the New Credit Facility, and 2.5% per annum for each letter of credit issued and quarterly administrative fees of $10,000.
We are required to pay interest and fees monthly, with the outstanding principal amount plus all accrued but unpaid interest

18

and fees payable in full at the maturity date of October 29, 2014.
The proceeds of the New Credit Facility have been used to refinance some of our existing indebtedness, including repayment of the Credit Facility and a portion of our 2010 Notes, and to finance general corporate purposes, including permitted acquisitions and permitted investments, capital expenditures, working capital, letters of credit, and fees and expenses associated with the New Credit Facility.
The New Credit Facility, contains covenants that, among other things, limit our ability to create liens, merge, consolidate, dispose of assets, incur indebtedness and guarantees, repurchase or redeem capital stock and indebtedness, make certain investments, acquisitions and capital expenditures, enter into certain transactions with affiliates or change the nature of our business. Events of default under the New Credit Facility, include, but are not limited to, payment defaults, covenant defaults, breaches of representations and warranties, cross defaults to certain other material agreements and indebtedness, bankruptcy and other insolvency events, actual or asserted invalidity of security interests or loan documents, and certain change of control events.
The New Credit Facility, also restricts our ability to pay dividends or make other distributions on our stock and requires that we comply with certain financial conditions. As of July 31, 2011, we had borrowed $25.0 million of term debt and had repaid the $2.2 million of Term Loan A and $0.7 million of Term Loan B. As of July 31, 2011, we had $13.3 million in unused revolving loans under the New Credit Facility.
As of July 31, 2011, we were in compliance with the financial covenants contained in the New Credit Facility.
Convertible notes
On September 11, 2009, we completed an exchange offer pursuant to which an aggregate principal amount of $26.7 million of our 2010 Notes were exchanged for $26.7 million principal amount of newly issued 2014 Notes. On May 15, 2010, we repaid the $23.2 million remaining outstanding balance of the 2010 Notes.
Our 2014 Notes mature on May 15, 2014 and bear interest at 6% per annum, with interest payable on May 15 and November 15 of each year, commencing May 15, 2010. The 2014 Notes are convertible into shares of our common stock at an initial conversion price of $1.80 per share, for an aggregate of approximately 14.83 million shares. Upon conversion, the holders of the 2014 Notes will receive shares of our common stock. The 2014 Notes are unsecured senior indebtedness, which rank equally in right of payment to the New Credit Facility. The 2014 Notes are effectively subordinated in right of payment to the New Credit Facility, to the extent of the security interest held by Wells Fargo Bank in our assets. After May 15, 2013, we have the option to redeem the 2014 Notes for cash in an amount equal to 100% of the aggregate outstanding principal amount at the time of such redemption.
During the first quarter of fiscal 2011, we repurchased $2.75 million aggregate principal amount of the 2014 Notes, representing approximately 10.3% of the previously outstanding aggregate principal amount of the 2014 Notes, in private transactions. These purchases were funded from our working capital.
During the second quarter of fiscal 2011, we engaged in separately negotiated transactions with certain holders of our 2014 Notes. Pursuant to those transactions, the holders converted an aggregate principal amount of $20.7 million of the 2014 Notes, representing 77.5% of the previously outstanding aggregate principal amount, into 11.5 million shares of our common stock. We incurred an inducement fee of $2.3 million on of the 2014 Notes.
As of July 31, 2011, approximately $3.25 million of the 2014 Notes remained outstanding and are convertible into approximately 1.8 million shares of our common stock. From time to time, we may enter into additional transactions in the future with respect to the repurchase or conversion of the $3.25 million remaining balance of convertible notes due May 2014 whenever conditions are sufficiently attractive. We will evaluate any such transactions in light of then-existing market conditions, taking into account our current liquidity and prospects for future access to capital. The amounts involved in any such transactions, individually or in the aggregate, may be material.
Contractual obligations
As of July 31, 2011, our principal contractual obligations are $38.25 million from fiscal 2012 through fiscal 2014. Contractual obligations consist of the operating leases on our office facilities of $4.4 million, $2.3 million in capital lease obligations for computer equipment, $4.6 million of purchase obligations, a term loan of $22.0 million, $1.7 million in letters of credit, and $3.25 million in 2014 Notes. We have no material commitments for capital expenditures and, as a result of the cost reduction plans we initiated in fiscal 2009, we do not anticipate an increase in our capital expenditures and lease commitments. Purchase obligations represent an estimate of all open purchase orders and contractual obligations in the normal course of business for which we have not received the goods or services as of July 31, 2011. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule and adjust our requirements based on our business needs prior to the delivery of goods or performance of services. In addition, we have other obligations for goods and services entered into in the normal course of business. These obligations, however, are either unenforceable or not legally binding or are subject to change based on our business decisions.

19

Our acquisition agreements related to certain business combination and asset purchase transactions have obligated us to pay certain contingent cash consideration based on meeting certain financial or project milestones and continued employment of certain employees. As of July 31, 2011, we did not have any outstanding contingent cash considerations to be paid under our acquisition agreements. The earnout period on our acquisitions ended March 31, 2011.
Off-balance Sheet Arrangements
As of July 31, 2011, we did not have any “off-balance-sheet arrangements,” as defined in Item 303(a)(4)(ii) of Regulation S-K.
Indemnification Obligations
We enter into standard license agreements in the ordinary course of business. Pursuant to these agreements, we agree to indemnify our customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to our products. These indemnification obligations have specified terms. Our normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification we may be required to make may exceed our normal business practices. We estimate the fair value of our indemnification obligations as insignificant, based on our historical experience concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of July 31, 2011.
We have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we retain directors' and officers' liability insurance that reduces our exposure and enables us to recover portions of amounts paid. As a result of our insurance coverage, we believe the estimated fair value of these indemnification agreements is insignificant. Accordingly, no liabilities have been recorded for these agreements as of July 31, 2011.
In connection with certain of our recent business acquisitions, we have also agreed to assume, or cause our subsidiaries to assume, the indemnification obligations of those companies to their respective officers and directors. No liabilities have been recorded for these agreements as of July 31, 2011.
Warranties
We warrant to our customers that our products will conform to the documentation provided. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, we have no liabilities recorded for these warranties as of July 31, 2011. We assess the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the future.
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in widely diversified short-term and long-term investments, consisting primarily of investment grade securities. As of July 31, 2011, a hypothetical 100 basis point increase in interest rates would not result in a material impact on the fair value of our cash equivalents.
The fair value of our fixed rate long-term debt is sensitive to interest rate changes. Interest rate changes would result in increases or decreases in the fair value of our debt, due to differences between market interest rates and rates in effect at the inception of our debt obligation. Changes in the fair value of our fixed rate debt have no impact on our cash flows or consolidated financial statements.

Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents, short-term investments and accounts receivable. The Company’s cash, cash equivalents and short-term investments generally consist of government agencies, municipal obligations and money market funds with high-quality financial institutions. Accounts receivable are typically unsecured and are derived from license and service sales. The Company performs ongoing credit evaluations of its customers and maintains allowances for doubtful accounts.
Foreign Currency Exchange Rate Risk
A majority of our revenue, expense, and capital purchasing activities are transacted in U.S. dollars. However, we transact

20

some portions of our business in various foreign currencies, primarily related to a portion of revenue in Japan and operating expenses in Europe, Japan and Asia-Pacific. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. As of July 31, 2011, we had approximately $5.4 million of cash and money market funds in foreign currencies. We enter into foreign currency forward contracts to mitigate exposure in movements between the U.S. dollar and foreign currencies. The derivatives do not qualify for hedge accounting treatment. We recognize the gain and loss on foreign currency forward contracts in the same period as the remeasurement loss and gain of the related foreign currency-denominated exposures. In the three months ended July 31, 2011, net foreign exchange loss of $0.2 million was included in “Other (expense), net” in our consolidated statements of operations.
ITEM 4.    CONTROLS AND PROCEDURES    
Evaluation of Disclosure Controls and Procedures.
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this report (the “Evaluation Date”). Based on that evaluation, our principal executive officer and principal financial officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective. In arriving at this conclusion, management considered the results of the investigation overseen by the Audit Committee of the Board of Directors, of whistleblower allegations related to business expense reimbursements, executive and other employee compensation, and restructuring costs. The investigation was concluded in the first quarter of fiscal 2012. The investigation was conducted by independent legal and accounting firms hired by the Audit Committee. We incurred approximately $1.9 million of costs, these costs were solely professional fees charged by the legal and accounting firms conducting the investigation and did not include any settlements or penalties. The deficiencies did not result in a misstatement of financial statements of any prior periods.
Changes in Internal Control over Financial Reporting
In the course of our investigation, certain deficiencies in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) (“internal controls”) were revealed. We are reviewing the relevant internal controls and related compliance policies and procedures for remediation, including the review, expansion and formalization of policies relating to expense reports and reimbursement procedures and the enhancement of training of employees regarding compliance with these and other policies. We are in the process of determining and intend to implement, changes to relevant internal controls. However, there were no changes in our internal control over financial reporting that occurred during the fiscal quarter ended July 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. We expect to implement changes to internal controls to remediate these deficiencies during the second and third fiscal quarters of 2012.
PART II. OTHER INFORMATION
ITEM 1.    LEGAL PROCEEDINGS
We are subject to certain legal proceedings and disputes that arise in the ordinary course of business. The number and significance of these legal proceedings and disputes may increase as our size changes. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. As a result, these legal proceedings and disputes could harm our business and have an adverse effect on our consolidated financial statements. However, the results of any litigation or dispute are inherently uncertain and, at July 31, 2011, no estimate could be made of the loss or range of loss, if any, from such litigation matters and disputes. Liabilities are recorded when a loss is probable and the amount can be reasonably estimated. No accrued legal settlement liabilities are recorded on the condensed consolidated balance sheet as of July 31, 2011 or May 1, 2011. Litigation settlement and legal fees are expensed in the period in which they are incurred.
In Genesis Insurance Company v. Magma Design Automation, et al., Case No. 06-5526-JW, filed on September 8, 2006 in the United States District Court for the Northern District of California, Genesis seeks a declaration of its rights and obligations under an excess directors and officers liability policy for defense and settlement costs arising out of the securities class action against us, In re: Magma Design Automation, Inc. Securities Litigation, as well as a related derivative lawsuit. Genesis seeks a return of $5.0 million it paid towards the settlement of the securities class action and derivative lawsuits from us or from another of our excess directors and officers liability insurers, National Union. We contend that either Genesis or National Union owes the settlement amounts, but not us. The trial court granted summary judgment for us and National Union, finding that Genesis owed the settlement amount. Genesis appealed to the Ninth Circuit Court of Appeals, and we cross-appealed. On July 12, 2010, the Court of Appeals reversed, ruling that Genesis does not owe the settlement amount under its policy, and remanded the case to the trial court for further proceedings. On December 20, 2010, the trial ruled on various cross-motions that National Union owes the settlement amount to Genesis.
The court entered a judgment in favor of Genesis and Magma on March 2, 2011, requiring that National Union pay $5.0

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million plus prejudgment interest to Genesis. On April 1, 2011, National Union appealed the trial court's judgment to the Ninth Circuit Court of Appeals. The opening brief of National Union is due by October 3, 2011. While there can be no assurance as to the ultimate disposition of the litigation, we do not believe that its resolution will have a material adverse effect on our financial position, results of operations or cash flows.
ITEM 1A.    RISK FACTORS
A restated description of the risk factors associated with our business is set forth below. This description supersedes the description of the risk factors associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended May 1, 2011. We do not believe any of the changes constitute material changes from the risk factors previously disclosed in the Form 10-K for the year ended May 1, 2011.
Our business faces many risks. The risk factors below describe the material risks to our business of which we are presently aware. If any of the events or circumstances described in the following risk factors actually occurs, our business, financial condition or results of operations could suffer, and the trading price of our common stock could decline.
We rely on a relatively small number of customers for a significant portion of our revenue, and our revenue could decline if customers delay orders or fail to renew licenses or if we are unable to maintain or develop relationships with current or potential customers.
Our business depends on sales to a relatively small number of customers, and we expect that we will generally continue to depend upon a relatively small number of customers for a substantial portion of our revenue for the foreseeable future. If we fail to sell sufficient quantities of our products and services to one or more customers in any particular period, or if a large customer reduces purchases of our products or services, defers orders, defaults on its payment obligations to us, or fails to renew licenses, our business and operating results could be harmed. In addition, if our customers believe that we are not financially sound, they may choose to stop doing business with us, which would materially adversely affect our business and financial condition.
Most of our customers license our software under time-based licensing agreements, with terms that typically range from 15 months to 48 months. Most of our license agreements automatically expire at the end of the term unless the customer renews the license with us or purchases a perpetual license. If our customers do not renew their licenses or renew their licenses with shorter terms, we may not be able to maintain our current revenue or may not generate additional revenue. Some of our license agreements allow customers to terminate an agreement prior to its expiration under limited circumstances-for example, if our products do not meet specified performance requirements or goals. If these agreements are terminated prior to expiration or we are unable to collect under these agreements, our revenue may decline.
Some contracts with extended payment terms provide for payments that are weighted toward the latter part of the contract term. Accordingly, for license agreements that include maintenance or services where VSOE is not established, as the payment terms are extended, the revenue from these contracts is not recognized evenly over the contract term, but is recognized as the lesser of the cumulative amounts due and payable or ratably. For license agreements that include maintenance or services where VSOE is established, as the payment terms are extended, the revenue from these contracts is recognized as amounts become due and payable. Revenue recognized under these arrangements will be higher in the latter part of the contract term, which potentially puts our future revenue recognition at greater risk of the customer's continued credit-worthiness. In addition, some of our customers have extended payment terms, which create additional credit risk.
We are currently party to and may enter into debt arrangements in the future, each of which may subject us to restrictive covenants which could limit our ability to operate our business.
We are party to a $40.0 million credit facility with Wells Fargo Capital Finance, LLC, pursuant to which we had outstanding borrowings of $22.0 million of term loans and two letters of credit totaling $1.7 million as of July 31, 2011. Our credit facility imposes various restrictions and covenants on us that limit our ability to incur or guarantee indebtedness, make investments, declare dividends or make distributions, acquire or merge into other entities, sell substantial portions of our assets and grant security interests in our assets. In the future, we may incur additional indebtedness through arrangements such as credit agreements, term loans or the issuance of debt securities that may also impose similar restrictions and covenants. These restrictions and covenants limit, and any future covenants and restrictions may limit, our ability to respond to market conditions, make capital investments or take advantage of business opportunities. Any debt arrangements we enter into may require us to make regular interest or principal payments, which would adversely affect our results of operations.
We cannot assure you that we will be able to satisfy or comply with the provisions, covenants, financial tests and ratios of our debt instruments, which can be affected by events beyond our control. If we fail to satisfy or comply with such provisions, covenants, financial tests and ratios, or if we disagree with our lenders about whether or not we are in compliance, we cannot assure you that we will be able to obtain waivers from our lenders for any failures to comply with our financial covenants or any other terms of the debt instruments. We also may not be able to obtain amendments that will prevent a failure to comply in the future. A breach of any of the provisions, covenants, financial tests or ratios under our debt instruments could result in a default under the applicable agreement, which in turn could accelerate the timing of our repayment obligations such that our indebtedness

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would become immediately due and payable and could trigger cross-defaults under our other debt instruments, any of which would materially adversely affect our business and financial condition and could make it difficult for us to incur additional indebtedness on comparable terms in the future.
We may be unable to service our indebtedness.
We will be required to generate cash sufficient to conduct our business operations and pay our indebtedness and other liabilities, including all amounts, both principal and interest, as they become due on the 6% Convertible Senior Notes due 2014 Notes (the "2014 Notes") and under our credit facility with the Wells Fargo Bank, N.A. We may not generate sufficient cash flow from operations to cover our anticipated debt service obligations, including making payments on any outstanding notes or our credit facility. Our ability to make principal and interest payments on our indebtedness will depend upon our future performance, which will be subject to general economic conditions, industry cycles and financial, business and other factors affecting our operations, many of which are beyond our control. If we cannot generate sufficient cash flow from operations in the future to service our debt, we may, among other things: 
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seek additional financing in the debt or equity markets, and the documentation governing any future financing may contain covenants that limit or restrict our strategic, operating or financing activities;
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attempt to refinance or restructure all or a portion of our indebtedness;
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attempt to sell selected assets;
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reduce or delay planned capital expenditures; or
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reduce or delay planned research and development expenditures.
These measures may not be successful, may not be sufficient to enable us to service our indebtedness and may harm our business and prospects.
In addition, we may try to access private and public sources of external financing, including debt and equity, to repay our existing indebtedness. Such financing may not be available in sufficient amounts, when needed or on terms acceptable to us, or at all. In addition, any equity financing may not be desirable because of resulting dilution to our stockholders, which may be significant. We also may, from time to time, redeem, tender for, exchange for, or repurchase our securities in the open market or in privately-negotiated transactions depending upon availability of our cash resources, market conditions and other factors. Moreover, the availability of funds under our existing $40.0 million credit facility may be adversely affected by our financial condition, results of operations and incurrence or maintenance of additional debt.
Volatile financial market conditions may impede our access to or increase the cost of financing operations and investments, which could materially adversely affect our business and financial condition.
In recent years, volatility and disruption in the capital and credit markets reached unprecedented levels. Volatility, disruption or tightening of the U.S. and global financial, equity and credit markets could negatively impact our ability to obtain additional sources of financing to repay or restructure our indebtedness or to obtain financing for our operations or investments or may increase the cost of obtaining financing. If we are unable to obtain needed financing or generate sufficient cash from operations, our ability to expand, develop or enhance our services or products, fund our working capital requirements or respond to competitive pressures would be limited, which would materially adversely affect our business and financial condition.
We have a substantial amount of indebtedness that could adversely affect our business, operating results or financial condition.
We currently have, and will continue to have for the foreseeable future, a substantial amount of indebtedness. As of July 31, 2011, we had an aggregate principal amount of approximately $27.0 million in outstanding debt, which was comprised of $3.25 million aggregate principal amount of 2014 Notes, as well as $22.0 million of outstanding term loan borrowings and two letters of credit totaling $1.7 million under our credit facility with Wells Fargo Capital Finance, LLC, which expires on October 29, 2014. If cash on hand and cash flow from operations are not sufficient to meet our working capital needs, capital requirements, and debt repayment obligations, we may need to incur additional indebtedness. Our outstanding indebtedness will also require us to use a substantial portion of our cash flow from operations to make debt service payments. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments, or if we fail to comply with the various requirements of our indebtedness, we would be in default, which would permit the holders of our indebtedness to accelerate the maturity of the indebtedness and which could cause a default under any other indebtedness then outstanding. Any default under our indebtedness would have a material adverse effect on our business, operating results and financial condition.
In addition, our high level of indebtedness may:
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make it difficult for us to satisfy our financial obligations;
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limit our ability to use our cash flow in our operations, use our available financings to the fullest extent possible, or obtain

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additional financing for future working capital, capital expenditures, acquisitions or other general corporate purposes;
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limit our flexibility to plan for, or react to, changes in our business and industry;
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place us at a competitive disadvantage compared to our less leveraged competitors and our competitors with greater access to capital resources;
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increase our vulnerability to the impact of adverse economic and industry conditions;
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increase our vulnerability in the event of an increase in interest rates if we must incur new debt to satisfy our obligations under our current indebtedness; and
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cause our business to go into bankruptcy or cause our business to fail.
Customer payment defaults may cause us to be unable to recognize revenue from backlog, and changes in the type of orders comprising backlog could affect the proportion of revenue recognized from backlog each quarter, which could have a material adverse effect on our financial condition and results of operations.
Twenty four percent of our revenue backlog is variable based on volume of usage of our products by customers or includes specific future deliverables or is recognized as revenue on a cash receipts basis. Management has estimated variable usage based on customers' forecasts, but there can be no assurance that these estimates will be realized. In addition, it is possible that customers from whom we expect to derive revenue from backlog will default, and, as a result, we may not be able to recognize revenue from backlog as expected. If a customer defaults and fails to pay amounts owed, or if the level of defaults increases, our bad debt expense is likely to increase. Moreover, existing customers may seek to renegotiate preexisting contractual commitments due to adverse changes in their own businesses, which may increase if current economic conditions do not improve or worsen. Any material payment default by our customers or material renegotiation of preexisting contractual commitments could have a material adverse effect on our financial condition and results of operations.
To gain market share and maintain revenue, we must compete successfully against companies that hold a large share of the EDA market and competition is increasing among EDA vendors as customers tightly control their EDA spending and use fewer vendors to meet their needs.
We currently compete with companies that hold dominant shares in the EDA market, such as Cadence Design Systems, Synopsys, Inc. and Mentor Graphics Corporation. Each of these companies has a longer operating history and significantly greater financial, technical and marketing resources than we do, as well as greater name recognition and a larger installed customer base. Our competitors are better able to offer aggressive discounts on their products, a practice they often employ. Competition and corresponding pricing pressures among EDA vendors or other factors could cause the overall market for EDA products to have low growth rates, remain relatively flat or even decrease in terms of overall dollars. In addition, our competitors offer a more comprehensive range of products than we do. For example, we do not offer logic simulation, which can sometimes be an impediment to our winning a particular customer order. Our industry has traditionally viewed acquisitions as an effective strategy for growth in products and market share, and our competitors' greater cash resources and higher market capitalization could give them a relative advantage over us in acquiring companies with promising new chip design products or companies that may be too large for us to acquire without a strain on our resources and liquidity.
Competition in the EDA market has increased as customers rationalized their EDA spending by using products from fewer EDA vendors. Continued consolidation in the EDA market could intensify this trend. In addition, gaining market share in the EDA market can be difficult as it may take years for a customer to move from a competitor. Many of our competitors, such as Cadence, Synopsys and Mentor, have established relationships with our current and potential customers and can devote substantial resources aimed at preventing us from establishing or enhancing our customer relationships. Competitive pressures may prevent us from obtaining new customers and gaining market share, may require us to reduce the price of products and services or cause us to lose existing customers, which could harm our business. To execute our business strategy successfully, we must continue our efforts to increase our sales worldwide. If we fail to do so in a timely manner or at all, we may not be able to gain market share and our business and operating results could suffer.
Also, a variety of small companies continue to emerge, developing and introducing new products that may compete with our products. Any of these companies could become a significant competitor in the future. We also compete with the internal chip design automation development groups of our existing and potential customers. Therefore, these customers may not require, or may be reluctant to purchase, products offered by independent vendors.
Our competitors may develop or acquire new products or technologies that have the potential to replace our existing or new product offerings. The introduction of these new or additional products by competitors may cause potential customers to defer purchases of our products or decide against purchasing our products. If we fail to compete successfully, we will not gain market share, or our market share may decrease, and our business may fail.
If the industries into which we sell our products experience a recession or other cyclical effects affecting our customers'

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research and development budgets, our revenue would be adversely affected.
Demand for our products is driven by new integrated circuit design projects. The demand from semiconductor and systems companies is uncertain and difficult to predict. A sharp economic downturn (such as that experienced in the semiconductor and systems industries in 2008 and 2009), a reduced number of design starts, a reduction in the complexity of integrated circuits, a reduction in our customers' EDA budgets or consolidation among our customers would have an adverse effect on our revenue and would harm our business and financial condition. The primary customers for our products are companies in the communications, computing, consumer electronics, networking and semiconductor industries. A cutback of research and development budgets or the delay of software purchases by our customers due to a downturn in our customers' markets, in general economic conditions or otherwise would likely result in lower demand for our products and services and could harm our business. The continuing threat of terrorist attacks in the United States and worldwide, the ongoing events in Afghanistan, Iraq, Iran, the Middle East, North Korea and other parts of the world, recent problems with the financial system, such as problems involving banks as well as the mortgage markets and the recent financial crisis, and other worldwide events, including the impact of the earthquakes and related events in Japan, have increased uncertainty in the United States and global economies. If global economic conditions do not improve or worsen, existing customers may decrease their purchases of our software products or delay their implementation of our software products, and prospective customers may decide not to adopt our software products, any of which could negatively impact our business and operating results.
Our industry is subject to cyclical fluctuation, which could affect our operating results.
The electronics industry has historically been subject to cyclical fluctuations in demand for its products, and this trend may continue in the future. These industry downturns have been and may continue to be characterized by diminished product demand, excess manufacturing capacity and subsequent erosion of average selling prices. Any such cyclical industry downturns could harm our operating results.
Our lengthy and unpredictable sales cycle and the large size of some orders make it difficult for us to forecast revenue and increase the magnitude of quarterly fluctuations, which could harm our stock price.
Customers for our software products typically commit significant resources to evaluate available software. The complexity of our products requires us to spend substantial time and effort to assist potential customers in evaluating our software and in benchmarking our products against those of our competitors. As the complexity of the products we sell increases, we expect our sales cycle to lengthen. In addition, potential customers may be limited in their current spending by existing time-based licenses with their legacy vendors. In these cases, customers delay a significant new commitment to our software until the term of the existing license has expired. Also, because our products require our customers to invest significant time and incur significant costs, we must target those individuals within our customers' organizations who are able to make these decisions on behalf of their companies. These individuals tend to be senior management in an organization, typically at the vice president level. We may face difficulty identifying and establishing contact with such individuals. Even after those individuals decide to purchase our products, the negotiation and documentation processes can be lengthy and could lead the decision-maker to reconsider the purchase. Consequently, we may incur substantial expense and devote significant management time and effort to develop potential relationships that do not result in agreements or revenues and that may prevent us from pursuing other opportunities.
Our sales cycle typically ranges between three and nine months but can be longer. Any delay in completing sales in a particular quarter could cause our operating results to fall below expectations. Furthermore, economic downturns, technological changes, litigation risk or other competitive factors could cause some customers to shorten the terms of their licenses significantly, and such shorter terms could in turn have an impact on our total results for orders for this fiscal year. In addition, the precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. Even if we achieve the target level of total orders, we may not meet our revenue targets if we are unable to achieve our target license mix. In particular, we may fall short of our revenue targets if we deliver more long-term or ratable licenses than expected, or we may exceed our revenue targets if we deliver more short-term licenses than expected.
Consolidation among our customers, as well as within the industries in which we operate, may negatively impact our operating results.
A number of business combinations, including mergers, asset acquisitions and strategic partnerships, among our customers and in the semiconductor and electronics industries have occurred recently, and more could occur in the future. Consolidation among our customers could lead to fewer customers or the loss of customers, increased customer bargaining power, or reduced customer spending on software and services. Moreover, business combinations within the industries in which we compete may result in stronger competition from companies that are better able to compete as sole source vendors to customers. The loss of customers or reduced customer spending could adversely affect our business and financial condition.
Our quarterly results are difficult to predict, and if we fail to reach certain quarterly financial expectations, our stock price is likely to decline.
Our quarterly revenue and operating results fluctuate from quarter to quarter and are difficult to predict. It is likely that our

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operating results in some periods will be below investor expectations. If this happens, the market price of our common stock is likely to decline. Fluctuations in our future quarterly operating results may be caused by many factors, including:
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size and timing of customer orders, which are received unevenly and unpredictably throughout a fiscal year;
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the mix of products licensed and types of license agreements;
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our ability to recognize revenue in a given quarter;
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timing of customer license payments;
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the relative mix of time-based licenses bundled with maintenance, unbundled time-based license agreements and perpetual license agreements, each of which requires different revenue recognition practices;
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size and timing of revenue recognized in advance of actual customer billings and customers with graduated payment schedules which may result in higher accounts receivable balances and days sales outstanding (“DSO”);
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changes in accounting rules and practices related to revenue recognition;
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the relative mix of our license and services revenue;
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our ability to win new customers and retain existing customers;
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changes in our pricing and discounting practices and licensing terms and those of our competitors;
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changes in the level of our operating expenses, including general compensation levels as well as increases in incentive compensation payments that may be associated with future revenue growth;
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higher-than-anticipated costs in connection with litigation;
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the timing of product releases or upgrades by us or our competitors; and
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the integration, by us or our competitors, of newly-developed or acquired products or businesses.
We have faced lawsuits related to patent infringement and other claims, and we may face additional intellectual property infringement claims or other litigation. Lawsuits can be costly to defend, can take the time of our management and employees away from day-to-day operations, and could result in our losing important rights and paying significant damages.
We have faced lawsuits related to patent infringement and other claims in the past. For example, Synopsys previously filed various suits, including actions for patent infringement, against us. In addition, a putative stockholder class action lawsuit and a putative derivative lawsuit were filed against us. All claims brought against us by Synopsys have been fully resolved by a settlement and a license under the asserted patents, although other similar litigation involving Synopsys or other parties may follow. For another example, we currently face a lawsuit in which one of our insurers, Genesis Insurance Company, seeks the return of $5.0 million it paid towards the settlement of the putative stockholder and derivative lawsuits that arose out of the Synopsys patent infringement lawsuit. The case is pending and described in more detail in Part II, Item 1, “Legal Proceedings”. In the future, other parties may assert intellectual property infringement claims or other claims against us or our customers. We may have acquired or may in the future acquire software as a result of our acquisitions, and we could be subject to claims that such software infringes the intellectual property rights of third parties. We also license technology from certain third parties and could be subject to claims if the software that we license is deemed to infringe the rights of others. In addition, we are often involved in or threatened with commercial litigation unrelated to intellectual property infringement claims such as labor litigation and contract claims, and we may acquire companies that are actively engaged in such litigation.
Our products may be found to infringe intellectual property rights of third parties, including third-party patents. In addition, many of our contracts contain provisions in which we agree to indemnify our customers against third-party intellectual property infringement claims that are brought against them based on their use of our products. Also, we may be unaware of filed patent applications that relate to our software products. We believe that the patent portfolios of our competitors generally are far larger than ours. This disparity between our patent portfolio and the patent portfolios of our competitors may increase the risk that they may sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses.
The outcome of intellectual property litigation and other types of litigation could result in our loss of critical proprietary rights and unexpected operating costs and substantial monetary damages. Intellectual property litigation and other types of litigation are expensive and time-consuming and could divert our management's attention from our business. If there is a successful claim against us for infringement, we may be ordered to pay substantial monetary damages (including punitive damages), be prevented from distributing all or some of our products, and be required to develop non-infringing technology or enter into royalty or license agreements, which may not be available on acceptable terms, if at all. Our failure to develop non-infringing technologies or license any required proprietary rights on a timely basis could harm our business.

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Publicly announced developments in litigation matters, as well as other factors, may cause our stock price to decline sharply and suddenly, and we are subject to ongoing risks of securities class action litigation related to volatility in the market price for our common stock.
We may not be successful in defending some or all claims that may be brought against us. Regardless of the outcome, litigation can result in substantial expense and could divert the efforts of our management and technical personnel from our business. In addition, the ultimate resolution of the lawsuits could have a material adverse effect on our financial position, results of operations and cash flow, and harm our ability to execute our business plan.
Our operating results will be harmed if chip designers do not adopt or continue to use Talus, FineSim, the Tekton and Quartz family of products, Titan or our other current and future products.
Talus (and its predecessor product line, Blast Fusion) accounted for the largest portion of our revenue since our inception, and we believe that revenue from Talus, Tekton, FineSim, Titan and Excalibur will account for most of our revenue for the foreseeable future. We have dedicated significant resources to developing and marketing Talus, Tekton, FineSim, Titan, and Excalibur and our other products in order to achieve our growth strategy and financial success. Moreover, if integrated circuit designers do not continue to adopt or use Talus, Tekton, FineSim, Titan, and Excalibur or other current and future products, our operating results will be significantly harmed.
We have a history of losses, except for fiscal 2003 and fiscal 2004, and we had an accumulated deficit of approximately $387.2 million as of July 31, 2011. If we continue to incur losses, the trading price of our stock may decline.
We had an accumulated deficit of approximately $387.2 million as of July 31, 2011. Except for fiscal 2003 and fiscal 2004, we incurred losses in all other fiscal years since our incorporation in 1997. If we incur losses in the future, or if we fail to achieve profitability at levels expected by securities analysts or investors, the market price of our common stock may decline. If we incur losses in the future, we may not be able to maintain or increase our number of employees or our investment in capital equipment, sales, marketing, and research and development programs.
Our operating results may be harmed if our customers do not adopt, or are slow to adopt, 28-nanometer and smaller design geometries on a large scale.
Our customers are currently working on a range of design geometries, including 28-nanometer, 40-nanometer, 65-nanometer, 90-nanometer and 130-nanometer designs. We continue to work towards developing and enhancing our product line in anticipation of increased customer demand for 28-nanometer and other smaller-design geometries. Notwithstanding our efforts to support 28-nanometer and other smaller design geometries, customers may fail to adopt, or may face technical difficulties in adopting these geometries on a large scale and we may be unable to persuade our customers to purchase our related software products. Accordingly, any revenue we receive from enhancements to our products or acquired technologies may be less than the development or acquisition costs. If customers fail to adopt or delay the adoption of 28-nanometer and other smaller design geometries on a large scale, our operating results may be harmed. In addition, if customers are not able to successfully generate profits as they adopt smaller geometries, demand for our products may be adversely affected, and our operating results may be harmed.
Difficulties in developing and achieving market acceptance of new products and delays in planned release dates of our software products and upgrades may harm our business and cause our operating results to decline.
The semiconductor industry is characterized by rapid technology developments, changes in industry standards and customer requirements and frequent new product introductions and improvements. For our business to be successful, we will need to develop or acquire innovative new products. We may not have the financial resources necessary to fund all required future innovations. Expanding into new technologies or extending our product line into areas we have not previously addressed may be more costly or difficult than we presently anticipate. Also, any revenue that we receive from enhancements or new generations of our proprietary software products may be less than the costs that we incur to develop or acquire those technologies and products. If we fail to develop and market new products in a timely manner, or if new products do not meet performance features as marketed, our reputation and our business could suffer.
In particular, the semiconductor industry has recently made significant technological advances in deep sub-micron technology, which have required EDA companies to develop or acquire new products and enhance existing products continuously. The evolving nature of our industry could render our existing products and services obsolete. Our success will depend, in part, on our ability to:
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enhance our existing products and services;
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develop and introduce new products and services in a timely and cost-effective manner that will keep pace with technological developments and evolving industry standards;
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address the increasingly sophisticated needs of our customers; and
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acquire other companies that have complementary or innovative products.

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If we are unable, for technical, legal, financial or other reasons, to respond in a timely manner to changing market conditions or customer requirements, our business and operating results could be seriously harmed.
Our research and development expenditures may not be sufficient to enable us to develop new products or update existing products, which may reduce our revenue growth, and increases in our research and development expenditures could negatively affect our operating results.
Developing EDA technology and integrating acquired technology into existing platforms is expensive, and these investments often require a long time to generate returns. We devote a substantial portion of our resources to developing new products and enhancing our existing products, conducting product testing and quality assurance testing, improving our core technology and strengthening our technological expertise in the EDA market. We believe that we must continue to devote substantial resources to our research and development efforts to maintain and improve our competitive position. Our research and development expenditures for the first fiscal quarter of fiscal 2012 and for fiscal year 2011 was $12.8 million and $49.9 million, respectively. If we are required to invest significantly greater resources than anticipated in research and development efforts in the future, our operating expenses would increase, which could negatively affect our operating results. If these increased efforts do not result in a corresponding increase in revenue, our operating results could decline. Further, research and development expenses are likely to fluctuate from time to time to the extent we make periodic incremental investments in research and development, and these investments may be independent of our level of revenue, which could negatively affect our operating results.
Our costs of customer engagement and support are high, so our gross margin may decrease if we incur higher-than-expected costs associated with providing support services in the future or if we reduce our prices.
Because of the complexity of our products, we typically incur high field application engineering support costs to engage new customers and assist them in their evaluations of our products. If we fail to manage our customer engagement and support costs, our operating results could suffer. In addition, our gross margin may decrease if we are unable to manage support costs associated with the services revenue we generate or if we reduce prices in response to competitive pressure. 
If chip designers and manufacturers do not integrate our software into existing design flows, or if other software companies do not cooperate in working with us to interface our products with their design flows, demand for our products may decrease.
To implement our business strategy successfully, we must provide products that interface with the software of other EDA software companies. Our competitors may not support efforts by us or by our customers to integrate our products into their existing design flows. We must develop cooperative relationships with competitors so that they will work with us to integrate our software into customers' design flow. Currently, our software is designed to interface with the existing software of Cadence, Synopsys and others. If we are unable to persuade customers to adopt our software products instead of those of competitors (including competitors offering a broader set of products), or if we are unable to persuade other software companies to work with us to interface our software to meet the demands of chip designers and manufacturers, our business and operating results will suffer.
Product defects could cause us to lose customers and revenue, or to incur unexpected expenses.
Our products depend on complex software, which we either developed internally or acquired or licensed from third parties. Our customers may use our products with other companies' products, which also contain complex software. If our software does not meet our customers' performance requirements or meet the performance features as marketed, our customer relationships may suffer. Also, a limited number of our contracts include specified ongoing performance criteria. If our products fail to meet these criteria, it may lead to termination of these agreements and loss of future revenue. Complex software often contains errors. Any failure or poor performance of our software or the third-party software with which it is integrated could result in:
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delayed market acceptance of our software products;
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delays in product shipments;
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unexpected expenses and diversion of resources to identify the source of errors or to correct errors;
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loss of customers and damage to our reputation;
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increased service costs:
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delayed or lost revenue; and
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product liability claims.
Our product functions are often critical to our customers, especially because of the resources our customers expend on the design and fabrication of integrated circuits. Many of our licensing agreements contain provisions to provide a limited warranty. In addition, some of our licensing agreements provide the customer with a right of refund for the license fees if we are unable to correct errors reported during the warranty period. If our contractual limitations are unenforceable in a particular jurisdiction or if we are exposed to claims that are not covered by insurance, a successful claim could harm our business. We currently carry

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insurance coverage and limits that we believe are consistent with similarly situated companies within the EDA industry; however, our insurance coverage may prove insufficient to protect against any claims that we may experience.
We may not be able to hire or retain the number of qualified personnel required for our business, particularly engineering personnel, which would harm the development and sales of our products and limit our ability to grow.
Competition in our industry for senior management, technical, sales, marketing and other key personnel is intense. If we are unable to retain our existing personnel, or attract and train additional qualified personnel, our growth may be limited due to a lack of capacity to develop and market our products.
Our success depends on our ability to identify, hire, train and retain qualified engineering personnel with experience in integrated circuit design. Specifically, we need to be able to continue to attract and retain field application engineers to work with our direct sales force to technically qualify new sales opportunities and perform design work to demonstrate our products' capabilities to customers during the benchmark evaluation process. Competition for qualified engineers is intense, particularly in the Silicon Valley area where our headquarters are located. If we lose the services of a significant number of our employees or if we cannot hire additional employees of the same caliber, we will be unable to increase our sales or implement or maintain our growth strategy. 
If we fail to offer and maintain competitive compensation packages for our employees, we might have difficulty recruiting and retaining our employees and our business may be harmed.
If the compensation of our employees is not competitive or satisfactory to the employees, we may have difficulty in recruiting and retaining our employees and our business may be harmed. In today's competitive technology industry, employment decisions of highly skilled personnel are influenced by equity compensation packages.
We issue stock options and restricted stock units and maintain an employee stock purchase plan as a key component of our overall compensation. We may be forced to grant additional options or other equity in order to successfully recruit and retain employees. This in turn could result in:
•
immediate and substantial dilution to investors resulting from the grant of additional options or other equity necessary to retain employees; and
•
compensation charges against us, which would negatively impact our operating results.
In addition, the NASDAQ Marketplace Rules require stockholder approval for new equity compensation plans and significant amendments to existing equity compensation plans, including increases in shares available for issuance under such plans, and prohibit brokers holding shares of our common stock in customer accounts from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions. These regulations could make it more difficult for us to grant equity compensation to employees in the future. To the extent that these regulations make it more difficult or expensive to grant equity compensation to employees, we may incur increased compensation costs or find it difficult to attract, retain and motivate employees, which could adversely affect our business.
Our success is highly dependent on our ability to successfully motivate and retain our senior executives and other key research and development, sales and marketing employees.
We depend on our senior executives and certain key research and development and sales and marketing personnel, who are critical to our business. Specifically, for our sales force, we have experimented, and continue to experiment, with different systems of sales force compensation. If our incentives are not well designed, we may experience reduced revenue generation, and we may also lose the services of our more productive sales personnel, either of which would reduce our revenue or potential revenue. We do not have long-term employment agreements with any of our key employees, and we do not maintain any key person life insurance policies. Furthermore, our larger competitors may be able to offer more generous compensation packages to executives and key employees, and therefore we risk losing key personnel to those competitors. If we lose the services of any of our key personnel, our product development processes and sales efforts could be harmed. We may also incur increased operating expenses and be required to divert the attention of our senior executives to search for their replacements. The integration of new executives or new personnel could disrupt our ongoing operations.
If we become subject to unfair hiring claims, we could be prevented from hiring needed employees, incur liability for damages and incur substantial costs in defending ourselves.
Companies in our industry that lose employees to competitors frequently claim that these competitors have engaged in unfair hiring practices or that the employment of these persons would involve the disclosure or use of trade secrets. These claims could prevent us from hiring employees or cause us to incur liability for damages. We could also incur substantial costs in defending ourselves or our employees against these claims, regardless of their merits. Defending ourselves from these claims could also divert the attention of our management away from our operations.
We have had to implement a series of restructuring efforts recently. In the event that these efforts result in ineffective

29

interoperability between our products or ineffective collaboration among our employees, or we are unable to continue to manage the pace of our growth, our business could be harmed.
The global economic downturn negatively affected the semiconductor industry and our business, and in response to these adverse conditions we implemented a series of restructuring efforts. We incurred restructuring charges primarily for costs related to severance, expatriate relocation, facilities consolidation and termination, discontinued use of purchased software, and other costs related to the restructuring. This reduction in force might harm operating results by making it more difficult for the reduced workforce to take advantage of business opportunities and reach revenue goals. Furthermore, if our product marketing strategy initiative and sales and marketing organizational restructuring results in ineffective interoperability between our products or ineffective collaboration among our employees, then our operating results may be harmed. For example, we could experience delays in new product development that could cause us to lose customer orders, which could harm our operating results. We cannot assure you that if semiconductor industry or general economic conditions worsen, we will not be required to make further cost reductions.
To pace the growth of our operations with the growth in our revenue, we must continue to improve administrative, financial and operations systems, procedures and controls. Failure to improve our internal procedures and controls could hinder our efforts to manage our growth adequately, disrupt operations, lead to additional expenses associated with restructuring, lead to deficiencies in our internal controls and financial reporting and otherwise harm our business.
We may be unable to make payments to satisfy our indemnification obligations.
We enter into standard license agreements in the ordinary course of business. Pursuant to these agreements, we agree to indemnify certain of our customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to our products. These indemnification obligations continue over the software license period, and are perpetual in some instances. Our normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification we may be required to make may exceed our normal business practices. We estimate that the fair value of our indemnification obligations are insignificant, based upon our historical experience concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of July 31, 2011. If an indemnification event were to occur, we might not have enough funds to pay our indemnification obligations. Further, any material indemnification payment could have a material adverse effect on our financial condition and the results of our operations.
We have entered into certain indemnification agreements whereby certain of our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. Additionally, in connection with certain of our recent business acquisitions, we agreed to assume, or cause our subsidiaries to assume, indemnification obligations to the officers and directors of the acquired companies. While we have directors and officers insurance that reduces our exposure and enables us to recover a portion of any future amounts paid pursuant to our indemnification obligations to our officers and directors, the maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. However, as a result of our directors and officers insurance coverage and our belief that our estimated potential exposure to our officers and directors for indemnification liabilities is minimal, no liabilities have been recorded for these agreements as of July 31, 2011. Therefore, if an indemnification event were to occur, we might not have enough funds to pay our indemnification obligations. Further, any material indemnification payment could have a material adverse effect on our financial condition and the results of our operations.
Acquisitions are an important element of our strategy. We may not find suitable acquisition candidates and we may not be successful in integrating the operations of acquired companies and acquired technology.
Part of our growth strategy is to pursue acquisitions. We expect to continuously evaluate the possibility of accelerating our growth through acquisitions, as is customary in the EDA industry. The decline in the price of our common stock from 2008 levels and our focus on cash management may impact our ability to pursue acquisitions for some period of time. We also may analyze and pursue some acquisitions that are not consummated and, as a result, we may incur significant costs. Achieving the anticipated benefits of past and possible future acquisitions will depend in part upon whether we can integrate the operations, products and technology of acquired companies with our operations, products and technology in a timely and cost-effective manner. The process of integrating acquired companies and acquired technology is complex, expensive and time consuming, and may cause an interruption of, or loss of momentum in, the product development and sales activities and operations of both companies. In addition, the earnout arrangements we use, and expect to continue to use, to consummate some of our acquisitions, pursuant to which we agree to pay additional amounts of contingent consideration based on the achievement of certain revenue, bookings or product development milestones, can sometimes complicate integration efforts. We cannot be sure that we will find suitable acquisition candidates or that acquisitions we complete will be successful. Assimilating previously acquired companies such as Sabio Labs, Inc. (“Sabio”), Knights Technology, Inc. (“Knights”), ACAD Corporation (“ACAD”), Mojave, Silicon Metrics Corporation, or any other companies we have acquired or may seek to acquire in the future, involves a number of other risks, including, but not limited to:

30

•
adverse effects on existing customer relationships, such as cancellation of orders or the loss of key customers;
•
adverse effects on existing licensor or supplier relationships, such as termination of certain license agreements;
•
difficulties in integrating or retaining key employees of the acquired company;
•
the risk that earnouts based on revenue will prove difficult to administer due to the complexities of revenue recognition accounting;
•
the risk that actions incentivized by earnout provisions will ultimately prove not to be in our best interest if our interests change over time;
•
difficulties in integrating the operations of the acquired company, such as information technology resources, manufacturing processes, and financial and operational data;
•
difficulties in integrating the technologies of the acquired company into our products;
•
the risk that acquired products will fail to achieve projected sales;
•
diversion of our management's attention;
•
failure to realize anticipated cost savings and synergies;
•
potential incompatibility of business cultures;
•
post-acquisition discovery of previously unknown liabilities assumed with the acquired business;
•
unanticipated litigation in connection with or as a result of an acquisition;
•
potential dilution to existing stockholders if we incur debt or issue equity securities to finance acquisitions; and
•
additional expenses associated with the amortization of intangible assets.
Because much of our business is international, we are exposed to risks inherent in doing business internationally that could harm our business. We also intend to expand our international operations. If our revenue from this expansion does not exceed the expenses associated with this expansion, our business and operating results could suffer.
In the first quarter of fiscal 2012, we generated 34% of our total revenue from sales outside North America, as compared to 45% during the first quarter of fiscal 2011.
To the extent that we expand our international operations, we may need to continue to maintain offices in Europe, the Middle East, and the Asia Pacific region. If our revenue from international operations does not exceed the expense of establishing and maintaining our international operations, our business could suffer. Additional risks we face in conducting business internationally include:
•
difficulties and costs of staffing and managing international operations across different geographic areas;
•
changes in currency exchange rates and controls;
•
uncertainty regarding tax and regulatory requirements in multiple jurisdictions;
•
ineffective legal protection of intellectual property rights;
•
the possible lack of financial and political stability in foreign countries, preventing overseas sales growth;
•
current events in North Korea, the Middle East, and other parts of the world, including the recent earthquakes and related events in Japan;
•
the effects of terrorist attacks in the United States or against U.S. interests overseas;
•
recent problems with the financial system, such as problems involving banks as well as the mortgage markets and the recent financial crisis; and
•
any related conflicts or similar events worldwide.
In addition, our global operations are subject to numerous U.S. and foreign laws and regulations, including those related to anti-corruption, tax, imports and exports, privacy and labor relations. These laws and regulations are complex and may have differing or conflicting legal standards, making compliance difficult and costly. If we violate these laws and regulations, we could be subject to fines, penalties, criminal sanctions, and may be prohibited from conducting business in one or more countries. Although we have implemented policies and procedures to ensure compliance with these laws and regulations, there can be no assurance that our employees, contractors or agents will not violate these laws or regulations. Any violation individually or in the aggregate could have a material adverse effect on our operations and financial condition.

31

Failure to obtain export licenses could harm our business by preventing us from licensing or transferring our technology outside of the United States.
We are required to comply with U.S. Department of Commerce regulations when shipping our software products and/or transferring our technology outside of the United States or to certain foreign nationals. We believe we have complied with applicable export regulations; however, these regulations are subject to change, and future difficulties in obtaining export licenses for current, future developed and acquired products and technology, or any failure (if any) by us to comply with such requirements in the past, could harm our business, financial conditions and operating results.
We are subject to risks associated with changes in foreign currency exchange rates.
While most of our international sales to date have been denominated in U.S. dollars, our international operating expenses have been denominated in foreign currencies. As a result, a decrease in the value of the U.S. dollar relative to such foreign currencies could increase the relative costs of our overseas operations, which could reduce our operating margins. This exposure is primarily related to a portion of revenue in Japan and operating expenses in Europe, Japan and Asia-Pacific, which are denominated in the respective local currencies. As of July 31, 2011, we had approximately $5.4 million of cash and money market funds in foreign currencies. We enter into foreign exchange forward contracts to mitigate the effects of our currency exposure risk for foreign currency transactions. While we assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis, our assessments may prove incorrect. Therefore, movements in exchange rates could negatively impact our business operating results and financial condition.
Forecasting our tax rates is complex and subject to uncertainty.
Our management must make significant assumptions, judgments and estimates to determine our current provision for income taxes, deferred tax assets and liabilities, and any valuation allowance that may be recorded against our deferred tax assets. These assumptions, judgments and estimates are difficult to make due to their complexity, and the relevant tax law is often changing.
Our future effective tax rates could be adversely affected by the following:
•
an increase in expenses that are not deductible for tax purposes, including stock-based compensation and write-offs of acquired in-process research and development;
•
changes in the valuation of our deferred tax assets and liabilities;
•
future changes in ownership that may limit realization of certain assets;
•
changes in forecasts of pre-tax profits and losses by jurisdiction used to estimate tax expense by jurisdiction;
•
changes in geographic earnings mix;
•
assessment of additional taxes as a result of federal, state, or foreign tax examinations; or
•
changes in tax laws or interpretations of such tax laws.
Future changes in accounting standards, specifically changes affecting revenue recognition, could cause unexpected adverse revenue fluctuations for us.
Future changes in accounting standards or interpretations thereof, specifically those changes affecting software revenue recognition, could require us to change our methods of revenue recognition. These changes could result in deferral of revenue recognized in current periods to subsequent periods or in accelerated recognition of deferred revenue to current periods, each of which could cause shortfalls in meeting the expectations of investors and securities analysts. Our stock price could decline as a result of any shortfall.
Our ability to use our net operating losses (“NOLs”) and other tax attributes to offset future taxable income could be limited by an ownership change and/or decisions by California and other states to suspend the use of NOLs.
We have significant NOLs and research and development (“R&D”) tax credits available to offset our future U.S. federal and state taxable income. Our NOLs are subject to limitations imposed by Section 382 of the Internal Revenue Code (and applicable state law). In addition, our ability to utilize any of our NOLs and other tax attributes may be subject to significant limitations under Section 382 of the Internal Revenue Code (and applicable state law) if we undergo an ownership change. In the event of an ownership change, Section 382 imposes an annual limitation (based upon our value at the time of the ownership change, as determined under Section 382 of the Internal Revenue Code) on the amount of taxable income a corporation may offset with NOLs. If we undergo an ownership change, Section 382 would also limit our ability to use R&D tax credits. In addition, if the tax basis of our assets exceeded the fair market value of our assets at the time of the ownership change, Section 382 could also limit our ability to use amortization of capitalized R&D and goodwill to offset taxable income for the first five years following an ownership change. Any unused annual limitation may be carried over to later years until the applicable expiration date for the respective NOLs. As a result, our inability to utilize these NOLs, credits or amortization as a result of any ownership changes

32

could adversely impact our operating results and financial condition.
In addition, California and certain states have suspended use of NOLs for certain taxable years, and other states are considering similar measures. As a result, we may incur higher state income tax expense in the future. Depending on our future tax position, continued suspension of our ability to use NOLs in states in which we are subject to income tax could have an adverse impact on our operating results and financial condition.
We have incurred and will continue to incur significant costs as a result of being a public company.
As a public company, we incur significant legal, accounting and other expenses. In addition, the Sarbanes-Oxley Act of 2002, as well as rules subsequently implemented by the SEC and the Nasdaq Global Market, including rules to implement the Dodd-Frank Wall Street Reform and Protection Act recently passed by Congress, required changes in the corporate governance practices of public companies, which increase our legal and financial compliance costs and result in a diversion of management time and attention from revenue-generating activities to compliance activities. In particular, we have incurred and will continue to incur administrative expenses relating to compliance with Section 404 of the Sarbanes-Oxley Act, which requires that we implement and maintain an effective system of internal controls and annual certification of our compliance by our independent registered public accounting firm.
We are required to evaluate our internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002 and any adverse results from such evaluation could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”), we are required to report on, and our independent registered public accounting firm is required to attest to, the effectiveness of our internal control over financial reporting. Our assessment of the effectiveness of our internal control over financial reporting must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. We have an ongoing program to perform the system and process evaluation and testing necessary to comply with these requirements. Effective internal controls are necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports, there could be an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which ultimately could negatively impact our stock price.
In addition, we must continue to monitor and assess our internal control over financial reporting because a failure to comply with Section 404 could cause us to delay filing our public reports, potentially resulting in de-listing by the Nasdaq Global Market and penalties or other adverse consequences under our existing contractual arrangements. In particular, pursuant to the indenture for the 2014 Notes, if we fail to file our annual or quarterly reports in accordance with the terms of that indenture, or if we do not comply with certain provisions of the Trust Indenture Act specified in the indenture, after the passage of certain periods of time at the election of a certain minimum number of holders of the 2014 Notes, we may be in default under the indenture unless we pay a fee equal to 1% per annum of the aggregate principal amounts of the 2014 Notes, or the extension fee, to extend the default date. Even if we pay the applicable extension fee, we will eventually be in default for these filing failures if sufficient time passes and we have not made the applicable filing.
The effectiveness of disclosure controls is inherently limited.
We do not expect that our disclosure controls and procedures, or our internal control over financial reporting, will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system objectives will be met. The design of a control system must also reflect applicable resource constraints, and the benefits of controls must be considered relative to their costs. As a result of these inherent limitations, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. Failure of the control systems to prevent error or fraud could materially adversely impact our financial results and our business.
We may not obtain sufficient patent protection, which could harm our competitive position and increase our expenses.
Our success and ability to compete depends to a significant degree upon the protection for our software and other proprietary technology. We currently have a number of issued patents in the United States, but this number is relatively small in comparison to our competitors. Patents afford only limited protection for our technology. In addition, rights that may be granted under any patent application that may issue in the future may not provide competitive advantages to us. Further, patent protection in foreign jurisdictions where we may need this protection may be limited or unavailable. It is possible that:
•
our pending U.S. and non-U.S. patents may not be issued;
•
competitors may design around our present or future issued patents or may develop competing non-infringing technologies;
•
present and future issued patents may not be sufficiently broad to protect our proprietary rights; and
•
present and future issued patents could be successfully challenged for validity and enforceability.

33

We believe the patent portfolios of our competitors are far larger than ours, and this may increase the risk that they may sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses.
In addition to patents, we rely on trademark, copyright and trade secret laws and contractual restrictions to protect our proprietary rights. If these rights are not sufficiently protected, it could harm our ability to compete and generate income.
In addition to patents, we rely on a combination of trademark, copyright and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. Our ability to compete and grow our business could suffer if these rights are not adequately protected. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to agreements, which impose certain restrictions on the licensee's ability to utilize the software. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. Our proprietary rights may not be adequately protected because:
•
laws and contractual restrictions in U.S. and foreign jurisdictions may not prevent misappropriation of our technologies or deter others from developing similar technologies;
•
competitors may independently develop similar technologies and software;
•
for some of our trademarks, federal U.S. trademark protection may be unavailable to us;
•
our trademarks might not be protected or protectable in some foreign jurisdictions;
•
the validity and scope of our U.S. and foreign trademarks could be successfully challenged; and
•
policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we may be unable to determine the extent of this unauthorized use.
The laws of some countries in which we market our products may offer little or no protection for our proprietary technologies. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technologies could enable third parties to benefit from our technologies without paying us for them, which would harm our competitive position and market share.
Our use of open source software could negatively impact our ability to sell our products.
The products, services or technologies we acquire, license, provide or develop may incorporate or use open source software. We monitor our use of open source software in an effort to avoid unintended consequences, such as reciprocal license grants, patent retaliation clauses, and the requirement to license our products at no cost. There is little or no legal precedent for interpreting the terms of these open source licenses; therefore, we may be subject to unanticipated obligations regarding our products that incorporate open source software. In addition, disclosing the content of our source code could limit the intellectual property protection we can obtain or maintain for that source code or the products containing that source code and could facilitate intellectual property infringement claims against us.
The price of our common stock may fluctuate significantly, which may make it difficult for our stockholders to resell our stock at attractive prices.
Our common stock trades on the Nasdaq Global Market under the symbol “LAVA”. There have been previous quarters in which we have experienced shortfalls in revenue and earnings from levels expected by securities analysts and investors, which have had an immediate and significant adverse effect on the trading price of our common stock. Furthermore, the price of our common stock has fluctuated significantly in recent periods.
The market price of our stock is subject to significant fluctuations in response to a number of factors, including the risk factors set forth in this Quarterly Report on Form 10-Q, many of which are beyond our control. Such fluctuations, as well as economic conditions generally, may adversely affect the market price of our common stock.
In addition, equity markets in general and technology companies' equities in particular have recently experienced extreme price and trading volume fluctuations that often have been unrelated or disproportionate to the operating performance of individual companies. These fluctuations have in the past and may in the future adversely affect the price of our common stock, regardless of our operating performance. Recent problems with the financial system, such as problems involving banks as well as the mortgage markets, might increase such market fluctuations.
Our certificate of incorporation and bylaws, Delaware corporate law and the indenture for the 2014 Notes contain anti-takeover provisions that could delay or prevent a change in control even if the change in control would be beneficial to our stockholders. We could also adopt a stockholder rights plan, which could also delay or prevent a change in control.
Delaware law, as well as our certificate of incorporation and bylaws, contain anti-takeover provisions that could delay or prevent a change in control of our company, even if the change in control would be beneficial to the stockholders. These provisions

34

could lower the price that future investors might be willing to pay for shares of our common stock. These anti-takeover provisions:
•
authorize our Board of Directors to create and issue, without prior stockholder approval, preferred stock that can be issued, increasing the number of outstanding shares and deter or prevent a takeover attempt;
•
prohibit stockholder action by written consent, thereby requiring all stockholder actions to be taken at a meeting of our stockholders;
•
establish a classified Board of Directors requiring that not all members of the Board be elected at one time;
•
prohibit cumulative voting in the election of directors, which would otherwise allow less than a majority of stockholders to elect director candidates; and
•
limit the ability of stockholders to call special meetings of stockholders.
In addition, the indenture for the 2014 Notes provides that a change in control will be deemed to have occurred under the 2014 Notes if at any time after the issuance of such notes, the “continuing directors” do not constitute a majority of our Board of Directors. In such event, the holders of the 2014 Notes will have the right to require us to purchase all or any part of their 2014 Notes as of a date that is 30 business days after the occurrence of the change in control. This provision could limit the ability of our stockholders to elect directors whose nomination for election by our stockholders is not duly approved by the vote of a majority of our current directors. The indenture for the 2014 Notes also provides that a change in control will be deemed to have occurred under certain circumstances relating to a merger or sale of assets of our company, including a merger in exchange for cash consideration. In such event, the holders of the 2014 Notes will have the right to require us to purchase all or any part of their 2014 Notes, which could discourage, delay or prevent a change in control of our company.
Section 203 of the Delaware General Corporation Law and the terms of our equity incentive plans also may discourage, delay or prevent a change in control of our company. Section 203 generally prohibits a Delaware corporation from engaging in a business combination with an interested stockholder for three years after the date the stockholder became an interested stockholder. Our equity incentive plans include change-in-control provisions that allow us to grant options or other equity awards that will become vested immediately upon a change in control.
Our Board of Directors also has the power to adopt a stockholder rights plan, which could delay or prevent a change in control of us even if the change in control is generally beneficial to our stockholders. These plans, sometimes called “poison pills,” are sometimes criticized by institutional investors or their advisors and could affect our rating by such investors or advisors. If our Board were to adopt such a plan, it might have the effect of reducing the price that new investors are willing to pay for shares of our common stock.
There may be dilution to our current stockholders upon achievement of various milestones pursuant to our mergers and acquisitions.
There may be dilution to our current stockholders upon achievement of various milestones pursuant to our mergers and acquisitions. Such dilution would also dilute the voting power and ownership interest of our existing stockholders and could cause the market price of our common stock to decline and could increase the fluctuations in our stock price.
Our business operations may be adversely affected in the event of an earthquake or other natural disaster.
Our corporate headquarters and much of our research and development operations are located in San Jose, California, in California's Silicon Valley region, which is an area known for its seismic activity. Other of our offices in the United States and in other countries around the world may be adversely impacted by catastrophic events, such as the recent earthquake and tsunami in Japan. If an earthquake, fire, tsunami or other significant natural disaster, whether the result of global climate change or other factors, occurs at or near any of our offices, our operations may be interrupted, which could have a material adverse impact on our business, financial condition and/or operating results. In addition, if a natural disaster impacts a significant number of our customers, our business and results of operations could suffer.
ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Recent Sales of Unregistered Securities
None.
Purchases of Equity Securities by the Issuer
None


35

ITEM 6.
EXHIBITS
The following documents are filed as Exhibits to this report:
 
  
 
Incorporated by Reference
  
 
 
 
Exhibit
Number
  
Exhibit Description
Form    
 
File No.    
 
Exhibit    
 
Filing Date    
  
Furnished
Herewith
 
Filed
Herewith
31.1  
  
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 
 
 
 
 
 
 
  
 
 
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
31.2  
  
Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
 
 
 
 
 
 
 
  
 
 
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
32.1  
  
Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
  
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
32.2  
  
Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
  
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.INS
 
XBRL Instance Document*
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document*
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document*
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.LAB
 
XBRL Taxonomy Extension Calculation Linkbase Document*
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.PRE
 
XBRL Taxonomy Extension Calculation Linkbase Document*
 
 
 
 
 
 
 
 
X
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.DEF
 
XBRL Taxonomy Extension Calculation Linkbase Document*
 
 
 
 
 
 
 
 
X
 
 
* XBRL (Extensible Business Reporting Language) information is furnished and not filed herewith, is not deemed part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.


36

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 
 
 
 
 
MAGMA DESIGN AUTOMATION, INC.
 
 
 
 
 
 
Dated:
September 9, 2011
 
 
 
/s/ Peter S. Teshima
 
 
 
 
 
Peter S. Teshima
 
 
 
 
 
Corporate Vice President—Finance and
Chief Financial Officer
 
 
 
 
 
(Principal Financial Officer
and Duly Authorized Signatory)


37

EXHIBIT INDEX
TO
MAGMA DESIGN AUTOMATION, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED JULY 31, 2011
 
 
 
Incorporated by Reference
 
 
 
 
Exhibit
Number
Exhibit Description
Form    
 
File No.    
 
Exhibit    
 
Filing Date    
 
Furnished
Herewith
 
Filed
Herewith
31.1
 
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 
 
 
 
 
 
 
 
 
 
X
31.2
 
Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
 
 
 
 
 
 
 
 
 
 
X
32.1
 
Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
X
 
 
32.2
 
Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
 
 
 
 
X
 
 
101.INS
 
XBRL Instance Document*
 
 
 
 
 
 
 
 
X
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document*
 
 
 
 
 
 
 
 
X
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document*
 
 
 
 
 
 
 
 
X
 
 
101.LAB
 
XBRL Taxonomy Extension Calculation Linkbase Document*
 
 
 
 
 
 
 
 
X
 
 
101.PRE
 
XBRL Taxonomy Extension Calculation Linkbase Document*
 
 
 
 
 
 
 
 
X
 
 
101.DEF
 
XBRL Taxonomy Extension Calculation Linkbase Document*
 
 
 
 
 
 
 
 
X
 
 
* XBRL (Extensible Business Reporting Language) information is furnished and not filed herewith, is not deemed part of a registration statement or Prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections


38

MAGMA DESIGN AUTOMATION INC Reports