| “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and all other statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words “believes,” “expects,” “projections” and words of similar meaning, constitute forward-looking statements that involve a number of risks and uncertainties that are difficult to predict |
| Forward-looking statements regarding financial performance in future periods, including the statements under “Outlook for 2006”, do not reflect potential impacts of mergers or acquisitions or other significant transactions or events that have not been announced as of the time the statements are made |
| Actual outcomes and results may differ materially from what is expressed or forecast in forward-looking statements |
| We disclaim any obligation to update forward-looking statements to reflect future events or revised expectations |
| The following discussion highlights factors that could cause actual results to differ materially from the results expressed or implied by our forward-looking statements |
| Forward-looking statements should be considered in light of these factors |
| Weakness in the United States and international economies may materially adversely impact us |
| The United States and international economies can experience economic downturns, which may have a material adverse affect on our results of operations |
| Weakness in these economies may materially adversely impact the timing and receipt of orders for our products and our results of operations |
| Revenue levels are dependent on the level of technology capital spending, which includes worldwide expenditures for EDA software, hardware and consulting services |
| In addition, mergers and company restructurings in the worldwide electronics industry may materially adversely impact demand for our products and services resulting in decreased or delayed capital spending patterns |
| We are subject to the cyclical nature of the integrated circuit and electronics systems industries and any future downturns may materially adversely impact us |
| Purchases of our products and services are highly dependent upon new design projects initiated by customers in the integrated circuit (IC) and electronics systems industries |
| These industries are highly cyclical and are subject to constant and rapid technological change, rapid product obsolescence, price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand |
| The IC and electronics systems industries regularly experience significant downturns, often connected with, or in anticipation of, maturing product cycles within such companies and/or a decline in general economic conditions |
| These downturns cause diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices |
| During such downturns, the number of new design projects generally decreases, which can materially adversely impact demand for our products and services |
| Our forecasts of our revenues and earnings outlook may be inaccurate and could materially adversely impact our business or our planned results of operations |
| Our revenues, particularly new software license revenues, are difficult to forecast |
| We use a “pipeline” system, a common industry practice, to forecast revenues and trends in our business |
| Sales personnel monitor the status of potential business and estimate when a customer will make a purchase decision, the dollar amount of the sale and the products or services to be sold |
| These estimates are aggregated periodically to generate a sales pipeline |
| Our pipeline estimates may prove to be unreliable either in a particular quarter or over a longer period of time, in part because the “conversion rate” of the pipeline into contracts can be very difficult to estimate and requires management judgment |
| A variation in the conversion rate could cause us to plan or budget incorrectly and materially adversely impact our business or our planned results of operations |
| In particular, a slowdown in customer spending or weak economic conditions generally can reduce the conversion rate in a particular quarter as purchasing decisions are delayed, reduced in amount or cancelled |
| The conversion rate can also be affected by the tendency of some of our customers to wait until the end of a quarter in the hope of obtaining more favorable terms |
| Fluctuations in quarterly results of operations due to customer seasonal purchasing patterns, the timing of significant orders and the mix of licenses used to sell our products could materially adversely impact our business and the market price of our common stock |
| We have experienced, and may continue to experience, varied quarterly operating results |
| Various factors affect our quarterly operating results and some of these are not within our control, including customer demand and the timing of significant orders |
| We experience seasonality in demand for our products, due to the purchasing cycles of our customers, with revenues in the fourth quarter generally being the highest |
| We receive a majority of our software product revenues from current quarter order performance, of which a substantial amount is usually booked in the last few weeks of each quarter |
| A significant portion of our revenues come from multi-million dollar contracts, the timing of the completion of and the terms of delivery of which can have a material impact on revenue for a given quarter |
| If we fail to receive expected orders, particularly large orders, our revenues for that quarter could be materially adversely impacted |
| In such an event, we could fail to meet investors’ expectations, which could have a material adverse impact on our stock price |
| 7 ______________________________________________________________________ [32]Table of Contents Our revenues are also affected by the mix of licenses entered into where we recognize software product revenues as payments become due and payable or ratably over the license term as compared to revenues recognized at the beginning of the license term |
| We recognize revenues ratably over the license term when the customer is provided with rights to unspecified or unreleased future products |
| A shift in the license mix toward increased ratable or due and payable revenue recognition would result in increased deferral of software product revenues to future periods and would decrease current revenues, resulting in not meeting near-term revenue expectations |
| The gross margin on our software products is greater than that for our hardware products, software support and professional services |
| Therefore, our gross margin may vary as a result of the mix of products and services sold |
| Additionally, the gross margin on software products varies year to year depending on the amount of royalties due to third parties for the mix of products sold |
| We also have a significant amount of fixed or relatively fixed costs, such as employee costs and purchased technology amortization, and costs which are committed in advance and can only be adjusted periodically |
| As a result, a small failure to reach planned revenues would likely have a relativity large negative effect on resulting earnings |
| If anticipated revenues do not materialize as expected, our gross margins and operating results would be materially adversely impacted |
| We use fixed-term license agreements as a standard business practice with customers we believe are credit-worthy |
| These multi-year, multi-element term license agreements are typically three years in length and have payments spread over the license term |
| The complexity of these agreements tends to increase the risk associated with collectibility from customers that can arise for a variety of reasons including ability to pay, product dissatisfaction, disagreements and disputes |
| If we are unable to collect under any of these multi-million dollar agreements, our results of operations could be materially adversely impacted |
| We use these fixed-term license agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services |
| If we no longer had a history of collecting without providing concessions on term agreements, then revenue would be required to be recognized as the payments become due and payable over the license term |
| This change would have a material impact on our results |
| Accounting rules governing revenue recognition may change |
| The accounting rules governing software revenue recognition have been subject to authoritative interpretations that have generally made it more difficult to recognize software product revenues at the beginning of the license period |
| If this trend continues, new and revised standards and interpretations could materially adversely impact our ability to meet revenue expectations |
| Forecasting our tax rates is complex and subject to uncertainty |
| Forecasts of our income tax position and resultant effective tax rate are complex and subject to uncertainty as our income tax position for each year combines: (a) the effects of a mix of profits (losses) earned by us and our subsidiaries in tax jurisdictions with a broad range of income tax rates, (b) benefits from available deferred tax assets, (c) taxes, interest or penalties resulting from tax audits and (d) changes in tax laws or the interpretation of such tax laws |
| In order to forecast our global tax rate, pre-tax profits and losses by jurisdiction are estimated and tax expense by jurisdiction is calculated |
| If the mix of profits and losses or effective tax rates by jurisdiction are different than those estimates, our actual tax rate could be materially different than forecast |
| New accounting standard related to equity compensation will cause us to recognize an additional expense, which will result in a reduction in our net income |
| In December 2004, the FASB issued SFAS Nodtta 123R, “Share-Based Payment”, which replaces SFAS Nodtta 123 and supercedes APB Opinion Nodtta 25, relating to the accounting for equity-based compensation |
| This statement requires us to record a charge to compensation expense for stock option grants |
| We currently account for stock options under SFAS Nodtta 123, “Accounting for Stock-Based Compensation” |
| As permitted by SFAS Nodtta 123, we have elected to use the intrinsic value method prescribed by Accounting Principles Board Opinion (APB) Nodtta 25, “Accounting for Stock Issued to Employees,” to measure compensation expense for stock-based awards granted to employees, under which the granting of stock options is not considered compensation if the option exercise price is not less than the fair market value of the common stock at the grant date |
| Starting in January 2006, the FASB’s statement requires that stock-based awards be accounted for using a fair-value based method, which will require us to measure the compensation expense for all such awards, including stock options, at fair-value at the grant date |
| In Note 2, “Summary of Significant Accounting Policies,” in Item 8, “Financial Statements and Supplementary Data,” we calculate pro forma net income and earnings per share as if we had used a fair value-based method similar to the methods required under SFAS 123R to measure the compensation expense for employee stock awards during the periods presented |
| 8 ______________________________________________________________________ [33]Table of Contents Our business is subject to evolving corporate governance and public disclosure regulations that have increased both costs and the risk of noncompliance, which could have a material adverse impact on us |
| Because our common stock is publicly traded on the NASDAQ Stock Market, we are subject to rules and regulations promulgated by a number of governmental and self-regulated organizations, including the SEC, NASDAQ and the Public Company Accounting Oversight Board, which monitors the accounting practices of public companies |
| Many of these regulations continue to evolve, making compliance difficult and uncertain |
| In particular, Section 404 of Sarbanes-Oxley Act of 2002 and related regulations have required us to include a management assessment of our internal controls over financial reporting and auditor attestation of that assessment in our annual reports |
| This effort has required, and continues to require, the commitment of significant financial and managerial resources |
| A failure to complete a favorable assessment and obtain an auditors’ attestation could have a material adverse impact on us |
| The outcome of Internal Revenue Service and other tax authorities examinations could have a material adverse affect on us |
| The Internal Revenue Service and other tax authorities regularly examine our income tax returns |
| Significant judgment is required in determining the provision for income taxes |
| In determining the adequacy of income taxes, we assess the likelihood of adverse outcomes resulting from the Internal Revenue Service and other tax authorities’ examinations |
| The ultimate outcome of these examinations cannot be predicted with certainty |
| Should the Internal Revenue Service or other tax authorities assess additional taxes as a result of examinations, we may be required to record charges to operations that could have a material impact on the results of operations, financial position or cash flows |
| There are limitations on the effectiveness of controls |
| We do not expect that disclosure controls or internal control over financial reporting will prevent all error and all fraud |
| A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met |
| Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs |
| Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected |
| Failure of our control systems to prevent error or fraud could materially adversely impact us |
| The lengthy sales cycle for our products and services and delay in customer consummation of projects, make the timing of our revenues difficult to predict |
| We have a lengthy sales cycle that generally extends between three and six months |
| A lengthy customer evaluation and approval process is generally required due to the complexity and expense associated with our products and services |
| Consequently, we may incur substantial expenses and devote significant management effort and expense to develop potential relationships that do not result in agreements or revenues and may prevent us from pursuing other opportunities |
| In addition, sales of our products and services may be delayed if customers delay approval or commencement of projects due to customers’ budgetary constraints, internal acceptance review procedures, timing of budget cycles or timing of competitive evaluation processes |
| Any loss of our leadership position in certain segments of the EDA market could have a material adverse affect on us |
| The industry in which we compete is characterized by very strong leadership positions in specific segments of the EDA market |
| For example, one company may enjoy a large percentage of sales in the physical verification segment of the market while another will have a similarly strong position in mixed-signal simulation |
| These strong leadership positions can be maintained for significant periods of time as the software is difficult to master and customers are disinclined to make changes once their employees, as well as others in the industry, have developed familiarity with a particular software product |
| For these reasons, much of our profitability arises from niche areas in which we are the strong leader |
| Conversely, it is difficult for us to achieve significant profits in niche areas where other companies are the leaders |
| If for any reason we lose our leadership position in a niche, we could be materially adversely impacted |
| We may not realize revenues as a result of our investments in research and development |
| We incur substantial expense to develop new software products |
| Research and development activities are often performed over long periods of time |
| This effort may not yield a successful product offering or the product may not satisfy customer requirements |
| As a result, we would realize little or no revenues related to our investment in research and development |
| Intense competition in the EDA industry could materially adversely impact us |
| Competition in the EDA industry is intense, which can lead to, among other things, price reductions, longer selling cycles, lower product margins, loss of market share and additional working capital requirements |
| If our competitors offer significant discounts on certain products, we may need to lower our prices or offer other favorable terms in order to compete successfully |
| Any such changes would likely reduce margins and could materially adversely impact our operating results |
| Any broad-based changes to our prices and pricing policies could cause new software license and service revenues to decline or be delayed as the sales force implements and our customers adjust to the new pricing policies |
| Some of our competitors may bundle software products for promotional purposes or as a long-term pricing strategy |
| These practices could significantly constrain prices we can charge for our products |
| Our success depends upon our ability to acquire or develop and market products and services that are innovative and cost-competitive and that meet customer expectations |
| 9 ______________________________________________________________________ [34]Table of Contents We currently compete primarily with two large companies: Cadence Design Systems, Inc |
| and Synopsys, Inc |
| We compete with numerous smaller companies, a number of which have combined with other EDA companies |
| We also compete with manufacturers of electronic devices that have developed, or have the capability to develop, their own EDA products internally |
| We may acquire other companies and may not successfully integrate them |
| The industry in which we compete has seen significant consolidation in recent years |
| During this period, we have acquired numerous businesses and have frequently been in discussions with potential acquisition candidates, and we may acquire other businesses in the future |
| While we expect to carefully analyze all potential transactions before committing to them, we cannot assure that any transaction that is completed will result in long-term benefits to us or our shareholders or that our management will be able to manage the acquired businesses effectively |
| In addition, growth through acquisition involves a number of risks |
| If any of the following events occurs after we acquire another business, it could materially adversely impact us: • difficulties in combining previously separate businesses into a single unit; • the substantial diversion of management’s attention from day-to-day business when integrating the acquired business; • the discovery after the acquisition has been completed of previously unknown liabilities assumed with the acquired business; • the failure to realize anticipated benefits, such as cost savings and increases in revenues; • the failure to retain key personnel of the acquired business; • difficulties related to assimilating the products of an acquired business in, for example, distribution, engineering and customer support areas; • unanticipated costs; • adverse impacts on existing relationships with suppliers and customers; and • failure to understand and compete effectively in markets in which we have limited experience |
| Acquired businesses may not perform as projected, which could result in impairment of acquisition-related intangible assets |
| Additional challenges include integration of sales channels, training and education of the sales force for new product offerings, integration of product development efforts, integration of systems of internal controls and integration of information systems |
| Accordingly, in any acquisition there will be uncertainty as to the achievement and timing of projected synergies, cost savings and sales levels for acquired products |
| All of these factors can impair our ability to forecast, meet revenues and earnings targets and manage effectively our business for long-term growth |
| We cannot assure that we can effectively meet these challenges |
| Risks of international operations and the effects of foreign currency fluctuations can materially adversely impact our business and operating results |
| We realize more than half of our revenues from customers outside the United States and we generate approximately one-third of our expenses outside the United States |
| Significant changes in exchange rates can have an adverse impact on us |
| For further discussion of foreign currency effects, see “Effects of Foreign Currency Fluctuations” discussion in Item 7 |
| ” In addition, international operations subject us to other risks including longer receivables collection periods, changes in a specific country’s or region’s economic or political conditions, trade protection measures, import or export licensing requirements, loss or modification of exemptions for taxes and tariffs, limitations on repatriation of earnings and difficulties with licensing and protecting our intellectual property rights |
| The delay in production of components or the ordering of excess components for our emulation hardware products could materially adversely impact us |
| The success of our emulation product depends on our ability to procure hardware components on a timely basis from a limited number of suppliers, assemble and ship systems on a timely basis with appropriate quality control, develop distribution and shipment processes, manage inventory and related obsolescence issues and develop processes to deliver customer support for hardware |
| Our inability to be successful in any of the foregoing could materially adversely impact us |
| We commit to purchase component parts from suppliers based on sales forecasts of our emulation products |
| If we cannot change or be released from these non-cancelable purchase commitments, and if orders for our products do not materialize, we could incur significant costs related to the purchase of excess components which could become obsolete before we can use them |
| Additionally, a delay in production of the components could materially adversely impact our operating results |
| Our failure to adequately protect our proprietary rights or to obtain software or other intellectual property licenses could materially adversely impact us |
| Our success depends, in large part, upon our proprietary technology |
| We generally rely on patents, copyrights, trademarks, trade secret laws, licenses and restrictive agreements to establish and protect our proprietary rights in technology and products |
| Despite precautions we may take to protect our intellectual property, we cannot assure that third parties will not try to challenge, invalidate or circumvent these protections |
| The companies in the EDA industry, as well as entities and persons outside the 10 ______________________________________________________________________ [35]Table of Contents industry, are obtaining patents at a rapid rate |
| Many of these entities have substantially larger patent portfolios than we have |
| As a result, we may on occasion be forced to engage in costly patent litigation to protect our rights or defend our customers’ rights |
| We may also need to settle these claims on terms that are unfavorable; such settlements could result in the payment of significant damages or royalties, or force us to stop selling or redesign one or more products |
| We cannot assure that the rights granted under our patents will provide us with any competitive advantage, that patents will be issued on any of our pending applications or that future patents will be sufficiently broad to protect our technology |
| Furthermore, the laws of foreign countries may not protect our proprietary rights in those countries to the same extent as United States law protects these rights in the United States |
| Some of our products include software or other intellectual property licensed from third parties, and we may have to seek new licenses or renew existing licenses for software and other intellectual property in the future |
| Our failure to obtain software or other intellectual property licenses or rights on favorable terms could materially adversely impact us |
| Future litigation may materially adversely impact us |
| Any future litigation may result in injunctions against future product sales and substantial unanticipated legal costs and divert the efforts of management personnel, any and all of which could materially adversely impact us |
| We may become subject to unfair hiring claims, which could prevent us from hiring needed employees, incur liability for damages or incur substantial unanticipated legal costs |
| Companies whose employees accept positions with competitors frequently claim that these competitors have engaged in unfair hiring practices or that the employment of these persons would involve the disclosure or use of confidential information or trade secrets |
| These claims could prevent us from hiring needed employees |
| They may result in us incurring liability for damages and/or substantial unanticipated legal costs |
| These claims also may divert the efforts of management personnel from our operations |
| Errors or defects in our products and services could expose us to liability and harm our reputation |
| Our customers use our products and services in designing and developing products that involve a high degree of technological complexity and have unique specifications |
| Due to the complexity of the systems and products with which we work, some of our products and designs can be adequately tested only when put to full use in the marketplace |
| As a result, our customers or their end users may discover errors or defects in our software or the systems we design, or the products or systems incorporating our designs and intellectual property may not operate as expected |
| Errors or defects could result in: • loss of current customers and loss of, or delay in, revenue and loss of market share; • failure to attract new customers or achieve market acceptance; • diversion of development resources to resolve the problems resulting from errors or defects; and • increased service costs |
| Our failure to attract and retain key employees may harm us |
| We depend on the efforts and abilities of our senior management, our research and development staff and a number of other key management, sales, support, technical and services personnel |
| Competition for experienced, high-quality personnel is intense, and we cannot assure that we can continue to recruit and retain such personnel |
| The failure by us to hire and retain such personnel would impair our ability to develop new products and manage our business effectively |
| Regulations adopted by the NASDAQ Stock Market require stockholder approval for new stock option plans and significant amendments to existing plans, including increasing the number of options available for grant |
| 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 and retain employees, which could materially adversely impact us |
| Terrorist attacks and other acts of violence or war may materially adversely impact the markets on which our securities trade, the markets in which we operate, our operations and our profitability |
| Terrorist attacks may negatively affect our operations and investment in our business |
| These attacks or armed conflicts may directly impact our physical facilities or those of our suppliers or customers |
| Furthermore, these attacks may make travel more difficult and expensive and ultimately affect our revenues |
| Any armed conflict entered into by the United States could have an adverse impact on our revenues and our ability to deliver products to our customers |
| Political and economic instability in some regions of the world may also result from an armed conflict and could negatively impact our business |
| We currently have operations in Pakistan, Egypt and Israel, countries that may be particularly susceptible to this risk |
| The consequences of any armed conflict are unpredictable, and we may not be able to foresee events that could have an adverse impact on us |
| 11 ______________________________________________________________________ [36]Table of Contents More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economy |
| They also could result in economic recession in the United States or abroad |
| Any of these occurrences could have a significant impact on our operating results, revenues and costs and may result in volatility of the market price for our common stock |
| Our articles of incorporation, Oregon law and our shareholder rights plan may have anti-takeover effects |
| Our board of directors has the authority, without action by the shareholders, to designate and issue up to 1cmam200cmam000 shares of incentive stock in one or more series and to designate the rights, preferences and privileges of each series without any further vote or action by the shareholders |
| Additionally, the Oregon Control Share Act and the Business Combination Act limit the ability of parties who acquire a significant amount of voting stock to exercise control over us |
| These provisions may have the effect of lengthening the time required for a person to acquire control of us through a proxy contest or the election of a majority of the board of directors |
| In February 1999, we adopted a shareholder rights plan, which has the effect of making it more difficult for a person to acquire control of us in a transaction not approved by our board of directors |
| The potential issuance of incentive stock, the provisions of the Oregon Control Share Act and the Business Combination Act and our shareholder rights plan may have the effect of delaying, deferring or preventing a change of control of us, may discourage bids for our common stock at a premium over the market price of our common stock and may materially adversely impact the market price of, and the voting and other rights of the holders of, our common stock |
| Our debt obligations expose us to risks that could materially adversely impact our business, operating results and financial condition, and could prevent us from fulfilling our obligations under such indebtedness |
| We have a substantial level of indebtedness |
| As of December 31, 2005, we had dlra294dtta0 million of outstanding indebtedness, which includes dlra171dtta5 million of 6 7/8prca Convertible Subordinated Notes (Notes) due 2007 and dlra110dtta0 million of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023 |
| This level of indebtedness among other things, could: • make it difficult for us to satisfy our payment obligations on our debt; • make it difficult for us to incur additional indebtedness or obtain any necessary financing in the future for working capital, capital expenditures, debt service, acquisitions or general corporate purposes; • limit our flexibility in planning for or reacting to changes in our business; • reduce funds available for use in our operations; • make us more vulnerable in the event of a downturn in our business; • make us more vulnerable in the event of an increase in interest rates if we must incur new debt to satisfy our obligations under the Notes and Debentures; or • place us at a possible competitive disadvantage relative to less leveraged competitors and competitors that have greater access to capital resources |
| If we experience a decline in revenues due to any of the factors described in Item 1A “Risk Factors,” we could have difficulty paying amounts due on our indebtedness |
| Any default under our indebtedness could have a material adverse impact on our business, operating results and financial condition |