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MAGMA DESIGN AUTOMATION INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) 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-------------------------------------------------------------------------------- Table of Contents 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-------------------------------------------------------------------------------- Table of Contents 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-------------------------------------------------------------------------------- Table of Contents 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-------------------------------------------------------------------------------- Table of Contents 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-------------------------------------------------------------------------------- Table of Contents 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, May 1, 2011 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-------------------------------------------------------------------------------- Table of Contents 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-------------------------------------------------------------------------------- Table of Contents 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): July 31, % of August 1, % of Dollar Three Months Ended: 2011 Revenue 2010 Revenue 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): July 31, % of % of % Three Months Ended: 2011 Revenue August 1, 2010 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-------------------------------------------------------------------------------- Table of Contents 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-------------------------------------------------------------------------------- Table of Contents July 31, % of August 1, % of Dollar % Three Months Ended: 2011 Revenue 2010 Revenue 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-------------------------------------------------------------------------------- Table of Contents 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): July 31, % of August 1, % of Dollar % Three Months Ended: 2011 Revenue 2010 Revenue 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, August 1, 2011 2010Income (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-------------------------------------------------------------------------------- Table of Contents 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, May 1, 2011 2011 Cash and cash equivalents $ 51,101 $ 47,088 Three Months Ended July 31, August 1, 2011 2010Net 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-------------------------------------------------------------------------------- Table of Contents 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-------------------------------------------------------------------------------- Table of Contents 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-------------------------------------------------------------------------------- Table of Contents 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. |