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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended April 30, 2011

Or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File No. 1-34795

 

 

MENTOR GRAPHICS CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Oregon   93-0786033

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

 

8005 SW Boeckman Road, Wilsonville, Oregon   97070-7777
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (503) 685-7000

None

(Former name, former address and former

fiscal year, if changed since last report)

 

 

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨    Smaller reporting company  ¨
    (Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Number of shares of common stock, no par value, outstanding as of June 3, 2011: 111,073,739

 

 

 


Table of Contents

MENTOR GRAPHICS CORPORATION

Index to Form 10-Q

 

          Page Number  

PART I. FINANCIAL INFORMATION

  

Item 1.

  

Financial Statements (unaudited)

  
   Condensed Consolidated Statements of Operations for the three months ended April 30, 2011 and 2010      3   
   Condensed Consolidated Balance Sheets as of April 30, 2011 and January 31, 2011      4   
   Condensed Consolidated Statements of Cash Flows for the three months ended April 30, 2011 and 2010      5   
   Notes to Unaudited Condensed Consolidated Financial Statements      6   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      23   

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk      34   

Item 4.

   Controls and Procedures      36   

PART II. OTHER INFORMATION

  

Item 1A.

  

Risk Factors

     37   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     43   

Item 6.

  

Exhibits

     44   

SIGNATURES

     45   

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

Mentor Graphics Corporation

Condensed Consolidated Statements of Operations

(Unaudited)

 

Three months ended April 30,

   2011     2010  
In thousands, except per share data             

Revenues:

    

System and software

   $ 139,645      $ 97,450   

Service and support

     90,390        83,127   
                

Total revenues

     230,035        180,577   
                

Cost of revenues:

    

System and software

     13,016        3,954   

Service and support

     24,166        22,320   

Amortization of purchased technology

     3,357        3,569   
                

Total cost of revenues

     40,539        29,843   
                

Gross margin

     189,496        150,734   
                

Operating expenses:

    

Research and development

     69,906        64,132   

Marketing and selling

     76,404        73,652   

General and administration

     21,873        22,499   

Equity in earnings of Frontline

     (1,017     (184

Amortization of intangible assets

     1,610        2,361   

Special charges

     4,547        3,268   
                

Total operating expenses

     173,323        165,728   
                

Operating income (loss)

     16,173        (14,994

Other expense, net

     (475     (1,141

Interest expense

     (17,440     (4,327
                

Loss before income tax

     (1,742     (20,462

Income tax expense

     611        2,563   
                

Net loss

   $ (2,353   $ (23,025
                

Net loss per share:

    

Basic

   $ (0.02   $ (0.22
                

Diluted

   $ (0.02   $ (0.22
                

Weighted average number of shares outstanding:

    

Basic

     111,769        103,763   
                

Diluted

     111,769        103,763   
                

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Mentor Graphics Corporation

Condensed Consolidated Balance Sheets

(Unaudited)

 

As of

   April 30,
2011
    January 31,
2011
 
In thousands             

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 116,481      $ 133,113   

Trade accounts receivable, net of allowance for doubtful accounts of $3,780 as of April 30, 2011 and $3,941 as of January 31, 2011

     321,040        347,075   

Other receivables

     11,945        8,797   

Inventory

     7,491        8,255   

Prepaid expenses and other

     22,841        20,072   

Deferred income taxes

     16,370        15,992   
                

Total current assets

     496,168        533,304   

Property, plant, and equipment, net of accumulated depreciation of $268,000 as of April 30, 2011 and $257,576 as of January 31, 2011

     137,488        139,340   

Term receivables

     179,014        167,425   

Goodwill

     511,977        510,508   

Intangible assets, net of accumulated amortizaton of $161,448 as of April 30, 2011 and $156,481 as of January 31, 2011

     27,730        31,189   

Deferred income taxes

     1,055        869   

Other assets

     52,568        45,343   
                

Total assets

   $ 1,406,000      $ 1,427,978   
                

Liabilities and Stockholders’ Equity

    

Current liabilities:

    

Short-term borrowings

   $ 9,055      $ 15,544   

Current portion of notes payable

     —          2,000   

Accounts payable

     14,550        16,724   

Income taxes payable

     4,847        5,517   

Accrued payroll and related liabilities

     58,577        109,173   

Accrued liabilities

     33,506        39,513   

Deferred revenue

     179,602        171,416   
                

Total current liabilities

     300,137        359,887   

Notes payable

     210,787        207,348   

Deferred revenue

     13,062        13,953   

Income tax liability

     42,422        44,095   

Other long-term liabilities

     25,113        25,981   
                

Total liabilities

     591,521        651,264   
                

Commitments and contingencies (Note 9)

    

Stockholders’ equity:

    

Common stock, no par value, 300,000 shares authorized as of April 30, 2011 and January 31, 2011; 110,870 shares issued and outstanding as of April 30, 2011 111,249 shares issued and outstanding as of January 31, 2011

     795,756        765,179   

Incentive stock, no par value, 1,200 shares authorized and none issued as of April 30, 2011 and January 31, 2011

     —          —     

Accumulated deficit

     (22,511     (20,158

Accumulated other comprehensive income

     41,234        31,693   
                

Total stockholders’ equity

     814,479        776,714   
                

Total liabilities and stockholders’ equity

   $ 1,406,000      $ 1,427,978   
                

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Mentor Graphics Corporation

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

Three months ended April 30,

   2011     2010  
In thousands             

Operating Cash Flows:

    

Net loss

   $ (2,353   $ (23,025

Adjustments to reconcile net loss to net cash (used in) provided by operating activities:

    

Depreciation and amortization of property, plant, and equipment

     7,750        7,837   

Amortization of intangible assets and debt costs

     6,651        6,421   

Equity in (income) losses of unconsolidated entities, net of dividends received

     (2     86   

Loss on debt extinguishment

     3,518        —     

Write-off of debt discount and debt issuance costs

     8,010        132   

Stock-based compensation

     5,680        6,581   

Deferred income taxes

     (563     (1,505

Changes in other long-term liabilities

     (1,506     (543

Other

     28        96   

Changes in operating assets and liabilities, net of effect of acquired businesses:

    

Trade accounts receivable, net

     36,157        31,959   

Prepaid expenses and other

     (3,259     (659

Term receivables, long-term

     (6,930     23,697   

Accounts payable and accrued liabilities

     (61,698     (38,629

Income taxes payable

     (4,016     367   

Deferred revenue

     3,271        14,833   
                

Net cash (used in) provided by operating activities

     (9,262     27,648   
                

Investing Cash Flows:

    

Purchases of property, plant, and equipment

     (6,345     (7,608

Acquisitions of businesses and equity interests, net of cash acquired

     (2,036     (9,787
                

Net cash used in investing activities

     (8,381     (17,395
                

Financing Cash Flows:

    

Proceeds from issuance of common stock

     7,368        2,167   

Repurchase of common stock

     (24,997     —     

Net decrease in short-term borrowings

     (6,624     (11,091

Debt and equity issuance costs

     (8,575     (631

Proceeds from notes payable and revolving credit facility

     253,000        50,000   

Repayments of notes payable and revolving credit facility

     (219,919     (50,000
                

Net cash provided by (used in) financing activities

     253        (9,555
                

Effect of exchange rate changes on cash and cash equivalents

     758        (309
                

Net change in cash and cash equivalents

     (16,632     389   

Cash and cash equivalents at the beginning of the period

     133,113        99,340   
                

Cash and cash equivalents at the end of the period

   $ 116,481      $ 99,729   
                

See accompanying notes to unaudited condensed consolidated financial statements.

 

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Mentor Graphics Corporation

Notes to Unaudited Condensed Consolidated Financial Statements

All numerical dollar and share references are in thousands, except for per share data.

 

(1) General—The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with United States (U.S.) generally accepted accounting principles (GAAP) and reflect all material normal recurring adjustments. However, certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). In the opinion of management, the condensed consolidated financial statements include adjustments necessary for a fair presentation of the results of the interim periods presented. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes included in our Annual Report on Form 10-K for the fiscal year ended January 31, 2011.

The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and contingencies as of the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates. Any changes in estimates will be reflected in the financial statements in future periods.

 

(2) Summary of Significant Accounting Policies

Principles of Consolidation

The condensed consolidated financial statements include our financial statements and those of our wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

We do not have off-balance sheet arrangements, financings, or other similar relationships with unconsolidated entities or other persons, also known as special purpose entities. In the ordinary course of business, we lease certain equipment and certain real properties, primarily field sales offices, research and development facilities, and equipment, as described in Note 9. “Commitments and Contingencies.”

Revenue Recognition

We report revenue in two categories based on how the revenue is generated: (i) system and software and (ii) service and support.

System and software revenues – We derive system and software revenues from the sale of licenses of software products, emulation hardware systems, and finance fee revenues from our long-term installment receivables resulting from product sales. We primarily license our products using two different license types:

1. Term licenses – We use this license type primarily for software sales. This license type provides the customer with the right to use a fixed list of software products for a specified time period, typically three years, with payments spread over the license term, and does not provide the customer with the right to use the products after the end of the term. Term license arrangements may allow the customer to share products between multiple locations and remix product usage from the fixed list of products at regular intervals during the license term. We generally recognize product revenue from term license arrangements upon product delivery and start of the license term. In a term license agreement where we provide the customer with rights to unspecified or unreleased future products, we recognize revenue ratably over the license term.

2. Perpetual licenses – We use this license type for software and emulation hardware system sales. This license type provides the customer with the right to use the product in perpetuity and typically does not provide for extended payment terms. We generally recognize product revenue from perpetual license arrangements upon product delivery assuming all other criteria for revenue recognition have been met.

We include finance fee revenues from the accretion on the discount of long-term installment receivables in system and software revenues.

Service and support revenues – We derive service and support revenues from software and hardware post-contract maintenance or support services and professional services, which include consulting, training, and other services. We recognize revenue ratably over the support services term. We record professional service revenue as the services are provided to the customer.

 

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We determine whether product revenue recognition is appropriate based upon the evaluation of whether the following four criteria have been met:

1. Persuasive evidence of an arrangement exists – Generally, we use either a customer signed contract or qualified customer purchase order as evidence of an arrangement for both term and perpetual licenses. For professional service engagements, we generally use a signed professional services agreement and a statement of work to evidence an arrangement. Sales through our distributors are evidenced by an agreement governing the relationship, together with binding purchase orders from the distributor on a transaction-by-transaction basis.

2. Delivery has occurred – We generally deliver software and the corresponding access keys to customers electronically. Electronic delivery occurs when we provide the customer access to the software. We may also deliver the software on a compact disc. With respect to emulation hardware systems, we transfer title to the customer upon shipment. Our software license and emulation hardware system agreements generally do not contain conditions for acceptance.

3. Fee is fixed or determinable – We assess whether a fee is fixed or determinable at the outset of the arrangement, primarily based on the payment terms associated with the transaction. We have established a history of collecting under the original contract with installment terms without providing concessions on payments, products, or services. Additionally, for installment contracts, we determine that the fee is fixed or determinable if the arrangement has a payment schedule that is within the term of the licenses and the payments are collected in equal or nearly equal installments, when evaluated on a cumulative basis. If the fee is not deemed to be fixed or determinable, we recognize revenue as payments become due and payable.

Significant judgment is involved in assessing whether a fee is fixed or determinable. We must also make these judgments when assessing whether a contract amendment to a term arrangement (primarily in the context of a license extension or renewal) constitutes a concession. Our experience has been that we are able to determine whether a fee is fixed or determinable for term licenses. If we no longer were to have a history of collecting under the original contract without providing concessions on term licenses, revenue from term licenses would be required to be recognized when payments under the installment contract become due and payable. Such a change could have a material impact on our results of operations.

4. Collectibility is probable – To recognize revenue, we must judge collectibility of the arrangement fees on a customer-by-customer basis pursuant to our credit review process. We typically sell to customers with whom there is a history of successful collection. We evaluate the financial position and a customer’s ability to pay whenever an existing customer purchases new products, renews an existing arrangement, or requests an increase in credit terms. For certain industries for which our products are not considered core to the industry or the industry is generally considered troubled, we impose higher credit standards. If we determine that collectibility is not probable based upon our credit review process or the customer’s payment history, we recognize revenue as payments are received.

Multiple element arrangements involving software licenses – For multiple element arrangements involving software and other software-related deliverables, vendor-specific objective evidence of fair value (VSOE) must exist to allocate the total fee among all delivered and non-essential undelivered elements of the arrangement. If undelivered elements of the arrangement are essential to the functionality of the product, we defer revenue until the essential elements are delivered. If VSOE does not exist for one or more non-essential undelivered elements, we defer revenue until such evidence exists for the undelivered elements, or until all elements are delivered, whichever is earlier. If VSOE of all non-essential undelivered elements exist but VSOE does not exist for one or more delivered elements, we recognize revenue using the residual method. Under the residual method, we defer revenue related to the undelivered elements based upon VSOE and we recognize the remaining portion of the arrangement fee as revenue for the delivered elements, assuming all other criteria for revenue recognition are met. If we can no longer establish VSOE for non-essential undelivered elements of multiple element arrangements, we defer revenue until all elements are delivered or VSOE was established for the undelivered elements, whichever is earlier.

We base our VSOE for certain product elements of an arrangement upon the pricing in comparable transactions when the element is sold separately. We primarily base our VSOE for term and perpetual support services upon customer renewal history where the services are sold separately. We also base VSOE for professional services and installation services for emulation hardware systems upon the price charged when the services are sold separately.

Multiple element arrangements involving hardware – For multiple element arrangements involving our emulation hardware systems, we allocate revenue to each element based on the relative selling price of each deliverable. In order to meet the separation criteria to allocate revenue to each element we must determine the standalone selling price of each element using a hierarchy of evidence. The authoritative guidance requires that, in the absence of VSOE or third-party evidence (TPE), a company must develop an estimated selling price (ESP). ESP is defined as the price at which the vendor would transact if the deliverable was sold by the vendor regularly on a standalone basis. A company should consider market conditions as well as entity-specific factors when estimating a selling price.

When VSOE or TPE does not exist, we base our ESP for certain elements in arrangements based on either costs incurred to manufacture a product plus a reasonable profit margin or standalone sales to similar customers. In

 

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determining profit margins, we consider current market conditions, pricing strategies related to the class of customer, and the level of penetration we have with the customer. In other cases, we may have limited sales on a standalone basis to the same or similar customers and/or guaranteed pricing on future purchases of the same item. If we are unable to demonstrate value on a standalone basis of an element, we could be required to combine elements which could impact the timing of revenue recognition if not delivered together.

Reclassification

Certain immaterial reclassifications have been made in the condensed consolidated balance sheet to correct the presentation as of January 31, 2011. Specifically, we made a reclassification to other assets of $5,481 which was incorrectly classified as other receivables.

 

(3) Fair Value Measurement—We measure financial instruments at fair value on a quarterly basis. The Financial Accounting Standards Board established a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources. Unobservable inputs reflect our market assumptions. The fair value hierarchy consists of the following three levels:

 

   

Level 1—Quoted prices for identical instruments in active markets;

 

   

Level 2—Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations whose significant inputs are observable; and

 

   

Level 3—One or more significant inputs to the valuation model are unobservable.

The following table presents information about financial assets and liabilities required to be carried at fair value on a recurring basis as of April 30, 2011:

 

     Fair Value     Level 1      Level 2      Level 3  

Foreign currency exchange contracts

   $ 1,851      $ —         $ 1,851       $ —     

Contingent consideration

     (6,475     —           —           (6,475
                                  

Total

   $ (4,624   $ —         $ 1,851       $ (6,475
                                  

The following table presents information about financial assets and liabilities required to be carried at fair value on a recurring basis as of January 31, 2011:

 

     Fair Value     Level 1      Level 2      Level 3  

Foreign currency exchange contracts

   $ 826      $ —         $   826       $ —     

Contingent consideration

     (5,342     —           —           (5,342
                                  

Total

   $ (4,516   $ —         $ 826       $ (5,342
                                  

In connection with certain acquisitions, payment of a portion of the purchase price is contingent upon the acquired business’ achievement of certain revenue goals. We have estimated the fair value of this contingent consideration as the present value of the expected contingent payments over the term of the arrangements and have included $795 of the balance in accrued liabilities and the remaining $5,680 in other long-term liabilities on our condensed consolidated balance sheet.

The following table summarizes Level 3 activity:

 

Balance as of January 31, 2011

   $ 5,342   

Additions

     1,090   

Payments

     (8

Interest accretion

     51   
        

Balance as of April 30, 2011

   $ 6,475   
        

 

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The following table summarizes the fair value and carrying value of notes payable:

 

As of

   April 30, 2011      January 31, 2011  

Fair value of notes payable

   $ 263,484       $ 222,591   

Carrying value of notes payable

   $ 210,787       $ 209,348   

We based the fair value of notes payable on the quoted market price or rates available to us for instruments with similar terms and maturities. Of the total carrying value of notes payable, $2,000 as of January 31, 2011 was classified as current on our condensed consolidated balance sheets. The carrying amount of short-term borrowings of $9,055 as of April 30, 2011 and $15,544 as of January 31, 2011 approximates fair value because of the short-term nature of the instruments.

 

(4) Business Combinations—For each business we acquire, the excess of the fair value of the consideration transferred over the fair value of the net tangible assets acquired and net tangible liabilities assumed was allocated to various identifiable intangible assets and goodwill. Identifiable intangible assets typically consist of purchased technology and customer-related intangibles, which are amortized to expense over their useful lives. Goodwill, representing the excess of the purchase consideration over the fair value of net tangible and identifiable intangible assets, is not amortized.

During the three months ended April 30, 2011, we acquired one privately-held company, which was not material individually or in the aggregate, for a total consideration of $1,890.

The separate results of operations for the acquisitions during the three months ended April 30, 2011 were not material, individually or in the aggregate, compared to our overall results of operations and accordingly, pro-forma financial statements of the combined entities have been omitted.

 

(5) Derivative Instruments and Hedging Activities—We are exposed to fluctuations in foreign currency exchange rates. To manage the volatility, we aggregate exposures on a consolidated basis to take advantage of natural offsets. The primary exposures are the Japanese yen, where we are in a long position, and the euro and the British pound, where we are in a short position. Most large European revenue contracts are denominated and paid to us in U.S. dollars while our European expenses, including substantial research and development operations, are paid in local currencies causing a short position in the euro and the British pound. In addition, we experience greater inflows than outflows of Japanese yen as almost all Japanese-based customers contract and pay us in Japanese yen. While these exposures are aggregated on a consolidated basis to take advantage of natural offsets, substantial exposures remain.

To partially offset the net exposures in the euro, British pound, and the Japanese yen, we enter into foreign currency exchange contracts of less than one year which are designated as cash flow hedges. Any gain or loss on Japanese yen contracts is classified as product revenue when the hedged transaction occurs while any gain or loss on euro and British pound contracts is classified as operating expense when the hedged transaction occurs.

We formally document all relationships between foreign currency exchange contracts and hedged items as well as our risk management objectives and strategies for undertaking various hedge transactions. All hedges designated as cash flow hedges are linked to forecasted transactions and we assess, both at inception of the hedge and on an ongoing basis, the effectiveness of the foreign currency exchange contracts in offsetting changes in the cash flows of the hedged items. We report the effective portions of the net gains or losses on foreign currency exchange contracts as a component of accumulated other comprehensive income in stockholders’ equity. Accumulated other comprehensive income associated with hedges of forecasted transactions is reclassified to the condensed consolidated statement of operations in the same period the forecasted transaction occurs. We discontinue hedge accounting prospectively when we determine that a foreign currency exchange contract is not highly effective as a hedge. To the extent a forecasted transaction is no longer deemed probable of occurring, we prospectively discontinue hedge accounting treatment and we reclassify deferred amounts to other expense, net in the condensed consolidated statement of operations. We noted no such instance during the three months ended April 30, 2011 or 2010.

 

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The fair values and balance sheet presentation of our derivative instruments as of April 30, 2011 are summarized as follows:

 

     Location      Asset
Derivatives
     Liability
Derivatives
 

Derivatives designated as hedging instruments:

        

Cash flow forwards

     Other receivables       $ 725       $ (161

Derivatives not designated as hedging instruments:

        

Non-designated forwards

     Other receivables         1,911         (624
                    

Total derivatives

      $ 2,636       $ (785
                    

The fair values and balance sheet presentation of our derivative instruments as of January 31, 2011 are summarized as follows:

 

     Location      Asset
Derivatives
     Liability
Derivatives
 

Derivatives designated as hedging instruments:

        

Cash flow forwards

     Other receivables       $ 575       $ (414

Derivatives not designated as hedging instruments:

        

Non-designated forwards

     Other receivables         1,125         (460
                    

Total derivatives

      $ 1,700       $ (874
                    

During the three months ended April 30, 2011, we entered into 366 new foreign currency forward contracts. We had a total of 37 contracts outstanding with a total gross notional value of $126,716 outstanding as of April 30, 2011. For the three months ended April 30, 2010, we entered into 337 new foreign currency contracts. We had a total of 43 contracts with a total gross notional value of $203,281 outstanding as of April 30, 2010. Notional amounts do not quantify risk or represent our assets or liabilities but are used in the calculation of cash settlements under the contracts.

By using derivative instruments, we subject ourselves to credit risk. If a counterparty fails to fulfill its performance obligations under a derivative contract, our credit risk will equal the fair value of the derivative instrument. Generally, when the fair value of our derivative contracts is a net asset, the counterparty owes us, thus creating a receivable risk. We minimize counterparty credit risk by entering into derivative transactions with major financial institutions and, therefore, we do not expect material losses as a result of default by our counterparties.

 

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The pre-tax effect of derivative instruments in cash flow hedging relationships on income and other comprehensive income (OCI) for the three months ended April 30, 2011 is as follows:

 

Derivatives Designated

as Hedging Instruments

   Gain Recognized in
OCI on Derivatives
(Effective Portion)
    

Gain (loss) Reclassified from
Accumulated OCI into Income
(Effective  Portion)

   

Gain Recognized in Income on
Derivatives (Ineffective Portion and Amount
Excluded from Effectiveness Testing)

 
     Amount     

Location

   Amount    

Location

   Amount  

Cash flow forwards

   $ 586       Revenues    $ (449   Other expense, net    $ 24   
      Operating expenses      560        
                               

Total

   $ 586          $ 111         $ 24   
                               

The gain on cash flow forwards of $24 recognized in other expense, net for the three months ended April 30, 2011 is related to the time value exclusion of foreign currency forward contracts from our assessment of hedge effectiveness.

The pre-tax effect of derivative instruments in cash flow hedging relationships on income and OCI for the three months ended April 30, 2010 is as follows:

 

Derivatives Designated

as Hedging Instruments

   Loss Recognized in
OCI on Derivatives
(Effective Portion)
   

Loss Reclassified from
Accumulated OCI into Income
(Effective Portion)

   

Gain Recognized in Income on
Derivatives (Ineffective Portion and Amount
Excluded from Effectiveness Testing)

 
     Amount    

Location

   Amount    

Location

   Amount  

Cash flow forwards

   $ (1,250   Revenues    $ (131   Other expense, net    $ 30   
     Operating expenses      (1,713     
                              

Total

   $ (1,250      $ (1,844      $ 30   
                              

The gain on cash flow forwards of $30 recognized in other expense, net for the three months ended April 30, 2010 was related to the time value exclusion of foreign currency forward contracts from our assessment of hedge effectiveness.

The hedge balance in accumulated other comprehensive income was as follows:

 

As of

   April 30,
2011
     January 31,
2011
 

Accumulated OCI before tax effect

   $ 545       $ 69   

Accumulated OCI after tax effect

   $ 455       $ (2

The balance represents a net unrealized gain on foreign currency exchange contracts related to hedges of forecasted revenues and expenses expected to occur within the next twelve months. We will transfer this amount to the condensed consolidated statement of operations upon recognition of the related revenues and recording of the respective expenses. We expect substantially all of the hedge balance in accumulated other comprehensive income to be reclassified to the condensed consolidated statement of operations within the next twelve months.

We enter into foreign currency exchange contracts to offset the earnings impact relating to the variability in exchange rates on certain short-term monetary assets and liabilities denominated in non-functional currencies. We do not designate these foreign currency contracts as hedges. The effect of derivative instruments not designated as hedging instruments on income is as follows:

 

Derivatives Not Designated
as Hedging Instruments

  

Gain Recognized in Income on Derivatives

 
    

Location

   Amount as of April 30, 2011      Amount as of April 30, 2010  

Non-designated forwards

   Other expense, net    $ 3,281       $ 1,423   

 

(6) Term Receivables and Trade Accounts Receivable—We have long-term installment receivables that are attributable to multi-year, multi-element term license sales agreements. We include balances under term agreements that are due within one year in trade accounts receivable, net and balances that are due more than one year from the balance sheet date in term receivables, long-term. We discount the total product portion of the agreements to reflect the interest component of the transaction. We amortize the interest component of the transaction, using the effective interest method, to system and software revenues over the period in which payments are made and balances are outstanding. We determine the discount rate at the outset of the arrangement based upon the current credit rating of the customer. We reset the discount rate periodically considering changes in prevailing interest rates but do not adjust previously discounted balances.

 

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Term receivable and trade accounts receivable balances were as follows:

 

As of

   April 30,
2011
     January 31,
2011
 

Trade accounts receivable

   $ 139,028       $ 153,733   

Term receivables, short-term

   $ 182,012       $ 193,342   

Term receivables, long-term

   $ 179,014       $ 167,425   

Trade accounts receivable include billed amounts whereas term receivables, short-term is comprised of unbilled amounts. Term receivables, short term represent the portion of long-term installment agreements that are due within one year. Billings for term agreements typically occur 30 days prior to the contractual due date, in accordance with individual contract installment terms. Term receivables, long-term represent unbilled amounts which are scheduled to be collected beyond one year.

We perform a credit risk assessment of all customers using the S&P credit rating as our primary credit-quality indicator. The S&P credit ratings are based on the most recent S&P score available. For customers that do not have an S&P credit rating, we base our credit risk assessment on an internal credit assessment which is based on selected short-term financial ratios. Our internal credit assessment is based upon results provided in the customers’ most recent financial statements.

The credit risk assessment for our long-term receivables was as follows:

 

As of

   April 30,
2011
     January 31,
2011
 

S&P credit rating:

     

AAA+ through BBB-

   $ 106,906       $ 84,685   

BB+ and lower

     11,594         19,473   
                 
     118,500         104,158   

Internal credit assessment

     60,514         63,267   
                 

Total long-term term receivables

   $ 179,014       $ 167,425   
                 

We maintain allowances for doubtful accounts on trade accounts receivable and term receivables, long-term for estimated losses resulting from the inability of our customers to make required payments. We regularly evaluate the collectibility of our trade accounts receivable based on a combination of factors. When we become aware of a specific customer’s inability to meet its financial obligations, such as in the case of bankruptcy or deterioration in the customer’s operating results, financial position, or credit rating, we record a specific reserve for bad debt to reduce the related receivable to the amount believed to be collectible. We also record unspecified reserves for bad debt for all other customers based on a variety of factors including length of time the receivables are past due, the financial health of the customers, the current business environment, and historical experience. Current economic conditions we have considered include forecasted spending in the semiconductor industry, consumer spending for electronics, integrated circuit research and development spending, and volatility in gross domestic product. If these factors change or circumstances related to specific customers change, we adjust the estimates of the recoverability of receivables resulting in either additional selling expense or a reduction in selling expense in the period such determination is made.

The following shows the change in allowance for doubtful accounts for the three months ended April 30, 2011:

 

     Beginning
balance as of
January 31, 2011
     Charged (credited)
to expense
    Deductions(1)      Ending balance
as of April 30,
2011
 

Allowance for doubtful accounts

   $ 3,941       $ (182   $ 21       $ 3,780   

 

  (1) 

Specific account write-offs and foreign exchange.

We enter into agreements to sell qualifying accounts receivable from time to time to certain financing institutions on a non-recourse basis. We received net proceeds from the sale of receivables of $11,403 for the three months ended April 30, 2011 compared to $14,909 for the three months ended April 30, 2010.

 

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(7) Short-Term Borrowings—Short-term borrowings consisted of the following:

 

As of

   April 30,
2011
     January 31,
2011
 

Collections of previously sold accounts receivable

   $ 4,143       $ 10,680   

Other borrowings

     4,912         4,864   
                 

Short-term borrowings

   $ 9,055       $ 15,544   
                 

In April 2011, we entered into a syndicated, senior, unsecured, four-year revolving credit facility that terminates April 27, 2015. The revolving credit facility has a maximum borrowing capacity of $125,000. Under this revolving credit facility, we have the option to pay interest based on:

(i) London Interbank Offered Rate (LIBOR) with varying maturities commensurate with the borrowing period we select, plus a spread of between 2.25% and 3.25% based on a pricing grid tied to a financial covenant, or

(ii) A base rate plus a spread of between 1.25% and 2.25%, based on a pricing grid tied to a financial covenant.

The base rate is defined as the highest of:

(i) The federal funds rate, as defined, plus 0.5%,

(ii) The prime rate of the lead bank, or

(iii) One-month LIBOR plus 1.0%.

As a result of these interest rate options, our interest expense associated with borrowings under this revolving credit facility will vary with market interest rates. In addition, commitment fees are payable on the unused portion of the revolving credit facility at rates between 0.40% and 0.50% based on a pricing grid tied to a financial covenant. We paid commitment fees as follows:

 

Three months ended April 30,

   2011      2010  

Commitment fees

   $ 80       $ 66   

This revolving credit facility contains certain financial and other covenants, including the following:

 

   

Our adjusted quick ratio (ratio of the sum of cash and cash equivalents, short-term investments, and net current receivables to total current liabilities) shall not be less than 1.00;

 

   

Our tangible net worth (stockholders’ equity less goodwill and other intangible assets) must exceed the calculated required tangible net worth as defined in the credit agreement, which establishes a fixed level of required tangible net worth. Each quarter the required level increases by 70% of any positive net income in the quarter (but in the aggregate no more than 70% of positive net income for any full fiscal year), 100% of the amortization of intangible assets in the quarter, and 100% of certain stock issuance proceeds. The required level also decreases each quarter by 50% of amounts paid for dividends or repurchases of our stock and certain amounts of acquired intangible assets;

 

   

Our leverage ratio (ratio of total liabilities less subordinated debt to the sum of subordinated debt and tangible net worth) shall be less than 2.00;

 

   

Our senior leverage ratio (ratio of total debt less subordinated debt to the sum of subordinated debt and tangible net worth) shall not be greater than 0.90; and

 

   

Our minimum cash and accounts receivable ratio (ratio of the sum of cash and cash equivalents, short-term investments, and 42.0% of net current accounts receivable, to outstanding credit agreement borrowings) shall not be less than 1.25.

The revolving credit facility limits the aggregate amount we can pay for dividends and repurchases of our stock over the four year term of the facility to $50,000 plus 70% of our cumulative net income.

We were in compliance with all financial covenants as of April 30, 2011. If we were to fail to comply with the financial covenants and do not obtain a waiver from our lenders, we would be in default under the revolving credit facility and our lenders could terminate the facility and demand immediate repayment of all outstanding loans under the revolving credit facility.

Short-term borrowings include amounts collected from customers on accounts receivable previously sold on a non-recourse basis to financial institutions. These amounts are remitted to the financial institutions in the following quarter.

We generally have other short-term borrowings, including multi-currency lines of credit, capital leases, and other borrowings. Interest rates are generally based on the applicable country’s prime lending rate, depending on the currency borrowed.

 

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Table of Contents
(8) Notes Payable—Notes payable consist of the following:

 

As of

   April 30,
2011
     January 31,
2011
 

4.00% Debentures due 2031

   $ 209,474       $ —     

6.25% Debentures due 2026, issued 2006

     —           157,843   

6.25% Debentures due 2026, issued fiscal 2011

     —           31,705   

Term Loan due 2013

     —           18,500   

Other

     1,313         1,300   
                 

Notes payable

     210,787         209,348   

Term Loan due 2013, current portion

     —           (2,000
                 

Notes payable, long-term

   $ 210,787       $ 207,348   
                 

4.00% Debentures due 2031: In April 2011, we issued $253,000 of 4.00% Convertible Subordinated Debentures (4.00% Debentures) due 2031 in a private placement pursuant to SEC Rule 144A under the Securities Act of 1933. Interest on the 4.00% Debentures is payable semi-annually in April and October.

The 4.00% Debentures are convertible, under certain circumstances, into our common stock at a conversion price of $20.538 per share for a total of 12,319 shares as of April 30, 2011. These circumstances include:

 

   

The market price of our common stock exceeding 120% of the conversion price;

 

   

A call for redemption of the 4.00% Debentures;

 

   

Specified distributions to holders of our common stock;

 

   

If a fundamental change, such as a change of control, occurs;

 

   

During the two months prior to, but not on, the maturity date; or

 

   

The market price of the 4.00% Debentures declining to less than 98% of the value of the common stock into which the 4.00% Debentures are convertible.

Upon conversion of any 4.00% Debentures, a holder will receive:

 

  (i) Cash up to the principal amount of the 4.00% Debentures that are converted; and

 

  (ii) Cash or shares of common stock, at our election, for the excess, if any, of the value of the converted shares over the principal amount.

If a holder elects to convert their 4.00% Debentures in connection with a fundamental change in the company that occurs prior to April 5, 2016, the holder will also be entitled to receive a make whole premium upon conversion in some circumstances.

We may redeem some or all of the 4.00% Debentures for cash on or after April 5, 2016 at the following redemption prices expressed as a percentage of principal, plus any accrued and unpaid interest:

 

Period

   Redemption Price  

Beginning on April 5, 2016 and ending on March 31, 2017

     101.143

Beginning on April 1, 2017 and ending on March 31, 2018

     100.571

On April 1, 2018 and thereafter

     100.000

The holders, at their option, may redeem the 4.00% Debentures in whole or in part for cash on April 1, 2018, April 1, 2021, and April 1, 2026, and in the event of a fundamental change in the company. In each case, our repurchase price will be 100% of the principal amount of the 4.00% Debentures plus any accrued and unpaid interest.

 

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Table of Contents

As the 4.00% Debentures contain conversion features that the debt may be settled in cash upon conversion, we separately account for the implied liability and equity components of the 4.00% Debentures. The principal amount, unamortized debt discount, net carrying amount of the liability component, and carrying amount of the equity component of the 4.00% Debentures are as follows:

 

As of

   April 30,
2011
 

Principal amount

   $ 253,000   

Unamortized debt discount

     (43,526
        

Net carrying amount of the liability component

   $ 209,474   
        

Equity component

   $ 43,930   
        

The unamortized debt discount will be amortized to interest expense using the effective interest method through March 2018.

We recognized the following amounts in interest expense in the condensed consolidated statement of operations related to the 4.00% debentures:

 

Three months ended April 30,

   2011  

Interest expense at the contractual interest rate

   $ 759   

Amortization of debt discount

   $ 404   

The effective interest rate on the 4.00% Debentures was 7.25% for the three months ended April 30, 2011.

6.25% Debentures due 2026: In March 2006, we issued $200,000 of 6.25% Convertible Subordinated Debentures (6.25% Debentures) due 2026 in a private offering pursuant to SEC Rule 144A under the Securities Act of 1933. Interest on the 6.25% Debentures was payable semi-annually in March and September.

The principal amount, unamortized debt discount, net carrying amount of the liability component, and carrying amount of the equity component of the 6.25% Debentures, issued 2006, were as follows:

 

As of

   April 30,
2011
     January 31,
2011
 

Principal amount

   $ —         $ 165,000   

Unamortized debt discount

     —           (7,157
                 

Net carrying amount of the liability component

   $ —         $ 157,843   
                 

Equity component

   $ —         $ 21,766   
                 

We recognized the following amounts in interest expense in the condensed consolidated statements of operations related to the 6.25% Debentures, issued 2006:

 

Three months ended April 30,

   2011      2010  

Interest expense at the contractual interest rate

   $ 2,900       $ 2,578   

Amortization of debt discount

   $ 793       $ 729   

The effective interest rate on the 6.25% Debentures, was 8.60% for the three months ended April 30, 2011 and 2010.

The principal amount, unamortized premium, and net carrying amount of the 6.25% Debentures, issued fiscal 2011, were as follows:

 

As of

   April 11,
2011
     January 31,
2011
 

Principal amount

   $ —         $ 31,509   

Unamortized debt premium

     —           196   
                 

Net carrying amount of the liability component

   $ —         $ 31,705   
                 

No equity component was recorded for the 6.25% Debentures, issued fiscal 2011, as the conversion feature was deemed to be non-beneficial when the debt was issued.

During the three months ended April 30, 2011, we redeemed the remaining $196,509 principal amount of 6.25% Debentures utilizing proceeds received from the issuance of the 4.00% Debentures and cash on hand. In connection with this redemption, we incurred a before tax net loss on the early extinguishment of debt of $11,192, which included a $6,190 write-off of net unamortized debt discount, a $3,518 premium on redemption of the 6.25% Debentures, and a write-off of $1,484 for the unamortized debt issuance costs. This loss is included in interest expense on the condensed consolidated statement of operations. No balance remains outstanding following this redemption.

 

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Table of Contents

Term Loan due 2013: In April 2010, we entered into a three-year term loan (Term Loan) for $20,000 to repay borrowings under our revolving credit facility used to purchase office buildings in Fremont, California. Fixed principal of $500 and accrued interest payments were payable quarterly in February, May, August, and November.

During the three months ended April 30, 2011, we repaid the remaining obligation of $18,500 under the Term Loan utilizing proceeds received from the issuance of the 4.00% Debentures. In connection with this repayment, we incurred a before tax net loss on early retirement of debt of $312, representing the write-off of the unamortized debt issuance costs. This loss is included in interest expense on the condensed consolidated statement of operations. The effective interest rate was 4.81% for the three months ended April 30, 2011. No balance remains outstanding following this repayment.

Other Notes Payable: In November 2009, we issued a subordinated note payable as part of a business combination. The note bears interest at a rate of 3.875% and is due in full along with all accrued interest on November 17, 2012.

 

(9) Commitments and Contingencies

Leases

We lease a majority of our field sales offices and research and development facilities under non-cancelable operating leases. In addition, we lease certain equipment used in our research and development activities. This equipment is generally leased on a month-to-month basis after meeting a six-month lease minimum. There have been no significant changes to the future minimum lease payments due under non-cancelable operating leases disclosed in our Annual Report on Form 10-K for the fiscal year ended January 31, 2011.

Indemnifications

Our license and services agreements generally include a limited indemnification provision for claims from third parties relating to our intellectual property. The indemnification is generally limited to the amount paid by the customer or a set cap. As of April 30, 2011, we were not aware of any material liabilities arising from these indemnification obligations.

Legal Proceedings

From time to time we are involved in various disputes and litigation matters that arise in the ordinary course of business. These include disputes and lawsuits relating to intellectual property rights, contracts, distributorships, and employee relations matters. Periodically, we review the status of various disputes and litigation matters and assess our potential exposure. When we consider the potential loss from any dispute or legal matter probable and the amount or the range of loss can be estimated, we will accrue a liability for the estimated loss. Legal proceedings are subject to uncertainties, and the outcomes are difficult to predict. Because of such uncertainties, we base accruals on the best information available at the time. As additional information becomes available, we reassess the potential liability related to pending claims and litigation matters and may revise estimates. We believe that the outcome of current litigation, individually and in the aggregate, will not have a material effect on our results of operations.

 

(10) Employee Stock and Savings Plans

Stock Options Plans and Stock Plans

On July 1, 2010, our shareholders approved the 2010 Omnibus Incentive Plan (Incentive Plan) which replaced our prior 1982 Stock Option Plan, Nonqualified Stock Option Plan, 1986 Stock Plan, and 1987 Non-Employee Directors’ Stock Plan. The Incentive Plan is administered by the Compensation Committee of our Board of Directors and permits accelerated vesting of outstanding options, restricted stock units, restricted stock awards, and other equity incentives upon the occurrence of certain changes in control of our company. The implementation of the Incentive Plan did not modify the terms of any awards granted under prior plans.

Stock options under the Incentive Plan are generally expected to vest over four years, have an expiration date of ten years from the date of grant, and an exercise price not less than the fair market value of the shares on the date of grant.

As of April 30, 2011, a total of 8,924 shares of common stock were available for future grant under the above Incentive Plan.

We assumed the stock plans of Valor Computerized Systems, Ltd. (Valor) on March 18, 2010. Under the terms of our merger agreement with Valor, options outstanding under these plans were converted to options to purchase shares of our common stock. Options issued under these plans vest over four years from the original grant date and have an expiration date of ten years from the original grant date. The exercise price of each converted option is equal to the product of the original exercise price and the original number of options granted divided by the number of converted options received. These stock plans have been suspended and no future awards will be granted under these plans. Options for a total of 2,160 shares of our common stock have been authorized and issued under the Valor plans.

 

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Table of Contents

On December 14, 2009, our shareholders approved the exchange of certain options for restricted stock units. Eligible for the exchange were options held by non-executive employees with an exercise price equal to or greater than $11.00 which were granted prior to January 7, 2009 and expire after August 15, 2010. The offer expired February 5, 2010. Effective February 8, 2010 a total of 6,945 options were exchanged for 557 restricted stock units. Total incremental cost of $491 resulted from this exchange. The incremental cost will be amortized over two years.

Stock options outstanding, the weighted average exercise price, and transactions involving the stock option plans are summarized as follows:

 

     Options
Outstanding
    Weighted
Average
Exercise Price
 

Balance as of January 31, 2011

     11,867      $ 9.94   

Granted

     —          —     

Exercised

     (1,096     6.76   

Forfeited

     (73     8.11   

Expired

     (23     17.13   
                

Balance as of April 30, 2011

     10,675      $ 10.27   
                

The following table summarizes activity involving restricted stock, including restricted stock units:

 

     Restricted
Stock
    Weighted
Average Grant
Date Fair Value
 

Nonvested as of January 31, 2011

     2,131      $ 9.61   

Granted

     107        15.29   

Released

     (229     8.07   

Cancelled

     (26     9.74   
                

Nonvested as of April 30, 2011

     1,983      $ 10.22   
                

Employee Stock Purchase Plans

We have an employee stock purchase plan (ESPP) for U.S. employees and an ESPP for certain foreign subsidiary employees. The ESPPs provide for six month offerings commencing on January 1 and July 1 of each year with purchases on June 30 and December 31 of each year. Each eligible employee may purchase up to six thousand shares of stock on each purchase date at prices no less than 85% of the lesser of the fair market value of the shares on the offering date or on the purchase date. As of April 30, 2011, 3,934 shares remain available for future purchase under the ESPPs.

Stock-Based Compensation Expense

We estimate the fair value of stock options and purchase rights under our ESPPs using a Black-Scholes option-pricing model. The Black-Scholes option-pricing model incorporates several highly subjective assumptions including expected volatility, expected term, and interest rates.

In reaching our determination of expected volatility for options, we include the following elements:

 

   

Historical volatility of our shares of common stock;

 

   

Historical volatility of shares of comparable companies;

 

   

Implied volatility of our traded options; and

 

   

Implied volatility of traded options of comparable companies.

In determining expected volatility for purchase rights under our ESPP, we use the historical volatility of our shares of common stock. The expected term is the six month offering period. We base the expected term of our stock options on historical experience.

The risk-free interest rate for periods within the contractual life of the award is based on the U.S. Treasury yield curve in effect at the time of the grant.

 

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Table of Contents

The fair value of restricted stock units is the market value as of the grant date.

The weighted average grant date fair values are summarized as follows:

 

Three months ended April 30,

   2011      2010  

Options granted

   $ —         $ 4.29   

Restricted stock units granted

   $ 15.29       $ 7.99   

ESPP purchase rights

   $ —         $ —     

The fair value calculations used the following assumptions:

 

Three months ended April 30,

   2010  

Stock Option Plans

      

Risk-free interest rate

     2.4

Dividend yield

     0

Expected life (in years)

     5.5   

Weighted average volatility

     55

Three months ended April 30,

   2010  

Acquired Company Options Exchange

      

Risk-free interest rate

     0.1% - 3.3

Dividend yield

     0

Expected life (in years)

     0.1 - 7.7   

Volatility (range)

     35% - 72

Weighted average volatility

     60

Three months ended April 30,

   2010  

Employee Options Exchange

      

Risk-free interest rate

     0.2% - 2.7

Dividend yield

     0

Expected life (in years)

     0.5 - 5.9   

Volatility (range)

     43% - 77

Weighted average volatility

     43

 

(11) Incentive Stock Rights—Our Board of Directors has the authority to issue incentive stock in one or more series and to determine the relative rights and preferences of the incentive stock. On June 24, 2010, we adopted an Incentive Stock Purchase Rights Plan and declared a dividend distribution of one Right for each outstanding share of common stock, payable to holders of record on July 6, 2010. As long as the Rights are attached to our common stock, we will issue one Right with each new share of common stock so that all such shares will have attached Rights. Under certain conditions, each Right may be exercised to purchase 1/10,000 of a share of Series B Junior Participating Incentive Stock (Incentive Stock) at a purchase price of fifty dollars, subject to adjustment. The Rights are not presently exercisable and will only become exercisable if a person or group acquires or commences a tender offer to acquire 15% or more of our common stock. If a person or group acquires 15% or more of the common stock, each Right will be adjusted to entitle its holder to receive, upon exercise, common stock (or, in certain circumstances, other assets of ours) having a value equal to two times the exercise price of the Right or each Right will be adjusted to entitle its holder to receive, upon exercise, common stock of the acquiring company having a value equal to two times the exercise price of the Right, depending on the circumstances. The Rights expire on December 31, 2011 and may be redeemed by us for $0.001 per Right. The Rights do not have voting or dividend rights and have no dilutive effect on our earnings.

 

(12) Net Loss Per Share—We compute basic net loss per share using the weighted average number of common shares outstanding during the period. We compute diluted net loss per share using the weighted average number of common shares and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares consist of common shares issuable upon exercise of stock options, restricted stock units, purchase rights from ESPPs, and warrants using the treasury stock method and common shares issuable upon conversion of the convertible subordinated debentures, if dilutive.

 

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Table of Contents

The following provides the computation of basic and diluted net loss per share:

 

     Three months ended April 30,  
         2011             2010      

Net loss

   $ (2,353   $ (23,025
                

Weighted average common shares used to calculate basic and diluted net loss per share

     111,769        103,763   
                

Basic and diluted net loss per share

   $ (0.02   $ (0.22
                

We excluded from the computation of diluted net loss per share stock options, restricted stock units, and ESPP purchase rights to purchase 6,959 shares of common stock for the three months ended April 30, 2011 compared to 16,938 for the three months ended April 30, 2010. The stock options, restricted stock units, and ESPP purchase rights were anti-dilutive either because we incurred a net loss for the period or the stock options were determined to be anti-dilutive as a result of applying the treasury stock method.

The effect of the conversion of the Floating Rate Convertible Subordinated Debentures (Floating Rate Debentures) due 2023 (retired during fiscal 2011), the 6.25% Debentures (retired during the three months ended April 30, 2011), and the 4.00% Debentures was anti-dilutive and therefore excluded from the computation of diluted net income (loss) per share. We assume that the 6.25% Debentures and the 4.00% Debentures will be settled in common stock for purposes of calculating the dilutive effect of the 6.25% Debentures and the 4.00% Debentures.

The conversion features of the 4.00% Debentures, which allow for settlement in cash or a combination of cash and common stock, are further described in Note 8. “Notes Payable.”

 

(13) Comprehensive Income (Loss)—The following provides a summary of comprehensive income (loss):

 

Three months ended April 30,

   2011     2010  

Net loss

   $ (2,353   $ (23,025

Change in unrealized gain on derivative instruments

     457        611   

Change in accumulated translation adjustment

     9,084        (3,764
                

Comprehensive income (loss)

   $ 7,188      $ (26,178
                

 

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(14) Special ChargesThe following is a summary of the components of the special charges:

 

Three months ended April 30,

   2011      2010  

Employee severance and related costs

   $ 1,147       $ 1,589   

Excess leased facility costs

     252         474   

Other costs

     3,148         1,205   
                 

Total special charges

   $ 4,547       $ 3,268   
                 

Special charges primarily consist of costs incurred for employee terminations due to a reduction of personnel resources driven by modifications of business strategy or business emphasis. Special charges may also include expenses incurred related to acquisitions, excess facility costs, and asset related charges.

Employee severance and related costs of $1,147 for the three months ended April 30, 2011 included severance benefits, notice pay, and outplacement services. The total rebalance charge represents the aggregate of numerous unrelated rebalance plans which impacted several employee groups, none of which was individually material to our financial position or results of operations. We determined termination benefit amounts based on employee status, years of service, and local statutory requirements. We communicated termination benefits to the affected employees prior to the end of the quarter in which we recorded the charge. Approximately 27% of these costs were paid during the three months ended April 30, 2011. We expect to pay the remainder during the fiscal year ending January 31, 2012. There have been no significant modifications to the amount of these charges.

Excess leased facility costs of $252 for the three months ended April 30, 2011 were primarily due to the abandonment of leased facilities.

Other special charges for the three months ended April 30, 2011 included costs of $3,102 related to consulting fees associated with our proxy contest. Also included in other special charges for the three months ended April 30, 2011 was $46 representing legal and other costs related to acquisitions.

Employee severance and related costs of $1,589 for the three months ended April 30, 2010 included severance benefits, notice pay, and outplacement services. The total rebalance charge represents the aggregate of numerous unrelated rebalance plans which impacted several employee groups, none of which was individually material to our financial position or results of operations. We determined termination benefit amounts based on employee status, years of service, and local statutory requirements. We communicated termination benefits to the affected employees prior to the end of the quarter in which we recorded the charge. Substantially all of these costs were paid during the fiscal year ending January 31, 2011. There have been no significant modifications to the amount of these charges.

Excess leased facility costs of $474 for the three months ended April 30, 2010 were primarily due to the abandonment of leased facilities and changes in the estimate of sublease income for previously abandoned leased facilities.

Other special charges for the three months ended April 30, 2010 included costs of $1,175 related to advisory fees and other costs of $30.

Accrued special charges are included in accrued liabilities and other long-term liabilities in the condensed consolidated Balance Sheets. The following table shows changes in accrued special charges during the three months ended April 30, 2011:

 

     Accrued special
charges as of
January 31, 2011
     Charges
during the three
months ended
April 30, 2011
     Payments
during the three
months ended
April 30, 2011
    Accrued special
charges as of
April 30, 2011 (1)
 

Employee severence and related costs

   $ 2,664       $ 1,147       $ (1,587   $ 2,224   

Excess leased facility costs

     1,930         252         (429     1,753   

Other costs

     2,336         3,148         (2,194     3,290   
                                  

Total accrued special charges

   $ 6,930       $ 4,547       $ (4,210   $ 7,267   
                                  

 

  (1) 

Of the $7,267 total accrued special charges as of April 30, 2011, $1,113 represented the long-term portion of accrued lease termination fees and other facility costs, net of sublease income. The remaining balance of $6,154 represented the short-term portion of accrued special charges.

 

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(15) Other Expense, Net—Other expense, net was comprised of the following:

 

Three months ended April 30,

   2011     2010  

Interest income

   $ 534      $ 277   

Foreign currency exchange gain (loss)

     (651     (650

Other, net

     (358     (768
                

Other expense, net

   $    (475 )        $ (1,141 )     
                

 

(16) Income Taxes—The provision for income taxes was comprised of the following:

 

Three months ended April 30,

   2011     2010  

Income tax expense

   $      611         $    2,563      

Generally, the provision for income taxes is the result of the mix of profits and losses earned by us and our subsidiaries in tax jurisdictions with a broad range of income tax rates, withholding taxes (primarily in certain foreign jurisdictions), changes in tax reserves, and the application of valuation allowances on deferred tax assets. Accounting guidance requires that on a quarterly basis we evaluate our provision for income tax expense (benefit) of U.S. and non-U.S. jurisdictions based on our projected results of operations for the full year and record an adjustment in the current quarter.

 

Three months ended April 30,

   2011     2010  

Effective Tax Rate

     (35%)        (13%)   

Period specific items expense (benefit)

   $   (1,334 )      $     353      

Without period specific items, our effective tax rate is (112%) for the three months ended April 30, 2011. Under our forecast of income for the year, we project a 12% effective tax rate with the inclusion of period specific items. Our effective tax rate differs from tax computed at the U.S. federal statutory rate of 35% primarily due to:

 

   

The benefit of lower tax rates on earnings of foreign subsidiaries;

 

   

Reduction in reserves for uncertain foreign tax positions; and

 

   

The application of tax incentives for research and development in certain foreign jurisdictions.

These differences are partially offset by:

 

   

U.S. losses for which no tax benefit has been recognized;

 

   

Non-deductible employee stock purchase plan compensation expense; and

 

   

Withholding taxes in certain foreign jurisdictions.

Actual results may differ significantly from our current projections. Further, on a quarterly basis, our effective tax rate could fluctuate considerably and could be adversely affected to the extent earnings are higher or lower than anticipated in countries where we have corresponding higher or lower statutory rates.

As of April 30, 2011, we had a liability of $42,422 for income taxes associated with uncertain income tax positions. All of these tax positions are classified as long-term liabilities in our condensed consolidated balance sheet. We are not able to reasonably estimate the timing of any cash payments required to settle these liabilities; however, we generally do not anticipate the settlement of the liabilities will require payment of cash within the next twelve months. We do not believe that the ultimate settlement of these liabilities will materially affect our liquidity. Further, certain liabilities may result in the reduction of deferred tax assets rather than settlement in cash.

 

(17) Related Party Transactions—Certain members of our Board of Directors also serve on the board of directors of certain of our customers. Management believes the transactions between these customers and us were carried out on an arm’s-length basis. The following table shows revenue recognized from these customers:

 

Three months ended April 30,

   2011     2010  

Revenue from customers

   $     17,306      $   12,631   

Percentage of total revenue

     7.5     7.0

 

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(18) Supplemental Cash Flow Information—The following provides information concerning supplemental disclosures of cash flow activities:

 

Three months ended April 30,

         2011                2010      

Cash paid, net for:

     

Interest

   $ 8,538       $ 5,939   

Income taxes

   $ 2,353       $ 3,665   

As part of the Valor acquisition in fiscal 2011, we acquired an investment in Frontline. During the three months ended April 30, 2011, we received returns on investment of $1,015 from Frontline which is included in net cash provided by operating activities in our condensed consolidated statement of cash flows.

 

(19) Segment Reporting—Our Chief Operating Decision Makers (CODMs), which consist of the Chief Executive Officer and the President, review our consolidated results within one operating segment. In making operating decisions, our CODMs primarily consider consolidated financial information accompanied by disaggregated revenue information by geographic region.

We eliminate all intercompany revenues in computing revenues by geographic regions. Revenues related to operations in the geographic regions were:

 

Three months ended April 30,

   2011      2010  

Revenues:

     

North America

   $ 90,323       $ 65,165   

Europe

     52,197         42,577   

Japan

     41,634         31,668   

Pacific Rim

     45,881         41,167   
                 

Total revenues

   $ 230,035       $ 180,577   
                 

For the three months ended April 30, 2011, one customer accounted for 21% of total revenues. No single customer accounted for 10% or more of total revenues for the three months ended April 30, 2010.

We segregate revenue into five categories of similar products and services. Each category includes both product and related support revenues. Revenue information is as follows:

 

Three months ended April 30,

   2011      2010  

Revenues:

     

IC Design to Silicon

   $ 86,288       $ 71,532   

Integrated System Design

     51,545         44,591   

Scalable Verification

     58,742         36,737   

New & Emerging Products

     17,968         13,328   

Services & Other

     15,492         14,389   
                 

Total revenues

   $ 230,035       $ 180,577   
                 

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Unless otherwise indicated, numerical references are in millions, except for percentages and per share data.

Overview

The following discussion should be read in conjunction with the condensed consolidated financial statements and notes included elsewhere in this Form 10-Q. Certain of the statements below contain forward-looking statements. These statements are predictions based upon our current expectations about future trends and events. Actual results could vary materially as a result of certain factors, including but not limited to, those expressed in these statements. In particular, we refer you to the risks discussed in Part II, Item 1A. “Risk Factors” and in our other Securities and Exchange Commission (SEC) filings, which identify important risks and uncertainties that could cause our actual results to differ materially from those contained in the forward-looking statements.

We urge you to consider these factors carefully in evaluating the forward-looking statements contained in this Form 10-Q. All subsequent written or spoken forward-looking statements attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The forward-looking statements included in this Form 10-Q are made only as of the date of this Form 10-Q. We do not intend, and undertake no obligation, to update these forward-looking statements.

The Company

We are a supplier of electronic design automation (EDA) systems — advanced computer software and emulation hardware systems used to automate the design, analysis, and testing of electronic hardware and embedded systems software in electronic systems and components. We market our products and services worldwide, primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia, and transportation industries. Through the diversification of our customer base among these various customer markets, we attempt to reduce our exposure to fluctuations within each market. We sell and license our products through our direct sales force and a channel of distributors and sales representatives. In addition to our corporate offices in Wilsonville, Oregon, we have sales, support, software development, and professional service offices worldwide.

We focus on products and design platforms where we have leading market share, enabling us to spend more effort to cause adoption of our technology in new applications, especially for new markets in which EDA companies have not participated. We believe this strategy leads to a more diversified product and customer mix and can help reduce the volatility of our business and our credit risk while increasing our potential for growth. System customers make up a much larger percentage of our business than that of most of our EDA competitors.

We derive system and software revenues primarily from the sale of term software license contracts, which are typically three to four years in length. We generally recognize revenue for these arrangements upon product delivery at the beginning of the license term. Larger enterprise-wide customer contracts, which can represent as much as 50% of our system and software revenue, drive the majority of our period-to-period revenue variances. We identify term licenses where collectibility is not probable and recognize revenue on those licenses when cash is received. Ratable license revenues also include short-term term licenses as well as other term licenses where we provide the customer with rights to unspecified or unreleased future products. For these reasons, the timing of large contract renewals, customer circumstances, and license terms are the primary drivers of revenue changes from period to period, with revenue changes also being driven by new contracts and increases in the capacity of existing contracts, to a lesser extent.

The EDA industry is competitive and is characterized by very strong leadership positions in specific segments of the EDA market. These strong leadership positions can be maintained for significant periods of time as the software can be 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 areas in which we are the leader. We will continue our strategy of developing high quality tools with number one market share potential, rather than being a broad-line supplier with undifferentiated product offerings. This strategy allows us to focus investment in areas where customer needs are greatest and where we have the opportunity to build significant market share.

Our products and services are dependent to a large degree on new design projects initiated by customers in the integrated circuit and electronics system industries. These industries can be 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. Furthermore, extended economic downturns can result in reduced funding for development due to downsizing and other business restructurings. These pressures are offset by the need for the development and introduction of next generation products once an economic recovery occurs.

 

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Our revenue has historically fluctuated quarterly and has generally been the highest in the fourth quarter of our fiscal year due to our customers’ corporate calendar year-end spending trends and the timing of contract renewals.

Known Trends and Uncertainties Impacting Future Results of Operations

Our top ten accounts make up approximately 40% of our receivables, including both short and long-term balances. We have not experienced and do not presently expect to experience collection issues with these customers. Net of reserves, we have no receivables greater than 60 days past due, and continue to experience no difficulty in factoring our high quality receivables.

Bad debt expense recorded for the three months ended April 30, 2011 was not material. However, we do have exposures within our receivables portfolio to customers with weak credit ratings. These receivables balances do not represent a material portion of our portfolio but could have a material adverse effect on earnings in any given quarter, should additional allowances for doubtful accounts be necessary.

A multi-quarter increase or decrease in service and support revenue can be an early indicator that our business is either strengthening or weakening. Our experience is that customers will scale back on the purchase of outside services in times of economic decline or weakness. In the first quarter of fiscal 2012 compared to the fourth quarter of fiscal 2011, software maintenance revenues were flat. During the fiscal year ended January 31, 2011, we noted an increase in software maintenance revenues.

Bookings during the first quarter of fiscal 2012 increased by approximately 5% compared to the first quarter of fiscal 2011. Bookings are the value of executed orders during a period for which revenue has been or will be recognized within six months for products and within twelve months for professional services and training. The ten largest transactions for the first quarter of fiscal 2012 accounted for approximately 40% of total system and software bookings compared to approximately 50% for the first quarter of fiscal 2011. The number of new customers during the first quarter of fiscal 2012, excluding PADS (our ready to use printed circuit board design tools) increased approximately 20% from the levels experienced during the first quarter of fiscal 2011.

We are focused on continued expense control in the operation of our business. We have plans to reduce sales, general, and administrative expenses as a percentage of revenue over the next three fiscal years.

Product Developments

During the three months ended April 30, 2011, we continued to execute our strategy of focusing on challenges encountered by customers, as well as building upon our well-established product families. We believe that customers, faced with leading-edge design challenges in creating new products, generally choose the best EDA products in each category to build their design environment. Through both internal development and strategic acquisitions, we have focused on areas where we believe we can build a leading market position or extend an existing leading market position.

We believe that the development and commercialization of EDA software tools is generally a three to five year process with limited customer adoption and sales in the first years of tool availability. Once tools are adopted, however, their life spans tend to be long. During the first quarter of fiscal 2012, we introduced new products and upgrades to existing products and did not have any significant products reaching the end of their useful economic life.

Critical Accounting Policies

We base our discussion and analysis of our financial condition and results of operations upon our condensed consolidated financial statements which have been prepared in accordance with United States (U.S.) generally accepted accounting principles (GAAP). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, and contingencies as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We evaluate our estimates on an on-going basis. We base our estimates on historical experience, current facts, and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenue, costs, and expenses that are not readily apparent from other sources. As future events and their effects cannot be determined with precision, actual results could differ from those estimates.

We believe that the accounting for revenue recognition, valuation of trade accounts receivable, valuation of deferred tax assets, income tax reserves, goodwill, intangible assets, long-lived assets, special charges, and accounting for stock-based compensation are the critical accounting estimates and judgments used in the preparation of our condensed consolidated financial statements. For further discussion of our critical accounting policies, see Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” in Part II of our Annual Report on Form 10-K for the year ended January 31, 2011.

 

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Table of Contents

RESULTS OF OPERATIONS

Revenues and Gross Margins

 

Three months ended April 30,

   2011     Change     2010  

System and software revenues

   $ 139.6        43 %      $ 97.5   

System and software gross margin

   $ 123.3        37 %      $ 89.9   

Gross margin percent

     88       92

Service and support revenues

   $ 90.4        9 %      $ 83.1   

Service and support gross margin

   $ 66.2        9 %      $ 60.8   

Gross margin percent

     73       73

Total revenues

   $ 230.0        27 %      $ 180.6   

Total gross margin

   $ 189.5        26 %      $ 150.7   

Gross margin percent

     82       83

System and Software

 

Three months ended April 30,

   2011     Change     2010  

Upfront license revenues

   $ 118.3         65   $   71.5      

Ratable license revenues

     21.3         (18 %)      26.0   
                  

Total system and software revenues

   $ 139.6         43   $ 97.5   
                  

We derive system and software revenues from the sale of licenses of software products and emulation hardware systems, including finance fee revenues from our long-term installment receivables resulting from product sales. Upfront license revenues consist of perpetual licenses and term licenses for which we recognize revenue upon product delivery at the start of a license term. We identify term licenses where collectability is not probable and recognize revenue on those licenses when cash is received. Additionally, ratable license revenues also include short-term term licenses, term licenses where we provide the customer with rights to unspecified or unreleased future products, and finance fees from the accretion of the discount on long-term installment receivables.

Our top ten customers accounted for approximately 60% of system and software revenues for the three months ended April 30, 2011 and approximately 45% for the three months ended April 30, 2010.

System and software revenues increased for the three months ended April 30, 2011 compared to the three months ended April 30, 2010 as a result of an increase in term license revenues of $23.5, driven by contract renewals during the three months ended April 30, 2011 compared to the three months ended April 30, 2010, an increase in perpetual license revenues of $17.5, primarily due to an increase in emulation revenues, and the effect of acquisitions completed in fiscal 2011 of $1.2.

For the three months ended April 30, 2011, one customer accounted for approximately 21% of total revenues. For the three months ended April 30, 2010, no single customer accounted for 10% or more of total revenues.

System and software gross margin percentage was lower for the three months ended April 30, 2011 compared to the three months ended April 30, 2010 primarily due to a change in product mix as a result of higher emulation hardware product revenues. Emulation hardware product revenues typically have lower margins compared to our software product revenues.

Amortization of purchased technology to system and software cost of revenues was $3.4 for the three months ended April 30, 2011 compared to $3.6 for the three months ended April 30, 2010.

Service and Support

We derive service and support revenues from software and hardware post-contract maintenance or support services and professional services, which includes consulting, training, and other services. Professional services are a lower margin offering which is staffed according to fluctuations in demand. Support services operate under a less variable cost structure.

The increase in service and support revenues for the three months ended April 30, 2011 compared to the three months ended April 30, 2010 was driven by increased support revenues of $4.2 resulting from of an increase in installed base, which included the effect of acquisitions completed in fiscal 2011 of $1.9. Consulting and training services increased by $2.4 for the three months ended April 30, 2011 compared to the three months ended April 30, 2010, primarily due to increased customer demand for services. The effect of acquisitions completed in fiscal 2011 for Consulting and training services for the three months ended April 30, 2011 compared to the three months ended April 30, 2010 was $0.9.

 

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Table of Contents

Geographic Revenues Information

Revenue by Geography

 

Three months ended April 30,

   2011      Change     2010  

North America

   $ 90.3         39   $ 65.1   

Europe

     52.2         23     42.6   

Japan

     41.6         31     31.7   

Pacific Rim

     45.9         11     41.2   
                   

Total revenues

   $ 230.0         27   $ 180.6   
                   

For the three months ended April 30, 2011, approximately one-fourth of European and all Japanese revenues were subject to exchange rate fluctuations as they were booked in local currencies. We recognize additional revenues in periods when the U.S. dollar weakens in value against foreign currencies. Likewise, we recognize lower revenues in periods when the U.S. dollar strengthens in value against foreign currencies.

Foreign currency had a favorable impact of $3.0 for the three months ended April 30, 2011 compared to the three months ended April 30, 2010 primarily due to the strengthening Japanese yen against the U.S. dollar.

For additional description of how changes in foreign exchange rates affect our condensed consolidated financial statements, see discussion in Part I, “Item 3. Quantitative and Qualitative Disclosures About Market Risk –Foreign Currency Risk.”

Operating Expenses

 

Three months ended April 30,

   2011     Change     2010  

Research and development

   $ 69.9        9   $ 64.1   

Marketing and selling

     76.4        4     73.6   

General and administration

     21.9        (3 %)      22.5   

Equity in earnings of Frontline

     (1.0     (400 %)      (0.2

Amortization of intangible assets

     1.6        (33 %)      2.4   

Special charges

     4.5        36     3.3   
                  

Total operating expenses

   $ 173.3        5   $ 165.7   
                  

Selected Operating Expenses as a Percentage of Total Revenues

 

Three months ended April 30,

   2011     2010  

Research and development

     30     36

Marketing and selling

     33     41

General and administration

     10     12
                

Total selected operating expenses

     73     89
                

Research and Development

Research and development expenses increased by $5.8 for the three months ended April 30, 2011 compared to the three months ended April 30, 2010. The components of this increase are summarized as follows:

 

     Change for the three
months ended April 30,
 

Salaries, variable compensation, and benefits expenses

   $ 4.3   

Expenses associated with acquired businesses

     2.4   

Other expenses

     (0.9
        

Total change in research and development expenses (1)

   $ 5.8   
        

 

(1) 

The increase in expense for the three months ended April 30, 2011 compared to the three months ended April 30, 2010 includes approximately $3.2, which reflects a change in estimate associated with the allocation of salaries and related costs of our Technical Marketing Engineers (TMEs). Previously all of these costs were allocated to marketing and selling. We further refined our estimate based on research and development activities performed by the TMEs which includes development, code writing and testing.

 

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Table of Contents

Marketing and Selling

Marketing and selling expenses increased by $2.8 for the three months ended April 30, 2011 compared to the three months ended April 30, 2010. The components of this increase are summarized as follows:

 

     Change for the three
months ended April 30,
 

Expenses associated with acquired businesses

   $ 2.4   

Travel expenses

     1.8   

Other expenses

     (1.4
        

Total change in marketing and selling expenses (1)

   $ 2.8   
        

 

(1) 

The increase in expense for the three months ended April 30, 2011 compared to the three months ended April 30, 2010 includes a reduction of approximately $(3.2), which reflects a change in estimate associated with the allocation of salaries and related costs of our Technical Marketing Engineers (TMEs). See additional discussion regarding the change in estimate in the Research and Development analysis above.

General and Administration

General and administration expenses decreased by $0.6 for the three months ended April 30, 2011 compared to the three months ended April 30, 2010. There were no significant changes within General and administration expenses for the three months ended April 30, 2011 compared to the three months ended April 30, 2010.

We incur a substantial portion of our operating expenses outside the U.S. in various foreign currencies. When currencies weaken against the U.S. dollar, our operating expense performance is positively affected and when currencies strengthen, our operating expense performance is adversely affected. For the three months ended April 30, 2011 compared to the three months ended April 30, 2010, we experienced unfavorable currency movements of approximately $2.1 in total operating expenses. The impact of these currency movements is reflected in the movements in operating expenses detailed above.

Equity in Earnings of Frontline

In connection with our acquisition of Valor Computerized Systems, Ltd. (Valor) on March 18, 2010, we acquired Valor’s 50% interest in a joint venture, Frontline P.C.B. Solutions Limited Partnership (Frontline). Frontline is owned equally by Valor and Orbotech, Ltd., an Israeli company.

 

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Table of Contents

Frontline reports on a calendar year basis. As such, we record our interest in the earnings or losses of Frontline in the subsequent month following incurrence. The following presents the summarized financial information of Mentor’s 50% interest in Frontline for the three months ended March 31, 2011 and for the period from March 18, 2010 through March 31, 2010:

 

     For the three
months ended
March 31, 2011
     For the period
from March 18,
2010 through
March 31, 2010
 

Net income-as reported

   $ 2.2       $ 0.8   

Amortization of purchased technology and other identified intangible assets

     1.2         0.6   
                 

Equity in earnings of Frontline

   $ 1.0       $ 0.2   
                 

Special Charges

 

Three months ended April 30,

   2011      Change     2010  

Employee severance and related costs

   $ 1.1         (31 %)    $ 1.6   

Excess leased facility costs

     0.3         (40 %)      0.5   

Other costs, net

     3.1         158     1.2   
                   

Total special charges

   $ 4.5         36   $ 3.3   
                   

Special charges primarily consist of costs incurred for employee terminations and were due to a reduction of personnel resources driven by modifications of business strategy or business emphasis. Special charges may also include expenses incurred related to potential acquisitions, excess facility costs, and asset-related charges.

Employee severance and related costs of $1.1 for the three months ended April 30, 2011 included severance benefits, notice pay, and outplacement services. The total rebalance charge represents the aggregate of numerous unrelated rebalance plans which impacted several employee groups, none of which was individually material to our financial position or results of operations. We determined termination benefit amounts based on employee status, years of service, and local statutory requirements. We communicated termination benefits to the affected employees prior to the end of the quarter in which we recorded the charge. Approximately 27% of the costs were paid during the three months ended April 30, 2011. We expect to pay the remainder during the fiscal year ending January 31, 2012. There have been no significant modifications to the amount of these charges.

Excess leased facility costs of $0.3 for the three months ended April 30, 2011 were primarily due to the abandonment of leased facilities.

Other special charges for the three months ended April 30, 2011 included costs of $3.1 related to consulting fees associated with our proxy contest.

Employee severance and related costs of $1.6 for the three months ended April 30, 2010 included severance benefits, notice pay, and outplacement services. The total rebalance charge represents the aggregate of numerous unrelated rebalance plans which impacted several employee groups, none of which were individually material to our financial position or results of operations. We determined termination benefit amounts based on employee status, years of service, and local legal requirements. We communicated termination benefits to the affected employees prior to the end of the quarter in which we recorded the charge. Substantially all of these costs were paid during the fiscal year ended January 31, 2011. There have been no significant modifications to the amount of these charges.

Excess leased facility costs of $0.5 for the three months ended April 30, 2010 were primarily due to the abandonment of leased facilities and changes in the estimate of sublease income for previously abandoned leased facilities.

Other special charges for the three months ended April 30, 2010 included costs of $1.2 related to advisory fees.

Interest Expense

Interest expense increased by $13.1 to $17.4 for the three months ended April 30, 2011 compared to $4.3 for the three months ended April 30, 2010. The increase was primarily due to the repayment of debt in April 2011 and the resulting losses of $11.5 on the early extinguishment of debt, which included a $6.2 write-off of the net unamortized debt discount, a $3.5 premium for the redemption of the 6.25% Debentures, and a write-off of $1.8 for the remaining portion of unamortized debt issuance costs.

 

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Other Expense, Net

 

Three months ended April 30,

   2011     Change     2010  

Interest income

   $ 0.5        67   $ 0.3   

Foreign currency exchange gain (loss)

     (0.6     —          (0.6

Other, net

     (0.4     50     (0.8
                  

Other expense, net

   $ (0.5     55   $ (1.1
                  

Provision for Income Taxes

Our income tax expense for the three months ended April 30, 2011 was $0.6 compared to $2.6 for the same period in 2010. Generally, the provision for income taxes is the result of the mix of profits and losses earned by us and our subsidiaries in tax jurisdictions with a broad range of income tax rates, withholding taxes (primarily in certain foreign jurisdictions), changes in tax reserves, and the application of valuation allowances on deferred tax assets. Accounting guidance requires that on a quarterly basis we evaluate our provision for income tax expense (benefit) of U.S. and non-U.S. jurisdictions based on our projected results of operations for the full year and record an adjustment in the current quarter.

The effective tax rate for the three months ended April 30, 2011 was (35%), compared to (13%) for the same period in 2010, inclusive of period specific items. Without period specific items of ($1.3), our effective tax rate is (112%). We anticipate income for the year, resulting in a projected 12% effective tax rate with the inclusion of period specific items. Our effective tax rate differs from tax computed at the U.S. federal statutory rate of 35% primarily due to:

 

   

The benefit of lower tax rates on earnings of foreign subsidiaries;

 

   

Reduction in reserves for uncertain foreign tax positions; and

 

   

The application of tax incentives for research and development in certain foreign jurisdictions;

These differences are partially offset by:

 

   

U.S. losses for which no tax benefit has been recognized;

 

   

Non-deductible employee stock purchase plan compensation expense; and

 

   

Withholding taxes in certain foreign jurisdictions.

We have not provided for income taxes on the undistributed earnings of our foreign subsidiaries to the extent they are considered permanently reinvested outside of the U.S. Upon repatriation, some of these earnings may be sheltered by U.S. loss carryforwards, research and development credits and foreign tax credits, which may reduce the federal tax liability associated with any future foreign dividend. Determination of the amount of unrecognized deferred U.S. income tax liability on permanently reinvested foreign earnings is not practicable. To the extent that the earnings of our foreign subsidiaries are not treated as permanently reinvested, which include earnings of certain countries, we have considered the impact in our provision.

We determined deferred tax assets and liabilities based on differences between the financial reporting and tax basis of assets and liabilities. In addition, we record deferred tax assets for net operating loss carryforwards and tax credit carryforwards. We calculated the deferred tax assets and liabilities using the enacted tax rates and laws that will be in effect when we expect the differences to reverse. A valuation allowance is recorded when it is more likely than not that all or some portion of the deferred tax asset will not be realized. Since 2004, we have determined it is uncertain whether our U.S. entity will generate sufficient taxable income and foreign source income to utilize net operating loss carryforwards, research and experimentation credit carryforwards, and foreign tax credit carryforwards before expiration. Accordingly, we recorded a valuation allowance against those deferred tax assets for which realization does not meet the more likely than not standard. We have established valuation allowances related to certain foreign deferred tax assets based on historical losses as well as future expectations in certain jurisdictions. We will continue to evaluate the realizability of the deferred tax assets on a periodic basis.

We are subject to income taxes in the U.S. and in numerous foreign jurisdictions. 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 varies from jurisdiction to jurisdiction. In some cases it may be extended or be unlimited. Furthermore, net operating loss and tax credit carryforwards may be subject to adjustment after the expiration of the statute of limitations of the year such net operating losses and tax credits originated. Our larger jurisdictions generally provide for a statute of limitations from three to five years. We are currently under examination in various jurisdictions. The examinations are in different stages and timing of their resolution is difficult to predict. For U.S. federal income tax purposes, the tax years that remain open are fiscal year 2008 and forward.

 

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We have reserves for taxes to address potential exposures involving tax positions that are being challenged or that could be challenged by taxing authorities even though we believe that the positions we have taken are appropriate. We believe our tax reserves are adequate to cover potential liabilities. We review the tax reserves quarterly and as circumstances warrant and adjust the reserves as events occur that affect our potential liability for additional taxes. It is often difficult to predict the final outcome or timing of resolution of any particular tax matter. Various events, some of which cannot be predicted, such as clarifications of tax law by administrative or judicial means, may occur and could require us to increase or decrease our reserves and effective tax rate. We expect to record additional reserves in future periods with respect to our tax filing positions. To the extent that uncertain tax positions resolve in our favor, it could have a positive impact on our effective tax rate.

LIQUIDITY AND CAPITAL RESOURCES

Our primary ongoing cash requirements are for product development, operating activities, capital expenditures, debt service, and acquisition opportunities that may arise. Our primary sources of liquidity are cash generated from operations and borrowings on our revolving credit facility.

As of April 30, 2011, we had cash and cash equivalents of $116.5. The available cash and cash equivalents are held in accounts managed by third-party financial institutions and consist of cash in our operating accounts.

Invested cash is held in interest bearing funds managed by third-party financial institutions. To date, we have experienced no loss or lack of access to our invested cash; however, we can provide no assurances that access to our cash and cash equivalents will not be impacted by adverse conditions in the financial markets.

At any point in time, we have significant balances in operating accounts that are with individual third-party financial institutions, which may exceed the Federal Deposit Insurance Corporation insurance limits or other regulatory insurance program limits. While we monitor daily the cash balances in our operating accounts and adjust the cash balances as appropriate, these cash balances could be impacted if the underlying financial institutions fail or are subject to other adverse conditions in the financial markets.

We anticipate that the following will be sufficient to meet our working capital needs on a short-term (twelve months or less) and a long-term (more than twelve months) basis:

 

   

Current cash balances;

 

   

Anticipated cash flows from operating activities, including the effects of selling and financing customer term receivables;

 

   

Amounts available under existing revolving credit facilities; and

 

   

Other available financing sources, such as the issuance of debt or equity securities.

We have experienced no difficulties to date in raising debt. However, capital markets have been volatile, and we cannot assure you that we will be able to raise debt or equity capital on acceptable terms, if at all.

 

Three months ended April 30,

   2011     2010  

Cash provided by (used in) operating activities

   $ (9.3   $ 27.6   

Cash used in investing activities

   $ (8.4   $ (17.4

Cash provided by (used in) financing activities

   $ 0.3      $ (9.6

Operating Activities

Cash flows from operating activities consist of our net income (loss), adjusted for certain non-cash items and changes in operating assets and liabilities. For the three months ended April 30, 2011, our cash used in operating activities was primarily driven by incentive payments made during the quarter on fiscal 2011 year-end accruals, as discussed below. Our cash flows from operating activities are also significantly influenced by the payment terms on our license agreements and by our sales of qualifying accounts receivable. Our customers’ inability to fulfill payment obligations could adversely affect our cash flow. Though we have not, to date, experienced a material level of defaults, material payment defaults by our customers as a result of negative economic conditions or otherwise could have a material adverse effect on our financial condition. We monitor our accounts receivable portfolio for customers with low or declining credit ratings and increase our collection efforts when necessary.

 

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Trade Accounts and Term Receivables

 

As of

   April 30,
2011
     January 31,
2011
 

Trade accounts receivable, net

   $ 321.0       $ 347.1   

Term receivables, long-term

   $ 179.0       $ 167.4   

Average days sales outstanding in short-term receivables

     126 days         102 days   

Average days sales outstanding in short-term receivable, net, excluding the current portion of term receivables

     54 days         45 days   

The increase in the average days sales outstanding in short-term receivables for the three months ended April 30, 2011 compared to the three months ended January 31, 2011 was due to a decrease in revenue in the first quarter of fiscal 2012 compared to the fourth quarter of fiscal 2011.

The current portion of term receivables was $182.0 as of April 30, 2011 and $193.3 as of January 31, 2011. Term receivables are attributable to multi-year term license sales agreements. We include amounts for term agreements that are due within one year in trade accounts receivable, net, and balances that are due in more than one year in term receivables, long-term. We use term agreements as a standard business practice and have a history of successfully collecting under the original payment terms without making concessions on payments, products, or services. Total term receivables were $361.0 as of April 30, 2011 compared to $360.8 as of January 31, 2011.

We enter into agreements to sell qualifying accounts receivable from time to time to certain financing institutions on a non-recourse basis. We received net proceeds from the sale of receivables of $11.4 for the three months ended April 30, 2011 compared to $14.9 for the three months ended April 30, 2010. We continue to have no difficulty in factoring receivables and continue to evaluate the economics of the sale of accounts receivable. We have not set a target for the sale of accounts receivables for the remainder of fiscal 2012.

Accrued Payroll and Related Liabilities

 

As of

   April 30,
2011
     January 31,
2011
 

Accrued payroll and related liabilities

   $ 58.6       $ 109.2   

The decrease in accrued payroll and related liabilities as of April 30, 2011 compared to January 31, 2010 was primarily due to incentive payments made during the quarter on fiscal 2011 year-end accruals. We generally experience higher accrued payroll and related liability balances at year end primarily due to increased commission accruals associated with an increase in revenues in the fourth quarter. Additionally, we generally experience an increase in variable compensation at year end which result from the full year achievement of results.

Deferred Revenue

 

As of

   April 30,
2011
     January 31,
2011
 

Deferred revenue

   $ 192.7       $ 185.4   

 

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The increase in deferred revenue is primarily due to the addition of short-term software leases and an increase in current billings of support revenue and other services during the quarter ended April 30, 2011.

Investing Activities

Cash used in investing activities for the three months ended April 30, 2011 primarily consisted of cash paid for capital expenditures.

Expenditures for property, plant, and equipment decreased to $6.3 for the three months ended April 30, 2011 compared to $7.6 for the three months ended April 30, 2010. The expenditures for property, plant, and equipment for the three months ended April 30, 2011 were primarily a result of spending on information technology and infrastructure improvements within facilities. We expect total capital expenditures for property, plant, and equipment for fiscal 2012 to be approximately $50.0. We plan to finance our investments in property, plant, and equipment using cash on hand or borrowings on the revolving credit facility.

During the three months ended April 30, 2011, we acquired one privately held company. We plan to finance future business acquisitions through a combination of cash and common stock issuances. The cash expected to be utilized includes cash on hand, cash generated from operating activities, and borrowings on the revolving credit facility.

Financing Activities

For the three months ended April 30, 2011, cash provided by financing activities consisted primarily of proceeds from the issuance of the 4.00% Convertible Subordinated Debentures (4.00% Debentures) due 2031, offset in part by the redemption of the 6.25% Convertible Subordinated Debentures (6.25% Debentures) due 2026. Additional discussion regarding these notes payable are presented in the section below.

In April 2011, we announced a share repurchase program under which we may purchase up to $150.0 of our common stock over the three-year period through April 2014. During the three months ended April 30, 2011, we repurchased 1.7 shares of common stock for a total price of $25.0 utilizing proceeds received from the issuance of the 4.00% Debentures. Under the terms of our revolving credit facility, the amount we can repurchase under the remaining $125.0 of our share repurchase program is limited to $50.0 plus 70% of our cumulative net income for periods after January 31, 2011.

Other factors affecting liquidity and capital resources

4.00% Debentures due 2031

In April 2011, we issued $253,000 of the 4.00% Debentures. Interest on the 4.00% Debentures due 2031 is payable semi-annually in April and October. The 4.00% Debentures are convertible, under certain circumstances, into our common stock at a conversion price of $20.538 per share for a total of 12.3 shares as of April 30, 2011. Upon conversion of any 4.00% Debentures, a holder will receive:

 

  (i) Cash up to the principal amount of the 4.00% Debentures that are converted; and

 

  (ii) Cash or shares of common stock, at our election, for the excess, if any, of the value of the converted shares over the principal amount.

If a holder elects to convert their 4.00% Debentures in connection with a fundamental change in the company that occurs prior to April 5, 2016, the holder will also be entitled to receive a make whole premium upon conversion in some circumstances.

We may redeem some or all of the 4.00% Debentures for cash on or after April 5, 2016 at the following redemption prices expressed as a percentage of principal, plus any accrued and unpaid interest:

 

Period

   Redemption Price  

Beginning on April 5, 2016 and ending on March 31, 2017

     101.143

Beginning on April 1, 2017 and ending on March 31, 2018

     100.571

On April 1, 2018 and thereafter

     100.000

The holders, at their option, may redeem the 4.00% Debentures in whole or in part for cash on April 1, 2018, April 1, 2021, and April 1, 2026, and in the event of a fundamental change in the company. In each case, the repurchase price will be 100% of the principal amount of the 4.00% Debentures plus any accrued and unpaid interest.

6.25% Debentures due 2026

Interest on the 6.25% Debentures was payable semi-annually in March and September. During April 2011, we redeemed the remaining $196.5 principal amount of the 6.25% Debentures utilizing proceeds received from the issuance of the 4.00% Debentures and cash on hand. In connection with this redemption, during the three months ended April 30, 2011, we

 

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incurred a before tax net loss on the early extinguishment of debt of $11.2, which included a $6.2 write-off of the net unamortized debt discount, a $3.5 premium on the redemption of the 6.25% Debentures, and a write-off of $1.5 for the remaining portion of unamortized debt issuance costs. No balance remains outstanding following this redemption.

Term Loan due 2013

In April 2010, we entered into a three-year term loan (Term Loan) to repay borrowings under our revolving credit facility used to purchase office buildings in Fremont, California. A fixed principal amount of $0.5 and interest payments were payable quarterly in February, May, August, and November.

In April 2011, we repaid the remaining $18.5 utilizing proceeds received from the issuance of the 4.00% Debentures. No balance remains outstanding following this repayment.

For further information on the 4.00% Debentures, 6.25% Debentures, and the Term Loan, see Note 8. “Notes Payable” in Part I, Item 1. “Financial Statements.”

Revolving Credit Facility

In April 2011, we entered into a syndicated, senior, unsecured, four-year revolving credit facility with a maximum borrowing capacity of $125.0. We have the option to pay interest on this revolving credit facility based on:

 

  (i) London Interbank Offered Rate (LIBOR) with varying maturities which are commensurate with the borrowing period we select, plus a spread of between 2.25% and 3.25% based on a pricing grid tied to a financial covenant; or

 

  (ii) A base rate plus a spread of between 1.25% and 2.25%, based on a pricing grid tied to a financial covenant.

The base rate is defined as the highest of:

 

  (i) The federal funds rate, as defined, plus 0.5%;

 

  (ii) The prime rate of the lead bank; or

 

  (iii) One-month LIBOR plus 1.0%.

As a result of these interest rate options, our interest expense associated with borrowings under this revolving credit facility will vary with market interest rates. In addition, commitment fees are payable on the unused portion of the revolving credit facility at rates between 0.40% and 0.50% based on a pricing grid tied to a financial covenant.

We had no borrowings against the revolving credit facility during the three months ended April 30, 2011. The base interest rate was 4.50% as of April 30, 2011.

For further information on our revolving credit facility, see Note 7. “Short-Term Borrowings” in Part I, Item 1. “Financial Statements.”

OFF-BALANCE SHEET ARRANGEMENTS

We do not have off-balance sheet arrangements, financings, or other similar relationships with unconsolidated entities or other persons, also known as special purpose entities. In the ordinary course of business, we lease certain real properties, primarily field sales offices, research and development facilities, and equipment.

OUTLOOK FOR FISCAL 2012

We expect revenues for the second quarter of fiscal 2012 to be approximately $210 with loss per share for the same period of approximately $(0.05) per diluted share. For the full fiscal year 2012, we expect revenues of approximately $1,004 with earnings per share of $0.67 per diluted share.

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Unless otherwise indicated, all numerical references in tables are in millions, except interest rates and contract rates.

Interest Rate Risk

We are exposed to interest rate risk primarily through our investment portfolio, short-term borrowings, and notes payable. We do not use derivative financial instruments for speculative or trading purposes.

We place our investments in instruments that meet high quality credit standards, as specified in our investment policy. The policy also limits the amount of credit exposure to any one issuer and type of instrument. We do not expect any material loss with respect to our investment portfolio.

The table below presents the carrying amount and related weighted-average fixed interest rates for our investment portfolio. The carrying amount approximates fair value as of April 30, 2011. In accordance with our investment policy, all short-term investments mature in twelve months or less.

 

Principal (notional) amounts in United States dollars

   Carrying
Amount
     Average Fixed
Interest Rate
 

Cash equivalents – fixed rate

   $ 6.0         0.01

We had convertible subordinated debentures with a principal balance of $253.0 outstanding with a fixed interest rate of 4.00% as of April 30, 2011 compared to a principal balance of $165.0 with a fixed interest rate of 6.25% as of April 30, 2010. Interest rate changes for fixed rate debt affect the fair value of the debentures but do not affect future earnings or cash flow.

As of April 30, 2011, we had a syndicated, senior, unsecured, revolving credit facility, which expires on April 27, 2015. Borrowings under the revolving credit facility are permitted to a maximum of $125.0. Under this revolving credit facility, we have the option to pay interest based on:

 

  (i) LIBOR with varying maturities which are commensurate with the borrowing period we select, plus a spread of between 2.25% and 3.25%; or

 

  (ii) A base rate plus a spread of between 1.25% and 2.25%, based on a pricing grid tied to a financial covenant.

The base rate is defined as the highest of:

 

  (i) The federal funds rate, as defined, plus 0.5%;

 

  (ii) The prime rate of the lead bank; or

 

  (iii) One-month LIBOR plus 1.0%.

As a result of these interest rate options, our interest expense associated with borrowings under this revolving credit facility will vary with market interest rates. This revolving credit facility contains certain financial and other covenants, including financial covenants requiring the maintenance of specified liquidity ratios, leverage ratios, and minimum tangible net worth as well as restrictions on the payment of dividends. As of April 30, 2011 and 2010, we had no balance outstanding against this revolving credit facility. Interest rate changes for variable interest rate debt generally do not affect the fair market value, but do affect future earnings and cash flow. For further information on our revolving credit facility, see Note 7. “Short-Term Borrowings” in Part I, Item 1. “Financial Statements.”

We had other short-term borrowings of $4.9 outstanding as of April 30, 2011 and $4.3 as of April 30, 2010 with variable rates based on market indexes. Interest rate changes for variable interest rate debt generally do not affect the fair market value, but do affect future earnings and cash flow.

If the interest rates as of April 30, 2011 on the above variable rate borrowings were to increase or decrease by 1% and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by approximately $0.1.

Foreign Currency Risk

We transact business in various foreign currencies and have established a foreign currency hedging program to hedge certain foreign currency forecasted transactions and exposures from existing assets and liabilities. Our derivative instruments consist of short-term foreign currency exchange contracts, with a duration period of a year or less. We enter into contracts with counterparties who are major financial institutions and, as such we do not expect material losses as a result of defaults by our counterparties. We do not hold or issue derivative financial instruments for speculative or trading purposes.

 

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We enter into foreign currency forward contracts to protect against currency exchange risk associated with expected future cash flows. Our practice is to hedge a majority of our existing material foreign currency transaction exposures, which generally represent the excess of expected euro and British pound denominated expenses over expected euro and British pound denominated revenues, and the excess of Japanese yen denominated revenue over expected Japanese yen denominated expenses. We also enter into foreign currency forward contracts to protect against currency exchange risk associated with existing assets and liabilities.

The following table provides volume information about our foreign currency forward program. The information provided is in U.S. dollar equivalent amounts. The table presents the gross notional amounts, at contract exchange rates, and the weighted average contractual foreign currency exchange rates. These forward contracts mature within the next twelve months.

 

As of

   April 30, 2011      January 31, 2011  
     Gross
Notional
Amount
     Weighted
Average
Contract Rate
     Gross
Notional
Amount
     Weighted
Average
Contract Rate
 

Forward Contracts:

           

Japanese yen

   $ 44.3         82.71       $ 99.6         82.99   

Euro

     15.7         0.72         40.7         0.75   

Indian rupee

     12.2         44.49         12.1         45.78   

Swedish krona

     11.3         6.32         12.9         6.65   

Canadian dollar

     10.1         0.97         8.4         0.99   

British pound

     8.8         0.62         13.3         0.63   

Other (1)

     24.3         —           22.6         —     
                       

Total forward contracts

   $ 126.7          $ 209.6      
                       

 

(1)

Other includes 11 currencies which are the Taiwan dollar, Korean won, Israeli shekel, Danish kroner, Hungarian forints, Russian ruble, Polish zloty, Chinese yuan, Swiss franc, Norwegian kroner, and Singapore dollars.

 

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Item 4. Controls and Procedures

(1) Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (Exchange Act), that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of the end of the period covered by this report.

(2) Changes in Internal Controls Over Financial Reporting

There has been no change in our internal control over financial reporting that occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1A. Risk Factors

The forward-looking statements contained under “Outlook for Fiscal 2012” in Part I, Item 2, “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. Moreover, from time to time, we may issue other forward-looking statements. Forward-looking statements regarding financial performance in future periods, including the statements under “Outlook for Fiscal 2012,” 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. Our business faces many risks, and set forth below are some of the 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 (U.S.) and international economies may harm our business.

Our revenue levels are generally dependent on the level of technology capital spending, which includes worldwide expenditures for electronic design automation (EDA) software, hardware, and consulting services. Periods of economic uncertainty, such as the recession experienced in 2008 and much of 2009, can adversely affect our customers and postpone decisions to license or purchase our products, decrease our customers’ spending, and jeopardize or delay our customers’ ability or willingness to make payment obligations, any of which could adversely affect our business.

Our forecasts of our revenues and earnings outlook may be inaccurate.

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 fiscal quarter attempting to obtain more favorable terms. This may result in failure to agree to terms within the fiscal quarter and cause expected revenue to slip into a subsequent quarter.

Our business could be impacted by fluctuations in quarterly results of operations due to customer seasonal purchasing patterns, the timing of significant orders, and the mix of licenses and products purchased by our customers.

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 typically 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. If planned contract renewals are delayed or the average size of renewed contracts do not increase as we anticipate, we could fail to meet our and investors’ expectations, which could have a material adverse impact on our stock price.

Our revenues are also affected by the mix of licenses entered into where we recognize software revenues as payments become due and payable, on a cash basis, 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, for instance, when the customer is provided with rights to unspecified or unreleased future products. A shift in the license mix toward increased ratable, due and payable, and/or cash-based revenue recognition could result in increased deferral of software revenues to future periods and would decrease current revenues, which could result in us not meeting near-term revenue expectations.

The gross margin on our software is greater than that for our emulation hardware systems, software support, and professional services. Therefore, our gross margin may vary as a result of the mix of products and services 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 relatively large negative effect on resulting earnings. If anticipated revenues do not materialize as expected, our gross margins and operating results could be materially adversely impacted.

 

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We face intense price competition in the EDA industry.

Price 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 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 certain software products at low prices for promotional purposes or as a long-term pricing strategy. These practices could significantly reduce demand for our products or limit prices we can charge.

We currently compete primarily with two large companies: Synopsys, Inc. and Cadence Design Systems, Inc. We also compete with smaller companies and compete with manufacturers of electronic devices that have developed their own EDA products internally. Some large customers may also develop internal tools, thereby reducing demand for our products.

Foreign currency fluctuations may have an adverse impact on our operating results.

We typically generate about half of our revenues from customers outside the U.S. and we generate approximately one-third of our expenses outside the U.S. While most of our international sales are denominated in U.S. dollars, our international operating expenses are typically denominated in foreign currencies. Significant changes in currency exchange rates, particularly in the Japanese yen, euro, and the British pound, could have an adverse impact on our operating results.

Our international operations involve risks that could increase our expenses, adversely affect our operating results, and require increased time and attention of our management.

Our international operations subject us to risks in addition to those we face in our domestic operations, including longer receivables collection periods, changes in a specific country’s or region’s economic or political conditions, trade protection measures, local labor laws, import or export licensing requirements, anti-corruption and other similar laws, loss or modification of exemptions for taxes and tariffs, limitations on repatriation of earnings, and difficulties with licensing and protecting our intellectual property rights. If we violate applicable laws related to our business, we could be subject to penalties, fines, or other sanctions and could be prohibited or limited from doing business in one or more countries.

We derive a substantial portion of our revenues from relatively few product groups.

We derive a substantial portion of our revenues from sales of relatively few product groups and related support services. As a result, any factor adversely affecting sales of these products, including the product release cycles, market acceptance, product competition, performance and reliability, reputation, price competition, and economic and market conditions, could harm our operating results.

We are subject to the cyclical nature of the integrated circuit (IC) and electronics systems industries.

Purchases of our products and services are highly dependent upon new design projects initiated by customers in the 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 increasing complexity of ICs and resulting increase in costs to design and manufacture ICs have in recent years led to fewer design starts, which could cause a reduced demand for our products. In addition, the IC and electronics systems industries regularly experience significant downturns, often connected with, or in anticipation of, maturing product cycles within such companies or decline in general economic conditions. These downturns could cause diminished demand for our products and services.

Shortages of components for our hardware products may delay or reduce our sales and increase our costs.

The inability to obtain sufficient quantities of components and other materials necessary for the production of our hardware products could result in reduced or delayed sales or lost orders. Any delay in or loss of sales could adversely impact our operating results. From time to time, materials and components used in our production or in other aspects of our customers’ products may become subject to allocation because of shortages of these materials and components. Future shortages of materials and components, including potential supply constraints of silicon, could cause delayed shipments, customer dissatisfaction, and lower revenue.

Customer payment defaults could adversely affect our timing of revenue recognition.

We use fixed-term license agreements as standard business practices with customers we believe are creditworthy. These multi-year, multi-element term license agreements have payments spread over the license term and are typically about three years in length for semiconductor companies and about four years in length for military and aerospace companies. The complexity of these agreements tends to increase the risk associated with collectibility from customers that can arise for a

 

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variety of reasons including ability to pay, product dissatisfaction, and disputes. If we are unable to collect under these agreements, our results of operations could be materially adversely impacted. We use these fixed-term license agreements as a standard business practice and have 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 the terms of the agreements, then revenue would be required to be recognized under U.S. generally accepted accounting principles as the payments become due and payable over the license term. This change could have a material adverse impact on our near-term results.

IC and printed circuit board (PCB) technology evolves rapidly.

The complexity of ICs and PCBs continues to rapidly increase. In response to this increasing complexity, new design tools and methodologies must be invented or acquired quickly to remain competitive. If we fail to quickly respond to new technological developments, our products could become obsolete or uncompetitive, which could materially adversely impact our business.

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 products or systems designed with or manufactured using tools that 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 support or service costs.

In addition, we include limited amounts of third-party technology in our products and we rely on those third parties to provide support services to us. Failure of those third parties to provide necessary support services could materially adversely impact our business.

Long sales cycles and delay in customer completion of projects make the timing of our revenues difficult to predict.

We have a lengthy sales cycle. 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 is sometimes discretionary and may be delayed if customers delay approval or commencement of projects due to 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 harm our business.

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 have a large percentage of sales in the physical verification segment of the market while another may 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 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.

Accounting rules governing revenue recognition are complex and may change.

The accounting rules governing software revenue recognition are complex and have been subject to authoritative interpretations that have generally made it more difficult to recognize software revenues at the beginning of the license period.

 

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We may have additional tax liabilities.

Significant judgments and estimates are required in determining the provision for income taxes and other tax liabilities. Our tax expense may be impacted if our intercompany transactions, which are required to be computed on an arm’s-length basis, are challenged and successfully disputed by the tax authorities. Also, our tax expense could be impacted depending on the applicability of withholding taxes on software licenses and related intercompany transactions in certain jurisdictions. In determining the adequacy of income taxes, we assess the likelihood of adverse outcomes resulting from the Internal Revenue Service (IRS) and other tax authorities’ examinations. The tax authorities in the U.S. and its various states and in countries where we do business regularly examine our tax returns. The ultimate outcome of these examinations cannot be predicted with certainty. Should the 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.

Forecasting our income tax rate is complex and subject to uncertainty.

The computation of income tax expense (benefit) is complex as it is based on the laws of numerous taxing jurisdictions and requires significant judgment on the application of complicated rules governing accounting for tax provision under U.S. generally accepted accounting principles. Income tax expense (benefit) for interim quarters is based on a forecast of our U.S. and non-U.S. effective tax rates for the year, which includes forward looking financial projections, including the expectations of profit and loss by jurisdiction, and contains numerous assumptions. Various items cannot be accurately forecasted, and may be treated as discrete accounting. Examples of items which could cause variability in the rate include tax deductions for stock option expense, application of transfer pricing rules, and changes in our valuation allowance for deferred tax assets. Future events, such as changes in our business and the tax law in the jurisdictions where we do business, could also affect our U.S. and non-U.S. effective rates. For these reasons, our overall global tax rate may be materially different than our forecast.

There are limitations on the effectiveness of controls.

We do not expect that disclosure controls or internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’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.

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 result in a successful product offering because of either a change in market conditions or a failure to successfully develop products based on that research and development activity. As a result, we could realize little or no revenues related to our investment in research and development.

We may acquire other companies and may not successfully integrate them.

The industry in which we compete has experienced 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 completed transaction will result in long-term benefits to us or our shareholders or that we 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 ongoing business when integrating 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;

 

   

Unanticipated liabilities or litigation in connection with or as a result of an acquisition, including claims from terminated employees, customers, or third parties;

 

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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 could 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.

We may not adequately protect our proprietary rights or we may fail to obtain software or other intellectual property licenses.

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 industry, are obtaining patents at a rapid rate. We cannot predict if any of these patents will cover any of our products. In addition, 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 U.S. law protects these rights in the U.S.

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. Failure to obtain software or other intellectual property licenses or rights from third parties on favorable terms could materially adversely impact us.

Our use of open source software could negatively impact our ability to sell our products and may subject us to unanticipated obligations.

The products, services or technologies we acquire, license, provide or develop may incorporate or use open source software. We monitor our use of open source software in an effort to avoid unintended consequences, such as reciprocal license grants, patent retaliation clauses, and the requirement to license our products at no cost. Nevertheless, we may be subject to unanticipated obligations regarding our products which incorporate open source software.

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. Our failure to hire and retain such personnel could impair our ability to develop new products and manage our business effectively.

We have global sales and research and development offices in parts of the world that are not as politically stable as the United States.

We have global sales and research and development offices, some of which are in parts of the world that are not as politically stable as the United States. In particular our offices in Egypt and Pakistan may be subject to disruption or closure from time to time. As a result, we may face a greater risk of business interruption as a result of potential unrest, terrorist acts, or military conflicts than businesses located domestically.

Oregon law and our shareholder rights plan may have anti-takeover effects.

The Oregon Business Combination Act limits the ability of parties who acquire a significant amount of voting stock to exercise control over us. This provision may have the effect of lengthening the time required to acquire control of us through a proxy contest or the election of a majority of the Board of Directors. In June 2010, 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 provisions of the Oregon Business Combination Act and our shareholder rights plan could have the effect of delaying, deferring, or preventing a change of control of us, could discourage bids for our common stock at a premium over the market price of our common stock and could materially adversely impact the market price of, and the voting and other rights of the holders of, our common stock.

 

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Our revolving credit facility has financial and non-financial covenants, and default of any covenant could materially adversely impact us.

Our bank revolving credit facility imposes operating restrictions on us in the form of financial and non-financial covenants. Financial covenants include adjusted quick ratio, tangible net worth, leverage ratio, senior leverage ratio, and minimum cash and accounts receivable ratio. If we were to fail to comply with the financial covenants and did not obtain a waiver from our lenders, we would be in default under the revolving credit facility and our lenders could terminate the facility and demand immediate repayment of all outstanding loans under the revolving credit facility. The declaration of an event of default could have a material adverse effect on our financial condition. We could also find it difficult to obtain other bank lines or credit facilities on comparable terms.

We have a substantial level of indebtedness.

As of April 30, 2011, we had $263.4 million of outstanding indebtedness, which includes $253.0 million of 4.00% Convertible Subordinated Debentures (4.00% Debentures) due 2031, $1.3 in other notes payable, and $9.1 million in short-term borrowings. 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; and

 

   

Place us at a possible competitive disadvantage relative to less leveraged competitors and competitors that have greater access to capital resources.

We may also be unable to borrow funds as a result of an inability of financial institutions to lend due to restrictive lending policies and/or institutional liquidity concerns.

If we experience a decline in revenues, 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.

Our stock price could become more volatile, and your investment could lose value.

All of the factors discussed in this “Risk Factors” section could affect our stock price. The timing of announcements in the public market regarding new products, product enhancements, or technological advances by our competitors or us, and any announcements by us of acquisitions, major transactions, or management changes could also affect our stock price. Our stock price is subject to speculation in the press and the analyst community, changes in recommendations or earnings estimates by financial analysts, changes in investors’ or analysts’ valuation measures for our stock, our credit ratings, and market trends unrelated to our performance. A significant drop in our stock price could also expose us to the risk of securities class actions lawsuits, which could result in substantial costs and divert management’s attention and resources, which could adversely affect our business.

Our business could be negatively affected as a result of actions of activist shareholders.

Responding to actions by activist shareholders can be costly and time-consuming, disrupting our operations and diverting the attention of management and our employees. The perceived uncertainties as to our future direction may result in the loss of potential business opportunities, and may make it more difficult to attract and retain qualified personnel and business partners.

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The table below sets forth information regarding repurchases of our common stock by us during the three months ended April 30, 2011:

 

Period

   Total number
of shares
purchased
     Average price
paid per share
     Total number of
shares purchased as
part of publicly
announced

programs (a)
     Maximum dollar value
of shares that may

yet be purchased
under the programs
 

February 01 - February 28, 2011

     —           —           —           —     

March 01 - March 31, 2011

     —           —           —           —     

April 01 - April 30, 2011

     1,704,000       $ 14.67         —         $ 150,000,000   
                             

Total

     1,704,000       $ 14.67         —        
                             

 

(a) 

Shares repurchased during April 2011 were acquired in open-market transactions using proceeds from our issuance of 4.00% Debentures.

On April 18, 2011, we announced a share repurchase program approved by our Board of Directors under which we are authorized to purchase up to $150.0 million of our common stock over a three year period. As of April 30, 2011, no shares have been repurchased under this program.

 

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Item 6. Exhibits

 

  31.1    Certification of Chief Executive Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  31.2    Certification of Chief Financial Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
  32    Certifications of Chief Executive Officer and Chief Financial Officer of Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS    XBRL Instance Document
101.SCH    XBRL Taxonomy Extension Schema Document
101.CAL    XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF    XBRL Taxonomy Extension Definition Linkbase Document
101.LAB    XBRL Taxonomy Extension Label Linkbase Document
101.PRE    XBRL Taxonomy Extension Presentation Linkbase Document

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Dated: June 7, 2011    

MENTOR GRAPHICS CORPORATION

(Registrant)

    /S/ GREGORY K. HINCKLEY
    Gregory K. Hinckley
    President, Chief Financial Officer

 

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