Synopsys 10-Q 2009
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FOR THE QUARTERLY PERIOD ENDED JANUARY 31, 2009
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 0-19807
(Exact name of registrant as specified in its charter)
700 EAST MIDDLEFIELD ROAD
(Address of principal executive offices, including zip code)
(Registrants telephone number, including area code)
Indicate by check mark whether the registrant (l) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
As of March 6, 2009, there were 143,436,108 shares of the registrants common stock outstanding.
QUARTERLY REPORT ON FORM 10-Q
FOR THE FISCAL QUARTER ENDED JANUARY 31, 2009
(in thousands, except par value amounts)
See accompanying notes to unaudited condensed consolidated financial statements.
(in thousands, except per share amounts)
See accompanying notes to unaudited condensed consolidated financial statements.
See accompanying notes to unaudited condensed consolidated financial statements.
Note 1. Description of Business
Synopsys, Inc. (Synopsys or the Company) is a world leader in electronic design automation (EDA), supplying the global electronics market with software, intellectual property (IP) and services used in semiconductor design and manufacturing. The Company delivers technology-leading semiconductor design and verification platforms and integrated circuit (IC) manufacturing related products to the global electronics market, enabling the development and production of complex systems-on-chips (SoCs). In addition, the Company provides IP, system-level solutions and design services to simplify the design process and accelerate time-to-market for our customers, and software and services that help customers prepare and optimize their designs for manufacturing.
Note 2. Summary of Significant Accounting Policies
The Company has prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Pursuant to these rules and regulations, the Company has condensed or omitted certain information and footnote disclosures it normally includes in its annual consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP). In managements opinion, the Company has made all adjustments (consisting only of normal, recurring adjustments, except as otherwise indicated) necessary to fairly present its financial position, results of operations and cash flows. The Companys interim period operating results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and notes thereto in Synopsys Annual Report on Form 10-K for the fiscal year ended October 31, 2008 filed with the SEC on December 22, 2008.
To prepare financial statements in conformity with GAAP, management must make estimates and assumptions that affect the amounts reported in the unaudited condensed consolidated financial statements and accompanying notes. Actual results could differ from these estimates and may result in material effects on the Companys operating results and financial position.
Principles of Consolidation. The consolidated financial statements include the accounts of the Company and all of its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Fiscal Year End. The Company has adopted a fiscal year ending on the Saturday nearest to October 31. The Companys first fiscal quarter ended on January 31, 2009. Fiscal 2009 is a 52-week fiscal year. For presentation purposes, the unaudited condensed consolidated financial statements and accompanying notes refer to the applicable calendar month end.
Note 3. Fair Value Measurements of Financial Assets and Liabilities
Effective November 1, 2008, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements (SFAS 157), which defines fair value, establishes guidelines and enhances disclosures for fair value measurements. In February 2008, the Financial Accounting Standards Board (FASB) issued Staff Position (FSP) FSP 157-2, Effective Date of FASB Statement No. 157 (FSP 157-2). FSP 157-2 delays the effective date of SFAS 157 for all non-financial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis, until the Companys fiscal year 2010. SFAS 157 clarifies the definition of fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In addition to defining fair value, SFAS 157 establishes a three-tier fair value hierarchy that encourages the use of observable inputs but allows for unobservable inputs when observable inputs do not exist:
Level 1Observable inputs that reflect quoted prices (unadjusted) for identical instruments in active markets;
Level 2Observable inputs other than quoted prices included in Level 1 for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-driven valuations in which all significant inputs and significant value drivers are observable in active markets; and
Level 3Unobservable inputs to the valuation derived from fair valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. In accordance with SFAS 157, the Companys cash equivalents, short-term investments, and marketable equity security are classified within Level 1 or Level 2. These classifications are based on the
fact that cash equivalents and marketable securities are valued using quoted market prices in an active market or alternative pricing sources and models utilizing market observable inputs.
The Companys foreign currency derivative contracts are classified within Level 2 as the valuation inputs are based on quoted prices and market observable data of similar instruments.
The Companys deferred compensation plan assets and liabilities are classified within Level 2 as the inputs to measure the fair value are only indirectly observable. The deferred compensation plan assets and liabilities consist of mutual funds invested in domestic and international marketable securities.
The Companys strategic investments in privately held companies are classified within Level 3 as most of the inputs used to value the investments are unobservable.
Assets/Liabilities Measured at Fair Value on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis are summarized below as of January 31, 2009:
(1) In the first quarter of fiscal 2009, the Company recorded $0.9 million of other-than-temporary impairment charges in other income, net, due to the decline of the stock price of a public company in our long-term investment portfolio.
Assets/Liabilities Measured at Fair Value on a Non-recurring Basis
Equity investments in privately-held companies are accounted for under the cost method of accounting. These equity investments (also called non-marketable equity investments) are classified within Level 3 as they are valued using unobservable data or data in an inactive market. The Company evaluates the fair value of each investment when an event or circumstance indicates an other-than-temporary decline in value has occurred. In the first quarter of fiscal 2009, the Company determined one investment had impairment indicators and thus calculated the fair value of this investment by determining what a willing buyer would pay to purchase the investment using a financial model based on business enterprise value and calculating its liquidity preference. The inputs to the financial model were based on cash flow projections. As a result of the fair value measurement, the Company recorded $2.1 million of other-than-temporary impairment charges on the investment in other (loss) income, net, on the unaudited condensed consolidated statement of operations in the first quarter of fiscal 2009.
The following table presents the balance of assets and liabilities measured at fair value on a non-recurring basis as of January 31, 2009, and losses recorded during the three months ended January 31, 2009:
Effective January 1, 2009, the Company also adopted SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities including an Amendment of FASB Statement No. 115. Under this statement, entities may choose to measure certain financial instruments and liabilities at fair value on a contract-by-contract basis, with changes in fair value recognized in earnings. As of January 31, 2009, the Company did not elect such option for its financial instruments and liabilities.
Note 4. Business Combinations
On December 18, 2008, the Company acquired the assets of a business for cash and incurred acquisition related costs. The Company preliminarily allocated the total purchase consideration to the assets and liabilities acquired, including identifiable intangible assets, based on their respective fair values at the acquisition date, resulting in goodwill of $19.8 million, in process research and development expense of $0.6 million, and identifiable intangible assets of $6.9 million. The intangible assets are being amortized over one to six years. Goodwill, which is deductible for tax purposes, represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired and will not be amortized.
During the first quarter of fiscal 2009, the Company paid $1.2 million for achievement of certain product milestones related to a prior acquisition. This payment was recorded as an adjustment to goodwill in the prior year.
Note 5. Goodwill and Intangible Assets
Goodwill as of January 31, 2009 consisted of the following:
(1) Addition relates to an acquisition of assets of a business in the first quarter fiscal of 2009 as described in Note 4.
(2) Adjustments relate to reduction of merger costs and income tax adjustments for prior year acquisitions.
Intangible assets as of January 31, 2009 consisted of the following:
Intangible assets as of October 31, 2008 consisted of the following:
Amortization expense related to intangible assets consisted of the following:
(1) Amortization of capitalized software development costs is included in cost of license revenue in the unaudited condensed consolidated statements of operations.
The following table presents the estimated future amortization of intangible assets:
Note 6. Accounts Payable and Accrued Liabilities
Accounts payable and accrued liabilities consisted of the following:
Note 7. Credit Facility
On October 20, 2006, the Company entered into a five-year, $300.0 million senior unsecured revolving credit facility providing for loans to the Company and certain of its foreign subsidiaries. The amount of the facility may be increased by up to an additional $150.0 million through the fourth year of the facility. The facility contains financial covenants requiring the Company to maintain a minimum leverage ratio and specified levels of cash, as well as other non-financial covenants. The facility terminates on October 20, 2011. Borrowings under the facility bear interest at the greater of the administrative agents prime rate or the federal funds rate plus 0.50%; however, the Company has the option to pay interest based on the outstanding amount at Eurodollar rates plus a spread between 0.50% and 0.70% based on a pricing grid tied to a financial covenant. In addition, commitment fees are payable on the facility at rates between 0.125% and 0.175% per year based on a pricing grid tied to a financial covenant. As of January 31, 2009, the Company had no outstanding borrowings under this credit facility and was in compliance with all the covenants.
Note 8. Comprehensive Income
The following table presents the components of comprehensive income:
Note 9. Stock Repurchase Program
The Company is authorized to purchase up to $500.0 million of its common stock under a stock repurchase program originally established by the Companys Board of Directors (Board) in December 2004 and replenished to $500.0 million in March 2007. The Company repurchases shares to offset dilution caused by ongoing stock issuances from existing plans for equity compensation awards, acquisitions, and when management believes it is a good use of cash. Repurchases are transacted in accordance with Rule 10b-18 under the Securities Exchange Act of 1934 (Exchange Act) through open market purchases, plans executed under Rule 10b5-1 under the Exchange Act and structured transactions.
There were no stock repurchases during the three months ended January 31, 2009. During the three months ended January 31, 2008, the Company purchased 3.4 million shares at an average price of $24.27 per share for an aggregate purchase price of $82.9 million. During the three months ended January 31, 2009 and 2008, approximately 0.2 million and 0.7 million shares were reissued, respectively, for employee share-based compensation requirements. As of January 31, 2009, $209.7 million remained available for future purchases under the program.
Note 10. Share-based Compensation
The Company uses the Black-Scholes option-pricing model to determine the fair value of stock options and employee stock purchase plan awards under SFAS No. 123 (Revised 2004), Share-Based Payment, (SFAS123(R)). The Black-Scholes option-pricing model incorporates various subjective assumptions including expected volatility, expected term and interest rates. The expected volatility for both stock options and employee stock purchase plan (ESPP) is estimated by a combination of implied volatility for publicly traded options of the Companys stock with a term of six months or longer and the historical stock price volatility over the estimated expected term of the Companys share-based awards. The expected term of the Companys share-based awards is based on historical experience.
As of January 31, 2009, there was $93.2 million of unamortized share-based compensation expense which is expected to be amortized over a weighted-average period of approximately 3.3 years. The intrinsic values of options exercised during the three months ended January 31, 2009 and 2008, were $0.2 million and $5.1 million, respectively.
The compensation cost recognized in the unaudited condensed consolidated statements of operations for these share-based compensation arrangements was as follows for the first quarters of fiscal years 2009 and 2008:
Note 11. Net Income per Share
The Company computes basic income per share by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted net income per share reflects the dilution of potential common shares outstanding such as stock options and unvested restricted stock units and awards during the period using the treasury stock method.
The table below illustrates the weighted-average common shares used to calculate basic net income per share with the weighted-average common shares used to calculate diluted net income per share:
Diluted net income per share excludes 23.3 million and 8.8 million of anti-dilutive stock options and unvested restricted stock units and awards for the three months ended January 31, 2009 and 2008, respectively. While these stock options and unvested restricted stock units and awards were anti-dilutive for the respective periods, they could be dilutive in the future.
Note 12. Segment Disclosure
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, (SFAS 131) requires disclosures of certain information regarding operating segments, products and services, geographic areas of operation and major customers. SFAS 131 reporting is based upon the management approach, i.e., how management organizes the Companys operating segments for which separate financial information is (1) available and (2) evaluated regularly by the Chief Operating Decision Maker (CODM) in deciding how to allocate resources and in assessing performance. Synopsys CODMs are the Companys Chief Executive Officer and Chief Operating Officer.
The Company provides software and hardware products and consulting services in the electronic design automation software industry. The Company operates in a single segment. In making operating decisions, the CODMs primarily consider consolidated financial information, accompanied by disaggregated information about revenues by geographic region. Specifically, the CODMs consider where individual seats or licenses to the Companys products are used in allocating revenue to particular geographic areas. Revenue is defined as revenues from external customers. Goodwill is not allocated since the Company operates in one reportable operating segment.
The following table presents the revenues related to operations by geographic areas:
Geographic revenue data for multi-region, multi-product transactions reflect internal allocations and is therefore subject to certain assumptions and to the Companys methodology.
One customer accounted for more than ten percent of the Companys consolidated revenue in the three months ended January 31, 2009 and 2008.
Note 13. Other Income, net
The following table presents the components of other income, net:
Note 14. Taxes
Effective Tax Rate
The Company estimates its annual effective tax rate at the end of each fiscal quarter. The Companys estimate takes into account estimations of annual pre-tax income, the geographic mix of pre-tax income and the Companys interpretations of tax laws and possible outcomes of audits.
The following table presents the provision for income taxes and the effective tax rates:
The Companys effective tax rate for the three months ended January 31, 2009 is lower than the statutory federal income tax rate of 35% primarily due to the tax impact of non-U.S. operations, which are taxed at lower rates, and research and development credits, partially offset by state taxes and non-deductible share-based compensation recorded under SFAS 123(R). The effective tax rate increased in the three months ended January 31, 2009, as compared to the same period in fiscal 2008, primarily due to a decrease in tax exempt investment income and changes in mix of geographical earnings, partially offset by the recognition of a prior year foreign tax benefit. During the three months ended January 31, 2009, there were no other material changes to the total gross unrecognized tax benefits.
The timing of the resolution of income tax examinations is highly uncertain as well as the amounts and timing of various tax payments that are part of the settlement process. This could cause large fluctuations in the balance sheet classification of current and non-current assets and liabilities. The Company believes that in the next twelve months it is reasonably possible that the statute of limitations on certain state and foreign income and withholding taxes will expire, and that certain federal and foreign transfer pricing issues could be effectively settled. Given the uncertainty as to ultimate settlement terms, the timing of payment and the impact of such settlements on other uncertain tax positions, the range of the estimated potential decrease in underlying unrecognized tax benefits is between $0 and $74 million. See IRS Examinations below for the status of current federal income tax audits.
On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (the Act), which has significant tax implications for certain businesses and individuals. The Company has not yet fully analyzed all provisions of the Act but does not anticipate it having a material impact on our effective tax rate for fiscal 2009.
The Company is regularly audited by the IRS.
On June 30, 2008, the Appeals Office of the IRS and the Company executed a final Closing Agreement with respect to a Revenue Agents Report (RAR) received for the audit of fiscal years 2000 and 2001, in connection with a transfer pricing dispute. As a result of the Closing Agreement and the Companys concurrent evaluation of its ability to use certain foreign tax credits, the Companys provision for income taxes in its third fiscal quarter of 2008 included a net income tax benefit (net of decreases in related deferred tax assets) of $17.3 million.
In July 2008, the IRS completed its field examination of fiscal years 2002-2004 and issued an RAR in which the IRS proposed an adjustment that would result in an aggregate tax deficiency for the three year period of approximately $236.2 million, $130.5 million of which would be a reduction of certain tax losses and credits that would otherwise be available either as refund claims or to offset taxes due in future periods. The IRS is contesting the Companys tax deduction for payments made in connection with litigation between Avant! Corporation and Cadence Design Systems, Inc. In addition, the IRS has asserted that the Company is required to make an additional transfer pricing adjustment with a wholly owned non-U.S. subsidiary as a result of the Companys acquisition of Avant! in 2002. The IRS has also proposed adjustments to the Companys transfer pricing arrangements with its foreign subsidiaries, deductions for foreign trade income and certain temporary differences. The Company has agreed to additional taxes of approximately $20.0 million for these proposed adjustments, which have been fully provided for in prior years. The total adjustments proposed by the IRS, if sustained, would also result in additional state taxes (net of the federal tax benefit for state taxes paid) of approximately $17 million. The IRS imposes interest on any resulting tax deficiencies. The Company strongly believes the proposed IRS adjustment and resulting proposed deficiency are inconsistent with applicable tax laws, and that the Company has meritorious defenses to this proposed IRS adjustment. On August 9, 2008, the Company timely filed a protest with the IRS and intends to seek resolution of these issues through the Appeals Office, which could take several years. The Company continues to discuss a resolution of this matter with the examination division, which, if successful, could settle the matter within the next twelve months. The Company believes it has adequately provided for potential tax liabilities related to these years.
Note 15. Contingencies
See also the disclosure in Note 14 above regarding the IRS Revenue Agents Report.
The Company is also subject to other routine legal proceedings, as well as demands, claims and threatened litigation, that arise in the normal course of its business. The ultimate outcome of any litigation is uncertain and unfavorable outcomes could have a negative impact on the Companys financial position and results of operations.
Note 16. Effect of New Accounting Pronouncements
The effect of recent accounting pronouncements has not changed from the Companys Annual Report on Form 10-K for the fiscal year ended October 31, 2008.
This Quarterly Report on Form 10-Q, and in particular the following discussion, includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (the Securities Act) and Section 21E of the Securities Exchange Act of 1934 (the Exchange Act). These statements include but are not limited to statements concerning: our business, product and platform strategies, expectations regarding previous and future acquisitions; completion of development of our unfinished products, or further development or integration of our existing products; continuation of current industry trends towards vendor consolidation; expectations regarding our license mix; expectations regarding customer interest in more highly integrated tools and design flows; expectations of the success of our intellectual property and design for manufacturing initiatives; expectations concerning recent completed acquisitions; expectations regarding the likely outcome of the Internal Revenue Services proposed net tax deficiencies for fiscal years 2000 through 2004 and other outstanding litigation; expectations that our cash, cash equivalents and short-term investments and cash generated from operations will satisfy our business requirements for the next 12 months; and our expectations of our future liquidity requirements. Our actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties, including, without limitation, those identified below in Part II, Item 1A of this Form 10-Q. The words may, will, could, would, anticipate, expect, intend, believe, continue, or the negatives of these terms, or other comparable terminology and similar expressions identify these forward-looking statements. However, these words are not the only means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The information included herein is given as of the filing date of this Form 10-Q with the Securities and Exchange Commission (SEC) and future events or circumstances could differ significantly from these forward-looking statements. Accordingly, we caution readers not to place undue reliance on these statements. Unless required by law, we undertake no obligation to update publicly any forward-looking statements. All subsequent written or oral forward-looking statements attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. Readers are urged to carefully review and consider the various disclosures made in this report and in other documents we file from time to time with the SEC that attempt to advise interested parties of the risks and factors that may affect our business.
The following summary of our financial condition and results of operations should be read together with our unaudited condensed consolidated financial statements and the related notes thereto contained in Part I, Item 1 of this report and with our audited consolidated financial statements and the related notes thereto contained in our Annual Report on Form 10-K for the fiscal year ended October 31, 2008, filed with the SEC on December 22, 2008.
Fiscal Year End. Our fiscal year ends on the Saturday nearest to October 31. Our first fiscal quarter ended on January 31, 2009. Fiscal 2009 is a 52-week fiscal year. For presentation purposes, the unaudited condensed consolidated financial statements and accompanying notes refer to the applicable calendar month end.
Business Environment Summary
We are a world leader in electronic design automation (EDA) software and related services for semiconductor design companies. We offer a broad portfolio of solutions that are highly integrated to solve our customers needs at each stage of the semiconductor chip design process. We deliver technology-leading semiconductor design and verification software platforms and integrated circuit (IC) manufacturing software products to the global electronics market, enabling the development and production of complex systems-on-chips (SoCs). In addition, we provide intellectual property (IP), system-level design hardware and software products, and design services to simplify the design process and accelerate time-to-market for our customers. Finally, we provide software and services that help customers prepare and optimize their designs for manufacturing.
We generate a substantial majority of our revenue from large customers in the semiconductor and electronics industries. Our customers typically fund purchases of our software and services largely out of their research and development (R&D) budgets and, to a lesser extent, their manufacturing and capital budgets. Our customers continually face the competing challenges of developing increasingly advanced electronics products while reducing their design and manufacturing costs in order to meet ongoing consumer demand for lower prices. Our customers business outlook and willingness to invest in new and increasingly complex chip designs affect their spending decisions and vendor selections. The recent crisis in the financial markets and the continued weakening of the global economy have exacerbated these challenges.
Our customers bargain on various aspects of the contractual arrangements they make with us. Our customers often demand a broader portfolio of solutions, support and services and seek more favorable terms such as expanded license usage, future purchase rights and other unique rights at an overall lower total cost of design. Our customer arrangements are complex, involving hundreds of products and various license rights. No one factor drives our customers buying decisions and we compete on all fronts to capture a higher portion of our customers budgets in a highly competitive EDA market. Customers generally negotiate the total value of the arrangement rather than just unit pricing or volumes. Collectively, the increase in the value of all of our customer contracts is the primary driver of our overall growth in revenue over time. As further described below, the effect of an increase in value for a particular customer is typically recognized over the life of the customer contract rather than in one particular period.
Our business model allows a substantial majority of our customers to pay for licenses over a period of time and generates recurring revenue for us over a period of time, generally three years. We continue to target achieving greater than 90% of our total revenue as recurring revenue, which we refer to in our financial statements as time-based license and maintenance and service revenue. Accordingly, most of the revenue we recognize in any particular quarter results from our selling efforts in each of the prior periods during the last three or so years rather than from efforts or changes in the current period. The timing of orders is less important to us in the short term and we have been able to resist typical software industry quarter-end pressures and to avoid business with terms, including pricing terms, which may be less favorable to us.
Short-term fluctuations in industry or general economic conditions or in orders generally do not immediately affect our financial results due to our business model. While the electronics, semiconductor and EDA industries are currently experiencing unprecedented uncertainty and weakness due to the recent severe downturn in the global economy, to date, our business model has substantially protected our financial results. Nevertheless, if the downturn persists or worsens for any extended period of time, our future revenues and financial results would be negatively affected. The turmoil and uncertainty about future economic conditions could cause our customers to postpone their decision-making, decrease their spending, delay their payments, consolidate with other customers, or file for bankruptcy protection, any of which could adversely affect our business and our future revenues. The downturn has negatively impacted several of our competitors, and a few have recently announced lower revenues than they had previously expected. We will continue to monitor market conditions and make adjustments to our business in order to reduce the adverse impact that a prolonged economic downturn could have on our business.
Financial Performance Summary for the Three Months Ended January 31, 2009
· Total revenue of $339.8 million was up 8% from $315.5 million in the same quarter in fiscal 2008. The increase was primarily attributable to bookings of Technology Subscription Licenses (TSLs) in prior periods which increase time-based revenue recognized in later periods and to a lesser extent from Synplicity product sales from our acquisition in May 2008.
· Time-based license revenue of $285.1 million was up 6% from $267.9 million in the same quarter in fiscal 2008. The increase was primarily attributable to bookings of TSLs in prior periods which increase time-based revenue recognized in later periods.
· Upfront license revenue of $18.3 million was up 46% from $12.5 million in the same quarter in fiscal 2008. The increase reflected the impact of Synplicity product sales.
· We derived approximately 95% of our total revenue from time-based, maintenance and services revenues, and 5% from upfront revenue in the first quarter of fiscal 2009, compared to approximately 96% and 4%, respectively, in the same quarter in fiscal 2008. This reflects our adherence to our business model.
· Maintenance revenue of $20.7 million was up 26% from $16.4 million in the same quarter in fiscal 2008. The increase was primarily attributable to the increase in Synplicity product sales which were mostly perpetual based. Professional services and other revenue of $15.7 million was down 16% from $18.7 million in the same quarter in fiscal 2008. The decrease was primarily driven by the timing of completion of performed milestones under service contracts.
· Net income of $52.4 million was up 13% from $46.4 million in the same quarter in fiscal 2008. The increase was primarily due to increases in revenues and cost control efforts.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial results under the heading Result of Operations below are based on our unaudited condensed consolidated financial statements, which we have prepared in accordance with U.S. generally accepted accounting principles. In preparing these financial statements, we make assumptions, judgments and estimates that can affect the reported amounts of assets, liabilities, revenues and expenses and net income. On an on-going basis, we evaluate our estimates based on historical experience and various other assumptions we believe are reasonable under the circumstances. Our actual results may differ from these estimates.
The accounting policies that most frequently require us to make assumptions, judgments and estimates, and therefore are critical to understanding our results of operations, are:
· Revenue recognition; and
· Income taxes.
We describe our revenue recognition and income taxes policies below. Our remaining critical accounting policies and estimates are discussed in Part II, Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the fiscal year ended October 31, 2008, filed with the SEC on December 22, 2008.
We recognize revenue from software licenses and related maintenance and service revenue and, to a lesser extent, from hardware sales. Software license revenue consists of fees associated with the licensing of our software. Maintenance and service revenue consists of maintenance fees associated with perpetual and term licenses and professional service fees.
We have designed and implemented revenue recognition policies in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended, and EITF 00-21, Revenue Arrangements with Multiple Deliverables.
With respect to software licenses, we utilize three license types:
· Technology Subscription Licenses (TSLs) are time-based licenses for a finite term, and generally provide the customer limited rights to receive, or to exchange certain quantities of licensed software for, unspecified future technology. We bundle and do not charge separately for post-contract customer support (maintenance) for the term of the license.
· Term Licenses are also for a finite term, but do not provide the customer any rights to receive, or to exchange licensed software for, unspecified future technology. Customers purchase maintenance separately for the first year and may renew annually for the balance of the term. The annual maintenance fee is typically calculated as a percentage of the net license fee.
· Perpetual Licenses continue as long as the customer renews maintenance plus an additional 20 years. Perpetual licenses do not provide the customer any rights to receive, or to exchange licensed software for, unspecified future technology. Customers purchase maintenance separately for the first year and may renew annually.
For the three software license types, we recognize revenue as follows:
· TSLs. We typically recognize revenue from TSL fees (which include bundled maintenance) ratably over the term of the license period, or as customer installments become due and payable, whichever is later. Revenue attributable to TSLs is reported as time-based license revenue in the unaudited condensed consolidated statement of operations.
· Term Licenses. We recognize revenue from term licenses in full upon shipment of the software if payment terms require the customer to pay at least 75% of the license fee within one year from shipment and all other revenue recognition criteria are met. Revenue attributable to these term licenses is reported as upfront license revenue in the unaudited condensed consolidated statement of operations. For term licenses in which less than 75% of the license fee is due within one year from shipment, we recognize revenue as customer installments become due and payable. Such revenue is reported as time-based license revenue in the unaudited condensed consolidated statement of operations.
We generally recognize revenue from hardware sales in full upon shipment if all other revenue recognition criteria are met. If a technology subscription license is sold together with the hardware, we recognize revenue ratably over the term of the software license period, or as customer installments become due and payable, whichever is later. Revenue attributable to these hardware sales is reported as upfront license revenue in the unaudited condensed consolidated statement of operations.
In addition, we recognize revenue from maintenance fees ratably over the maintenance period to the extent cash has been received and recognize revenue from professional service and training fees as such services are performed and accepted by the customer. Revenue attributable to maintenance, professional services and training is reported as maintenance and service revenue in the unaudited condensed consolidated statement of operations.
Our determination of fair value of each element in multiple element arrangements is based on vendor-specific objective evidence (VSOE). We limit our assessment of VSOE of fair value for each element to the price charged when such element is sold separately.
We have analyzed all of the elements included in our multiple-element software arrangements and have determined that we have sufficient VSOE to allocate revenue to the maintenance components of our perpetual and term license products and to professional services. Accordingly, assuming all other revenue recognition criteria are met, we recognize license revenue from perpetual and term licenses upon delivery using the residual method, we recognize revenue from maintenance ratably over the maintenance term, and we recognize revenue from professional services as milestones are performed and accepted. We recognize revenue from TSLs ratably over the term of the license, assuming all other revenue recognition criteria are met, since there is not sufficient VSOE to allocate the TSL fee between license and maintenance services.
We make significant judgments related to revenue recognition. Specifically, in connection with each transaction involving our products, we must evaluate whether: (1) persuasive evidence of an arrangement exists, (2) delivery of software or services has occurred, (3) the fee for such software or services is fixed or determinable, and (4) collectability of the full license or service fee is probable. All four of these criteria must be met in order for us to recognize revenue with respect to a particular arrangement. We apply these revenue recognition criteria as follows:
We calculate our current and deferred tax provisions in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). Our estimates and assumptions used in such provisions may differ from the actual results as reflected in our income tax returns and we record the required adjustments when they are identified and resolved.
We recognize deferred tax assets and liabilities for the temporary differences between the book and tax bases of assets and liabilities using enacted tax rates in effect for the year in which we expect the differences to reverse. We record a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. In evaluating our ability to utilize our deferred tax assets, we consider all available positive and negative evidence, including our past operating results, the existence of cumulative losses in the most recent fiscal years and our forecast of future taxable income on a jurisdiction by jurisdiction basis, as well as feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we are using to manage the underlying businesses. We believe that the net deferred tax assets of approximately $294 million that are recorded on our balance sheet will ultimately be realized. However, if we determine in the future that it is more likely than not we will not be able to realize a portion or the full amount of deferred tax assets, we would record an adjustment to the deferred tax asset valuation allowance as a charge to earnings in the period such determination is made.
Included in our net deferred tax assets as of October 31, 2008 are federal foreign tax credits of $70.1 million of which $63.9 million will expire from fiscal 2013 through 2018. The remaining $6.2 million in foreign tax credits are from acquired companies, which have a valuation allowance of $3.4 million, and will expire between fiscal 2009 and 2017. Foreign tax credits can only be carried forward ten years, unlike net operating loss and federal research credit carryforwards that have a twenty year carryforward period, and may only be used after foreign tax credits arising in each subsequent year have been used first. Our ability to utilize foreign tax credits is dependent upon having sufficient foreign source income during the carryforward period. We have recorded a valuation allowance of $19.7 million with respect to our foreign tax credit carryforward, of which $14.6 million was recorded as a result of the 2000-2001 final IRS settlement. See Results of OperationsIncome TaxesIRS Examinations, below, and Note 14 of Notes to Unaudited Condensed Consolidated Financial Statements. The need for a valuation allowance with respect to foreign tax credits is subject to change based upon a number of factors, including the amount of foreign tax credits arising in future years, our forecasts of future foreign source income, the amount of our undistributed earnings of our foreign subsidiaries and changes in income tax laws that may affect our ability to use such credits.
The calculation of tax liabilities involves the inherent uncertainty associated with the application of complex tax laws. We are also subject to examination by various taxing authorities. We believe we have adequately provided in our financial statements for potential additional taxes. If we ultimately determine that these amounts are not owed, we would reverse the liability and recognize the tax benefit in the period in which we determine that the liability is no longer necessary. If an ultimate tax assessment exceeds our estimate of tax liabilities, we would record an additional charge to earnings. See Note 14 of Notes to Unaudited Condensed Consolidated Financial Statements for a discussion of taxes and the Revenue Agents Reports from the IRS we received in June 2005 and July 2008 asserting very large net increases to our U.S. tax arising from the audit of fiscal 2000 through 2001 and fiscal 2002 through 2004, respectively.
Results of Operations
We generate our revenue from the sale of software licenses, maintenance and professional services. Under current accounting rules and policies, we recognize revenue from orders we receive for software licenses and services at varying times. In most instances, we recognize revenue on a TSL software license order over the license term and on a term or perpetual software license order in the quarter in which the license is shipped. Substantially all of our current time-based licenses are TSLs with an average license term of approximately three years. Maintenance orders normally bring in revenue ratably over the maintenance period (normally one year). Professional service orders generally turn into revenue upon completion and customer acceptance of contractually agreed milestones. A more complete description of our revenue recognition policy can be found above under Critical Accounting Policies and Estimates.
Our revenue in any fiscal quarter is equal to the sum of our time-based license, upfront license, maintenance and professional service revenue for the period. We derive time-based license revenue in any quarter largely from TSL orders received and delivered in prior quarters. We derive upfront license revenue directly from term and perpetual license orders mostly booked and shipped during the quarter. We derive maintenance revenue in any quarter largely from maintenance orders received in prior quarters since our maintenance orders generally yield revenue ratably over a term of one year. We also derive professional service revenue primarily from orders received in prior quarters, since we recognize revenue from professional services when those services are delivered and accepted, not when they are booked.
Our license revenue is sensitive to the mix of TSLs and perpetual or term licenses delivered during a reporting period. A TSL order typically yields lower current quarter revenue but contributes to revenue in future periods. For example, a $120,000 order for a three-year TSL shipped on the last day of a quarter typically generates no revenue in that quarter, but $10,000 in each of the twelve succeeding quarters. Conversely, perpetual licenses and term licenses with greater than 75% of the license fee due within one year from shipment typically generate current quarter revenue but no future revenue (e.g., a $120,000 order for a perpetual license generates $120,000 in revenue in the quarter the product is shipped, but no future revenue).
The increase in total revenue for the first quarter of fiscal 2009 compared to the same quarter of fiscal 2008 was primarily due to our time-based license model which reflects prior period bookings contributing to current period time-based revenue and, to a lesser extent, product sales from our Synplicity acquisition in May 2008.
Time-Based License Revenue
The increase in time-based license revenue in the first quarter of fiscal 2009 compared to the same quarter in fiscal 2008 was primarily due to prior period bookings leading to increased current period time-based revenue.
Upfront License Revenue
Upfront license revenue increased in the first quarter of fiscal 2009 compared to the same quarter in fiscal 2008, reflecting the presence of Synplicity product sales in the first quarter of fiscal 2009, as such sales were absent in the first quarter of fiscal 2008, and the normal fluctuations in customer license requirements which can drive the amount of upfront orders and revenue in any particular quarter.
Maintenance and Service Revenue
Maintenance revenue increased in the first quarter of fiscal 2009 compared to the same period in fiscal 2008 primarily because of the maintenance revenue stream on perpetual-based products, as well as the sale of perpetual licenses to the products that we acquired in our acquisition of Synplicity in the third quarter of fiscal 2008. We expect our second quarter of fiscal 2009 to similarly reflect the impact of the Synplicity acquisition on a year-over-year comparative basis, but do not expect the acquisition-related increases to continue thereafter. In addition, some customers may in the future choose not to renew maintenance on upfront licenses for economic or other factors, which would lower our future maintenance revenue.
Professional services and other revenue decreased in the first quarter of fiscal 2009 compared to the same period in fiscal 2008 due principally to the timing of customer acceptance of services performed under ongoing contracts.
Events Affecting Cost of Revenues and Operating Expenses
Functional Allocation of Operating Expenses. We allocate certain human resource programs, information technology and facility expenses among our functional income statement categories based on headcount within each functional area. Annually, or upon a significant change in headcount (such as a workforce reduction, realignment or acquisition) or other factors, management reviews the allocation methodology and expenses included in the allocation pool.
Cost of Revenue
We divide cost of revenue into three categories: cost of license revenue, cost of maintenance and service revenue, and amortization of intangible assets. We segregate expenses directly associated with providing consulting and training from cost of license revenue associated with internal functions providing license delivery and post-customer contract support services. We then allocate these group costs between cost of license revenue and cost of maintenance and service revenue based on license and service revenue reported.
Cost of license revenue. Cost of license revenue includes costs associated with the sale and licensing of our software products. Additionally, cost of license revenue also includes allocated costs of license delivery, such as employee salaries and benefits related to software delivery, software production costs, product packaging, amortization of capitalized software development costs, documentation and royalties to third party vendors.
Cost of maintenance and service revenue. Cost of maintenance and service revenue includes employee salary and benefits for consulting professionals and associated costs to maintain the infrastructure necessary to operate our services and training organization. Further, cost of maintenance and service revenue also includes allocated costs which provide post customer contract services, such as employee salary and benefits related to customer services, such as hotline and on-site support, production services and documentation of maintenance updates.
Amortization of intangible assets. Amortization of intangible assets, which is amortized to cost of revenue and operating expenses, includes the amortization of the contract rights associated with certain executory contracts and the amortization of core/developed technology, trademarks, trade names, customer relationships, covenants not to compete and other intangibles related to acquisitions.
Cost of revenue as a percentage of total revenue was flat at 19% for the first quarter of fiscal 2009 compared with the same period in fiscal 2008. The increase of $4.1 million in total cost of revenue was primarily due to an increase in personnel related costs, and amortization of intangible assets, as a result of our acquisition of Synplicity in May 2008.
Research and Development
The increase in research and development expense in the first quarter of fiscal 2009 compared with the same period in fiscal 2008 was primarily due to an increase of $5.4 million in personnel related costs, and an increase of $2.2 million in functionally allocated expenses, both reflecting headcount increases as a result of the Synplicity acquisition. The increase was partially offset by $1.7 million decline in the fair value of our deferred compensation plan obligation.
Sales and Marketing
Sales and marketing expenses were flat but expenses as a percentage to total revenue decreased for the first quarter of fiscal 2009 compared with the same period in fiscal 2008. The decrease in percentage of total revenue was primarily due to a decrease in variable compensation as a result of lower shipments.
General and Administrative
The increase in general and administrative expenses in the first quarter of fiscal 2009 compared with the same period in fiscal 2008 was primarily due to an increase of $1.8 million in facility and maintenance expense and an increase of $1.4 million in bad debt reserve based on our review of customer receivables.
Amortization of Intangible Assets
The increase in amortization of intangible assets is due to amortization of intangible assets from our Synplicity acquisition which occurred in May of fiscal 2008 and our recent acquisition in the first quarter of fiscal 2009, partially offset by certain intangible assets acquired in prior years becoming fully amortized. See Note 5 to Notes to Unaudited Condensed Consolidated Financial Statements for a schedule of future amortization amounts.
In-Process Research and Development
In-process research and development (IPRD) expense is composed of in-process technologies of $0.6 million associated with an acquisition of assets of a business completed during the first quarter of fiscal 2009. At the date of the acquisition, the project associated with the IPRD efforts had not yet reached technological feasibility and the research and development in process had no alternative future uses and therefore the amount was charged to expense.
Other Income, net
Other income, net, decreased in the first quarter of fiscal 2009, compared to the same period in fiscal 2008 primarily due to the fair market value fluctuations of investments in our deferred compensation plan, and a decrease in interest income due to lower interest rates and lower cash balances. These decreases were partially offset by foreign currency exchange gain.
See Note 14 of the Notes to Unaudited Condensed Consolidated Financial Statements.
Liquidity and Capital Resources
Our sources of cash, cash equivalents and short-term investments are funds generated from our business operations and funds that may be drawn down under our credit facility.
The following sections discuss changes in our balance sheet and cash flows, and other commitments on our liquidity and capital resources during the first quarter of fiscal 2009.
Cash and Cash Equivalents and Short-Term Investments
During the first quarter of fiscal 2009, our primary sources and uses of cash consisted of (1) cash used in operating activities of $81.9 million, (2) proceeds from sales and maturities of short-term investments of $64.0 million, (3) purchases of investments of $60.1 million and (4) cash paid for acquisitions of $27.3 million.
Cash used in operating activities. Cash used in operations is dependent primarily upon the payment terms of our license agreements. To be classified as upfront revenue, we require that 75% of a term or perpetual license fee be paid within the first year. Conversely, payment terms for TSLs are generally extended and the license fee is typically paid either quarterly or annually in even increments over the term of the license. Accordingly, we generally receive cash from upfront license revenue much sooner than from time-based licenses revenue. In addition, we typically pay bonuses and variable compensation during the first quarter of our fiscal year resulting in higher cash outflows in the first quarter as compared to the remaining periods in the year.
Cash used in operating activities primarily increased as a result of a decrease in deferred revenue due to the timing of billings and cash payment from certain customers and increased payments to vendors compared to the same period in fiscal 2008.
Cash used in investing activities. The decrease in cash used primarily relates to the timing of maturities of marketable securities offset by cash paid for acquisitions and a decrease in our purchases of marketable securities as compared to the same period in fiscal 2008.
Cash provided by (used in) financing activities. The decrease in cash used primarily relates to no common stock repurchases made under our stock repurchase program and a lower number of employee option exercises compared to the same period in fiscal 2008. See Note 9 of Notes to Unaudited Condensed Consolidated Financial Statements for details of our stock repurchase program.
We hold our cash, cash equivalents and short-term investments in the United States and in foreign accounts worldwide. As of January 31, 2009, we held an aggregate of $445.0 million in cash, cash equivalents and short-term investments in the United States and an aggregate of $397.3 million in foreign accounts. Funds in foreign accounts are generated from revenue outside North America.
We expect that cash used in or provided by operating activities may fluctuate in future periods as a result of a number of factors, including timing of our billings and collections, our operating results, the timing and amount of tax and other liability payments and cash used in any future acquisitions.
Accounts Receivable, net
Our accounts receivable and Days Sales Outstanding (DSO) are primarily driven by our billing and collections activities. Our DSO was 40 days at January 31, 2009, and 38 days at October 31, 2008. The increase in DSO, along with an increase in accounts receivable balance, primarily relates to timing of billings to customers in the first quarter of fiscal 2009 and stronger collections in the last quarter of fiscal 2008.
Net Working Capital. Working capital is composed of current assets less current liabilities, as shown on our unaudited condensed consolidated balance sheets. As of January 31, 2009, our net working capital was $482.0 million, compared to $413.3 million as of October 31, 2008. The increase in net working capital of $68.7 million was primarily due to increases in (1) accounts receivable of $2.7 million, (2) deferred taxes of $2.9 million, and (3) other current assets of $2.4 million, along with a decrease in (1) current income taxes accrual of $5.1 million, (2) accounts payable and accrued liabilities of $107.2 million, and (3) deferred revenue of $57.4 million. These increases were partially offset by our use of $109.0 million in cash, cash equivalents and short-term investments as described above.
Other CommitmentsRevolving Credit Facility. On October 20, 2006, we entered into a five-year, $300.0 million senior unsecured revolving credit facility providing for loans to Synopsys and certain of our foreign subsidiaries. The amount of the facility may be increased by up to an additional $150.0 million through the fourth year of the facility. The facility contains financial covenants requiring us to maintain a minimum leverage ratio and specified levels of cash, as well as other non-financial covenants. The facility terminates on October 20, 2011. Borrowings under the facility bear interest at the greater of the administrative agents prime rate or the federal funds rate plus 0.50%; however, we have the option to pay interest based on the outstanding amount at Eurodollar rates plus a spread between 0.50% and 0.70% based on a pricing grid tied to a financial covenant. In addition, commitment fees are payable on the facility at rates between 0.125% and 0.175% per year based on a pricing grid tied to a financial covenant. As of January 31, 2009, we had no outstanding borrowings under this credit facility and were in compliance with all covenants.
Our cash equivalent and short-term investment portfolio as of January 31, 2009, consists of investment grade municipal bonds, tax-exempt money market mutual funds and taxable money market mutual funds. We follow an established investment policy and set of guidelines to monitor, manage and limit our exposure to interest rate and credit risk. The policy sets forth credit quality standards and limits our exposure to any one issuer. As a result of current adverse financial market conditions, some financial instruments, such as structured investment vehicles, sub-prime mortgage-backed securities and collateralized debt obligations, may pose risks arising from liquidity and credit concerns. As of January 31, 2009, we had no direct holdings in these categories of investments and no exposure to these financial instruments through our indirect holdings in money market mutual funds. During the three months ended January 31, 2009, we had no impairment charge associated with our short-term investment portfolio. While we cannot predict future market conditions or market liquidity, we have taken steps, including regularly reviewing our investments and associated risk profiles, which we believe will allow us to effectively manage the risks of our investment portfolio.
As a result of the challenging conditions in the financial markets over the last several months, we have been more proactively managing our cash and cash equivalents and investments and closely monitoring our capital and stock repurchase expenditures. Additionally, we believe the overall credit quality of our portfolio is strong, with our cash equivalents and fixed income portfolio invested in securities with a weighted-average credit rating exceeding AA. The majority of our investments are priced by pricing vendors and are classified as Level 1 or Level 2 investments, as measured under SFAS 157, as these vendors either provide a quoted market price in an active market or use observable inputs. See Note 3 of Notes to the Unaudited Condensed Consolidated Financial Statements.
We believe that our current cash, cash equivalents, short-term investments, cash generated from operations, and available credit under our credit facility will satisfy our business requirements for at least the next twelve months.
Effect of New accounting Pronouncements
The effect of recent accounting pronouncements has not changed from our Annual Report on Form 10-K for the fiscal year ended October 31, 2008.
Our exposure to market risk has not changed materially since October 31, 2008. The average yield at purchase for our short-term investment portfolio remains approximately the same as of October 31, 2008. For more information in financial market risks related to changes in interest rates and foreign currency exchange rates, reference is made to Item 7A Quantitative and Qualitative Disclosure About Market Risk contained in Part II of our Annual Report on Form 10-K for the fiscal year ended October 31, 2008, filed with the SEC on December 22, 2008.
We are subject to routine legal proceedings, as well as demands, claims and threatened litigation, that arise in the normal course of our business. The ultimate outcome of any litigation is uncertain and unfavorable outcomes could have a negative impact on our results of operations and financial condition. Regardless of outcome, litigation can have an adverse impact on Synopsys because of the defense costs, diversion of management resources and other factors.
We describe our business risk factors below.
The current severe downturn and uncertainty in the global economy in general and weakness in the semiconductor and electronics industries in particular may harm our business, operating results and financial condition.
The worldwide economy is currently undergoing unprecedented turmoil amid stock market volatility, tightening of credit markets, concerns of inflation and deflation, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns and business insolvencies. This turmoil and the uncertainty about future economic conditions could negatively impact our customers and, among other things, postpone their decision-making, decrease their spending and jeopardize or delay their ability or willingness to make payment obligations, any of which could adversely affect our business. Uncertainty about current global economic conditions could also cause volatility of our stock price. In the event that the downturn persists or worsens for any extended period of time, we may need to restructure our operations and accordingly incur restructuring costs. We cannot predict the timing, strength or duration of this severe global economic downturn or subsequent recovery.
In addition, the semiconductor and electronics industries are cyclical in nature and are currently experiencing a severe downturn. The EDA industry has been adversely affected by many factors, including the current global downturn, ongoing efforts by semiconductor and electronics companies to reduce their spending, uncertainty regarding their long-term growth rate and underlying financial health, excess EDA tool capacity and increased competition. These factors could, among other things, limit our ability to maintain or increase our sales or recognize revenue from committed contracts and in turn adversely affect our business, operating results and financial condition.
If the general economy and the semiconductor and electronics industries do not improve, our business, financial condition and results of operations could be harmed.
In the event that downward fluctuations in the semiconductor or electronics industries or general economic conditions persist or worsen for any extended period of time, our revenues and financial results will be adversely affected.
Our business model allows a substantial majority of our customers to pay for licenses over a period of time and generates recurring revenue for us over a period of time, generally three years. Pursuant to our business model, we generally target achieving greater than 90% of our total revenue as recurring revenue.
Short-term fluctuations in industry or general economic conditions or in orders generally do not immediately affect our financial results due to our business model. While the electronics, semiconductor and EDA industries are currently experiencing unprecedented uncertainty and weakness due to the recent severe downturn in the global economy, to date, our business model has substantially protected our financial results. Nevertheless, if the downturn persists or worsens for any extended period of time, our future revenues and financial results would be adversely affected. Conversely, in the event of future upward fluctuations in conditions, the positive impact on our revenues and financial results may not be immediate.
Customer payment defaults or related issues could harm our operating results.
The majority of our backlog consists of customer payment obligations not yet due that are attributable to software we have already delivered. A significant portion of revenue we recognize in any period comes from backlog and is dependent upon our receipt of cash. Although customer payment obligations are not cancelable, we will not achieve expected revenue and cash flow if customers default, declare bankruptcy, or otherwise fail to pay amounts owed. Moreover, existing customers may seek to renegotiate pre-existing contractual commitments due to adverse changes in their own businesses. Though we have not, to date, experienced a material level of defaults or renegotiation requests, if the current economic downturn is prolonged, our customers financial condition and in turn their ability or willingness to fulfill their contractual and financial obligations could be adversely affected. If payment defaults by our customers significantly increase or we experience significant reductions in existing contractual commitments, our operating results would be harmed.
If we do not successfully compete in the EDA industry our business and financial condition will be harmed.
We compete with EDA vendors that offer varying ranges of products and services, primarily Cadence Design Systems, Inc., Mentor Graphics Corporation and Magma Design Automation, Inc. We also compete with other EDA vendors, including continual new entrants to the marketplace, that offer products focused on one or more discrete phases of the IC design process, as well as with customers internally developed design tools and capabilities. We compete principally on technology leadership, product quality and features (including ease-of-use), license terms, post contract customer support, interoperability with our own and other vendors products, price and payment terms. Specifically, we believe the following competitive factors affect our success:
In addition, new competitive factors may emerge from time to time. If we fail to successfully compete as described above or fail to address new competitive forces, our business will be harmed.
Lack of growth in new IC design starts, industry consolidation and other potentially long-term trends may adversely affect the EDA industry, including demand for our products and services.
The increasing complexities of SoCs and ICs, and customers concerns about managing costs and risks have also led to the following potentially long-term negative trends in our industry:
· The number of IC design starts has decreased and we expect it to continue to decline. New IC design starts are one of the key drivers of demand for EDA software.
· A number of mergers in the semiconductor and electronics industries have occurred and more are likely. Mergers can reduce the aggregate level of purchases of EDA software and services, and in some cases, increase customers bargaining power in negotiations with their suppliers, including Synopsys.
· Due to factors such as increased globalization, cost controls among customers appear to have become more permanent, adversely impacting our customers EDA spending.
· Industry changes, plus the cost and complexity of IC design, may be leading some companies in these industries to limit their design activity in general, to focus only on one discrete phase of the design process while outsourcing other aspects of the design to companies using our competitors products.
All of these trends, if sustained, could harm the EDA industry, including the demand for our products and services, which in turn would harm our financial condition and results of operations.
Changes in, or interpretations of, accounting principles could result in unfavorable accounting charges or effects, including changes to our prior financial statements, which could cause our stock price to decline.
We prepare our consolidated financial statements in conformity with U.S. generally accepted accounting principles. These principles are subject to interpretation by the SEC and various bodies formed to interpret and create appropriate accounting principles. A change in these principles, or in our interpretations of these principles, can have a significant effect on our reported results and may retroactively affect previously reported results.
We have received a Revenue Agents Report from the Internal Revenue Service claiming a significant increase in our U.S. taxable income. An adverse outcome could have an adverse effect on our results of operations and financial condition.
On July 11, 2008, we received a Revenue Agents Report in which the Internal Revenue Service, or IRS, proposed an adjustment that would result in an aggregate tax deficiency for fiscal 2002 through 2004 of approximately $236.2 million, $130.5 million of which would be a reduction of certain tax credits that would otherwise be available either as refund claims or to offset taxes due in future periods. In August 2008, we timely filed a protest to the proposed deficiency with the IRS, which will cause the matter to be referred to the Appeals Office of the IRS. An adverse outcome of this matter could result in significant tax expense and harm our results of operations and financial condition.
Unfavorable tax law changes, an unfavorable government review of our tax returns or changes in our geographical earnings mix or forecasts of foreign source income could adversely affect our effective tax rate and our operating results.
Our operations are subject to income and transaction taxes in the United States and in multiple foreign jurisdictions. A change in the tax law in the jurisdictions in which we do business, including an increase in tax rates or an adverse change in the treatment of an item of income or expense, could result in a material increase in our tax expense.
Our tax filings are subject to review or audit by the IRS and state, local and foreign taxing authorities. We exercise judgment in determining our worldwide provision for income taxes and, in the ordinary course of our business, there may be transactions and calculations where the ultimate tax determination is uncertain. The IRS examinations of our federal tax returns for the years 2000-2001 and 2002-2004 resulted in significant proposed adjustments. Although we believe our tax estimates are reasonable, we can provide no assurance that any final determination in an audit will not be materially different than the treatment reflected in our historical income tax provisions and accruals. An assessment of additional taxes as a result of an audit could adversely affect our income tax provision and net income in the period or periods for which that determination is made.
We have operations both in the United States and in multiple foreign jurisdictions with a wide range of statutory tax rates. Certain foreign operations are subject to temporary favorable foreign tax rates. Therefore, any changes in our geographical earning mix in various tax jurisdictions, including those resulting from transfer pricing adjustments and expiration of or amendments to foreign tax rulings, could materially increase our effective tax rate. Furthermore, we maintain deferred tax assets related to federal foreign tax credits and our ability to use these credits is dependent upon having sufficient future foreign source income in the United States. Changes in our forecasts of such future foreign source income could result in an adjustment to the deferred tax asset and a related charge to earnings which could materially affect our financial results.
Our revenue and earnings fluctuate and if our financial results fail to meet stockholder expectations our stock price could decline.
Many factors affect our revenue and earnings, including customer demand, license mix, the timing of revenue recognition on products and services sold, causing our revenue and earnings results to fluctuate. Accordingly, stockholders should not view our historical results as necessarily indicative of our future performance.
From time to time, we provide targets related to our future financial performance. In addition, financial analysts publish their own expectations of our future financial performance. Because our quarterly revenue and our operating results fluctuate, future financial performance is difficult to predict. Downward adjustments of our targets or the failure to meet our targets or the expectations of research analysts could cause the market price of our common stock to decline.
Some of the specific factors that could affect our revenue and earnings in a particular quarter or over several fiscal periods include, but are not limited to:
· The market for EDA products is dynamic and depends on a number of factors including consumer demand for our customers products, customer research and development and EDA budgets, pricing, our competitors product offerings and customer design starts. It is difficult to predict in advance the effect of these and other factors on our customers demand for our products on a medium or long term basis. As a result, actual future customer purchases could differ materially from our forecasts which, in turn, could cause our actual revenue to be materially different than our publicly disclosed targets.
· We base our operating expenses in part on our expectations for future revenue and generally must commit to expense levels in advance of revenue being recognized. Since only a small portion of our expenses varies with revenue, any revenue shortfall typically causes a direct reduction in net income.
· Our revenue and earnings targets over a number of fiscal periods assume a certain level of orders and a certain mix between upfront and time-based license revenue. The amount of orders received and changes in the mix due to factors such as the level of overall license orders, customer demand, customer payment terms and ship dates could result in lower revenue and harm our operating results. For example, if we ship more licenses generating upfront revenue than expected during any given fiscal period, our revenue and earnings for that period could be above our targets even if orders are below target; conversely, if we ship fewer licenses generating upfront revenue than expected, our revenue and earnings for that period could fall below our targets even if orders meet or even exceed our target. Similarly, if we receive a lower-than-expected level of license orders generating time-based revenue during a given period, our revenue in future periods could be negatively affected.
· We may be required to implement a number of cost control measures in order to meet our externally-communicated financial targets, any of which could fail to result in the anticipated cost savings or could harm our business.
· We often amend our contracts with our customers to extend the term or add new products. Although these amendments can provide a longer-term payment stream from the customers, they can also result in a lower amount of revenue being recognized per year than under the original arrangement even if the total value of the extended contract is larger.
· Certain of our license agreements provide customers the right to re-mix a portion of the software initially subject to the license for other specified Synopsys products. While this practice helps assure the customers access to the complete design flow needed to manufacture its product, use of these arrangements could result in reduced revenue compared to licensing the individual tools separately.
· In the past, we have regularly received a significant portion of our orders for a given quarter in the last one or two weeks of the quarter. The delay of one or more orders, particularly an order generating upfront revenue, could cause us to have lower revenue and/or earnings for that quarter.
· A large portion of our revenue is derived from a relatively small number of large customers. While our agreements with such customers are binding multi-year agreements, if we were to lose these customers or if they did not renew their agreements with us, over time our financial results could be adversely affected.
· We make significant judgments relating to revenue recognition, specifically determining the existence of proper documentation, establishing that the fee is fixed or determinable, verifying delivery of our products and services and assessing the creditworthiness of our customers. While we believe our judgments in these areas are reasonable, there can be no assurance that such judgments will not be challenged in the future. In such an event, we could be required to reduce the amount of revenue we have recognized in prior periods, which would have an adverse impact on our reported results of operations for those periods.
· Our customers spend a great deal of time reviewing and testing our products, either alone or against competing products, before making a purchase decision. Accordingly, our customers evaluation and purchase cycles may not match our fiscal quarters. Further, sales of our products and services may be delayed if customers delay project approvals or starts because of budgetary constraints or their budget cycles.