Xilinx 10-Q 2005
WASHINGTON, D.C. 20549
ý Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended October 1, 2005 or
o Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from to .
Commission File Number 0-18548
(Exact name of registrant as specified in its charter)
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 ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes ý No o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No ý
Shares outstanding of the Registrants common stock:
Part I. Financial Information
Item 1. Financial Statements
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
See notes to condensed consolidated financial statements.
CONDENSED CONSOLIDATED BALANCE SHEETS
(1) Derived from audited financial statements
See notes to condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to condensed consolidated financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The accompanying interim condensed consolidated financial statements have been prepared in conformity with United States (U.S.) generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X, and should be read in conjunction with the Xilinx, Inc. (Xilinx or the Company) consolidated financial statements filed on Form 10-K for the fiscal year ended April 2, 2005. The interim financial statements are unaudited, but reflect all adjustments which are, in the opinion of management, of a normal, recurring nature necessary to provide a fair statement of results for the interim periods presented. The results of operations for the interim periods shown in this report are not necessarily indicative of the results that may be expected for the fiscal year ending April 1, 2006 or any future period.
The Company uses a 52- to 53-week fiscal year ending on the Saturday nearest March 31. Fiscal 2006 is a 52-week year ending on April 1, 2006. Fiscal 2005, which ended on April 2, 2005, was also a 52-week fiscal year. The first and second quarters of fiscal 2006 and 2005 were all 13-week quarters.
Certain immaterial amounts from the prior periods have been reclassified to conform to the current periods presentation. These changes had no impact on previously reported net income.
During the second quarter of fiscal 2006, the Company made a reclassification adjustment of $502.6 million between Additional Paid-in Capital and Retained Earnings. This reclassification adjustment was a result of miscalculations on the gains and losses from the reissuance of the Companys treasury shares for fiscal 1995 through the first quarter of fiscal 2006. This miscalculation resulted in an intra-equity reclassification between Additional Paid-in Capital and Retained Earnings and had no impact on the Companys earnings, financial trends or ratios in any period. Total Stockholders Equity remained unchanged after the reclassification.
2. Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123(R), Share-Based Payment: An Amendment of FASB Statements No. 123 and 95 [(SFAS 123(R)]. This statement replaces SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123) and supersedes Accounting Principles Boards Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107) regarding the SECs interpretation of SFAS 123(R) and the valuation of share-based payments for public companies. SFAS 123(R) will require the Company to measure the cost of all employee stock-based compensation awards that are expected to be exercised and which are granted after the effective date based on the grant date fair value of those awards and to record that cost as compensation expense over the period during which the employee is required to perform service in exchange for the award (generally over the vesting period of the award). SFAS 123(R) addresses all forms of share-based payment awards, including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. In addition, the Company is required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. SFAS 123(R) will become effective for annual periods beginning after June 15, 2005. The Company will be required to implement the standard no later than the quarter beginning April 2, 2006. SFAS 123(R) permits public companies to adopt its requirements using either prospective recognition of compensation expense or retrospective recognition. The Company plans to adopt SFAS 123(R) using the modified-prospective method. As permitted by SFAS 123, the Company currently accounts for share-based payments to employees using APB 25s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)s fair value method will have a significant impact on the Companys results of operations. The impact of adoption of SFAS 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future.
In December 2004, the FASB issued Financial Staff Position (FSP) No. FAS 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of
2004 (FSP 109-2). On October 22, 2004, the American Jobs Creation Act of 2004 (the AJCA) was signed into law. The AJCA provides a one-time 85% dividends received deduction for certain foreign earnings that are repatriated under a plan for reinvestment in the United States, provided certain criteria are met. FSP 109-2 is effective immediately and provides accounting and disclosure guidance for the repatriation provision. FSP 109-2 allows companies additional time to evaluate the effects of the law on its unremitted earnings for the purpose of applying the indefinite reversal criteria under APB 23, Accounting for Income Taxes Special Areas, and requires explanatory disclosures for companies that have not yet completed the evaluation. The Company is currently considering the repatriation provision. The Company expects to complete this evaluation before the end of fiscal 2006. The range of possible amounts of unremitted earnings for repatriation under this provision is between zero and $500.0 million. The related potential range of income tax is between zero and $27.3 million.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections a replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS 154). This statement applies to all voluntary changes in accounting principle and changes required by an accounting pronouncement where no specific transition provisions are included. SFAS 154 requires retrospective application to prior periods financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Retrospective application is limited to the direct effects of the change; the indirect effects should be recognized in the period of the change. This statement carries forward without change the guidance contained in APB 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. However, SFAS 154 redefines restatement as the revising of previously issued financial statements to reflect the correction of an error. The provisions of SFAS 154 are effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and are required to be adopted by Xilinx in the quarter beginning April 2, 2006. The Company does not anticipate that the implementation of this standard will have a significant impact on its financial condition or results of operations.
In June 2005, the FASBs Emerging Issues Task Force reached a consensus on Issue No. 05-6, Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination (EITF 05-6). EITF 05-6 provides guidance on the amortization period for leasehold improvements in operating leases that are either acquired after the beginning of the initial lease term or acquired as the result of a business combination. This guidance requires leasehold improvements purchased after the beginning of the initial lease term to be amortized over the shorter of the assets useful life or a term that includes the original lease term plus any renewals that are reasonably assured at the date the leasehold improvements are purchased. This guidance is effective for reporting periods beginning after June 29, 2005. The adoption of this standard did not have a material impact on the Companys financial condition or results of operations.
3. Stock-Based Compensation
The Company accounts for stock-based compensation under APB 25 and related interpretations, using the intrinsic value method. In addition, the Company has adopted the disclosure requirements related to its stock plans according to SFAS 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (SFAS 148).
As required by SFAS 148, the following table shows the estimated effect on net income and net income per share as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation:
The fair values of stock options and stock purchase plan rights under the Companys stock option plans and employee stock purchase plan were estimated as of the grant date using the Black-Scholes option pricing model. The Black-Scholes model was originally developed for use in estimating a fair value of traded options and requires the input of highly subjective assumptions including expected stock price volatility. The Companys stock options and stock purchase plan rights have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimates. In the first quarter of fiscal 2006, the Company modified its volatility assumption to use implied volatility for options granted. Previously, the Company used only historical volatility in deriving its volatility assumption. Management determined that implied volatility is more reflective of market conditions and a better indicator of expected volatility than historical volatility. Calculated under SFAS 123, the per share weighted-average fair value of stock options granted during the second quarter of fiscal 2006 was $8.19 ($15.42 for the second quarter of fiscal 2005) and for the first six months of fiscal 2006 was $7.92 ($20.69 for the first six months of fiscal 2005). The pro forma stock-based employee compensation expenses for the second quarter and the first six months of fiscal 2005 have been adjusted for changes in the application of volatility assumptions used in estimating the fair value of employee stock options issued during this six-month period. The adjustment had no material impact to the pro forma condensed consolidated financial statements. Under the Companys 1990 Employee Qualified Stock Purchase Plan (Stock Purchase Plan), shares are only issued during the second and fourth quarters of the Companys fiscal year. The per share weighted-average fair values of stock purchase rights granted under the Stock Purchase Plan during the second quarter of fiscal 2006 and 2005 were $7.67 and $12.04, respectively.
Under the Stock Purchase Plan, employees purchased 631 thousand shares for $15.2 million in the second quarter of fiscal 2006 and 934 thousand shares for $15.0 million in the second quarter of fiscal 2005. The next scheduled purchase under the Stock Purchase Plan is in the fourth quarter of fiscal 2006. On August 4, 2005, the stockholders approved an amendment to increase the authorized number of shares available for issuance under the Stock Purchase Plan by 7.0 million shares. At October 1, 2005, 8.7 million shares were available for future issuance out of 34.5 million shares authorized.
4. Net Income Per Common Share
The computation of basic net income per common share for all periods presented is derived from the information on the condensed consolidated statements of income, and there are no reconciling items in the numerator used to compute diluted net income per common share. The total shares used in the denominator of the diluted net income per common share calculation includes 7.1 million and 7.2 million common equivalent shares attributable to outstanding stock options for the second quarter and the first six months of fiscal 2006, respectively, that are not included in basic net income per common share. For the second quarter and the first six months
of fiscal 2005, the total shares used in the denominator of the diluted net income per common share calculation includes 10.0 million and 11.5 million common equivalent shares attributable to outstanding stock options, respectively.
Outstanding out-of-the-money stock options to purchase approximately 29.8 million and 30.0 million shares, for the second quarter and the first six months of fiscal 2006, respectively, under the Companys stock option plans were excluded by the treasury stock calculation from diluted net income per common share as their inclusion would have been antidilutive. These options could be dilutive in the future if the Companys average share price increases and is greater than the exercise price of these options. For the second quarter and the first six months of fiscal 2005, respectively, 30.2 million and 28.8 million of the Companys stock options outstanding were excluded from the calculation.
Inventories are stated at the lower of cost (determined using the first-in, first-out method), or market (estimated net realizable value) and are comprised of the following:
6. Investment in United Microelectronics Corporation
At October 1, 2005, the fair value of the Companys equity investment in United Microelectronics Corporation (UMC) stock totaled $286.1 million. The Company accounts for its investment in UMC as available-for-sale marketable securities in accordance with SFAS 115, Accounting for Certain Debt and Equity Securities.
The following table summarizes the cost basis and fair values of the investment in UMC:
During the first six months of fiscal 2006, the fair value of the UMC investment increased by $40.0 million. The fair value of the Companys total UMC investment decreased by $10.9 million during the three months ended October 1, 2005. At October 1, 2005, the Company recorded $19.3 million of deferred tax liabilities and a net $27.8 million balance in accumulated other comprehensive income associated with the UMC investment. As of October 1, 2005, the Company classified $30.0 million in fair value ($25.1 million in adjusted cost) of the UMC investment as short-term investment as the Company intends to sell this portion of the investment within the next 12 months.
7. Common Stock Repurchase Programs
The Board of Directors has approved stock repurchase programs enabling the Company to repurchase its common stock in the open market. During the second quarter of fiscal 2006, the Company completed its $250.0 million repurchase program announced in April 2004 by repurchasing 2.1 million shares for $56.9 million. On April 20, 2005, the Board authorized the repurchase of up to an additional $350.0 million of common stock. These share repurchase programs have no stated expiration date. Through October 1, 2005, the Company had repurchased $26.0 million of the $350.0 million of common stock approved for repurchase under the April 2005 authorization. As of October 1, 2005, the Company held approximately 3.8 million shares of treasury stock in conjunction with the stock repurchase program. The Company held no shares of treasury stock in conjunction with the stock repurchase program as of April 2, 2005 since all treasury shares had been reissued under the employee stock option plans.
During the first six months of fiscal 2006, the Company entered into stock repurchase agreements with an independent financial institution. Under these agreements, Xilinx provided this financial institution with up-front payments of $50.0 million in each quarter. The financial institution agreed to deliver to Xilinx a certain number of shares based upon the volume weighted average price, during the contract period, less a specified discount. Upon payment, the $50.0 million per quarter was classified as treasury stock on the Companys condensed consolidated balance sheet. As of October 1, 2005, no up-front payment balances remained under these agreements. In addition, under the guidelines of SEC Rule 10b5-1, Xilinx entered into another agreement with the same independent financial institution each quarter to repurchase additional shares on its behalf after the conclusion of the purchase periods of the aforementioned agreements.
During the second quarter and the first six months of fiscal 2006, the Company repurchased a total of 3.0 million and 5.5 million shares of common stock for $82.9 million and $149.7 million, respectively, as adjusted for accrued and unsettled transactions and including the amounts purchased by the independent financial institution and remitted to the Company. During the second quarter and the first six months of fiscal 2005, the Company repurchased a total of 1.3 million and 2.1 million shares of common stock for $35.6 million and $66.9 million, respectively, as adjusted for accrued and unsettled transactions.
8. Comprehensive Income
The components of comprehensive income are as follows:
The components of accumulated other comprehensive income at October 1, 2005 and April 2, 2005 are as follows:
The change in the accumulated unrealized gain (loss) on available-for-sale securities, net of tax, at October 1, 2005, primarily reflects the increase in value of the UMC investment since April 2, 2005 (see Note 6). In addition, the unrealized gain on the Companys short-term and long-term investments increased by $800 thousand during the first six months of fiscal 2006.
9. Significant Customers and Concentrations of Credit Risk
Xilinx is subject to concentrations of credit risk primarily in its trade accounts receivable and investments in debt securities to the extent of the amounts recorded on the condensed consolidated balance sheet. The Company attempts to mitigate the concentration of credit risk in its trade receivables through its credit evaluation process, collection terms, distributor sales to diverse end customers and through geographical dispersion of sales. Xilinx generally does not require collateral for receivables from its end customers or from distributors.
On April 26, 2005, two of the Companys distributors, Avnet, Inc. (Avnet) and the Memec Group (Memec), announced that they had reached a definitive agreement for Avnet to acquire Memec. On July 5, 2005, Avnet announced that it had completed its acquisition of Memec. As of October 1, 2005, the combined Avnet/Memec entity accounted for 81% of total accounts receivable. Had this acquisition been completed for all periods presented, resale of product through this combined entity would have accounted for 70% and 76% of the Companys worldwide net revenues in the second quarter of fiscal 2006 and 2005, respectively, and 72% and 77% in the first six months of fiscal 2006 and 2005, respectively.
No end customer accounted for more than 10% of net revenues for any of the periods presented.
The Company mitigates concentrations of credit risk in its investments in debt securities by investing more than 80% of its portfolio in AA or higher grade securities as rated by Standard & Poors. Additionally, Xilinx limits its investments in the debt securities of a single issuer and attempts to further mitigate credit risk by diversifying risk across geographies and type of issuer.
10. Income Taxes
The Company recorded tax provisions of $12.7 million and $35.6 million for the second quarter and first six months of fiscal 2006, respectively, representing effective tax rates of 13% and 18%, respectively. The Company recorded tax provisions of $22.4 million and $51.3 million for the second quarter and first six months of fiscal 2005, respectively, representing effective tax rates of 21% and 22%, respectively. When compared to the same period last year, the reduction in the effective tax rate for the second quarter of fiscal 2006 reflects a tax benefit resulting from the favorable ruling by the U.S. Tax Court for Xilinx in its litigation with the Internal Revenue Service (IRS) for fiscal 1996 to 1999. The effective tax rate in the first six months of fiscal 2006 was positively impacted by the favorable U.S. Tax Court decision and by an increase in tax credits for research and development and affordable housing. The first six months of fiscal 2005 was negatively impacted by the non-deductibility of the write-off of acquired in-process research and development related to the acquisition of Hier Design Inc. (HDI) in June 2004, offset by a positive impact related to a tax stipulation agreement with the IRS for fiscal 1996 to 2000.
The IRS audited and issued proposed adjustments to the Company for fiscal 1996 through 2001. The Company filed petitions with the U.S. Tax Court in response to assertions by the IRS relating to fiscal 1996 through 2000. In addition, the IRS proposed adjustments to the Companys net operating loss for fiscal 2001. To date, all issues have been settled with the IRS.
On August 30, 2005, the Tax Court issued its opinion concerning whether the value of stock options must be included in the cost sharing agreement with Xilinx Ireland. The Tax Court agreed with the Company that no amount for stock options is to be included in the cost sharing agreement. Thus the court determined that the Company has no tax, interest, or penalties due for this issue. The IRS has not indicated whether it will appeal the decision to the Ninth Circuit Court of Appeals.
Xilinx leases some of its facilities and office buildings under operating leases that expire at various dates through February 2026. Some of the operating leases require payment of operating costs, including property taxes, repairs, maintenance and insurance.
Approximate future minimum lease payments under operating leases are as follows:
Most of the Companys leases contain renewal options for varying terms. Rent expense, net of rental income, under all operating leases was approximately $1.6 million and $3.3 million for the second quarter and the first six months of fiscal 2006, respectively. Rent expense, net of rental income, was approximately $1.0 million and $1.9 million for the second quarter and the first six months of fiscal 2005, respectively.
Other commitments at October 1, 2005 totaled approximately $116.3 million and consisted of purchases of inventory and other non-cancelable purchase obligations related to subcontractors that manufacture silicon wafers and provide assembly and test services. The Company expects to receive and pay for these materials and services in the next three to six months, as the products meet delivery and quality specifications. As of October 1, 2005, the Company also has approximately $20.1 million of non-cancelable obligations to providers of electronic design automation software expiring at various dates through July 2008.
In the fourth quarter of fiscal 2005, the Company committed up to $20.0 million to acquire, in the future, rights to intellectual property. License payments will be amortized over the useful life of the intellectual property acquired.
12. Product Warranty and Indemnification
The Company generally sells products with a limited warranty for product quality. The Company provides for known product issues if a loss is probable and can be reasonably estimated. The following table summarizes the warranty reserve activity for the first six months of fiscal 2006 and 2005:
The Company generally sells its products with a limited indemnification of customers against intellectual property infringement claims related to the Companys products. Xilinx has historically received only a limited number of requests for indemnification under these provisions and has not been requested to make any significant payments pursuant to these provisions.
The Company filed petitions with the U.S. Tax Court in response to assertions by the IRS that the Company owed additional tax for fiscal 1996 through 2000. On August 30, 2005, the Tax Court issued its opinion concerning the last substantive unresolved issue asserted by the IRS by ruling in favor of the Company. The IRS has not indicated whether it will appeal the decision to the Ninth Circuit Court of Appeals (see Note 10). Other than these petitions, Xilinx knows of no legal proceedings contemplated by any governmental authority or agency against the Company.
The Company allowed sales representative agreements with three related European entities, Reptronic S.A., Reptronic España, and Acsis S.r.l., a Reptronic Company (collectively Reptronic) to expire pursuant to their terms on March 31, 2003. In May 2003, Reptronic filed lawsuits in the High Court of Ireland against the Company claiming compensation arising from termination of an alleged commercial agency between Reptronic and the Company. On March 31, 2004, Reptronic amended each of its statements of claim to include an additional claim related to the termination of the alleged commercial agency. The Company filed its defenses in each case in November 2004. Pleadings are closed and discovery may commence.
On February 10, 2004, Reptronic S.A. filed a lawsuit against Xilinx SARL in the Commercial Court of Versailles. Reptronic alleged that Xilinx SARL engaged in unfair competition by not renewing the sales representative agreement and through Xilinxs activities to continue its business in the territory. In June 2005, the French Commercial Court rendered judgment in favor of Xilinx. Reptronic elected not to appeal the judgment.
On January 21, 2004, Reptronic S.A. joined Xilinx SARL into a lawsuit pending before the Labor Court of Versailles brought by five former Reptronic S.A. employees against Reptronic S.A. for unfair dismissal. By joining Xilinx SARL to this action, Reptronic S.A. seeks determination of whether the employees of Reptronic S.A. became the employees of Xilinx SARL or Xilinx Ireland by operation of French law upon the expiration of the sales representative agreement. The final hearing on this matter was held on October 6, 2005 and the court indicated it would deliver its judgment on December 22, 2005.
See Note 15 for additional pending legal proceedings.
The Company has accrued amounts that represent anticipated payments for liability for legal contingencies under the provisions of SFAS 5, Accounting for Contingencies including an increase of $3.2 million in the second quarter of fiscal 2006.
Except as stated above, there are no pending legal proceedings of a material nature to which the Company is a party or of which any of its property is the subject.
14. Goodwill and Acquisition-Related Intangibles
As of October 1, 2005 and April 2, 2005, the gross and net amounts of goodwill and acquisition-related intangibles for all acquisitions were as follows:
Amortization expense for all intangible assets for the second quarter and the first six months of fiscal 2006 was $1.8 million and $3.6 million, respectively. For the second quarter and the first six months of fiscal 2005, amortization expense for all intangible assets was $1.8 million and $3.2 million, respectively. Intangible assets are amortized on a straight-line basis. Based on the carrying value of acquisition-related intangibles recorded at October 1, 2005, and assuming no subsequent impairment of the underlying assets, the annual amortization expense for acquisition-related intangibles is expected to be as follows: fiscal 2006 (remaining six months) - $2.9 million; 2007 - $5.6 million; 2008 - $4.4 million; 2009 - $3.2 million; 2010 - $300 thousand.
15. Subsequent Event
On October 17, 2005 a patent infringement lawsuit was filed by Lizy K. John (John) against Xilinx, Inc. in the United States District Court for the Eastern District of Texas, Marshall Division. John seeks an injunction, unspecified damages and attorneys fees. The Company was served with the complaint on October 26, 2005. The Company is evaluating the claims and intends to defend the lawsuit vigorously. At this time, the Company is unable to determine if a loss is probable.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
The statements in this Managements Discussion and Analysis that are forward looking, within the meaning of the Private Securities Litigation Reform Act of 1995, involve numerous risks and uncertainties and are based on current expectations. The reader should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including those risks discussed under Factors Affecting Future Results and elsewhere in this document. Forward looking statements can often be identified by the use of forward looking words, such as may, will, could, should, expect, believe, anticipate, estimate, continue, plan, intend, project or other similar words. We disclaim any responsibility to update any forward-looking statement provided in this document.
Critical Accounting Policies and Estimates
The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our financial statements. The U.S. Securities and Exchange Commission (SEC) has defined critical accounting policies as those that are most important to the portrayal of our financial condition and results of operations and require us to make our most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, our critical policies include: valuation of marketable and non-marketable securities, which impacts losses on equity securities when we record impairments; revenue recognition, which impacts the recording of revenues; and valuation of inventories, which impacts cost of revenues and gross margin. Our critical accounting policies also include: the assessment of impairment of long-lived assets including acquisition-related intangibles, which impacts their valuation; the assessment of the recoverability of goodwill, which impacts goodwill impairment; and accounting for income taxes, which impacts the provision or benefit recognized for income taxes, as well as the valuation of deferred tax assets recorded on our consolidated balance sheet. Below, we discuss these policies further, as well as the estimates and judgments involved. We also have other key accounting policies that are not as subjective, and therefore, their application would not require us to make estimates or judgments that are as difficult, but which nevertheless could significantly affect our financial reporting.
Valuation of Marketable and Non-marketable Securities
The Companys short-term and long-term investments include marketable and non-marketable equity and debt securities. At October 1, 2005, the Company had an equity investment in UMC, a public Taiwanese semiconductor wafer manufacturing company, of $286.1 million and strategic investments in non-marketable equity securities of $21.6 million. In determining if and when a decline in market value below adjusted cost of marketable equity and debt securities is other-than-temporary, the Company evaluates quarterly the market conditions, trends of earnings, financial condition and other key measures for our investments. In determining whether a decline in value of non-marketable equity investments in private companies is other-than-temporary, the assessment is made by considering available evidence including the general market conditions in the investees industry, the investees product development status, the investees ability to meet business milestones and the financial condition and near-term prospects of the individual investee, including the rate at which the investee is using its cash and the investees need for possible additional funding at a lower valuation. When a decline in value is deemed to be other-than-temporary, the Company recognizes an impairment loss in the current periods operating results to the extent of the decline.
Sales to distributors are made under agreements providing distributor price adjustments and rights of return under certain circumstances. Revenue and costs relating to distributor sales are deferred until products are sold by the distributors to end customers. For the first six months of fiscal 2006, approximately 86% of our net revenues were from products sold to distributors for subsequent resale to original equipment manufacturers (OEMs) or their subcontract manufacturers. Revenue recognition depends on notification from the distributor that product has been sold to the end customer. Also reported by the distributor are product resale price, quantity and end customer shipment information, as well as inventory on hand. Reported distributor inventory on hand is reconciled to deferred revenue balances monthly. We maintain system controls to validate distributor data and verify that the reported information is accurate. Deferred income on shipments to distributors reflects the effects of distributor price adjustments and, the amount of gross margin expected to be realized when distributors sell through product purchased from us. Accounts receivable from distributors are recognized and inventory is relieved when title to inventories transfers, typically upon shipment from Xilinx at which point we have a legally enforceable right to collection under normal payment terms.
Revenue from sales to our direct customers is recognized upon shipment provided that persuasive evidence of a sales arrangement exists, the price is fixed, title has transferred, collection of resulting receivables is reasonably assured, and there are no customer acceptance requirements and no remaining significant obligations. For each of the periods presented, there were no formal acceptance provisions with our direct customers.
Revenue from software term licenses is deferred and recognized as revenue over the term of the licenses of one year. Revenue from support services is recognized when the service is performed. Revenue from support products, which includes software and services sales, was approximately 6% to 7% of net revenues for all of the periods presented.
Allowances for end customer sales returns are recorded based on historical experience and for known pending customer returns or allowances.
Valuation of Inventories
Inventories are stated at the lower of actual cost (determined using the first-in, first-out method) or market (estimated net realizable value). The valuation of inventory requires us to estimate excess or obsolete inventory as well as inventory that is not of saleable quality. We review and set standard costs quarterly at current manufacturing costs in order to approximate actual costs. Our manufacturing overhead standards for product costs are calculated assuming full absorption of forecasted spending over projected volumes, adjusted for excess capacity. Given the cyclicality of the market, the obsolescence of technology and product lifecycles, we write down inventory based on forecasted demand and technological obsolescence. These factors are impacted by market and economic conditions, technology changes, new product introductions and changes in strategic direction and require estimates that may include uncertain elements. The estimates of future demand that we use in the valuation of inventory are the basis for our published revenue forecasts, which are also consistent with our short-term manufacturing plans. If our demand forecast for specific products is greater than actual demand and we fail to reduce manufacturing output accordingly, we could be required to write down additional inventory, which would have a negative impact on our gross margin.
Impairment of Long-Lived Assets Including Acquisition-Related Intangibles
Long-lived assets and certain identifiable intangible assets to be held and used are reviewed for impairment if indicators of potential impairment exist. Impairment indicators are reviewed on a quarterly basis. When indicators of impairment exist and assets are held for use, we estimate future undiscounted cash flows attributable to the assets. In the event such cash flows are not expected to be sufficient to recover the recorded value of the assets, the assets are written down to their estimated fair values based on the expected discounted future cash flows attributable to the assets or based on appraisals. Factors affecting impairment of assets held for use include the overall profitability of the Companys business and our ability to generate positive cash flows.
When assets are removed from operations and held for sale, we estimate impairment losses as the excess of the carrying value of the assets over their fair value. Factors affecting impairment of assets held for sale include market conditions. Changes in any of these factors could necessitate impairment recognition in future periods for assets held for use or assets held for sale.
As required by SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), goodwill is not amortized but is subject to impairment tests on an annual basis, or more frequently if indicators of potential impairment exist, and goodwill is written down when it is determined to be impaired. We perform an annual impairment review in the fourth quarter of each year and compare the fair value of the reporting unit in which the goodwill resides to its carrying value. If the carrying value exceeds the fair value, the goodwill of the reporting unit is potentially impaired. For purposes of impairment testing under SFAS 142, Xilinx operates as a single reporting unit. We use the quoted market price method to determine the fair value of the reporting unit. Based on the impairment review performed during the fourth quarter of fiscal 2005, there was no impairment of goodwill in fiscal 2005. Unless there are indicators of impairment, our next impairment review for RocketChips, Triscend Corporation (Triscend) and HDI goodwill will be performed and completed in the fourth quarter of fiscal 2006. To date, no impairment indicators have been identified.
Accounting for Income Taxes
Xilinx is a multinational corporation operating in multiple tax jurisdictions. We must determine the allocation of income to each of these jurisdictions based on estimates and assumptions and apply the appropriate tax rates for these jurisdictions. We undergo routine audits by taxing authorities regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. Tax audits often require an extended period of time to resolve and may result in income tax adjustments if changes to the allocation are required between jurisdictions with different tax rates.
In determining income for financial statement purposes, we must make certain estimates and judgments. These estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenue and expense. Additionally, we must estimate the amount and likelihood of potential losses arising from audits or deficiency notices issued by taxing authorities. The taxing authorities positions and our assessment can change over time resulting in material impacts on the provision for income taxes in periods when these changes occur.
We must also assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a reserve, in the form of a valuation allowance, for the deferred tax assets that we estimate will not ultimately be recoverable. As of October 1, 2005 and April 2, 2005, we had a valuation allowance for the deferred tax assets relating to certain California tax credit carryforwards.
Results of Operations: Second quarter and first six months of fiscal 2006 compared to the second quarter and first six months of fiscal 2005
The following table sets forth statement of income data as a percentage of net revenues for the periods indicated:
Net revenues of $398.9 million in the second quarter of fiscal 2006 represented a 1% decrease from the comparable prior year period of $403.3 million. Net revenues for the first six months of fiscal 2006 were $804.3 million, a 3% decline from the prior year comparable period of $826.9 million.
The decrease in net revenues in the second quarter of fiscal 2006 resulted from weaker than expected sales in the Communications end market, especially 3G wireless infrastructure which declined double digits compared to the same period last year. The revenue growth in Consumer, Automotive, Industrial and Other end markets did not sufficiently offset weakness in the Communications end market. The weakness in the Communications end market also adversely affected our net revenues from Mainstream and Base Products, which declined double digits during the second quarter and the first six months of fiscal 2006, as many of these products serve the Communications end market.
No end customer accounted for more than 10% of net revenues for any of the periods presented.
Net Revenues by Product
We classify our product offerings into four categories: New, Mainstream, Base and Support Products. These product categories, excluding Support Products, are modified on a periodic basis to better reflect advances in technology. The most recent modification was on July 4, 2004, which was the beginning of our second quarter of fiscal 2005. Amounts for the prior periods have been reclassified to conform to the recategorization. New Products include our most recent product offerings and include the Spartan-3TM, Spartan-3E, Spartan-IIETM, Virtex-4TM, Virtex-II ProTM, EasyPathTM and CoolRunner-IITM product lines. Mainstream Products include the CoolRunnerTM, Spartan-IITM, SpartanXLTM, Virtex-IITM, Virtex-ETM and VirtexTM product lines. Base Products consist of our mature product families and include the XC3000, XC3100, XC4000, XC5200, XC9500, XC9500XL, XC9500XV, XC4000E, XC4000EX, XC4000XL, XC4000XLA, XC4000XV and SpartanTM families. Support Products make up the remainder of our product offerings and include configuration solutions (serial PROMs programmable read only memory), software, intellectual property (IP) cores, customer training, design services and support.
Net revenues by product categories for the second quarter and the first six-months of fiscal 2006 were as follows:
New Products continue to lead our revenue growth, increasing 71% and 91% in the second quarter and the first six months of fiscal 2006, respectively, compared to the same periods last year. New Products represented 30% and 28% of total net revenues in the second quarter and first six months of fiscal 2006 compared to 17% and 14% in the same periods last year, respectively.
The increase in New Products net revenues during the second quarter and the first six months of fiscal 2006 was due to the strong market acceptance of Virtex-4, Virtex-II Pro and Spartan-3 across a broad base of end markets. Our 130 nanometer Virtex-II Pro is currently the largest contributor to the New Products net revenues. However, design win momentum is rapidly shifting to 90 nanometer technology which is fueling the growth of our New Products category. Our 90 nanometer products include our high-volume, low-cost Spartan-3 family and our high-performance, high-density Virtex-4 family. We expect that sales of New Products will continue to increase over time as customer adoption of these products continues to be strong and customers begin moving their programs into volume production.
The decreases in both absolute dollars and as a percentage of total net revenues for Mainstream and Base Products during the second quarter and the first six months of fiscal 2006 were due to a decline in sales of our older and more mature products on 180 nanometer process technology or above.
The decrease in Support Products net revenues during the second quarter and the first six months of fiscal 2006 was due to a decline in configuration solutions (serial PROMs). PROM memories are used primarily to configure field programmable gate arrays (FPGAs).
Net Revenues by Geography
Geographic revenue information is based on the geographic location where we shipped our products to distributors or OEMs. This may differ from the geographic location of the end customers. Net revenues by geography for the second quarter and the first six months of fiscal 2006 and 2005 were as follows:
As a percentage of total net revenues and in absolute dollars, net revenues in North America declined during the second quarter and the first six months of fiscal 2006 compared to the same periods last year primarily because of the weakness in Communications and Industrial and Other end markets. The Industrial and Other end market consists of aerospace and defense, test and measurement and scientific and medical imaging. Net revenues in Europe declined during the second quarter and the first six months of fiscal 2006 compared to the same periods last year primarily because of weakness in the Communications end market.
Net revenues in Japan increased during the second quarter and the first six months of fiscal 2006 compared to the same periods last year. The increase was primarily due to growing adoption of our programmable logic devices (PLDs) in various communications and consumer applications that were previously served by application specific integrated circuits (ASICs).
Net revenues in Asia Pacific/Rest of World increased slightly in the second quarter and the first six months of fiscal 2006 compared to the same periods last year. In the second quarter of fiscal 2006, net revenues in Asia Pacific were impacted by a slowdown relating to several U.S.-based communications and storage companies with manufacturing operations in Asia. Xilinx refers to business generated by U.S. and European customers with Asian-based manufacturing operations as transfer business. Currently, over 50% of Asia Pacific net revenues are generated from transfer business.
Net Revenues by End Markets
Our end market revenue data is derived from our understanding of our end customers primary markets. In order to better reflect our diversification efforts and to provide more detailed end market information, we split the category formerly called Consumer, Industrial and Other into two components: Consumer and Automotive and Industrial and Other beginning with the quarter ended January 1, 2005.
As a result, we classify our net revenues by end markets into four categories: Communications, Storage and Servers, Consumer and Automotive, and Industrial and Other. Since historical comparisons of the two new categories are not available, we have combined them in the table below to show their aggregated changes over the comparable periods. The percentage change calculation in the table below represents the year-to-year dollar change in each end market. We will begin to show historical comparisons of the two new categories when available.
Net revenues by end markets for the second quarter and the first six months of fiscal 2006 and 2005 were as follows:
During the second quarter and the first six months of fiscal 2006, our top global customers, that comprised approximately 30% of our total net revenues, experienced broad-based weakness across several end markets including Storage, Communications, and Industrial and Other.
Net revenues from the Communications end market declined 10% in the second quarter of fiscal 2006 from the comparable period last year. Net revenues from the Communications end market for the first six months of fiscal 2006 declined 9% from the same period last year. This was attributed to a decline in wireless infrastructure business from a year ago.
Net revenues from the Storage and Servers end market were flat for the year-over-year periods but in general Storage revenues have been declining due to some customer programs migrating to lower cost alternatives.
The growth in Consumer, Automotive, Industrial and Other end markets for the second quarter and the first six months of fiscal 2006 was primarily driven by the success of our diversification efforts into new markets and applications. Our success in these end markets is due to many factors, including the enhanced features and low cost of our newer products, more customized product offerings and certain competitive advantages of PLDs which can enable shorter product design cycles for our customers.
The gross margin decline of 2.6 percentage points for the second quarter of fiscal 2006 compared to the prior period was due to a significant product mix shift towards 130 nanometer and 90 nanometer products, which currently have lower margins than our more mature products, and a decline in Mainstream and Base Products, which have higher gross margins.
Gross margin may be adversely affected in the future due to product mix shifts, competitive pricing pressure, manufacturing yield issues and wafer pricing. We expect to mitigate these risks by continuing to improve yields on process technologies of 130 and 90 nanometers, and employing a dual foundry strategy, which promotes price competition and manufacturing flexibility.
In order to compete effectively, we pass manufacturing cost reductions on to our customers in the form of reduced prices to the extent that we can maintain acceptable margins. Price erosion is common in the semiconductor industry, as advances in both product architecture and manufacturing process technology permit continual reductions in unit cost. We have historically been able to offset much of the revenue decline in our mature products with increased revenues from newer products.
Research and Development
The increase in research and development (R&D) expenses over the prior years comparable periods was primarily related to additional product development investment required for next generation products and our increased investments in new markets such as digital signal processing (DSP) and embedded processing.
We plan to continue to invest in R&D efforts in a wide variety of areas such as new products, 90 and 65-nanometer and more advanced process technologies, IP cores, DSP, embedded processing and the development of new design and layout software.
Selling, General and Administrative
Selling, general and administrative (SG&A) expenses were generally flat for the second quarter of fiscal 2006 compared to the same period last year. The decrease in SG&A expenses for the first six months of fiscal 2006 over the same period last year was attributable to lower commissions due to lower net revenues and a reduction in tax litigation costs and other variable expenses such as marketing and promotional expenses.
Amortization of Acquisition-Related Intangibles
Amortization expense was primarily related to the intangible assets attained from the RocketChips, Triscend and HDI acquisitions. Amortization expense for these intangible assets has increased from the comparable prior year periods, due to the acquisition of HDI in June 2004. We expect amortization of acquisition-related intangibles to be approximately $6.5 million for fiscal 2006 compared with $6.7 million for fiscal 2005.
Litigation Settlements and Contingencies
The Company has accrued amounts that represent anticipated payments for liability for legal contingencies under the provisions of SFAS 5, Accounting for Contingencies including an increase of $3.2 million in the second quarter of fiscal 2006. See Note 13 to our condensed consolidated financial statements included in Part 1. Financial Information and Item 1. Legal Proceedings included in Part II. Other Information.
Write-Off of Acquired In-Process Research and Development
In connection with the acquisition of HDI in the first quarter of fiscal 2005, approximately $7.2 million of in-process research and development costs were written off. The projects identified as in-process would have required additional effort in order to establish technological feasibility. These projects had identifiable technological risk factors indicating that successful completion, although expected, was not assured. If an identified project is not successfully completed, there is no alternative future use for the project; therefore, the expected future income will not be realized. The acquired in-process research and development represented the fair value of technologies in the development stage that had not yet reached technological feasibility and did not have alternative future uses.
To determine the value of HDIs in-process research and development, the expected future cash flow attributable to the in-process technology was discounted, taking into account the percentage of completion, utilization of pre-existing core technology, risks related to the characteristics and applications of the technology, existing and future markets, and technological risk associated with completing the development of the technology. We expensed these non-recurring charges in the period of acquisition. The development project was completed during the fourth quarter of fiscal 2005 at a cost that approximated the original estimate.
Interest Income and Other, Net
The increase in interest income and other, net over the prior years comparable periods was due to higher yields resulting from an increase in short-term interest rates and $3.4 million of interest income earned from an IRS prepayment relating to the Tax Court issue.
Provision for Income Taxes
When compared to the same period last year, the reduction in the effective tax rate for the second quarter of fiscal 2006 reflects a tax benefit resulting from the favorable ruling by the U.S. Tax Court for Xilinx in its litigation with the IRS for fiscal 1996 to 1999. The effective tax rate in the first six months of fiscal 2006 was positively imp