UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------------- FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JULY 4, 1998 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM __________ TO __________ COMMISSION FILE NUMBER 1-10606 ----------------------- CADENCE DESIGN SYSTEMS, INC. (Exact name of registrant as specified in its charter) ----------------------- DELAWARE 77-0148231 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 2655 SEELY AVENUE, BUILDING 5, SAN JOSE, CALIFORNIA 95134 (Address of principal executive offices) (Zip Code) (408) 943-1234 Registrant's telephone number, including area code ----------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- At August 7, 1998, there were 212,307,359 shares of the registrant's Common Stock, $0.01 par value outstanding.
CADENCE DESIGN SYSTEMS, INC. INDEX PAGE PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Condensed Consolidated Balance Sheets: July 4, 1998 and January 3, 1998 . . . . . . . . . . . . . . 3 Condensed Consolidated Statements of Income: Three and Six Months Ended July 4, 1998 and June 28, 1997 . . 4 Condensed Consolidated Statements of Cash Flows: Six Months Ended July 4, 1998 and June 28, 1997 . . . . . . . 5 Notes to Condensed Consolidated Financial Statements. . . . . . . . . . . 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . 9 Item 3. Quantitative and Qualitative Disclosures About Market Risk. . .19 PART II. OTHER INFORMATION Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . .22 Item 4. Submission of Matters to a Vote of Security Holders . . . . . .23 Item 5. Other Information . . . . . . . . . . . . . . . . . . . . . .23 Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . .24 Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 2
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CADENCE DESIGN SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) <TABLE> <CAPTION> ASSETS JULY 4, JANUARY 3, 1998 1998 ---------- ---------- (Unaudited) <S> <C> <C> Current assets: Cash and cash equivalents. . . . . . . . . . . . $ 134,914 $ 207,024 Short-term investments . . . . . . . . . . . . . 125,826 97,180 Accounts receivable, net . . . . . . . . . . . . 230,565 205,006 Prepaid expenses and other . . . . . . . . . . . 79,854 99,849 ---------- ---------- Total current assets . . . . . . . . . . . . . 571,159 609,059 Property, plant, and equipment, net. . . . . . . . 230,421 197,421 Software development costs, net. . . . . . . . . . 14,050 15,068 Purchased software and intangibles, net. . . . . . 31,546 10,117 Installment contract receivables . . . . . . . . . 103,966 61,326 Other non-current assets . . . . . . . . . . . . . 135,042 130,859 ---------- ---------- $1,086,184 $1,023,850 ---------- ---------- ---------- ---------- LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of long-term debt. . . . . . . . $ 802 $ 794 Accounts payable and accrued liabilities . . . . 148,367 156,426 Income taxes payable . . . . . . . . . . . . . . 8,710 5,161 Deferred revenue . . . . . . . . . . . . . . . . 104,256 106,414 ---------- ---------- Total current liabilities. . . . . . . . . . . 262,135 268,795 ---------- ---------- Long-term liabilities: Long-term debt . . . . . . . . . . . . . . . . . 1,048 1,599 Minority interest liability. . . . . . . . . . . 196 121 Other long-term liabilities. . . . . . . . . . . 33,529 26,238 ---------- ---------- Total long-term liabilities. . . . . . . . . . 34,773 27,958 ---------- ---------- Stockholders' equity: Preferred stock. . . . . . . . . . . . . . . . . -- -- Common stock and capital in excess of par value . . . . . . . . . . . . . . . . . . 596,638 502,602 Treasury stock at cost (8,351 and 6,739 shares, respectively) . . . . . . . . . . . . (167,905) (97,285) Retained earnings. . . . . . . . . . . . . . . . 369,842 328,934 Accumulated translation adjustment . . . . . . . (9,299) (7,154) ---------- ---------- Total stockholders' equity . . . . . . . . . . 789,276 727,097 ---------- ---------- $1,086,184 $1,023,850 ---------- ---------- ---------- ---------- </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 3
CADENCE DESIGN SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED ---------------------- -------------------- JULY 4, JUNE 28, JULY 4, JUNE 28, 1998 1997 1998 1997 ------- -------- ------- -------- <S> <C> <C> <C> <C> Revenue: Product. . . . . . . . . . . . . . . . . . . . . $ 162,547 $ 116,540 $ 316,596 $ 218,863 Services . . . . . . . . . . . . . . . . . . . . 64,727 39,614 117,029 73,368 Maintenance. . . . . . . . . . . . . . . . . . . 64,514 54,312 128,386 105,784 ---------- ---------- ---------- ---------- Total revenue . . . . . . . . . . . . . . . . 291,788 210,466 562,011 398,015 ---------- ---------- ---------- ---------- Costs and expenses: Cost of product. . . . . . . . . . . . . . . . . 12,374 10,090 24,711 19,043 Cost of services . . . . . . . . . . . . . . . . 48,351 27,868 88,005 52,062 Cost of maintenance. . . . . . . . . . . . . . . 10,188 5,634 20,531 11,386 Marketing and sales. . . . . . . . . . . . . . . 71,366 59,689 140,611 114,858 Research and development . . . . . . . . . . . . 42,961 33,799 84,668 65,052 General and administrative . . . . . . . . . . . 16,303 13,638 32,824 25,842 Unusual items. . . . . . . . . . . . . . . . . . -- 22,366 85,957 34,114 ---------- ---------- ---------- ---------- Total costs and expenses. . . . . . . . . . . 201,543 173,084 477,307 322,357 ---------- ---------- ---------- ---------- Income from operations. . . . . . . . . . . 90,245 37,382 84,704 75,658 Other income, net. . . . . . . . . . . . . . . . . 2,576 3,255 5,195 18,011 ---------- ---------- ---------- ---------- Income before provision for income taxes . 92,821 40,637 89,899 93,669 Provision for income taxes . . . . . . . . . . . . 26,454 12,191 48,991 28,101 ---------- ---------- ---------- ---------- Net income. . . . . . . . . . . . . . . . . $ 66,367 $ 28,446 $ 40,908 $ 65,568 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Basic net income per share . . . . . . . . . . . . $ 0.31 $ 0.15 $ 0.19 $ 0.36 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Diluted net income per share . . . . . . . . . . . $ 0.28 $ 0.13 $ 0.17 $ 0.32 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Weighted average common shares outstanding . . . . 212,210 191,194 211,112 183,564 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Weighted average common and potential common shares outstanding--assuming dilution . . . . . 236,205 213,732 235,601 206,643 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 4
CADENCE DESIGN SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> SIX MONTHS ENDED ------------------------- JULY 4, JUNE 28, 1998 1997 ----------- ----------- <S> <C> <C> Cash and Cash Equivalents at Beginning of Period . . . . . . . $ 207,024 $ 284,512 ----------- ----------- Cash Flows from Operating Activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . 40,908 65,568 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization . . . . . . . . . . . . . . 41,658 22,959 Deferred income taxes . . . . . . . . . . . . . . . . . . (5,628) (4,242) Write-offs of equipment and other assets, net . . . . . . 1,751 1,834 Write-off of in-process research and development. . . . . 82,000 4,860 Other long-term liabilities and minority interest expense. . . . . . . . . . . . . . . . . . . . 7,047 2,798 Gain on sale of subsidiary stock. . . . . . . . . . . . . -- (13,061) Changes in operating assets and liabilities, net of effect of acquired and disposed businesses: Accounts receivable . . . . . . . . . . . . . . . . . (19,629) 6,848 Prepaid expenses and other. . . . . . . . . . . . . . 22,697 (1,727) Installment contract receivables. . . . . . . . . . . (42,640) (6,500) Accrued liabilities and payables. . . . . . . . . . . (22,163) 17,615 Income taxes payable. . . . . . . . . . . . . . . . . 48,341 26,139 Deferred revenue. . . . . . . . . . . . . . . . . . . (2,234) (3,578) ----------- ----------- Net cash provided by operating activities . . . . . 152,108 119,513 ----------- ----------- Cash Flows from Investing Activities: Maturities of short-term investments--held-to-maturity . . . 38,498 13,059 Purchases of short-term investments--held-to-maturity . . . (35,843) (57,625) Maturities of short-term investments--available-for-sale . . 378,049 -- Purchases of short-term investments--available-for-sale. . . (409,350) -- Purchases of property, plant, and equipment. . . . . . . . . (55,822) (46,147) Capitalization of software development costs . . . . . . . . (11,590) (6,800) Increase in purchased software, intangibles, and other assets . . . . . . . . . . . . . . . . . . . . . (18,609) (10,613) Net proceeds from sale of subsidiary stock . . . . . . . . . -- 18,582 Effect of deconsolidation on cash. . . . . . . . . . . . . . -- (9,536) Purchase of businesses, net of acquired cash . . . . . . . . (51,313) 42,358 Sale of put warrants . . . . . . . . . . . . . . . . . . . . 23,149 5,688 Purchase of call options . . . . . . . . . . . . . . . . . . (23,149) (5,688) ----------- ----------- Net cash used for investing activities. . . . . . . . (165,980) (56,722) ----------- ----------- Cash Flows from Financing Activities: Principal payments on capital lease obligations and long-term debt . . . . . . . . . . . . . . . . . . . . (1,203) (19,529) Sale of common stock . . . . . . . . . . . . . . . . . . . . 43,411 12,693 Purchases of treasury stock. . . . . . . . . . . . . . . . . (98,103) (21,079) ----------- ----------- Net cash used for financing activities. . . . . . . . (55,895) (27,915) ----------- ----------- Effect of exchange rate changes on cash. . . . . . . . . . . . (2,343) (2,630) ----------- ----------- Increase (decrease) in Cash and Cash Equivalents . . . . . . . (72,110) 32,246 ----------- ----------- Cash and Cash Equivalents at End of Period . . . . . . . . . . $ 134,914 $ 316,758 ----------- ----------- ----------- ----------- </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 5
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) BASIS OF PRESENTATION The condensed consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company's annual report on Form 10-K for the fiscal year ended January 3, 1998. The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of management, necessary to state fairly the results for the periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full fiscal year. The preparation of condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain amounts in the consolidated financial statements as of January 3, 1998 and for the three and six months ended June 28, 1997, have been reclassified to conform with the 1998 presentation. REVENUE RECOGNITION Effective January 4, 1998, the Company adopted Statement of Position (SOP) 97-2, "Software Revenue Recognition." SOP 97-2 provides guidance on applying generally accepted accounting principles in recognizing revenue on software transactions. The adoption of SOP 97-2 did not have a material impact on the Company's consolidated financial position or results of operations. ACQUISITIONS In February 1998, the Company acquired all of the outstanding stock of Symbionics Group Limited, a U.K. corporation, for approximately 1 million shares of the Company's common stock and $21.3 million of cash. The total purchase price was $46.1 million, and the acquisition was accounted for as a purchase. In connection with the acquisition, net intangibles of $46 million were acquired, of which $40 million was reflected as a charge to operations for the write-off of in-process research and development that had not reached technological feasibility and, in management's opinion, had no probable alternative future use. Intangibles arising from the acquisition are being amortized on a straight-line basis over five years. 6
In March 1998, the Company acquired all of the outstanding stock of Excellent Design, Inc., a Japanese corporation, for cash. The total purchase price was $40.9 million, and the acquisition was accounted for as a purchase. In connection with the acquisition, net intangibles of $48.7 million were acquired, of which $42 million was reflected as a charge to operations for the write-off of in-process research and development that had not reached technological feasibility and, in management's opinion, had no probable alternative future use. Intangibles arising from the acquisition are being amortized on a straight-line basis over five years. COMPREHENSIVE INCOME In 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income," which was adopted by the Company in the first quarter of 1998. SFAS No. 130 requires companies to report a new, additional measure of income on the income statement or to create a new financial statement that has the new measure of income on it. "Comprehensive income" includes foreign currency translation gains and losses and other unrealized gains and losses that have been previously excluded from net income and reflected instead in equity. A summary of comprehensive income follows: <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED ---------------------- -------------------- July 4, June 28, July 4, June 28, 1998 1997 1998 1997 ------- -------- ------- -------- <S> <C> <C> <C> <C> (In thousands) Net income . . . . . . . . . . . . . . . . . . . . $ 66,367 $ 28,446 $ 40,908 $ 65,568 Foreign currency translation adjustment. . . . . . (939) 960 (2,145) (2,751) --------- --------- --------- --------- Comprehensive income . . . . . . . . . . . . . . . $ 65,428 $ 29,406 $ 38,763 $ 62,817 --------- --------- --------- --------- --------- --------- --------- --------- </TABLE> NET INCOME PER SHARE Basic net income per share is calculated by dividing net income by the weighted average shares of common stock outstanding during the period, and for diluted net income per share, net income is divided by the weighted average shares of common stock outstanding and potential common shares during the period. Potential common shares included in the dilution calculation consist of dilutive shares issuable upon the exercise of outstanding common stock options, warrants, and put warrants computed using the treasury stock method. The following is a reconciliation of the weighted average common shares used to calculate basic net income per share to the weighted average common and potential common shares used to calculate diluted net income per share: <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED ---------------------- -------------------- July 4, June 28, July 4, June 28, 1998 1997 1998 1997 ------- -------- ------- -------- <S> <C> <C> <C> <C> (In thousands) Weighted average common shares used to calculate basic net income per share . . . . . . . . . . . 212,210 191,194 211,112 183,564 Options . . . . . . . . . . . . . . . . . . . 23,707 22,115 24,222 22,706 Warrants and other contingent shares. . . . . 284 192 265 257 Puts. . . . . . . . . . . . . . . . . . . . . 4 231 2 116 ------- ------- ------- ------- Weighted average common and potential common shares used to calculate diluted net income per share . . . . . . . . . . . . . . . . . . . 236,205 213,732 235,601 206,643 ------- ------- ------- ------- ------- ------- ------- ------- </TABLE> 7
CONTINGENCIES Refer to Part II, Item 1 for a description of legal proceedings. PUT WARRANTS AND CALL OPTIONS The Company has two seasoned authorized stock repurchase programs. Under one program, the Company repurchases common stock to satisfy estimated requirements for shares to be issued under its Employee Stock Purchase Plan (ESPP) over the next 12 months. The shares acquired under the second program will be used to meet the recurring share issuance requirements of the 1997 Stock Option Plan. As part of its authorized repurchase programs, the Company has sold put warrants through private placements. At July 4, 1998, there were 5.3 million put warrants outstanding which entitle the holder to sell one share of common stock to the Company on a specified date and at a specified price ranging from $24.20 to $35.14 per share. Additionally, during this same period, the Company purchased call options that entitle the Company to buy on a specified date one share of common stock at a specified price. At July 4, 1998, the Company had 3.6 million call options outstanding at prices ranging from $24.44 to $35.39 per share to satisfy anticipated stock repurchase requirements under the Company's systematic repurchase programs. The put warrants and call options outstanding at July 4, 1998 are exercisable on various dates through November 12, 1999. If exercised, the put warrants will be settled with the issuance of stock equal to the difference between the exercise price and the fair value at the date of exercise. Accordingly, settlement of the put warrants could cause the Company to issue a substantial number of shares, depending on the exercise price of the put warrants and the per share fair value of the Company's common stock at the time of exercise. In addition, settlement of the put warrants could lead to the disposition by put warrant holders of shares of the Company's common stock that such holders may have accumulated in anticipation of the exercise of the put warrants or call options, which may impact the price of the Company's common stock. At July 4, 1998, because the put warrants will be settled with stock, if exercised, no amount was classified out of stockholders' equity in the consolidated balance sheet. The effect of the exercise of these put warrants and call options is reported in stockholders' equity. NEW ACCOUNTING STANDARDS In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. It requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met and that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999 and cannot be applied retroactively. The Company has not yet determined the impact SFAS No. 133 will have on its financial position, results of operations, or cash flows. In April 1998, the American Institute of Certified Public Accountants issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." The Company anticipates that SOP 98-1 will not have a material impact on its consolidated financial statements. 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED HEREIN, THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS BASED ON CURRENT EXPECTATIONS THAT INVOLVE CERTAIN RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE DISCUSSED HEREIN. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED BELOW IN "FACTORS THAT MAY AFFECT FUTURE RESULTS" AND "LIQUIDITY AND CAPITAL RESOURCES." RESULTS OF OPERATIONS REVENUE <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED ------------------- ------------------ July 4, June 28, July 4, June 28, 1998 1997 % CHANGE 1998 1997 % CHANGE ------- ------- --------- ------- -------- -------- <S> <C> <C> <C> <C> <C> <C> (In millions) Product. . . . . . . . . $ 162.6 $ 116.5 39% $ 316.6 $ 218.9 45% Services . . . . . . . . 64.7 39.6 63% 117.0 73.4 60% Maintenance. . . . . . . 64.5 54.4 19% 128.4 105.7 21% -------- -------- -------- -------- Total revenue. . . . . $ 291.8 $ 210.5 39% $ 562.0 $ 398.0 41% -------- -------- -------- -------- -------- -------- -------- -------- </TABLE> SOURCES OF REVENUE AS A PERCENT OF TOTAL REVENUE <TABLE> <S> <C> <C> <C> <C> Product. . . . . . . . . 56% 55% 56% 55% Services . . . . . . . . 22% 19% 21% 18% Maintenance. . . . . . . 22% 26% 23% 27% </TABLE> The increase in product revenue of $46.1 million and $97.7 million for the three and six month periods ended July 4, 1998, respectively, when compared to the same periods of 1997, was attributable primarily to increased demand for products used by customers to develop integrated circuits (ICs) and deep submicron designs, including design entry tools, custom layout tools, analog design tools, automatic place-and-route tools, and verification tools. Services revenue increased $25.1 million and $43.6 million in the three and six month periods ended July 4, 1998, respectively, when compared to the same periods of 1997. The increase in services revenue was primarily the result of increased demand for the Company's services offerings throughout the world. The increase in maintenance revenue of $10.1 million and $22.7 million for the three and six month periods ended July 4, 1998, respectively, as compared to the same periods of 1997, was attributable primarily to an increase in the Company's installed base of products and the sale of higher priced maintenance contracts which on average require higher support levels. Revenue from international sources was approximately $164.2 million and $104.8 million, or 56% and 50% of total revenue, for the second quarters of 1998 and 1997, respectively. For the six month period ended July 4, 1998, revenue from international sources was $285.8 million, as compared to $202.1 million for the same period of 1997, representing 51% of total revenue for each period. The increase in total revenue from international sources in the second quarter of 1998 was primarily attributable to strong revenue growth in Europe. Total revenue growth from international sources was partially offset by a $6.6 million negative impact on revenue as a result of the weakening of certain foreign currencies, primarily the Japanese yen, in relation to the U.S. dollar. 9
COST OF REVENUE <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED ------------------- ------------------ July 4, June 28, July 4, June 28, 1998 1997 % CHANGE 1998 1997 % CHANGE ------- ------- --------- ------- -------- -------- <S> <C> <C> <C> <C> <C> <C> (In millions) Product. . . . . . . . . $ 12.4 $ 10.1 23% $ 24.7 $ 19.0 30% Services . . . . . . . . $ 48.4 $ 27.9 74% $ 88.0 $ 52.1 69% Maintenance. . . . . . . $ 10.2 $ 5.6 81% $ 20.5 $ 11.4 80% </TABLE> COST OF REVENUE AS A PERCENT OF RELATED REVENUE <TABLE> <S> <C> <C> <C> <C> Product. . . . . . . . . 8% 9% 8% 9% Services . . . . . . . . 75% 70% 75% 71% Maintenance. . . . . . . 16% 10% 16% 11% </TABLE> Cost of product revenue includes costs of production personnel, packaging and documentation, and the amortization of capitalized software development costs. Cost of product increased by $2.3 million and $5.7 million for the three and six month periods ended July 4, 1998, respectively, as compared with the same periods of 1997, primarily due to higher amortization costs associated with software development costs. Cost of services revenue includes personnel and related costs associated with providing services to customers and the infrastructure to manage a services organization, as well as costs to recruit, develop and retain services professionals. Cost of services revenue increased by $20.5 million and $35.9 million for the three and six month periods ended July 4, 1998, respectively, as compared with the same periods of 1997, primarily due to the continued investment in developing new services offerings and the addition of services professionals by the Company, primarily through acquisitions and increased hiring. Services gross margins have been and may continue to be adversely affected by the cost of integrating new service professionals as well as the Company's inability to fully utilize these resources. In addition, services gross margins may continue to be adversely affected by the Company's inability to achieve operating efficiencies with its resources to implement a growing number of services offerings. Cost of maintenance revenue includes the cost of customer services such as hot-line and on-site support and the production cost of the maintenance renewal process. Cost of maintenance revenue increased by $4.6 million and $9.1 million for the three and six month periods ended July 4, 1998, respectively, as compared with the same periods of 1997, primarily due to additional costs associated with supporting a larger installed base of products and additional costs to provide higher support levels to customers. OPERATING EXPENSES <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED ------------------- ------------------ July 4, June 28, July 4, June 28, 1998 1997 % CHANGE 1998 1997 % CHANGE ------- ------- --------- ------- -------- -------- <S> <C> <C> <C> <C> <C> <C> (In millions) Marketing and sales. . . . . $ 71.4 $ 59.7 20% $ 140.6 $ 114.9 22% Research and development . . $ 43.0 $ 33.8 27% $ 84.7 $ 65.1 30% General and administrative . $ 16.3 $ 13.6 20% $ 32.8 $ 25.8 27% </TABLE> EXPENSES AS A PERCENT OF TOTAL REVENUE <TABLE> <S> <C> <C> <C> <C> Marketing and sales. . . . . 24% 28% 25% 29% Research and development . . 15% 16% 15% 16% General and administrative . 6% 6% 6% 6% </TABLE> 10
The increase in marketing and sales expenses of $11.7 million in the second quarter of 1998, as compared with the second quarter of 1997, was primarily the result of an increase of $9.1 million in employee related expenses attributable to increased headcount and commissions, as well as an increase in sales support costs in Japan of $1.4 million. The increase in marketing and sales expenses in the second quarter of 1998 was partially offset by a $1.6 million decrease resulting from the weakening of certain foreign currencies in relation to the U.S. dollar in the second quarter of 1998, as compared with the second quarter of 1997. For the six month period ended July 4, 1998, as compared with the same period of 1997, the increase in marketing and sales expenses of $25.7 million was primarily the result of an increase of $17.2 million in employee related expenses attributable to increased headcount and commissions, as well as an increase in sales support costs in Japan of $5.6 million. The Company's investment in research and development, prior to the reduction for capitalization of software development costs, was $49.1 million and $37.3 million for the second quarters of 1998 and 1997, respectively, representing 17% and 18% of total revenue, respectively. The increase in net research and development expenses for the second quarter of $9.2 million was primarily attributable to employee related costs of $6.9 million due to increased headcount and facilities costs of $3.3 million, partially offset by an increase in the capitalization of software development costs of $2.6 million. The Company capitalized $6.1 million and $3.5 million of software development costs for the second quarters of 1998 and 1997, respectively, which represented 13% and 9%, respectively, of total research and development expenditures made in each of those periods, resulting primarily from general increases in new product development. The increase in net research and development expenses of $19.6 million for the six month period ended July 4, 1998, as compared with the same period of 1997, was primarily the result of an increase of $11.7 million in employee related expenses attributable to increased headcount, facilities costs of $6.7 million and management information systems costs of $4.5 million, partially offset by an increase in the capitalization of software development costs of $4.8 million. For the six month periods ended July 4, 1998 and June 28, 1997, the Company capitalized $11.5 million and $6.8 million of software development costs, which represented 12% and 9%, respectively, of total research and development expenditures made in each of those periods, resulting primarily from general increases in new product development. In any given period, the amount of capitalized software development costs may vary depending on the exact nature of the development performed. General and administrative expenses increased by $2.7 million and $7 million for the three and six month periods ended July 4, 1998, respectively, as compared to the same periods of 1997. This was primarily attributable to an increase in consulting services fees for information services of $2.2 million and $4.1 million for the three and six month periods ended July 4, 1998, respectively, as compared to the same periods of 1997, and an increase in bad debt expense of $1.1 million and $1.9 million, respectively. UNUSUAL ITEMS There were no unusual items in the three month period ended July 4, 1998. For the three month period ended June 28, 1997, the Company incurred approximately $22.4 million of expenses related to its merger with CCT, which were included in unusual items, for the reduction of personnel whose duties were made redundant, closure of duplicated and excess facilities, fees of financial advisors, attorneys, and accountants, and other expenses associated with the merger. Additionally, the Company recorded expenses to restructure its international business operations to reduce the Company's cost structure and to further integrate and reduce selling and marketing activities. 11
In February 1998, the Company acquired all of the outstanding stock of Symbionics Group Limited, a U.K. corporation, for approximately 1 million shares of the Company's common stock and $21.3 million of cash. The total purchase price was $46.1 million, and the acquisition was accounted for as a purchase. In connection with the acquisition, net intangibles of $46 million were acquired, of which $40 million was reflected as a charge to operations for the write-off of in-process research and development that had not reached technological feasibility and, in management's opinion, had no probable alternative future use. In March 1998, the Company acquired all of the outstanding stock of Excellent Design, Inc., a Japanese corporation, for cash. The total purchase price was $40.9 million, and the acquisition was accounted for as a purchase. In connection with the acquisition, net intangibles of $48.7 million were acquired, of which $42 million was reflected as a charge to operations for the write-off of in-process research and development that had not reached technological feasibility and, in management's opinion, had no probable alternative future use. Included in unusual items for the six month period ended June 28, 1997 were a $4.9 million write-off of in-process research and development associated with an acquisition and a $29.2 million restructuring charge due to the Company's merger with High Level Design Systems, Inc. and CCT, reorganization into business units, and expenses to restructure the Company's international business operations. OTHER INCOME, NET AND INCOME TAXES Other income, net of other expenses, remained relatively flat in the three month period ended July 4, 1998, as compared to the same period of 1997. Other income, net of other expenses, decreased by $12.8 million for the six month period ended July 4, 1998, as compared to the same period of 1997, primarily due to the $13.1 million gain on the sale of stock recorded in the first quarter of 1997 and a decrease in interest income of $1.9 million, partially offset by the decrease in interest expense of $1.1 million. The Company's estimated effective tax rate in the three and six month periods ended July 4, 1998 was 28.5%, excluding the effect of the write-off of in-process research and development of $82.0 million in the first quarter of 1998, which is not deductible for income tax purposes. This compares to 30% for the same periods of the prior year. The decrease in the effective rate was due to the difference in tax rates between domestic and foreign operations. NEW ACCOUNTING STANDARDS Effective January 4, 1998, the Company adopted SOP 97-2, "Software Revenue Recognition." SOP 97-2 provides guidance on applying generally accepted accounting principles in recognizing revenue on software transactions. The adoption of SOP 97-2 did not have a material impact on the Company's consolidated financial position or results of operations. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument be recorded on the balance sheet as either an asset or liability measured at its fair value. It requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999 and cannot be applied retroactively. The Company has not yet determined the impact SFAS No. 133 will have on its financial position, results of operations, or cash flows. 12
In April 1998, the American Institute of Certified Public Accountants issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." The Company anticipates that SOP 98-1 will not have a material impact on its consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES At July 4, 1998, the Company's principal sources of liquidity consisted of $260.7 million of cash and short-term investments, compared to $304.2 million at January 3, 1998, and a $110 million senior secured revolving credit facility. As of August 7, 1998, the Company had no borrowings under the revolving line of credit. Cash generated from operating activities increased $32.6 million for the six months ended July 4, 1998, as compared to the six months ended June 28, 1997. The increase was due primarily to increases in net income excluding unusual items and other non-cash charges, partially offset by changes in the balances of operating assets and liabilities. At July 4, 1998, the Company had working capital of $309 million compared with $340.3 million at January 3, 1998. Working capital reductions were generated primarily by a decrease in cash and short-term investments of $43.5 million. The decrease in cash was primarily due to the repurchase of the Company's stock, capital expenditures, and acquisitions, partially offset by cash generated from operations. In addition to its short-term investments, the Company's primary investing activities were acquisitions, purchases of property and equipment, purchases of software, intangibles, and other assets, and the capitalization of software development costs that in the aggregate represented $137.3 million and $21.2 million of cash used for investing activities in the six months ended July 4, 1998 and June 28, 1997, respectively. For the six month period ended June 28, 1997, net proceeds related to the sale of Integrated Measurement Systems, Inc. (IMS) stock contributed $18.6 million, which was partially offset by the loss to the Company of IMS cash of $9.5 million due to deconsolidation. As part of its authorized stock repurchase programs, the Company has sold put warrants and purchased call options through private placements. The Company has a maximum potential obligation related to put warrants at July 4, 1998 to buy back 5.3 million shares of its common stock at an aggregate price of approximately $143.9 million. Anticipated cash requirements for the remainder of 1998 include the purchase of treasury stock through the exercise of call options for the Company's stock repurchase programs and the contemplated additions of property, plant, and equipment of approximately $45 million. As part of its overall investment strategy, the Company has committed to participating in a venture capital partnership as a limited partner. The Company's total committed investment of at least $50 million will be made over the next three to four years. As of July 4, 1998, the Company had contributed approximately $22.7 million, which was reflected in other non-current assets in the accompanying condensed consolidated balance sheet, net of operating losses. The Company anticipates that current cash and short-term investment balances, cash flows from operations, and the $110 million revolving credit facility will be sufficient to meet its working capital requirements for the foreseeable future. 13
FACTORS THAT MAY AFFECT FUTURE RESULTS RAPID TECHNOLOGICAL CHANGE; DEPENDENCE ON NEW PRODUCTS The EDA industry and the commercial electronic design and consulting industry in which the Company competes are subject to rapid technological developments, evolving industry standards, changes in customer requirements, and frequent new product introductions and enhancements. As a result, the Company's future revenues and operating results will depend on its ability to develop or acquire new products and enhance its existing products and processes on a timely basis to keep pace with innovations in technology and to support a range of changing computer software, hardware platforms, and customer preferences. Changes in manufacturing technology may render the Company's software tools obsolete. There can be no assurance that the Company will be able to successfully develop new products to address new customer requirements and technological changes, or that such products will achieve market acceptance. Lack of market acceptance or significant delays in product development could result in a loss of competitiveness of the Company's products, with a resulting loss of revenues. FLUCTUATIONS IN QUARTERLY RESULTS OF OPERATIONS The Company's operating expenses are partially based on its expectations regarding future revenue. Since expenses are usually committed in advance of revenues, and because only a small portion of expenses vary with revenue, the Company's consolidated results of operations may be disproportionately impacted by lower than expected revenue. Factors that may affect operating results include, among other things: (i) the timing and introduction of new products; (ii) the mix of products and services sold; (iii) the timing of significant orders from and shipments to or implementations for customers; (iv) product and services pricing and discounts; (v) the timing of completion of acquisitions; and (vi) general economic conditions. In addition, the Company's focus on providing services is relatively recent, and therefore quarter to quarter comparisons may not be meaningful. For example, the revenue growth from this source from the 1997 periods to the 1998 periods may not be indicative of future growth. Although the Company's revenues are not generally seasonal in nature, the Company has experienced, and may continue to experience, decreases in first quarter revenue compared with the preceding fourth quarter, which is believed to result primarily from the budgeting and expenditure cycles of the Company's customers. HIGHLY COMPETITIVE MARKET The Company operates in the highly competitive EDA industry and in the emerging commercial electronic design and consulting markets. The EDA industry continues to be characterized by falling prices, rapid technological change, and new market entrants. The Company's success is dependent upon its ability to develop innovative, cost competitive EDA software products and take them to market in a timely manner. The Company competes with a number of companies, including Avant! Corporation, Mentor Graphics Corp., Synopsys, Inc., and Zuken-Redac. The Company also experiences competition from manufacturers of electronic devices that have developed and/or have the capability to develop their own EDA software. Some of these companies may have substantially greater financial, marketing, and technological resources than the Company. 14
The EDA industry has relatively low barriers to entry, and, therefore, the number of the Company's actual and potential competitors is significant. A potential competitor that possesses the necessary knowledge of electronic circuit and systems design, production, and operations could develop competitive EDA tools using a moderately priced computer workstation and take such tools to market quickly. There can be no assurance that development of competitive products will not result in a shift of customer preferences away from the Company's products, resulting in a significant decrease in the sales of the Company's comparable products. In addition, there can be no assurance that the Company will successfully identify new product opportunities, develop and take new products to market in a timely manner and achieve market acceptance of its products. Failure to do so may have a material adverse effect on Cadence's business, operating results, and financial condition. In the electronic design and consulting markets, the Company competes with numerous EDA and other consulting companies. This emerging market represents the outsourcing of an activity by electronics manufacturers that has traditionally been performed in house, and is thus subject to the customers' "make versus buy" decisions. As a result, the Company's services business must also compete with the internal design capabilities of manufacturers of electronic devices, many of which have substantially greater financial, marketing, and technological resources than the Company. Therefore, the Company's ability to obtain such business is dependent upon its ability to offer better strategic concepts and technical solutions, competitive prices, a quicker response or a combination of these factors. There can be no assurance the Company will be able to effectively compete in this area, and any failure to compete in the electronic design and consulting market may have a material adverse effect on Cadence's business, operating results, and financial condition. The electronic design and consulting service businesses have relatively low barriers to entry and, therefore, EDA and other electronics companies and management consulting firms have entered and may continue to enter into this market. The pricing model for services is susceptible to supply and demand volatility for labor as well as the Company's continuing ability to provide competitive time-to-market benefits to its customers. Some of the Company's current and potential competitors in the electronic design and consulting services businesses may have substantially greater financial, marketing, and technological resources than the Company. There can be no assurance that the Company will be able to compete successfully in these businesses, and any failure to compete in this business may have a material adverse effect on Cadence's business, operating results, and financial condition. RISK OF SERVICES BUSINESS The Company has recently increased its focus on offering electronics design and consulting services. The market for such services in the electronics design area is relatively new and evolving rapidly. In order to increase revenues and sustain operating results from the Company's services business, the Company must continue to gain market acceptance for its professional services, which will depend substantially on its ability to offer better strategic concepts and technical solutions, competitive prices, a timely response or a combination of these factors. Failure to successfully operate its services business would have a material adverse effect on the Company's business, operating results, and financial condition. The Company's professional services contracts generally reflect a high amount of revenue per order. The loss of individual orders, therefore, could have a significant impact on the revenue and operating results of the Company. The timing of revenue from the Company's services business is also difficult to predict because of the length and variability of the sales and implementation cycles. In addition, a substantial portion of the Company's revenues from services are earned pursuant to fixed price contracts. Variances in costs associated with those contracts could have a material adverse effect on the Company's business, operating results, and financial condition. 15
The professional services business is labor-intensive. Accordingly, the ability to expand its services business is dependent on its ability to hire and retain adequate professional services personnel. The market for professional services personnel is highly competitive. In general, the high component of salaries in the cost structure of the professional services business results in lower gross margins than in the Company's software business. Services gross margins have been and may continue to be adversely affected by the cost of integrating new service professionals as well as the Company's inability to fully utilize these resources. In addition, services gross margins may continue to be adversely affected by the Company's inability to achieve operating efficiencies with its resources to implement a growing number of services offerings. RISKS ASSOCIATED WITH MERGERS AND ACQUISITIONS The Company has been involved, and may in the future be involved, in a number of merger and acquisition transactions. These transactions have been motivated by many factors, including the desire to obtain new technologies, the desire to expand and enhance the Company's product and services lines and the desire to attract personnel. Growth through acquisition has several identifiable risks, including risks related to integration of the previously distinct businesses into a single unit, the substantial management time devoted to such activities, undisclosed liabilities, the failure to realize anticipated benefits (such as cost savings and synergies) and issues related to product transition (such as distribution, engineering and customer support). Realization of any of these risks in connection with an acquisition by the Company could have a material adverse effect on the Company's business, operating results, and financial condition. DEPENDENCE ON KEY PERSONNEL The Company is dependent upon the efforts and abilities of its senior management, its research and development staff and a number of other key management, sales, support, technical, and services personnel. The Company has recently increased its focus on offering professional services to its customers, the growth of which is directly dependent on the attraction and retention of personnel. The market for highly skilled employees is intensely competitive. To the extent that the Company is not able to attract, retain, train, and motivate highly skilled employees, directly or through acquisition, who are able to provide EDA and other design services that satisfy customer's expectations, the Company's business, operating results, and financial condition could be materially adversely affected. 16
RISKS OF INTERNATIONAL OPERATIONS The Company expects that international revenues will continue to account for a significant portion of its total revenues. The Company's international operations involve a number of risks normally associated with such operations including, among others, adoption and expansion of government trade restrictions, volatile foreign exchange rates, currency conversion risks, limitations on repatriation of earnings, reduced protection of intellectual property rights, the impact of possible recessionary environments in economies outside the U.S., longer receivables collection periods and greater difficulty in accounts receivable collection, difficulties in managing foreign operations, political and economic instability, unexpected changes in regulatory requirements and tariffs and other trade barriers. In addition, political or economic conditions in a specific country or region, government spending factors and natural disasters could have a material adverse impact on the Company's future international business as well as the Company's international operations. Currency exchange fluctuations in countries in which the Company conducts business could also materially adversely affect the Company's business, operating results, and financial condition. A portion of the Company's international revenues are derived from Asia. Recent economic uncertainty and related weakening of foreign currencies has had, and may continue to have an adverse effect on the Company's revenues and operating results. The Company enters into forward contracts to hedge the short-term impact of foreign currency fluctuations. Although the Company attempts to reduce the impact of foreign currency fluctuations, significant exchange rate movements may have a material adverse impact on the Company's consolidated results of operations. DEPENDENCE ON PROPRIETARY TECHNOLOGY; RISKS OF INFRINGEMENT Cadence's success is dependent, in part, upon its proprietary technology. The Company generally relies upon patents, copyrights, trademarks, and trade secret laws to establish and maintain its proprietary rights in its technology and products. Cadence has a program to file applications for and obtain patents in the United States and in selected foreign countries where a potential market for Cadence's products exists. Cadence has been issued a number of patents; other patent applications are currently pending. There can be no assurance that any of these patents will not be challenged, invalidated or circumvented or that any rights granted thereunder will provide competitive advantages to Cadence. In addition, there can be no assurance that patents will be issued from pending applications, or that claims allowed on any future patents will be sufficiently broad to protect Cadence's technology. In addition, the laws of some foreign countries may not permit the protection of Cadence's proprietary rights to the same extent as do the laws of the United States. Although Cadence believes the protection afforded by its patents, patent applications, copyrights and trademarks has value, the rapidly changing technology in the EDA industry makes Cadence's future success dependent primarily on the innovative skills, technological expertise, and management abilities of its employees rather than on patent, copyright, and trademark protection. Because of the existence of a large number of patents in the EDA industry and the rapid rate of issuance of new patents, it is not economically practicable to determine in advance whether a product or any of its components infringe patent rights of others. From time to time, Cadence receives notices from or is sued by third parties regarding patent or other intellectual property claims or is called upon to defend or indemnify a customer against such a claim of a third party. If infringement is alleged, Cadence believes that, based upon industry practice, any necessary license or rights under such patents may be obtained on terms that would not have a material adverse effect on Cadence's business, operating results, and financial condition. Nevertheless, there can be no assurance that the necessary licenses would be available on acceptable terms, or at all, or that Cadence would prevail in any such challenge. Many of Cadence's products are designed to include software or other intellectual property licensed from third parties, and it may be necessary in the future to seek or renew licenses relating to various aspects of its products. The inability to obtain certain licenses or other rights or to obtain such licenses or rights on favorable terms, or the need to engage in litigation could have a material adverse effect on Cadence's business, operating results, and financial condition. 17
RISK OF FAILURE TO OBTAIN EXPORT LICENSES Cadence is required to comply with the regulations of the United States Department of Commerce with respect to the shipment of its products and other technologies outside the United States to certain countries and certain end users. Although to date, Cadence has not encountered any material difficulty in complying with these regulations, any difficulty in such compliance in the future could have an adverse effect on the Company's business, operating results, and financial condition. RISKS OF BUSINESS INTERRUPTION The Company's operations are dependent on its ability to protect its computer equipment and the information stored in its databases against damage by fire, natural disaster, power loss, telecommunications failures, unauthorized intrusion, and other catastrophic events. The Company believes it has taken prudent measures to reduce the risk of interruption in its operations. However, there can be no assurance that these measures will be sufficient. Any damage or failure that causes interruptions in the Company's operations could have a material adverse effect on its business, operating results, and financial condition. IMPLEMENTATION OF NEW SYSTEMS The Company is currently in the process of transitioning to new computer software for its financial, accounting, project system accounting, and order management information systems. The successful implementation of these new systems is crucial to the efficient operation of the Company's business. There can be no assurance that the Company will implement its new systems in an efficient and timely manner or that the new systems will be adequate to support the Company's operations. Problems with installation or initial operation of the new systems could cause substantial management difficulties in operations planning, financial reporting, and management and thus could have a material adverse effect on the Company's business, operating results, financial condition, and results of operations. YEAR 2000 COMPLIANCE The Company believes that its most current releases of its products will not cease to perform nor generate incorrect or ambiguous data or results solely due to a change in date to or after January 1, 2000, and will calculate any information dependent on such dates in the same manner, and with the same functionality, data integrity and performance, as such products do on or before December 31, 1999 (collectively, "Year 2000 Compliance"). Year 2000 Compliance issues may arise with respect to any modifications made to the Company's products by a party other than the Company or from the combination or use of the Company's products with any other software programs or hardware devices not provided by the Company, and therefore may result in unforeseen Year 2000 Compliance problems for some of the Company's customers, which may have a material adverse effect on the Company's business, operating results, and financial condition. Additionally, as with any company with a computing infrastructure and utilizing business-application software programs written over many years, the Company's internal operations may be subject to Year 2000 Compliance issues. The Company has been implementing enterprise-wide information systems which support a majority of the Company's operations. These systems are considered to be Year 2000 Compliant and are in use world-wide. Based solely due to a change in date to or after January 1, 2000, the Company believes that its internal operations will not be materially adversely impacted. 18
STOCK REPURCHASE PROGRAM RISKS The Company, as part of its authorized stock repurchase program, has purchased call options that entitle the Company to buy on a specified day one share of common stock at a specified price to satisfy anticipated stock repurchase requirements under the Company's systematic repurchase programs. Additionally, the Company has sold put warrants through private placements. If exercised, the put warrants will be settled with the issuance of stock. Accordingly, settlement of the put warrants could cause the Company to issue a substantial number of shares, depending on the exercise price of the put warrants and the per share fair value of the Company's common stock at the time of exercise. In addition, settlement of the put warrants could lead to the disposition by put warrant holders of shares of the Company's common stock that such holders may have accumulated in anticipation of the exercise of the put warrants or call options, which may impact the price of the Company's common stock. VOLATILITY OF STOCK PRICE Due to the foregoing, as well as other factors, past financial performance should not be considered an indicator of future performance. In addition, the Company's participation in a highly dynamic industry often results in significant volatility of the Company's common stock price. Factors such as fluctuations in revenues or operating results, including failure to meet expectations of securities analysts, announcements of technological innovations or new products by the Company or its competitors, or developments in or disputes regarding patents and proprietary rights could have a significant adverse effect on the trading price of the Company's common stock in any given period. Moreover, the stock market has from time to time experienced extreme price and volume fluctuations, which have particularly affected the market for technology companies, and which have often been unrelated to the operating performance of such companies. These broad market fluctuations, as well as general economic, political, and market conditions may adversely affect the market price of the Company's common stock. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISK The Company's exposure to market risk for changes in interest rates relates primarily to the Company's investment portfolio. The Company places its investments with high credit quality issuers and, by policy, limits the amount of credit exposure to any one issuer. As stated in its policy, the Company is averse to principal loss and seeks to preserve its invested funds by limiting default risk, market risk, and reinvestment risk. The Company mitigates default risk by investing in only high credit quality securities that it believes to be low risk and by positioning its portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer or guarantor. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. 19
The table below presents the carrying value and related weighted average interest rates for the Company's investment portfolio. The carrying value approximates fair value at July 4, 1998. All investments mature in one year or less. <TABLE> <CAPTION> Carrying Average Value Interest Rate -------- ------------- <S> <C> <C> (In millions, except for average interest rates) Investment Securities: Cash equivalents-fixed rate. . . . . . . . . . . . $ 35.1 5.32% Short-term investments-fixed rate. . . . . . . . . 66.9 5.69% Short-term investments-variable rate . . . . . . . 79.3 5.72% -------- Total investment securities . . . . . . . . . . 181.3 5.63% Cash equivalents-variable rate . . . . . . . . . . 21.0 5.48% -------- Total interest bearing instruments. . . . . . . $ 202.3 5.62% -------- -------- </TABLE> FOREIGN CURRENCY RISK The Company transacts business in various foreign currencies, primarily in Japanese yen and certain European currencies. The Company has established a foreign currency hedging program, utilizing foreign currency forward exchange contracts (forward contracts) to hedge certain foreign currency transaction exposures in Japan, Canada, Asia, and certain European countries. Under this program, increases or decreases in the Company's foreign currency transactions are partially offset by gains and losses on the forward contracts, so as to mitigate the possibility of foreign currency transaction gains and losses. The Company does not use forward contracts for trading purposes. All outstanding forward contracts at the end of a period are marked-to-market with unrealized gains and losses included in other income (expense), and thus are recognized in income in advance of the actual foreign currency cash flows. As these forward contracts mature, the realized gains and losses are recorded and are included in net income as a component of other income (expense). The Company's ultimate realized gain or loss with respect to currency fluctuations will depend on the currency exchange rates and other factors in effect as the contracts mature. The table below provides information as of July 4, 1998 about the Company's material forward contracts. The information is provided in U.S. dollar equivalent amounts. The table presents the notional amounts (at contract exchange rates) and the weighted average contractual foreign currency exchange rates. These forward contracts mature in less than thirty days. <TABLE> <CAPTION> Average Notional Contract Amount Rate -------- -------- <S> <C> <C> Forward Contracts: (In millions, except for average contract rates) Japanese yen . . . . . . . . . . . . . . . . . . $ 24.4 143.81 German deutschemarks . . . . . . . . . . . . . . $ 4.0 1.79 Italian lira . . . . . . . . . . . . . . . . . . $ 3.5 1,769.65 French francs. . . . . . . . . . . . . . . . . . $ 1.8 6.00 Swedish krona. . . . . . . . . . . . . . . . . . $ 1.2 8.03 Singapore dollars. . . . . . . . . . . . . . . . $ 1.1 1.76 Canadian dollars . . . . . . . . . . . . . . . . $ (2.5) 1.47 British pound sterling . . . . . . . . . . . . . $ (3.0) 0.61 </TABLE> The unrealized gain (loss) on the outstanding forward contracts at July 4, 1998 was immaterial to the Company's consolidated financial statements. Due to the short-term nature of the forward contracts, the fair value at July 4, 1998 was negligible. The realized gain (loss) on these contracts as they matured was not material to the consolidated operations of the Company. 20
EQUITY PRICE RISK The Company, as part of its authorized repurchase program, has purchased call options that entitle the Company to buy on a specified day one share of common stock at a specified price to satisfy anticipated stock repurchase requirements under the Company's systematic repurchase programs. Additionally, the Company has sold put warrants through private placements. The table below provides information at July 4, 1998 about the Company's put warrants and call options. The table presents the contract amounts and the weighted average strike prices. The put warrants and call options expire at various dates through November 12, 1999. <TABLE> <CAPTION> 1998 1999 Estimated Maturity Maturity Fair Value -------- -------- ---------- <S> <C> <C> <C> (Shares and contract amounts in millions) Put Warrants: Shares . . . . . . . . . . . . . . . . . . 2.4 2.9 Weighted average strike price. . . . . . . $24.33 $29.95 Contract amount. . . . . . . . . . . . . . $ 58.2 $ 85.7 $22.5 Call Options: Shares . . . . . . . . . . . . . . . . . . 1.7 1.9 Weighted average strike price. . . . . . . $24.45 $30.12 Contract amount. . . . . . . . . . . . . . $ 41.6 $ 57.2 $19.7 </TABLE> If exercised, the put warrants will be settled with stock. Settlement of the put warrants with stock could cause the Company to issue a substantial number of shares, depending on the exercise price of the put warrants and the per share fair value of the Company's common stock at the time of exercise. In addition, settlement of the put warrants in stock could lead to the disposition by put warrant holders of shares of the Company's common stock that such holders may have accumulated in anticipation of the exercise of the put warrants or call options, which may adversely impact the price of the Company's common stock. 21
PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time the Company is involved in various disputes and litigation matters which arise in the ordinary course of business. These include disputes and lawsuits related to intellectual property, licensing, contract law, distribution arrangements, and employee relations matters. The Company filed a complaint in the United States District Court for the Northern District of California on December 6, 1995 against Avant! Corporation (Avant!) and certain of its employees for misappropriation of trade secrets, copyright infringement, conspiracy, and other illegalities. On January 16, 1996, Avant! filed various counterclaims against the Company and the Company's former President and Chief Executive Officer, and with leave of the court, on January 29, 1998 filed a second amended counterclaim. The second amended counterclaim alleges, INTER ALIA, that the Company and its former President and Chief Executive Officer had cooperated with the Santa Clara County District Attorney and initiated and pursued its complaint against Avant! for anticompetitive reasons, engaged in wrongful activity in an attempt to manipulate Avant!'s stock price and utilized certain pricing policies and other acts to unfairly compete against Avant! in the marketplace. The second amended counterclaim also alleges that certain Company insiders engaged in illegal insider trading with respect to Avant!'s stock. The Company and its former President and Chief Executive Officer believe that each has meritorious defenses to Avant!'s claims, and each intends to defend such action vigorously. By an order dated July 13, 1996, the court bifurcated Avant!'s counterclaim from the Company's complaint and stayed the counterclaim pending resolution of the Company's complaint. The counterclaim remains stayed. On April 19, 1996, the Company filed a motion seeking a preliminary injunction to prevent further use of Cadence copyrighted code and trade secrets by Avant!. On March 18, 1997, the District Court issued an order in which it granted in part and denied in part that motion. On September 23, 1997, the United States Court of Appeals for the Ninth Circuit reversed the District Court's decision and directed the District Court (a) to issue an order enjoining the sale of Avant!'s ArcCell products and (b) to determine whether Avant!'s Aquarius software infringes Cadence's code and, if so, to enter an order enjoining the sale of that software. In an order issued on December 19, 1997, as modified on January 26, 1998, the district court entered an injunction barring any further infringement of Cadence's copyrights in Design Framework II software, or selling, licensing, or copying such product derived from Design Framework II, including but not limited to, Avant!'s ArcCell products. On February 19, 1998, Avant! filed a petition for WRIT OF CERTIORAI to the United States Supreme Court, requesting a review of the Ninth Circuit Court's decision. On April 17, 1998, the Company filed its opposition to Avant!'s Petition with the Supreme Court. That petition was denied without comment by the United States Supreme Court. On July 9, 1998, Cadence filed additional motions seeking to enjoin further sale of Avant!'s Aquarius products on copyright and trade secret grounds. Those motions remain pending. By an order dated July 22, 1997, the District Court stayed most activity in the case pending in that Court and ordered Avant! to post a $5 million bond, in light of criminal proceedings pending against Avant! and several of its executives. The District Court has not yet set a trial date. The Company intends to pursue its claim vigorously. Management believes that the ultimate resolution of the disputes and litigation matters discussed above will not have a material adverse impact on the Company's financial position or results of operations. 22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Annual Meeting of Stockholders held May 6, 1998, the stockholders of the Company approved the following matters: 1. A proposal to elect eight (8) directors of the Company to serve for the ensuing year and until their successors are elected or until such director's earlier resignation or removal. <TABLE> <CAPTION> Nominee In Favor Withheld - ------- ----------- -------- <S> <C> <C> Carol A. Bartz . . . . . . . . . . . . . . 184,126,069 214,043 H. Raymond Bingham . . . . . . . . . . . . 184,149,965 190,147 John R. Harding. . . . . . . . . . . . . . 184,150,739 189,373 Dr. Leonard Y. W. Liu. . . . . . . . . . . 184,075,024 265,088 Donald L. Lucas. . . . . . . . . . . . . . 184,133,161 206,951 Dr. Alberto Sangiovanni-Vincentelli. . . . 184,134,510 205,602 George M. Scalise. . . . . . . . . . . . . 184,123,866 216,246 Dr. John B. Shoven . . . . . . . . . . . . 184,106,111 234,001 </TABLE> 2. A proposal for the approval of an amendment to the Certificate of Incorporation, as amended, to increase the authorized shares of Common Stock of the Company from 300,000,000 to 600,000,000 was approved by a vote of 177,362,155 for, 6,684,396 opposed, and 61,044 withheld. 3. A proposal for the approval of an amendment to the 1987 Stock Option Plan, as amended, to (a) extend the term of such plan to May 31, 2007, and (b) increase the number of authorized shares reserved under the plan from 61,370,100 to 71,370,100, an increase of 10,000,000 shares was approved by a vote of 108,693,000 for, 50,721,131 opposed, and 342,738 withheld. 4. A proposal for the approval of the Senior Executive Bonus Plan was approved by a vote of 181,762,886 for, 2,059,907 opposed, and 284,803 withheld. 5. A proposal for the ratification of the selection of Arthur Andersen LLP as independent public accountants for the fiscal year ending January 2, 1999 was approved by a vote of 184,224,695 for, 86,210 opposed, and 32,807 withheld. ITEM 5. OTHER INFORMATION Pursuant to a recent change to the proxy rules, unless a stockholder who wishes to bring a matter before the stockholders at the Company's 1999 annual meeting of stockholders notifies the Company of such matter prior to February 14, 1999, management will have discretionary authority to vote all shares for which it has proxies in opposition to such matter. 23
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) The following exhibits are filed herewith: EXHIBIT NUMBER EXHIBIT TITLE -------- ------------- 3.01 (h) The registrant's Certificate of Retirement of Series A-1 Convertible Preferred Stock as filed with the Secretary of State of the State of Delaware on May 13, 1998. 3.01 (i) The Registrant's Certificate of Amendment of Certificate of Incorporation as filed with the Secretary of State of the State of Delaware on May 13, 1998. 3.01 (j) The Registrant's Restated Certificate of Incorporation as filed with the Secretary of State of the State of Delaware on May 13, 1998. 27.01 Financial data schedule for the period ended July 4, 1998. (b) Reports on Form 8-K: None. 24
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CADENCE DESIGN SYSTEMS, INC. (REGISTRANT) DATE: August 14, 1998 By: /s/ John R. Harding --------------------------- JOHN R. HARDING President and Chief Executive Officer DATE: August 14, 1998 By: /s/ H. Raymond Bingham --------------------------- H. RAYMOND BINGHAM Executive Vice President and Chief Financial Officer 25