- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 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 3, 1999 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, 95134 CALIFORNIA (Zip Code) (Address of Principal Executive Offices) (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 6, 1999, there were 243,766,741 shares of the registrant's common stock, $0.01 par value, outstanding. - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
CADENCE DESIGN SYSTEMS, INC. INDEX <TABLE> <CAPTION> PAGE ----- <S> <C> <C> PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Condensed Consolidated Balance Sheets: July 3, 1999 and January 2, 1999............................................................ 3 Condensed Consolidated Statements of Income: Three and Six Months Ended July 3, 1999 and July 4, 1998.................................... 4 Condensed Consolidated Statements of Cash Flows: Three and Six Months Ended July 3, 1999 and July 4, 1998.................................... 5 Notes to Condensed Consolidated Financial Statements.......................................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations......... 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................................... 33 PART II. OTHER INFORMATION Item 1. Legal Proceedings............................................................................. 37 Item 2. Changes in Securities and Use of Proceeds..................................................... 38 Item 3. Defaults Upon Senior Securities............................................................... 38 Item 4. Submission of Matters to a Vote of Security Holders........................................... 38 Item 5. Other Information............................................................................. 39 Item 6. Exhibits and Reports on Form 8-K.............................................................. 39 Signatures................................................................................................. 40 </TABLE> 2
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CADENCE DESIGN SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) ASSETS <TABLE> <CAPTION> JULY 3, JANUARY 2, 1999 1999 ------------ ------------ (UNAUDITED) <S> <C> <C> Current Assets: Cash and cash equivalents........................................................... $ 192,960 $ 209,074 Short-term investments.............................................................. 33,028 40,403 Receivables, net.................................................................... 254,091 305,143 Inventories......................................................................... 9,741 9,903 Prepaid expenses and other.......................................................... 117,408 101,629 ------------ ------------ Total current assets.............................................................. 607,228 666,152 Marketable securities................................................................. -- 19,969 Property, plant, and equipment, net................................................... 309,649 274,208 Software development costs, net....................................................... 10,732 13,045 Acquired intangibles, net............................................................. 278,350 286,088 Installment contract receivables...................................................... 104,036 100,529 Other assets.......................................................................... 190,287 180,231 ------------ ------------ $ 1,500,282 $ 1,540,222 ------------ ------------ ------------ ------------ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Notes payable and current portion of capital leases................................. $ 1,615 $ 1,273 Accounts payable and accrued liabilities............................................ 222,066 242,524 Income taxes payable................................................................ 7,858 21,241 Deferred revenue.................................................................... 130,159 106,786 ------------ ------------ Total current liabilities......................................................... 361,698 371,824 ------------ ------------ Long-term Liabilities: Long-term debt and capital leases................................................... 1,253 136,380 Deferred income taxes............................................................... 71,543 58,306 Minority interest liability......................................................... 41 377 Other long-term liabilities......................................................... 19,726 25,505 ------------ ------------ Total long-term liabilities....................................................... 92,563 220,568 ------------ ------------ Stockholders' Equity: Preferred stock..................................................................... -- -- Common stock and capital in excess of par value..................................... 871,100 817,978 Treasury stock at cost.............................................................. (223,575) (219,417) Retained earnings................................................................... 408,177 358,322 Unrealized gain (loss) on investments............................................... (31) 125 Accumulated other comprehensive loss................................................ (9,650) (9,178) ------------ ------------ Total stockholders' equity........................................................ 1,046,021 947,830 ------------ ------------ $ 1,500,282 $ 1,540,222 ------------ ------------ ------------ ------------ </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 3
CADENCE DESIGN SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED ---------------------- ---------------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 1999 1998 ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Revenue: Product........................................................ $ 117,890 $ 177,406 $ 305,247 $ 346,337 Services....................................................... 74,943 66,871 147,417 121,342 Maintenance.................................................... 71,360 71,459 146,720 141,845 ---------- ---------- ---------- ---------- Total revenue................................................ 264,193 315,736 599,384 609,524 ---------- ---------- ---------- ---------- Costs and expenses: Cost of product................................................ 20,064 22,118 38,600 39,053 Cost of services............................................... 48,844 48,771 96,102 89,150 Cost of maintenance............................................ 12,930 12,399 25,830 24,977 Amortization of acquired intangibles........................... 12,856 2,884 25,570 3,687 Marketing and sales............................................ 82,936 81,199 162,999 159,716 Research and development....................................... 50,359 49,439 101,227 97,131 General and administrative..................................... 20,903 20,002 42,163 39,480 Unusual items.................................................. 19,648 -- 33,840 60,857 ---------- ---------- ---------- ---------- Total costs and expenses..................................... 268,540 236,812 526,331 514,051 ---------- ---------- ---------- ---------- Income (loss) from operations.............................. (4,347) 78,924 73,053 95,473 Other income, net................................................ 141 3,365 276 6,683 ---------- ---------- ---------- ---------- Income (loss) before provision (benefit) for income taxes.................................................... (4,206) 82,289 73,329 102,156 Provision (benefit) for income taxes............................. (1,199) 22,327 23,474 44,148 ---------- ---------- ---------- ---------- Net income (loss).......................................... $ (3,007) $ 59,962 $ 49,855 $ 58,008 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Basic net income (loss) per share................................ $ (0.01) $ 0.26 $ 0.21 $ 0.25 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Diluted net income (loss) per share.............................. $ (0.01) $ 0.23 $ 0.19 $ 0.22 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Weighted average common shares outstanding....................... 241,978 234,842 241,026 233,681 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Weighted average common and potential common shares outstanding--assuming dilution................................. 241,978 260,021 257,016 259,529 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- </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 3, JULY 4, 1999 1998 --------- --------- <S> <C> <C> Cash and Cash Equivalents at Beginning of Period............................................. $ 209,074 $ 221,030 --------- --------- Cash Flows from Operating Activities: Net income................................................................................. 49,855 58,008 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization............................................................ 76,736 46,117 Deferred income taxes.................................................................... 13,584 (2,023) Write-off of software development costs, net............................................. 1,441 -- Write-off of prepaid expenses and other.................................................. 642 -- Write-off of equipment, acquired intangibles, and other assets........................... 4,641 1,840 Write-off of acquired in-process technology.............................................. 8,900 56,900 Change in other long-term liabilities and minority interest expense...................... (5,960) 7,047 Equity (income) loss from investments.................................................... 883 (496) Provisions for doubtful accounts......................................................... 6,250 2,010 Non-cash restructuring charges........................................................... 3,321 452 Write-off of non-current assets.......................................................... 2,145 -- Changes in operating assets and liabilities, net of effect of acquired and disposed businesses: Receivables............................................................................ (54,947) 7,448 Inventories............................................................................ 162 5,891 Prepaid expenses and other............................................................. (16,666) 23,224 Installment contract receivables....................................................... 18,980 (84,156) Accounts payable and accrued liabilities............................................... (9,762) (24,628) Income taxes payable................................................................... (783) 43,121 Deferred revenue....................................................................... 21,804 (1,739) --------- --------- Net cash provided by operating activities............................................ 121,226 139,016 --------- --------- Cash Flows from Investing Activities: Maturities of short-term investments--held-to-maturity..................................... 27,245 38,498 Purchases of short-term investments--held-to-maturity...................................... (57) (35,843) Maturities of short-term investments--available-for-sale................................... -- 390,078 Purchases of short-term investments--available-for-sale.................................... -- (423,422) Purchases of property, plant, and equipment................................................ (71,377) (61,067) Capitalization of software development costs............................................... (13,528) (11,590) Increase in acquired intangibles and other assets.......................................... (13,452) (19,382) Investment in venture capital partnership.................................................. (5,770) (2,774) Cash effect of business acquisitions and dispositions...................................... (2,806) (51,313) Sale of put warrants....................................................................... 3,609 9,659 Purchase of call options................................................................... (3,609) (9,659) --------- --------- Net cash used for investing activities............................................... (79,745) (176,815) --------- --------- Cash Flows from Financing Activities: Proceeds from long-term debt............................................................... 30,168 -- Principal payments on long-term debt and capital leases.................................... (165,000) (1,584) Proceeds from issuance of common stock..................................................... 49,642 44,274 Purchases of treasury stock................................................................ (49,125) (98,103) Proceeds from transfer of financial assets in exchange for cash............................ 77,162 27,163 --------- --------- Net cash used for financing activities............................................... (57,153) (28,250) --------- --------- Effect of exchange rate changes on cash...................................................... (442) (2,846) --------- --------- Decrease in Cash and Cash Equivalents........................................................ (16,114) (68,895) --------- --------- Cash and Cash Equivalents at End of Period................................................... $ 192,960 $ 152,135 --------- --------- --------- --------- </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 Cadence, 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, Cadence 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 Cadence's Annual Report on Form 10-K for the fiscal year ended January 2, 1999. 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 condensed consolidated financial statements as of January 2, 1999 and for the three and six months ended July 4, 1998, have been reclassified to conform with the 1999 presentation. ACQUISITIONS In June 1999, Cadence entered into a merger agreement with OrCAD, Inc. (OrCAD) and on July 19, 1999, completed its tender offer for all of the issued and outstanding shares of OrCAD common stock. OrCAD is a supplier of computer-aided engineering and computer-aided design software and services for the printed circuit board industry. Pursuant to a cash tender offer Cadence acquired approximately 96% of the outstanding shares of OrCAD at $13 per share for a total purchase price of approximately $121 million. In July 1999, Cadence acquired the balance of the OrCAD shares in a short form cash merger and the acquisition will be accounted for as a purchase. In May 1999, Cadence completed its merger with Quickturn Design Systems, Inc., a Delaware corporation (Quickturn). Quickturn designs, manufactures, sells, and supports hardware and software products that verify the design of computer chips and electronic systems. Cadence acquired all of the outstanding shares of Quickturn common stock in a tax-free, stock-for-stock transaction for approximately 24.6 million shares of Cadence common stock. The acquisition was accounted for as a pooling-of-interests. In addition, Cadence assumed approximately all outstanding stock options and warrants of Quickturn. All prior period condensed financial statements were restated as if the merger took place at the beginning of such periods, in accordance with required pooling of interests accounting and disclosures. For the three month periods ended April 3, 1999 and April 4, 1998, Cadence's revenues and net income (loss) were approximately $305.2 million and $270.2 million and $51.8 million and $(0.4) million, respectively. For the three month periods ended March 31, 1999 and 1998, Quickturn's revenues and net income (loss) were approximately $30 million and $23.6 million and $1.1 million and $(1.6) million, respectively. In January 1999, Cadence acquired Design Acceleration, Inc. (DAI). DAI is a supplier of design verification technology used in system-on-a-chip design. Cadence acquired all of the outstanding stock of 6
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) DAI for approximately 0.6 million shares of Cadence's common stock and $2.9 million of cash. The total purchase price was $25.7 million, and the acquisition was accounted for as a purchase. In connection with the acquisition, net intangibles of $24.1 million were acquired. The results of operations of DAI and the estimated fair value of the assets acquired and liabilities assumed are included in Cadence's condensed financial statements from the date of acquisition. Intangibles arising from the acquisition are being amortized on a straight-line basis over five years. Management estimates that $8.9 million of the purchase price represents acquired in-process technology that has not yet reached technological feasibility and has no alternative future use. Accordingly, this amount was immediately charged to expense in the condensed consolidated statements of operations upon consummation of the acquisition. The value assigned to acquired in-process technology was determined by identifying research projects in areas for which technological feasibility has not been established. The value was determined by estimating the costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects, and discounting the net cash flows back to their present value. The discount rate includes a factor that takes into account the uncertainty surrounding the successful development of the purchased in-process technology. If these projects are not successfully developed, future revenue, and profitability of Cadence may be adversely affected. Additionally, the value of other intangible assets acquired may become impaired. Comparative pro forma financial information has not been presented because the results of operations of DAI were not material to Cadence's condensed consolidated financial statements. INVENTORIES Cadence's inventories include high technology parts and components that were acquired in connection with the merger with Quickturn. A summary of inventories follows: <TABLE> <CAPTION> JULY 3, JANUARY 2, 1999 1999 ------- ---------- (IN THOUSANDS) <S> <C> <C> Work in process.............................. $ 9,521 $8,798 Raw materials................................ 220 1,105 ------- ---------- Total inventories.......................... $ 9,741 $9,903 ------- ---------- ------- ---------- </TABLE> 7
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) UNUSUAL ITEMS AND RESTRUCTURING A summary of unusual items and restructuring charges follows: <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ---------------- ---------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 1999 1998 ------- ------- ------- ------- (IN THOUSANDS) <S> <C> <C> <C> <C> Restructuring charges.............. $10,703 $ -- $12,888 $ 3,957 Merger costs....................... 8,435 -- 8,435 -- Asset impairment................... 3,510 -- 6,617 -- Litigation settlement.............. (3,000) -- (3,000) -- Write-off of acquired in-process technology....................... -- -- 8,900 56,900 ------- ------- ------- ------- Total unusual items.............. $19,648 $ -- $33,840 $60,857 ------- ------- ------- ------- ------- ------- ------- ------- </TABLE> RESTRUCTURING In the three month period ended July 3, 1999, Cadence recorded $10.7 million in restructuring charges including severance costs to terminate 49 employees and costs to consolidate facilities. Severance costs of $8.7 million relate to restructuring plans primarily aimed at reducing costs after Cadence merged with Quickturn, further actions taken to restructure the Cadence services business in Japan, and severance resulting from the resignation of Cadence's Chief Executive Officer. Facilities consolidation charges of $2 million are the result of the closure of 15 Quickturn facilities, including $1 million to close and exit the excess facilities and $1 million of related leasehold improvement abandonment costs. Closure and exit costs of $1 million include payments required under lease contracts (less any applicable sublease income) after the properties were abandoned, lease buyout costs, restoration costs associated with certain lease arrangements, and costs to maintain facilities during the period after abandonment. Asset related costs written-off consist of leasehold improvements to facilities that were abandoned and whose estimated fair market value is zero. Through July 1999, 80% of the sites have been vacated and the remaining sites will be vacated primarily during the third and fourth quarter of 1999. Noncancelable lease payments on vacated facilities will be paid out through 2003. In the three month period ended April 3, 1999, Cadence recorded $2.2 million in severance costs to terminate 45 employees. These actions were taken to complete Cadence's restructuring program initiated in the fourth quarter of 1998. The restructuring plan was primarily aimed at reducing the costs of excess personnel in its services business, and Cadence anticipates that the actions taken in the first quarter of 1999 will save an estimated additional $0.6 million in fiscal 1999. In each of the three month periods ended April 3, 1999 and July 3, 1999, all termination notices and benefits were communicated to the affected employees prior to quarter end and all severance benefits are expected to be paid in 1999. Included in unusual items for the six month period ended July 4, 1998 were restructuring charges of $4 million related to severance costs associated with Cadence's international business operations and consolidation and cancellation of a certain information technology support services contract. 8
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) The following tables summarize the Company's restructuring activity during the six months ended July 3, 1999: <TABLE> <CAPTION> FOR THE SIX MONTHS ENDED JULY 3, 1999 ------------------------------------------------------------- SEVERANCE AND EXCESS OTHER BENEFITS FACILITIES RESTRUCTURING ASSETS TOTAL ------------ ---------- ------------- ------- -------- (IN THOUSANDS) <S> <C> <C> <C> <C> <C> Balance, January 2, 1999........... $ 13,114 $ 14,496 $ 2,213 $11,304 $ 41,127 1999 restructuring charges....... 10,885 978 -- 1,025 12,888 Reclassifications................ (515) 179 501 (165) -- Non-cash charges................. (533) (331) (663) (1,794) (3,321) Cash charges..................... (11,811) (4,914) (1,337) (880) (18,942) ------------ ---------- ------------- ------- -------- Balance, July 3, 1999.............. $ 11,140 $ 10,408 $ 714 $ 9,490 $ 31,752 ------------ ---------- ------------- ------- -------- ------------ ---------- ------------- ------- -------- </TABLE> MERGER COSTS AND IN-PROCESS TECHNOLOGY In connection with the acquisition of Quickturn, Cadence charged to expense $8.4 million representing merger costs in the three month period ended July 3, 1999. These merger costs represent fees for financial advisors, attorneys, and accountants. In connection with the DAI acquisition in the first quarter of 1999, Cadence immediately charged to expense $8.9 million representing in-process technology that had not yet reached technological feasibility and had no alternative future use. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations--Merger Costs and In-Process Technology." ASSET IMPAIRMENT In the three month period ended July 3, 1999, Cadence incurred charges totaling $3.5 million in connection with the cancellation of an information technology services contract with a third-party and the abandonment of capitalized software development costs associated with Cadence products that will no longer be sold. In the three month period ended April 3, 1999, Cadence incurred charges totaling $3.1 million in connection with the abandonment of certain third-party software licenses that will no longer be used by its design services business and capitalized software development costs associated with Cadence products that will no longer be sold. The impairment losses recorded for the six month period ended July 3, 1999, were the amounts by which the carrying amounts of the intangible assets exceeded their fair market values. LITIGATION SETTLEMENT On June 23, 1999, Cadence and Mentor Graphics Corporation (Mentor) announced the settlement of a patent infringement action pending in the United States District Court for the District of Oregon. In the settlement, the parties agreed that the District Court in Portland would enter a judgment declaring that certain Quickturn patents are valid, enforceable, and were infringed by Mentor's sale of SimExpress products in the United States. Mentor is permanently enjoined from producing, marketing or selling 9
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) SimExpress emulation systems in the United States. In connection with the settlement, Mentor paid Cadence $3 million. CREDIT FACILITY During the six month period ended July 3, 1999, Cadence repaid $135 million of its revolving credit facility. At July 3, 1999, there were no borrowings under this revolving credit facility. COMPREHENSIVE INCOME (LOSS) "Comprehensive income (loss)" 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 (loss) follows: <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ---------------- ---------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 1999 1998 ------- ------- ------- ------- (IN THOUSANDS) <S> <C> <C> <C> <C> Net income (loss).................. $(3,007) $59,962 $49,855 $58,008 Translation loss................... (1,411) (1,179) (472) (2,648) Unrealized loss on investments..... (104) (8) (156) (25) ------- ------- ------- ------- Comprehensive income (loss)...... $(4,522) $58,775 $49,227 $55,335 ------- ------- ------- ------- ------- ------- ------- ------- </TABLE> NET INCOME (LOSS) PER SHARE Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted average shares of common stock outstanding during the period. Diluted net income (loss) per share is calculated by dividing net income (loss) by the sum of the weighted average shares of common stock outstanding and the incremental number of potential common shares issuable upon the exercise of outstanding common stock options, warrants, contingent issuances of common stock, and put warrants computed using the treasury stock method. For periods in which Cadence had losses, potential common shares from common stock options, warrants, contingent issuances of common stock, and put warrants are excluded from the computation of diluted net loss per share as their effect is antidilutive. 10
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) The following is a reconciliation of the weighted average common shares used to calculate basic net income (loss) per share to the weighted average common and potential common shares used to calculate diluted net income (loss) per share: <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ---------------- ---------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 1999 1998 ------- ------- ------- ------- (IN THOUSANDS) <S> <C> <C> <C> <C> Weighted average common shares used to calculate basic net income (loss) per share................. 241,978 234,842 241,026 233,681 Options.......................... -- 24,873 14,368 25,572 Warrants and other contingent shares......................... -- 302 307 274 Puts............................. -- 4 1,315 2 ------- ------- ------- ------- Weighted average common and potential common shares used to calculate diluted net income (loss) per share................. 241,978 260,021 257,016 259,529 ------- ------- ------- ------- ------- ------- ------- ------- </TABLE> Had Cadence recorded net income for the three months ended July 3, 1999, dilutive weighted outstanding options would have been 10.2 million shares and weighted outstanding warrants and other dilutive contingent shares would have been 2.6 million shares. CONTINGENCIES Refer to Part II, Item 1 for a description of legal proceedings. PUT WARRANTS AND CALL OPTIONS Cadence has authorized two seasoned systematic stock repurchase programs under which it repurchases common stock to satisfy estimated requirements for shares to be issued under its Employee Stock Purchase Plan (ESPP) and the 1997 Nonstatutory Stock Option Plan (the 1997 Plan). Such repurchases are intended to cover Cadence's expected reissuances under the ESPP and the 1997 Plan for the next 12 months and 24 months, respectively. As part of its authorized repurchase programs, Cadence has sold put warrants through private placements. At July 3, 1999, there were 4 million put warrants outstanding, each of which entitles the holder to sell one share of common stock to Cadence on a specified date and at a specified price ranging from $13.08 to $34.59 per share. Additionally, during this same period, Cadence purchased call options that entitle Cadence to buy shares of common stock at a specified price to satisfy anticipated stock repurchase requirements under Cadence's systematic stock repurchase programs. At July 3, 1999, Cadence had 3 million call options outstanding at prices ranging from $13.33 to $34.84 per share. The put warrants and call options outstanding at July 3, 1999 are exercisable on various dates through February 2000, and Cadence has the contractual ability to settle the options prior to their maturity. At July 3, 1999, the fair value of the call options was approximately $4.2 million and the fair value of the put warrants was approximately $36.4 million. The fair value of the put warrants and call options was estimated by Cadence's investment advisors. If exercised, Cadence has the right to settle the put warrants with Cadence common stock equal to the difference between the exercise price and the fair value at the date of exercise. Settlement of the put 11
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) warrants with stock could cause Cadence to issue a substantial number of shares, depending on the exercise price of the put warrants and the per share fair value of Cadence's common stock at the time of exercise. In addition, settlement of put warrants in stock could lead to the disposition by put warrant holders of shares of Cadence's common stock that such holders may have accumulated in anticipation of the exercise of the put warrants or call options, which may adversely affect the price of Cadence's common stock. At July 3, 1999, Cadence had the ability to settle these put warrants with stock and, therefore, no amount was classified out of stockholders' equity in the condensed consolidated balance sheets. SEGMENT REPORTING In 1998, Cadence adopted Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosures about Segments of an Enterprise and Related Information." Under SFAS No. 131, operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker when deciding how to allocate resources and when assessing performance. Cadence currently has three operating segments: Products, Services, and Maintenance. Cadence's chief operating decision making group is the Executive Staff, which includes the Company President and Chief Executive Officer and his senior staff. Cadence's business activities are organized on the basis of three operating segments. The Products segment designs and sells a variety of electronic design automation products that are licensed to customers. The Services segment offers methodology and design services either to assist companies in developing electronic designs or to assume responsibility for the design effort when customers wish to outsource this work. The Maintenance segment is primarily a technical support organization, and maintenance agreements are offered to customers either as part of our product license agreements or separately. Cadence's organizational structure reflects this segmentation, and segments have not been aggregated for purposes of this disclosure. Segment income from operations is defined as gross margin under generally accepted accounting principles and excludes operating expenses (marketing and sales, research and development, and general and administrative), unusual items, other income, net, and income taxes. Profitability information about Cadence's segments is available only to the extent of gross margin by segment, and operating expenses and other income and expense items are managed on a functional basis. There are no differences between the accounting policies used to measure profit and loss for segments and those used on a consolidated basis. Revenue is defined as revenue from external customers with no intersegment revenue or expenses. Cadence's management does not identify or allocate its assets, including capital expenditures, by operating segment. Accordingly, assets are not being reported by segment because the information is not available by segment and is not reviewed by Cadence's Executive Staff to make decisions about resources to be allocated among the segments or to assess their performance. Depreciation and amortization is allocated among the segments in order to determine each segments' gross margin. 12
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) The following tables present information about reported segments for the three months ended July 3, 1999 and July 4, 1998: <TABLE> <CAPTION> FOR THE THREE MONTHS ENDED JULY 3, 1999 ------------------------------------------------------ PRODUCT SERVICES MAINTENANCE OTHER TOTAL -------- -------- ----------- --------- -------- (IN THOUSANDS) <S> <C> <C> <C> <C> <C> Revenue............................ $117,890 $ 74,943 $71,360 $ -- $264,193 Cost of revenue.................... 20,064 48,844 12,930 -- 81,838 Amortization of acquired intangibles...................... 11,632 1,224 -- -- 12,856 -------- -------- ----------- --------- -------- Gross margin..................... 86,194 24,875 58,430 -- 169,499 Marketing and sales................ -- -- -- (82,936) (82,936) Research and development........... -- -- -- (50,359) (50,359) General and administrative......... -- -- -- (20,903) (20,903) Unusual items...................... -- -- -- (19,648) (19,648) Other income, net.................. -- -- -- 141 141 -------- -------- ----------- --------- -------- Income (loss) before provision (benefit) for income taxes....... $ 86,194 $ 24,875 $58,430 $(173,705) $ (4,206) -------- -------- ----------- --------- -------- -------- -------- ----------- --------- -------- <CAPTION> FOR THE THREE MONTHS ENDED JULY 4, 1998 ------------------------------------------------------ <S> <C> <C> <C> <C> <C> Revenue............................ $177,406 $ 66,871 $71,459 $ -- $315,736 Cost of revenue.................... 22,118 48,771 12,399 -- 83,288 Amortization of acquired intangibles...................... 1,769 1,115 -- -- 2,884 -------- -------- ----------- --------- -------- Gross margin..................... 153,519 16,985 59,060 -- 229,564 Marketing and sales................ -- -- -- (81,199) (81,199) Research and development........... -- -- -- (49,439) (49,439) General and administrative......... -- -- -- (20,002) (20,002) Unusual items...................... -- -- -- -- -- Other income, net.................. -- -- -- 3,365 3,365 -------- -------- ----------- --------- -------- Income (loss) before provision (benefit) for income taxes....... $153,519 $ 16,985 $59,060 $(147,275) $ 82,289 -------- -------- ----------- --------- -------- -------- -------- ----------- --------- -------- </TABLE> 13
CADENCE DESIGN SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) The following tables present information about reported segments for the six months ended July 3, 1999 and July 4, 1998: <TABLE> <CAPTION> FOR THE SIX MONTHS ENDED JULY 3, 1999 ------------------------------------------------------ PRODUCT SERVICES MAINTENANCE OTHER TOTAL -------- -------- ----------- --------- --------- (IN THOUSANDS) <S> <C> <C> <C> <C> <C> Revenue............................ $305,247 $147,417 $146,720 $ -- $ 599,384 Cost of revenue.................... 38,600 96,102 25,830 -- 160,532 Amortization of acquired intangibles...................... 22,951 2,619 -- -- 25,570 -------- -------- ----------- --------- --------- Gross margin..................... 243,696 48,696 120,890 -- 413,282 Marketing and sales................ -- -- -- (162,999) (162,999) Research and development........... -- -- -- (101,227) (101,227) General and administrative......... -- -- -- (42,163) (42,163) Unusual items...................... -- -- -- (33,840) (33,840) Other income, net.................. -- -- -- 276 276 -------- -------- ----------- --------- --------- Income (loss) before provision (benefit) for income taxes....... $243,696 $ 48,696 $120,890 $(339,953) $ 73,329 -------- -------- ----------- --------- --------- -------- -------- ----------- --------- --------- <CAPTION> FOR THE SIX MONTHS ENDED JULY 4, 1998 ------------------------------------------------------ <S> <C> <C> <C> <C> <C> Revenue............................ $346,337 $121,342 $141,845 $ -- $ 609,524 Cost of revenue.................... 39,053 89,150 24,977 -- 153,180 Amortization of acquired intangibles...................... 2,519 1,168 -- -- 3,687 -------- -------- ----------- --------- --------- Gross margin..................... 304,765 31,024 116,868 -- 452,657 Marketing and sales................ -- -- -- (159,716) (159,716) Research and development........... -- -- -- (97,131) (97,131) General and administrative......... -- -- -- (39,480) (39,480) Unusual items...................... -- -- -- (60,857) (60,857) Other income, net.................. -- -- -- 6,683 6,683 -------- -------- ----------- --------- --------- Income (loss) before provision (benefit) for income taxes....... $304,765 $ 31,024 $116,868 $(350,501) $ 102,156 -------- -------- ----------- --------- --------- -------- -------- ----------- --------- --------- </TABLE> 14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO INCLUDED ELSEWHERE HEREIN. EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED HEREIN, THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS BASED ON CURRENT EXPECTATIONS THAT INVOLVE CERTAIN RISKS AND UNCERTAINTIES. CADENCE'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE FORWARD LOOKING STATEMENTS DISCUSSED HEREIN. FACTORS THAT COULD CAUSE ACTUAL RESULTS OR PERFORMANCE TO DIFFER MATERIALLY OR CONTRIBUTE TO SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED BELOW IN "RESULTS OF OPERATIONS," "YEAR 2000 UPDATE," "LIQUIDITY AND CAPITAL RESOURCES," "FACTORS THAT MAY AFFECT FUTURE RESULTS," AND "DISCLOSURES ABOUT MARKET RISK." OVERVIEW Cadence provides software and hardware technology and comprehensive design and methodology services and technology for the product development requirements of the world's leading electronics companies. Cadence licenses its leading-edge electronic design automation (EDA) software and hardware technology and provides a variety of professional services to companies throughout the world ranging from methodology services to help optimize performance of the customer's product to design services to create the actual design of the electronic system for the customer's product. Cadence is a supplier of "design realization" solutions, which are used by companies to design and develop complex chips and electronic systems, including semiconductors, computer systems and peripherals, telecommunications and networking equipment, mobile and wireless devices, automotive electronics, consumer products, and other advanced electronics. In June 1999, Cadence entered into a merger agreement with OrCAD, Inc. (OrCAD) and on July 19, 1999, completed its tender offer for all of the issued and outstanding shares of OrCAD common stock. OrCAD is a supplier of computer-aided engineering and computer-aided design software and services for the printed circuit board industry. Pursuant to a cash tender offer Cadence acquired approximately 96% of the outstanding shares of OrCAD at $13 per share for a total purchase price of approximately $121 million. In July 1999, Cadence acquired the balance of the OrCAD shares in a short form cash merger and the acquisition will be accounted for as a purchase. In May 1999, Cadence completed its merger with Quickturn Design Systems, Inc., a Delaware corporation (Quickturn). Quickturn designs, manufactures, sells, and supports hardware and software products that verify the design of computer chips and electronic systems. Cadence acquired all of the outstanding shares of Quickturn common stock in a tax-free, stock-for-stock transaction for approximately 24.6 million shares of Cadence common stock. The acquisition was accounted for as a pooling of interests. In addition, Cadence assumed all of the outstanding stock options and warrants of Quickturn. All prior period condensed financial statements were restated as if the merger took place at the beginning of such periods, in accordance with required pooling of interests accounting and disclosures. In January 1999, Cadence acquired Design Acceleration, Inc. (DAI). DAI is a supplier of design verification technology used in system-on-a-chip design. Cadence acquired all of the outstanding stock of DAI for approximately 0.6 million shares of Cadence's common stock and $2.9 million of cash. The total purchase price was $25.7 million, and the acquisition was accounted for as a purchase. 15
RESULTS OF OPERATIONS REVENUE <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ----------------- ----------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 % CHANGE 1999 1998 % CHANGE ------- ------- -------- ------- ------- -------- (IN MILLIONS) <S> <C> <C> <C> <C> <C> <C> Product............................ $ 117.9 $ 177.4 (34)% $ 305.3 $ 346.3 (12)% Services........................... 74.9 66.9 12% 147.4 121.3 21% Maintenance........................ 71.4 71.4 0% 146.7 141.9 3% ------- ------- ------- ------- Total revenue.................... $ 264.2 $ 315.7 (16)% $ 599.4 $ 609.5 (2)% ------- ------- ------- ------- ------- ------- ------- ------- </TABLE> SOURCES OF REVENUE AS A PERCENT OF TOTAL REVENUE <TABLE> <S> <C> <C> <C> <C> <C> <C> Product............................ 45% 56% 51% 57% Services........................... 28% 21% 25% 20% Maintenance........................ 27% 23% 24% 23% </TABLE> The decreases in product revenue of $59.5 million and $41.1 million for the three and six month periods ended July 3, 1999, respectively, when compared to the same periods of 1998, were attributable primarily to a decrease in demand for IC implementation products, which include place and route and physical design tools, and IP creation products, which include verilog and algorithm design tools, partially offset by an increase in demand for Quickturn products. In July 1999, Cadence implemented a new software product licensing model that will include a new subscription license over a two-year term. This new product licensing model allows customers to purchase software products with licenses that have shorter periods and allow access to new technology. Because Cadence's new model includes undelivered technology, sales of software products under this model require revenue to be recognized ratably over the license period. Total revenues in the third quarter are expected to decrease from the current quarter primarily due to a larger portion of its software being licensed pursuant to the new subscription license, which will require revenue to be recognized ratably over the license period. See "Factors That May Affect Future Results." Services revenue increased $8 million and $26.1 million in the three and six month periods ended July 3, 1999, respectively, when compared to the same periods of 1998. The increases in services revenue were primarily the result of increased demand for Cadence's design services offerings. Maintenance revenue remained flat for the three month period ended July 3, 1999, and increased $4.8 million for the six month period ended July 3, 1999, when compared to the same periods of 1998, primarily due to continued growth of the installed customer base and the renewal of maintenance and support contracts. 16
REVENUE BY GEOGRAPHY <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ----------------- ----------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 % CHANGE 1999 1998 % CHANGE ------- ------- -------- ------- ------- -------- (IN MILLIONS) <S> <C> <C> <C> <C> <C> <C> Domestic........................... $ 142.9 $ 150.1 (5)% $ 284.2 $ 318.7 (11)% International...................... 121.3 165.6 (27)% 315.2 290.8 8% ------- ------- ------- ------- Total revenue...................... $ 264.2 $ 315.7 (16)% $ 599.4 $ 609.5 (2)% ------- ------- ------- ------- ------- ------- ------- ------- </TABLE> REVENUE BY GEOGRAPHY AS A PERCENT OF TOTAL REVENUE <TABLE> <S> <C> <C> <C> <C> <C> <C> Domestic........................... 54% 48% 47% 52% International...................... 46% 52% 53% 48% </TABLE> Total revenue from international sources decreased in the three month period ended July 3, 1999, as compared to the same period in 1998. The decrease was due primarily to a decrease in product and services in Europe, partially offset by an increase in maintenance in Europe and services in Japan. Total revenue from international sources increased for the six month period ended July 3, 1999, as compared to the same period in the prior year, due primarily to higher demand for products in Japan, services in Japan and Canada, and maintenance in Europe, partially offset by lower demand for products in Europe in the three month period ended July 3, 1999. Differences in the rate of growth of domestic and international revenue, over the periods presented and as compared geographically, are primarily due to fluctuations in demand and resulting sales volume of place-and-route, physical design, and verification products as well as methodology and design services offerings. Revenue growth is expected to be slower for the remainder of 1999 primarily due to a larger portion of its software being licensed pursuant to subscription licenses where revenue is recognized ratably over the licence period. Foreign currency exchange rates positively affected reported revenue by $3.9 million and $8 million during the three and six month periods ended July 3, 1999, primarily due to the strengthening of the Japanese yen in relation to the U.S. dollar. Foreign currency exchange rates negatively affected reported revenue by $6.8 million and $10.7 million during the three and six month periods ended July 4, 1998, primarily due to the weakening of the Japanese yen in relation to the U.S. dollar. COST OF REVENUE <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ----------------- ----------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 % CHANGE 1999 1998 % CHANGE ------- ------- -------- ------- ------- -------- (IN MILLIONS) <S> <C> <C> <C> <C> <C> <C> Product............................ $20.1 $22.1 (9)% $38.6 $39.1 (1)% Services........................... $48.8 $48.8 0% $96.1 $89.2 8% Maintenance........................ $12.9 $12.4 4% $25.8 $25.0 3% </TABLE> COST OF REVENUE AS A PERCENT OF RELATED REVENUE <TABLE> <S> <C> <C> <C> <C> <C> <C> Product............................ 17% 12% 13% 11% Services........................... 65% 73% 65% 73% Maintenance........................ 18% 17% 18% 18% </TABLE> 17
Cost of product revenue includes costs of production personnel, packaging and documentation, and amortization of capitalized software development costs for software products. Manufacturing costs associated with Quickturn hardware emulation system products include materials, labor, and overhead. Cost of product revenue decreased $2 million and $0.5 million for the three and six month periods ended July 3, 1999, respectively, as compared to the same periods of 1998. These decreases were primarily due to inventory obsolescence charges of $5.7 million in the three month period ended April 4, 1998, associated with Quickturn's introduction of the Mercury Design Verification System. The decrease was partially offset by increases in other Quickturn hardware manufacturing costs of $3.1 million and $3.6 million, increases in software product royalty expense of $1.7 million and $1.3 million, and increases in amortization of capitalized software development costs of $1 million and $1.8 million for the three and six month periods ended July 3, 1999, respectively, as compared to the same periods of 1998. Product gross margin decreased for the three and six month periods ended July 3, 1999, compared to the same periods of 1998 primarily due to lower demand and sales of software products. Product gross margin for the three and six month periods ended July 3, 1999, also declined due to a higher proportion of hardware revenue with lower gross margins than software product revenue. The majority of Cadence's costs of software product revenue do not vary significantly with changes in revenue. Product gross margin may continue to be adversely affected during the remainder of 1999 due to expected lower revenue. Cost of services revenue includes costs associated with providing services to customers, primarily salaries and costs to recruit, develop, and retain personnel, and costs to maintain the infrastructure necessary to manage a services organization. Cost of services revenue remained flat in the three month period ended July 3, 1999, and increased $6.9 million in the six months ended July 3, 1999, as compared to the same periods of 1998. The increase in the six month period ended July 3, 1999 was primarily due to the addition of services professionals, primarily through acquisitions completed in 1998. Services gross margin increased for the three and six months ended July 3, 1999, as compared to the same periods of 1998, primarily due to increased utilization of services capacity and the management of expenses. Services gross margin has been, and may continue to be, adversely affected by Cadence's inability to fully utilize its services resources. In addition, services gross margin may continue to be adversely affected by Cadence's inability to achieve operating efficiencies when implementing 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 production personnel, packaging, and documentation of maintenance updates. Cost of maintenance revenue in absolute dollars and as a percent of related revenue remained relatively flat in the three and six months ended July 3, 1999, as compared to the same periods of 1998. AMORTIZATION OF ACQUIRED INTANGIBLES <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ----------------- ----------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 1999 1998 ------- ------- ------- ------- (IN MILLIONS) <S> <C> <C> <C> <C> Amortization of acquired intangibles...................... $12.9 $2.9 $25.6 $3.7 </TABLE> AMORTIZATION OF ACQUIRED INTANGIBLES AS A PERCENT OF TOTAL REVENUE <TABLE> <S> <C> <C> <C> <C> Amortization of acquired intangibles...................... 5% 1% 4% 1% </TABLE> Amortization of acquired intangibles increased $10 million and $21.9 million for the three and six months ended July 3, 1999, respectively, as compared to the same periods in 1998, as a result of the subsequent acquisitions of Ambit Design Systems, Inc. (Ambit), Symbionics Group Limited, Bell Labs' 18
Integrated Circuit Design Automation group of Lucent Technologies, Inc. (BLDA), and Excellent Design, Inc. in 1998, and Design Acceleration, Inc. in the three month period ended April 3, 1999, which were accounted for using the purchase method of accounting. OPERATING EXPENSES <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ----------------- ----------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 % CHANGE 1999 1998 % CHANGE ------- ------- -------- ------- ------- -------- (IN MILLIONS) <S> <C> <C> <C> <C> <C> <C> Marketing and sales................ $82.9 $81.2 2% $ 163.0 $ 159.7 2% Research and development........... $50.4 $49.4 2% $ 101.2 $ 97.1 4% General and administrative......... $20.9 $20.0 5% $ 42.2 $ 39.5 7% </TABLE> EXPENSES AS A PERCENT OF TOTAL REVENUE <TABLE> <S> <C> <C> <C> <C> <C> <C> Marketing and sales................ 31% 26% 27% 26% Research and development........... 19% 16% 17% 16% General and administrative......... 8% 6% 7% 6% </TABLE> Marketing and sales expenses increased $1.7 million and $3.3 million for the three and six month periods ended July 3, 1999, respectively, as compared to the same periods of 1998. The three month period ended July 3, 1999 increased primarily due to an increase in sales support costs in Japan and sales commissions, partially offset by a decrease in salaries and travel expenses. For the six month period ended July 3, 1999, the increase in sales and marketing expenses of $3.3 million was primarily the result of an increase in sales support costs in Japan, partially offset by a decrease in employee related expenses, including salaries and bonus, and travel. Foreign currency exchange rates negatively affected reported marketing and sales expenses by $0.9 million and $1.4 million during the three and six month periods ended July 3, 1999, primarily due to the strengthening of the Japanese yen in relation to the U.S. dollar. During the three and six month periods ended July 4, 1998, foreign currency exchange rates positively affected marketing and sales expenses by $2.1 million and $3.9 million, respectively, primarily due to the weakening of the Japanese yen in relation to the U.S. dollar. Cadence's expenses for research and development, prior to the reduction for capitalization of software development costs, was $57.5 million for the three months ended July 3, 1999 and $55.6 million for the three months ended July 4, 1998, representing 22% and 18% of total revenue for each quarter, respectively. For the three and six month periods ended July 3, 1999 and July 4, 1998, Cadence capitalized $7.1 million and $6.1 million and $13.5 million and $11.6 million of software development costs, respectively, representing 12% and 11% of total research and development expenditures made in each of those periods, respectively. The increase in capitalized software development costs for the three and six months ended July 3, 1999 resulted primarily from general increases in new product development. The increase in net research and development expenses of $1 million for the three month period ended July 3, 1999, as compared with the same period of 1998, was primarily attributable to costs related to the operations of Ambit and BLDA. The increase in research and development expenses of $4.1 million for the six month period ended July 3, 1999, as compared with the same period of 1998, was primarily attributable to costs related to the operations of Ambit and BLDA. 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 $0.9 million and $2.7 million for the three and six months ended July 3, 1999, respectively, as compared to the same periods of 1998. The increase in the three month period ended July 3, 1999, as compared to the same period in 1998, was primarily attributable 19
to an increase in bad debt expense of $2.9 million, partially offset by a decrease in consulting services. The increase for the six months ended July 3, 1999, as compared to the same period in 1998, was primarily attributable to increases in bad debt expense of $4.7 million and legal expenses of $2.2 million, partially offset by a decrease in consulting and temporary services. Operating expenses as a percent of total revenue increased and may continue to increase during the remainder of 1999, as compared to 1998, primarily due to the decrease in total revenue resulting from lower demand for software products and due to a larger portion of Cadence's software being licensed pursuant to subscription licenses where revenue is recognized ratably over the license period. UNUSUAL ITEMS AND RESTRUCTURING The following table presents information regarding unusual items for the quarters ended July 3, 1999 and July 4, 1998: <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED ENDED ----------------- ----------------- JULY 3, JULY 4, JULY 3, JULY 4, 1999 1998 1999 1998 ------- ------- ------- ------- (IN MILLIONS) <S> <C> <C> <C> <C> Restructuring charges.............. $10.7 $ -- $12.9 $ 4.0 Merger costs....................... 8.4 -- 8.4 -- Asset impairment................... 3.5 -- 6.6 -- Litigation settlement.............. (3.0) -- (3.0) -- Write-off of acquired in-process technology....................... -- -- 8.9 56.9 ------- ------- ------- ------- Total unusual items.............. $19.6 $ -- $33.8 $60.9 ------- ------- ------- ------- ------- ------- ------- ------- </TABLE> RESTRUCTURING In the three month period ended July 3, 1999, Cadence recorded $10.7 million in restructuring charges including severance costs to terminate 49 employees and costs to consolidate facilities. Severance costs of $8.7 million relate to restructuring plans primarily aimed at reducing costs after Cadence merged with Quickturn, further actions taken to restructure the Cadence services business in Japan, and severance resulting from the resignation of Cadence's Chief Executive Officer. Facilities consolidation charges of $2 million are the result of the closure of 15 Quickturn facilities, including $1 million to close and exit the excess facilities and $1 million of related leasehold improvement abandonment costs. Closure and exit costs of $1 million include payments required under lease contracts (less any applicable sublease income) after the properties were abandoned, lease buyout costs, restoration costs associated with certain lease arrangements, and costs to maintain facilities during the period after abandonment. Asset related costs written-off consist of leasehold improvements to facilities that were abandoned and whose estimated fair market value is zero. Through July 1999, 80% of the sites have been vacated and the remaining sites will be vacated primarily during the third and fourth quarter of 1999. Noncancelable lease payments on vacated facilities will be paid out through 2003. In the three month period ended April 3, 1999, Cadence recorded $2.2 million in severance costs to terminate 45 employees. These actions were taken to complete Cadence's restructuring program initiated in the fourth quarter of 1998. The restructuring plan was primarily aimed at reducing the costs of excess personnel in its services business, and Cadence anticipates that the actions taken in the first quarter of 1999 will save an estimated additional $0.6 million in fiscal 1999. In each of the three month periods ended April 3, 1999 and July 3, 1999, all termination notices and benefits were communicated to the affected employees prior to quarter-end and all severance benefits are expected to be paid in 1999. 20
Included in unusual items for the six month period ended July 4, 1998 were restructuring charges of $4 million related to severance costs associated with Cadence's international business operations and consolidation and cancellation of a certain information technology support services contract. MERGER COSTS AND IN-PROCESS TECHNOLOGY In connection with the acquisition of Quickturn, Cadence charged to expense $8.4 million representing merger costs in the three month period ended July 3, 1999. These merger costs represent fees for financial advisors, attorneys, and accountants. In January 1999, Cadence acquired Design Acceleration, Inc. (DAI). DAI is a supplier of design verification technology used in system-on-a-chip design. Cadence acquired all of the outstanding stock of DAI for approximately 0.6 million shares of Cadence's common stock and $2.9 million of cash. The total purchase price was $25.7 million, and the acquisition was accounted for as a purchase. In connection with the acquisition, net intangibles of $24.1 million were acquired. Upon consummation of the DAI acquisition, Cadence immediately charged to expense $8.9 million representing acquired in-process technology that had not yet reached technological feasibility and had no alternative future use. See "Notes to Condensed Consolidated Financial Statements." The value was determined by estimating the costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects, and discounting the net cash flows back to their present value. The discount rate includes a factor that took into account the uncertainty surrounding the successful development of the acquired in-process technology. The in-process technology under development is expected to be commercially viable in 1999. Expenditures to complete the in-process technology is expected to total approximately $0.7 million. These estimates are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur. Additionally, these projects will require expenditures for additional research and development after they have reached a state of technological and commercial feasibility. At the time of its acquisition by Cadence, DAI was working on several significant research and development projects that were intended to provide a next generation environment for design verification and analysis. These efforts included the development of a highly automated approach for high-level test bench creation and analysis, a waveform viewer capable of supporting analog and mixed signal designs and a tool designed to analyze verification code coverage at the transactional level. The nature of the efforts to complete these in-process research and development projects relate, in varying degrees, to the completion of all planning, designing, prototyping, verification, and testing activities that are necessary to establish that the proposed in-process technologies meet their design specifications, which include functional, technical, and economic performance requirements. The net cash flows generated by the projects underway at DAI, which were used to value the acquired in-process technology, were based on management's estimates of revenue, cost of revenue, research and development costs, selling, general and administrative costs, and income taxes from such projects. The revenue projections were based on the potential market size for which these projects are addressing, Cadence's ability to gain market acceptance for these projects, and the life cycle of in-process technology. Estimated total revenues from the acquired in-process product areas peak in years 2001-2002 and decline rapidly thereafter as other new products are expected to enter the market. In addition, a portion of the anticipated revenue has been attributed to enhancements of the base technology under development, and has been excluded from net cash flow calculations. Existing technology was valued at $11.4 million. The net cash flows generated from the in-process technology are expected to reflect earnings before interest, taxes, and depreciation of approximately 60% for the sales generated from in-process technology. There can be no assurance that these assumptions will prove accurate, or that Cadence will realize the anticipated benefits of this acquisition. See "Factors That May Affect Future Results." The discount applied to the net cash flows to calculate the present value of such net cash flows was based on the weighted average cost of capital (WACC). The WACC calculation produces the average 21
required rate of return of an investment in an operating enterprise, based on various required rates of return from investments in various areas of the enterprise. The discount rate used to discount the net cash flows from purchased in-process technology was 22%. These discount rates are sometimes higher than the WACC due to the inherent uncertainties in the estimates, including the uncertainty surrounding the successful development of the acquired in-process technology, the useful life of such technology, the profitability levels of such technology, if any, and the uncertainty of technological advances, all of which are unknown at this time. As evidenced by their continued support for research and development projects, management believes Cadence is well positioned to successfully complete each of these projects. However, there is risk associated with the completion of the projects and there is no assurance that each will meet with either technological or commercial success. If these projects are not successfully developed, Cadence's business, operating results, and financial condition may be adversely affected in future periods. In addition, the value of other intangible assets acquired may become impaired. To date, DAI's results have not differed significantly from the forecast assumptions. In addition, Cadence's research and development expenditures since the acquisition have not differed materially from expectations. Revenue contribution from the acquired technology falls within an acceptable range of plans in its role in Cadence's suite of design systems and tools. The risks associated with the research and development are still considered high and no assurance can be made that future products will meet market expectations. In the three months ended April 4, 1998, Cadence acquired all of the outstanding stock of Excellent Design, Inc., a Japanese corporation (EXD) and Symbionics Group Limited, a U.K corporation (Symbionics). The total purchase price of EXD was $40.9 million, and the acquisition was accounted for as a purchase. EXD provides application-specific integrated circuit and system-on-a-chip (SOC) design and library development. Upon consummation of the EXD acquisition, Cadence immediately charged to expense $28.4 million representing acquired in-process technology that had not yet reached technological feasibility and had no alternative future use. The value was determined by estimating the costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects, and discounting the net cash flows back to their present value. The discount rate included a factor that took into account the uncertainty surrounding the successful development of the acquired in-process technology. At the time of the acquisition, the in-process technology under development was expected to be commercially viable on dates ranging from the end of 1998 through the year 2000. Expenditures to complete these projects were expected to total approximately $7 million. These estimates are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur. Additionally, these projects will require expenditures for additional research and development after they have reached a state of technological and commercial feasibility. The total purchase price of Symbionics was $46.1 million, and the acquisition was accounted for as a purchase. Symbionics provides product development design services to leading electronic manufacturers. Upon consummation of the Symbionics acquisition, Cadence immediately charged to expense $28.5 million representing acquired in-process technology that had not yet reached technological feasibility and had no alternative future use. The value was determined by estimating the costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects, and discounting the net cash flows back to their present value. The discount rate includes a factor that took into account the uncertainty surrounding the successful development of the acquired in-process technology. At the time of the acquisition, the in-process technology under development was expected to be commercially viable on dates ranging from the end of 1998 through the year 2000. 22
Expenditures to complete these projects were expected to total approximately $6 million. These estimates are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur. Additionally, these projects will require expenditures for additional research and development after they have reached a state of technological and commercial feasibility. To date, EXDs' and Symbionics' results have not differed significantly from the forecast assumptions. Cadence's research and development expenditures since the acquisitions have not differed materially from expectations. Revenue contribution from the acquired technology falls within an acceptable range of plans in its role in Cadence's suite of design systems and tools. The risks associated with the research and development are still considered high, and no assurance can be made that future products will meet market expectations. ASSET IMPAIRMENT In the three month period ended July 3, 1999, Cadence incurred charges totaling $3.5 million in connection with the cancellation of an information technology services contract with a third-party and the abandonment of capitalized software development costs associated with Cadence products that will no longer be sold. In the three month period ended April 3, 1999, Cadence incurred charges totaling $3.1 million in connection with the abandonment of certain third-party software licenses that will no longer be used by its design services business and capitalized software development costs associated with Cadence products that will no longer be sold. The impairment losses recorded for the six month period ended July 3, 1999, were the amounts by which the carrying amounts of the intangible assets exceeded fair market values. LITIGATION SETTLEMENT On June 23, 1999, Cadence and Mentor Graphics Corporation (Mentor) announced the settlement of a patent infringement action pending in the United States District Court for the District of Oregon. In the settlement, the parties agreed that the District Court in Portland would enter a judgment declaring that certain Quickturn patents are valid, enforceable, and were infringed by Mentor's sale of SimExpress products in the United States. Mentor is permanently enjoined from producing, marketing or selling SimExpress emulation systems in the United States. In connection with the settlement Mentor paid Cadence $3 million. OTHER INCOME AND INCOME TAXES Other income decreased $3.2 million and $6.4 million in the three and six months ended July 3, 1999, respectively, as compared to the same periods in 1998, primarily due to a decrease in interest income resulting from a lower average balance of invested cash and short-term investments and lower interest rates. Cadence's estimated effective tax rate for the three and six month periods ended July 3, 1999 was 28.5%, excluding the effect of the write-off of acquired in-process technology of $8.9 million, which is not deductible for income tax purposes. The effective tax rate for the three and six month periods ended July 4, 1998 was 27.1% and 27.8%, respectively, excluding the effect of the write-off of acquired in-process technology of $56.9 million, which is not deductible for income tax purposes. YEAR 2000 UPDATE The Year 2000 computer issue creates risks for Cadence, the full extent and scope of which have not yet been fully assessed. In the event that internal products and systems, or those products and systems 23
provided by, or utilized by, third parties do not correctly recognize and process date data information beyond the year 1999, it could have a material adverse effect on Cadence's business, operating results and financial condition. To address Year 2000 issues, Cadence initiated a program designed to address the most critical Year 2000 items that would affect Cadence's products, its worldwide business systems, and the operations of the following functions:research and development, finance, sales, manufacturing, and human resources. Assessment and remediation efforts regarding these critical items are proceeding in parallel. Cadence has created a plan to work with critical suppliers and customers to determine that such suppliers' and customers' operations and the products and services they provide are Year 2000 capable or to monitor their progress towards Year 2000 capability. Cadence has commenced work on contingency plans to address potential problems with its internal systems and with suppliers, customers, and other third parties. In 1997, Cadence commenced a program to inventory, assess, remediate, and test the Year 2000 capability of its products. As a result of those efforts, Cadence believes that the most current release of Cadence's software products, as set forth in the Year 2000 Software Compliance List (available on Cadence's web site), are Year 2000 Compliant. Cadence uses the term "Year 2000 Compliant" to mean that the software will not: (A) cease to perform due solely to a change in date to or after January 1, 2000, or (B) generate incorrect or ambiguous data or results with respect to same-century and/or multi-century formulas, functions, date values, and date data interfaces. Cadence does not believe that customers are using a significant amount of products that are not determined to be Year 2000 Compliant. Cadence continues to further validate current products, as well as new products, products acquired through acquisitions and releases through testing and code reviews. All Cadence Year 2000 activities concerning Cadence's products are expected to be completed by October 1999. In 1995, Cadence also commenced a worldwide business systems replacement project with systems that use programs primarily from SAP America, Inc. (SAP), PeopleSoft, Inc. (PeopleSoft), and Siebel Systems, Inc. (Siebel). The new systems are expected to make approximately 70% of Cadence's business computer systems Year 2000 Compliant. In addition, during September 1997, Cadence commenced an investigation of the condition of Year 2000 readiness for all of its other internal business applications. This effort began with an inventory to identify current business applications, an evaluation of their Year 2000 readiness status and development of plans for remediation and testing of all discovered issues. As of August 1999, of the 60 business application systems that had been identified, all 60 have been modified or replaced and determined to be Year 2000 ready. Cadence has identified additional areas requiring Year 2000 assessment, remediation and testing, specifically software interfaces, and applications used to interact with vendors, as well as applications that are unique to the various international operations. Cadence expects that all business critical applications will be Year 2000 Compliant by the end of the third quarter of 1999. In July 1998, Cadence established a cross functional Year 2000 Project Team to identify and resolve all remaining Year 2000 readiness issues. The primary remaining issues consist of assessing the Year 2000 impact for outside vendors, customers, facilities, and the remaining internal business systems that are not yet assessed as Year 2000 compliant. Project plans have been developed and include the process of identifying and prioritizing critical suppliers and customers at the direct interface level and communicating with them about their plans and progress in addressing Year 2000 issues. Detailed evaluations of the most critical third parties are well underway. It is expected that all Year 2000 project inventories will be completed by August 1999. This effort is being followed by each business function conducting a focused level of ranking and functional assessment of its inventory to establish the methods and actions required to resolve any Year 2000 issues discovered. The assessment efforts are estimated to be completed by October 1999. The remediation (modification or replacement of existing software or systems) efforts are expected to be completed by October 1999 and the testing phases of the Year 2000 Project Plans are expected to take place throughout most of 1999 and estimated to be completed, for all business critical items, during the fourth quarter of 1999. All remaining issues (which are considered low priority or low risk to the 24
business) are planned to be addressed as time permits and could continue through the first half of 2000. Recent acquisitions of Quickturn and OrCAD are undergoing Year 2000 program evaluations since both companies had existing Year 2000 programs in place prior to the acquisition. Estimated Year 2000 related costs to resolve remaining readiness issues will be approximately $13 million. The costs of implementing the SAP, PeopleSoft and Siebel business application systems are not included in these cost estimates. The total cost associated with required modifications to become Year 2000 compliant is not expected to have a material adverse effect on Cadence's business, operating results, and financial condition. Cadence's current estimates of the amount of time and costs necessary to implement and test its systems are based on the facts and circumstances existing at this time. The estimates were derived utilizing multiple assumptions of future events including the continued availability of certain resources, implementation success, and other factors. New developments may occur that could affect Cadence's estimates for Year 2000 compliance. These developments include, but are not limited to: (a) the availability and cost of personnel trained in this area, (b) the ability to locate and correct all relevant computer code and equipment, and (c) the planning and modification success needed to achieve full implementation. Readers are cautioned that the foregoing discussion regarding Year 2000 Update contains forward-looking statements based on current expectations that involve risks and uncertainties and should be considered in conjunction with the following. The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, certain normal business activities or operations of Cadence. Such failures could materially and adversely affect Cadence's business, operating results, and financial condition. Due in large part to the uncertainty of the Year 2000 readiness of third-party suppliers and customers, as well as the lack of remediation and testing for the remaining internal business systems that are not yet assessed as Year 2000 Compliant, Cadence is currently unable to determine whether the consequences of Year 2000 issues will have a material impact on Cadence's business, operating results, or financial condition. Cadence's risks associated with non-information technology systems and embedded systems are generally limited to systems that typically involve environmental control systems, interruptible power systems, elevator systems, and security systems. Cadence feels confident that through its research, testing, and corrective actions, any Year 2000 problems caused by these systems will not have a material adverse effect on its business, operating results, or financial condition. The reasonably likely worst case scenario of a Year 2000 problem for all of Cadence's material systems is that Cadence's operations could be disrupted for a few days before the problem could be identified and remediated. The reasonably likely worst case scenario associated with Cadence products for a Year 2000 problem is that a customer project could be delayed for a short period of time before the problem can be identified and remediated by Cadence's support process. Because of the small amount of software code that could be involved, it is anticipated that problems will be remediated within 5 business days from when the problem is recreated by Cadence's support organization. Cadence uses contract terms to limit indirect damages that may be incurred by customers, although no assurance can be given that such terms are enforceable. The Year 2000 Project is expected to significantly reduce Cadence's level of uncertainty regarding Year 2000 issues and, in particular, about the Year 2000 readiness of its material internal operations and external agents. In addition, Cadence believes that the current Year 2000 activities surrounding Cadence's software products and internal systems have significantly reduced the risk of any interruption caused by any Year 2000 issues in these areas. However, because of uncertainties with Year 2000 issues, Cadence is currently unable to determine whether and to what extent the Year 2000 problem will harm its business, operating results, or financial condition. 25
LIQUIDITY AND CAPITAL RESOURCES At July 3, 1999, Cadence's principal sources of liquidity consisted of $226 million of cash and short-term investments, compared to $249.5 million at January 2, 1999, and a $355 million senior unsecured credit facility. As of July 3, 1999, Cadence had no borrowings under its revolving credit facility. Cash provided by operating activities decreased $17.8 million to $121.2 million for the six months ended July 3, 1999, as compared to the six months ended July 4, 1998. The decrease was primarily due to decreases in net income and changes in adjustments to net income and in the balances of operating assets and liabilities. At July 3, 1999, Cadence had net working capital of $245.5 million compared with $294.3 million at January 2, 1999. The working capital decrease was driven primarily by decreases in receivables of $51.1 million and cash of $23.5 million and an increase in deferred revenue of $23.4 million, partially offset by decreases in accounts payable and accrued liabilities of $20.5 million and income taxes payable of $13.4 million and an increase in prepaid expenses of $15.8 million. The decrease in receivables was primarily attributable to a decrease in product revenues while the increase in deferred revenue was due to an increase in services and maintenance contracts. The increase in prepaid expenses was due primarily to estimated income tax payments. In addition to its short-term investments, Cadence's primary investing activities consisted of purchases of property, plant, and equipment, acquired intangibles and other assets, capitalization of software development costs, venture capital partnership investments, and the effect of business acquisitions and dispositions, which combined represented $106.9 million and $146.1 million of cash used for investing activities in the six months ended July 3, 1999 and July 4, 1998, respectively. In connection with the consummation of the merger with Quickturn, Cadence rescinded its stock repurchase program, with the exception of continued systematic stock repurchases under its seasoned stock repurchase programs for Cadence's 1997 Plan and ESPP. In August 1999, the Board of Directors approved a 10,000,000 share expansion of Cadence's existing seasoned systematic repurchase program. Of this amount, 2,500,000 shares were authorized to meet the share issuance requirements of Cadence's 1997 Stock Option Plan and 7,500,000 shares were authorized for Cadence's Employee Stock Purchase Plan. Cadence is now authorized to repurchase an aggregate of 13,000,000 shares for the 1997 Stock Option Plan and 13,400,000 shares for the ESPP. Since 1994, Cadence has sold put warrants and purchased call options through private placements. See "Notes to Condensed Consolidated Financial Statements." At July 3, 1999, Cadence has a maximum potential obligation related to put warrants to buy back 4 million shares of its common stock at an aggregate price of approximately $87 million. The put warrants will expire at various dates through February 2000, and Cadence has the contractual ability to settle the options prior to their maturity. Cadence has the ability to settle these put warrants with stock and, therefore, no amount was classified out of stockholders' equity in the condensed consolidated balance sheets. Anticipated cash requirements for the remainder of 1999 include the purchase of treasury stock through Cadence's seasoned stock repurchase programs and the contemplated additions of property, plant, and equipment of approximately $50 million. As part of its overall investment strategy, Cadence has committed to invest $50 million in a venture capital partnership as a limited partner over the next three to four years. As of July 3, 1999, Cadence had contributed approximately $33.5 million to this partnership, which is reflected in other assets in the accompanying condensed consolidated balance sheets, net of operating losses. Cadence's $355 million senior unsecured credit facility is divided between a $177.5 million three year revolving credit facility (the Three Year Facility) and a $177.5 million 364-day revolving credit facility (the 26
364-Day Facility). The 364-Day facility will expire on September 29, 1999, or at the option of the bank group, be renewed for an additional one year period. Cadence anticipates that current cash and short-term investment balances, cash flows from operations, and its revolving credit facility will be sufficient to meet its working capital requirements on a short-and long-term basis. FACTORS THAT MAY AFFECT FUTURE RESULTS CADENCE LACKS LONG-TERM EXPERIENCE IN ITS ELECTRONICS DESIGN AND METHODOLOGY SERVICES BUSINESS Cadence only recently began to focus on offering electronics design and methodology services and therefore may not be as experienced in this business as others. The market for these services is relatively new and rapidly evolving. Cadence's failure to succeed in these services businesses may seriously harm Cadence's business, operating results, and financial condition. THE SUCCESS OF CADENCE'S ELECTRONIC DESIGN AND METHODOLOGY SERVICES BUSINESSES DEPENDS ON MANY FACTORS THAT ARE BEYOND ITS CONTROL In order to be successful with its electronics design and methodology services, Cadence must overcome several factors that are beyond its control, including the following: - MANY SERVICE CONTRACTS GENERALLY REPRESENT LARGE AMOUNTS OF REVENUE. Cadence's electronics design and methodology services contracts generally represent a relatively large amount of revenue per order. Therefore, the loss of individual orders could seriously hurt Cadence's revenue and operating results. - MANY SERVICE CONTRACTS ARE AT A FIXED PRICE. A substantial portion of these service contracts are fixed-price contracts. This means that the customer pays a fixed price that has been agreed upon ahead of time, no matter how much time or how many resources Cadence must devote to perform the contract. If Cadence's cost in performing the services consistently and significantly exceeds the amount the customer has agreed to pay, it could seriously harm Cadence's business, operating results, and financial condition. - CADENCE'S COST OF SERVICE PERSONNEL IS HIGH AND REDUCES GROSS MARGIN. Gross margins represents the difference between the amount of revenue from the sale of services and Cadence's cost of providing those services. Cadence must pay high salaries to professional services personnel to attract and retain them. This results in a lower gross margin than the gross margin in Cadence's software business. In addition, the high cost of training new services personnel or not fully utilizing these personnel can significantly lower gross margin. CADENCE'S FAILURE TO RESPOND QUICKLY TO TECHNOLOGICAL DEVELOPMENTS COULD MAKE ITS PRODUCTS UNCOMPETITIVE AND OBSOLETE The industries in which Cadence competes experience rapid technology developments, changes in industry standards, changes in customer requirements and frequent new product introductions and improvements. Currently, the electronic chip design industry is experiencing several revolutionary trends: - Developments in manufacturing that enable production of chips with extremely small spacing between transistors, so-called deep submicron chips, that challenge the fundamental laws of physics and chemistry. - The ability of manufacturers to produce chips from 12 inch silicon wafers as opposed to today's eight inch wafers. This ability to place millions of additional transistors on each chip requires entirely new software tools for designers to design for these 12 inch wafers. 27
- The ability to design entire electronic systems on a single chip, so-called System-on-a-Chip or SOC, rather than a circuit board greatly increases design complexity and requires the ability to design both hardware and software on a single chip. If Cadence is unable to respond quickly and successfully to these developments and changes, Cadence may lose its competitive position and its products or technologies may become uncompetitive or obsolete. In order to compete successfully, Cadence must develop or acquire new products and improve its existing products and processes on a schedule that keeps pace with technological developments in its industries. Cadence must also be able to support a range of changing computer software, hardware platforms and customer preferences. There is no guarantee that Cadence will be successful in this regard. CADENCE'S FAILURE TO OBTAIN SOFTWARE OR OTHER INTELLECTUAL PROPERTY LICENSES OR ADEQUATELY PROTECT ITS PROPRIETARY RIGHTS COULD SERIOUSLY HARM ITS BUSINESS Cadence's success depends, in part, upon its proprietary technology. Many of Cadence's products include software or other intellectual property licensed from third parties, and Cadence may have to seek new or renew existing licenses for this software and other intellectual property in the future. Cadence's design services business also requires it to license software or other intellectual property of third parties. Cadence's failure to obtain for its use software or other intellectual property licenses or other intellectual property rights on favorable terms, or the need to engage in litigation over these licenses or rights, could seriously harm Cadence's business, operating results, and financial condition. Also, Cadence generally relies on patents, copyrights, trademarks and trade secret laws to establish and protect its proprietary rights in technology and products. Despite precautions Cadence may take to protect its intellectual property, Cadence cannot assure you that third parties will not try to challenge, invalidate, or circumvent these patents. Cadence also cannot assure you that the rights granted under its patents will provide it with any competitive advantages, patents will be issued on any of its pending applications, or future patents will be sufficiently broad to protect Cadence's technology. Furthermore, the laws of foreign countries may not protect Cadence's proprietary rights in those countries to the same extent as U.S. law protects these rights in the United States. Cadence cannot assure you that its reliance on licenses from or to third parties, or patent, copyright, trademark, and trade secret protection, will be enough to be successful and profitable in the industries in which Cadence competes. INTELLECTUAL PROPERTY INFRINGEMENT BY OR AGAINST CADENCE COULD SERIOUSLY HARM ITS BUSINESS There are numerous patents in the electronic design automation software industry and new patents are being issued at a rapid rate. It is not always economically practicable to determine in advance whether a product or any of its components infringes the patent rights of others. As a result, from time to time, Cadence may be forced to respond to or prosecute intellectual property infringement claims to protect its rights or defend a customer's rights. These claims, regardless of merit, could consume valuable management time, result in costly litigation or cause product shipment delays, all of which could seriously harm Cadence's business, operating results, and financial condition. In settling these claims, Cadence may be required to enter into royalty or licensing agreements with the third parties claiming infringement. These royalty or licensing agreements, if available, may not have terms acceptable to Cadence. Being forced to enter into a license agreement with unfavorable terms could seriously harm Cadence's business, operating results, and financial condition. CADENCE OBTAINS KEY COMPONENTS FOR ITS HARDWARE PRODUCTS FROM A LIMITED NUMBER OF SUPPLIERS Cadence depends on several suppliers for certain key components and board assemblies used in its hardware-based emulation products. Cadence's inability to develop alternative sources or to obtain sufficient quantities of these components or board assemblies could result in delays or deductions in 28
product shipments. In particular, Cadence currently relies on Xilinx, Inc. for the supply of key integrated circuits and on IBM for the hardware components for both Cadence's CoBALT-TM- product and Mercury Design Verification System-TM-. With regard to the Mercury Design Verification System-TM-, IBM recently replaced Cadence's previous supplier. IBM is currently providing the assembly services for several Mercury components on an order-by-order basis. Cadence is negotiating with IBM to establish an overall contract, but these negotiations may not be successfully completed. Other disruptions in supply may also occur. If there were a reduction or interruption, Cadence's results of operations would be seriously harmed. Even if Cadence can eventually obtain these components from alternative sources, a significant amount of time and resources would be required to redesign Cadence's products to accommodate the alternative supplier. FLUCTUATIONS IN QUARTERLY RESULTS OF OPERATIONS COULD HURT CADENCE'S BUSINESS AND THE MARKET PRICE OF ITS STOCK Cadence has experienced, and may continue to experience, varied quarterly operating results. Various factors affect Cadence's quarterly operating results and some of them are not within Cadence's control, including the mix of products and services sold, the mix of licenses used to sell products and the timing of significant orders for its software products by customers. Quarterly operating results are affected by the mix of products sold because there are significant differences in margins from the sale of hardware and software products and products and services. For example, in the past Cadence has realized gross margins on software product sales of approximately 87% but realizes gross margins of approximately 73% on hardware product sales and 35% on its performance of services. In addition, Cadence's quarterly operating results are affected by the mix of licenses entered into in connection with the sale of software products. Cadence has three basic licensing models: perpetual, fixed-term and subscription. Perpetual and fixed-term licenses recognize a larger portion of the revenue at the beginning of the license period and subscription licenses recognize revenue ratably over each quarter of the term of the license. If Cadence customers purchase more software products pursuant to a subscription agreement in any one quarter, the operating results for that quarter may be lower that that of comparable quarters in which perpetual and fixed-term licenses were used for more software products transactions. Finally, Cadence's quarterly operating results are affected by the timing of significant orders for its software products because a significant number of contracts for software products are in excess of $5 million. The failure to close a contract for the sale of one or more orders of Cadence's software products could seriously hurt its quarterly operating results. Cadence's hardware products typically have a lengthy sales cycle, during which Cadence may expend substantial funds and management effort without any assurance that a sale will result. Sales of Cadence's hardware products depend, in significant part, upon the decision of the prospective customer to commence a project for the design and development of complex computer chips and systems. Such projects often require significant amounts of time and commitments of capital. Cadence hardware sales may be delayed if customers delay commencement of projects. Lengthy hardware sales cycles subject Cadence to a number of significant risks over which Cadence has little or no control, including inventory obsolescence and fluctuations in quarterly operating results. In addition, Cadence bases its expense budgets partially on its expectations of future revenue. However, it is difficult to predict revenue levels or growth. Revenue levels that are below Cadence's expectations could seriously hurt Cadence's business, operating results, and financial condition. If revenue or operating results fall short of the levels expected by public market analysts and investors, the trading price of Cadence common stock could decline dramatically. Also, because of the large order size and its customers' buying patterns, Cadence may not learn of revenue shortfalls, earnings shortfalls or other failures to meet market expectations until late in a fiscal quarter, which could cause even more immediate and serious harm to the trading price of Cadence common stock. Because Cadence's focus on providing services is relatively recent, it believes that quarter-to-quarter comparisons of its results of operations may not be meaningful. Therefore, stockholders should not view Cadence's historical results of operations as reliable indicators of its future performance. 29
CADENCE EXPECTS TO ACQUIRE OTHER COMPANIES AND MAY NOT SUCCESSFULLY INTEGRATE THEM OR THE COMPANIES IT RECENTLY ACQUIRED Cadence has acquired other businesses before and may do so again. While Cadence expects to analyze carefully all potential transactions before committing to them, Cadence cannot assure you that any transaction that is completed will result in long-term benefits to Cadence or its stockholders or that Cadence's management will be able to manage the acquired businesses effectively. In addition, growth through acquisition involves a number of risks. If any of the following events occurs after Cadence acquires another business, it could seriously harm Cadence's business, operating results, and financial condition: - Difficulties in combining previously separate businesses into a single unit; - The substantial diversion of management's attention from day-to-day business when negotiating these transactions and later integrating an acquired business; - The discovery after the acquisition has been completed of liabilities assumed from the acquired business; - The failure to realize anticipated benefits such as cost savings and revenue enhancements; - Retention of key personnel; - Difficulties related to assimilating the products of an acquired business. For example, in distribution, engineering, and customer support areas; and - The failure to identify or correct a material Year 2000 problem of an acquired business. CADENCE'S INTERNATIONAL OPERATIONS MAY SERIOUSLY HARM ITS FINANCIAL CONDITION BECAUSE OF SEVERAL WEAK FOREIGN ECONOMIES AND THE EFFECT OF FOREIGN EXCHANGE RATE FLUCTUATIONS Cadence has operations outside the United States. Cadence's revenue from international operations as a percentage of total revenue was approximately 53% and 48% for the six month periods ended July 3, 1999, and July 4, 1998, respectively. Cadence also transacts business in various foreign currencies. Recent economic uncertainty and the weakening of foreign currencies in the Asia-Pacific region has had, and may continue to have, a seriously harmful effect on Cadence's revenue and operating results. Fluctuations in the rate of exchange between U.S. Dollars and the currencies of countries other than the U.S. in which Cadence conducts business could seriously harm its business, operating results, and financial condition. For example, if there is an increase in the rate at which a foreign currency exchanges into U.S. Dollars, it will take more of the foreign currency to equal a specified amount of U.S. Dollars than before the rate increase. If Cadence prices its products and services in the foreign currency, it will receive less in U.S. Dollars than it did before the rate increase went into effect. If Cadence prices its products and services in U.S. Dollars, an increase in the exchange rate will result in an increase in the price for Cadence's products and services compared to those products of its competitors that are priced in local currency. This could result in Cadence's prices being uncompetitive in markets where business is transacted in the local currency. Cadence's international operations may also be subject to other risks, including: - The adoption and expansion of government trade restrictions; - Volatile foreign exchange rates and currency conversion risks; - Limitations on repatriation of earnings; - Reduced protection of intellectual property rights in some countries; - Recessions in foreign economies; - Longer receivables collection periods and greater difficulty in collecting accounts receivable; 30
- Difficulties in managing foreign operations; - Political and economic instability; - Unexpected changes in regulatory requirements; - Tariffs and other trade barriers; and - U.S. government licensing requirements for export as licenses can be difficult to obtain. Cadence expects that revenue from its international operations will continue to account for a significant portion of its total revenue. Exposure to foreign currency transaction risk can arise when transactions are conducted in a currency different from the functional currency of a Cadence subsidiary. A subsidiary's functional currency is the currency in which it primarily conducts its operations, including product pricing, expenses and borrowings. Cadence uses foreign currency forward exchange contracts, as part of its foreign currency hedging program, to help protect against currency exchange risks. These contracts allow Cadence to buy or sell specific foreign currencies at specific prices on specific dates. Under this program, increases or decreases in the value of Cadence's foreign currency transactions are partially offset by gains and losses on these forward exchange contracts. Although Cadence attempts to reduce the impact of foreign currency fluctuations, significant exchange rate movements may hurt Cadence's results of operations as expressed in U.S. Dollars. Foreign currency exchange risk occurs for some of Cadence's foreign operations whose functional currency is the local currency. The primary effect of foreign currency translation on Cadence's results of operations is a reduction in revenue from a strengthening U.S. Dollar, offset by a smaller reduction in expenses. Exchange rate gains and losses on the translation into U.S. Dollars of amounts denominated in foreign currencies are included as a separate component of stockholders' equity. CADENCE'S INABILITY TO DEAL EFFECTIVELY WITH THE CONVERSION TO THE EURO MAY NEGATIVELY IMPACT ITS MARKETING AND PRICING STRATEGIES On January 1, 1999, 11 member countries of the European Union adopted the Euro as their common legal currency and established fixed conversion rates between their sovereign currencies and the Euro. Transactions can be made in either the sovereign currencies or the Euro until January 1, 2002, when the Euro must be used exclusively. Currently, only electronic transactions may be conducted using the Euro. Cadence believes that its internal systems and financial institution vendors are capable of handling the Euro conversion and is in the process of examining current marketing and pricing policies and strategies that may be affected by conversion to the Euro. The cost of this effort is not expected to materially hurt Cadence's results of operations or financial condition. However, Cadence cannot assure you that all issues related to the Euro conversion have been identified and that any additional issues would not materially hurt Cadence's results of operations or financial condition. For example, the conversion to the Euro may have competitive implications on Cadence's pricing and marketing strategies and Cadence may be at risk to the extent its principal European suppliers and customers are unable to deal effectively with the impact of the Euro conversion. Cadence has not yet completed its evaluation of the impact of the Euro conversion on its functional currency designations. FAILURE TO OBTAIN EXPORT LICENSES COULD HARM CADENCE'S BUSINESS Cadence must comply with United States Department of Commerce regulations in shipping its software products and other technologies outside the United States. Although Cadence has not had any significant difficulty complying with these regulations so far, any significant future difficulty in complying could harm Cadence's business, operating results, and financial condition. 31
CADENCE'S INABILITY TO COMPETE IN ITS INDUSTRIES COULD SERIOUSLY HARM ITS BUSINESS The electronic design automation software and the commercial electronic design and methodology services industries are highly competitive. If Cadence is unable to compete successfully in these industries, it could seriously harm Cadence's business, operating results, and financial condition. To compete in these industries, Cadence must identify and develop innovative and cost competitive electronic design automation software products and market them in a timely manner. It must also gain industry acceptance for its professional services and offer better strategic concepts, technical solutions, prices and response time, or a combination of these factors, than those of other design companies and the internal design departments of electronics manufacturers. Cadence cannot assure you that it will be able to compete successfully in these industries. Factors which could affect Cadence's ability to succeed include: - The development of competitive software products and design and methodology services could result in a shift of customer preferences away from Cadence's products and services and cause a significant decrease in revenue; - The electronics design and methodology services industries are relatively new industries and electronics design companies and manufacturers are only beginning to purchase these services from outside vendors; and - There are a significant number of current and potential competitors in the electronic design automation software industry and the cost of entry is low. In the electronic design automation software industry, Cadence currently competes with a number of large companies, including Avant! Corporation, Mentor Graphics Corporation, Synopsys, Inc. and Zuken-Redac, and numerous small companies. Cadence also competes with manufacturers of electronic devices that have developed or have the capability to develop their own electronic design automation software. Many manufacturers of electronic devices may be reluctant to purchase services from independent vendors like Cadence because they wish to promote their own internal design departments. In the electronics design and methodology services industries, Cadence competes with numerous electronic design and consulting companies as well as with the internal design capabilities of electronics manufacturers. Other electronics companies and management consulting firms continue to enter the electronic design and consulting industry. CADENCE'S FAILURE TO ATTRACT, TRAIN, MOTIVATE, AND RETAIN KEY EMPLOYEES MAY HARM ITS BUSINESS The competition for highly skilled employees is intense. Cadence's business depends on 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. Cadence's failure to attract, train, motivate, and retain such employees would impair its development of new products, its ability to provide design and methodology services and the management of its businesses. This would seriously harm Cadence's business, operating results, and financial condition. "YEAR 2000 COMPUTER PROBLEMS" COULD INTERRUPT CADENCE'S BUSINESS OPERATIONS. The so-called Year 2000 problem occurs when computer programs and embedded microprocessors fail to process date information correctly beginning in 1999. If Cadence experiences a Year 2000 problem, it could result in an interruption in, or a failure of, normal business operations. This could seriously harm Cadence's business, operating results, and financial condition. While Cadence has established a Year 2000 project team to identify and resolve its potential Year 2000 issues, Cadence has not fully assessed the risks the Year 2000 problem poses to its business. Cadence believes that its own internally-developed software products generally will not have Year 2000 problems. However, Cadence is uncertain as to the Year 2000 readiness of third-party suppliers and customers, and products acquired through recent acquisitions. Because of these uncertainties, Cadence is currently unable 32
to determine whether and to what extent the Year 2000 problem will harm its business, operating results, or financial condition. ANTI-TAKEOVER DEFENSES IN CADENCE'S CHARTER, BY LAWS, AND UNDER DELAWARE LAW COULD PREVENT AN ACQUISITION OF CADENCE OR LIMIT THE PRICE THAT INVESTORS MIGHT BE WILLING TO PAY FOR CADENCE COMMON STOCK Provisions of the Delaware General Corporation Law that apply to Cadence and its Certificate of Incorporation could make it difficult for another company to acquire control of Cadence. For example: - Section 203 of the Delaware General Corporation Law generally prohibits a Delaware corporation from engaging in any business combination with a person owning 15% or more of the voting stock of the corporation, or who is affiliated with the corporation and owned 15% or more of its voting stock at any time within 3 years prior to the proposed business combination, for a period of three years from the date the person became a 15% owner, unless specified conditions are met. - Cadence's Certificate of Incorporation allows the Cadence Board of Directors to issue at any time and without stockholder approval, preferred stock with such terms as it may determine. No shares of Cadence preferred stock are currently outstanding. However, the rights of holders of any Cadence preferred stock that may be issued in the future may be superior to the rights of holders of Cadence common stock. - Cadence has a rights plan, commonly known as a "poison pill," which would make it difficult for someone to acquire Cadence without the approval of Cadence's Board of Directors. All of these factors could limit the price that certain investors would be willing to pay for shares of Cadence common stock and could delay, prevent or allow the Board of Directors of Cadence to resist an acquisition of Cadence, even if the proposed transaction was favored by a majority of Cadence's independent stockholders. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISK Cadence's exposure to market risk for changes in interest rates relates primarily to its investment portfolio and long-term debt obligations. Cadence places its investments with high quality credit issuers and, by policy, limits the amount of credit exposure to any one issuer. As stated in its policy, Cadence's first priority is to reduce the risk of principal loss. Consequently, Cadence seeks to preserve its invested funds by limiting default risk, market risk and reinvestment risk. Cadence mitigates default risk by investing in only high quality credit 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. In October 1998, Cadence entered into a senior unsecured credit facility (the 1998 Facility) with a syndicate of banks that allows Cadence to borrow up to $355 million. The 1998 Facility is divided between a $177.5 million three year revolving credit facility (the Three Year Facility) and a $177.5 million 364-day revolving credit facility convertible to a three year term loan (the 364-Day Facility). The Three Year Facility expires September 29, 2001. The 364-Day Facility will either expire on September 29, 1999 and be converted to a three year term loan with a maturity date of September 29, 2002 or, at the option of the bank group, be renewed for an additional one year period. Cadence has the option to pay interest based on LIBOR plus a spread of between 0.50% and 1.00%, based on a pricing grid tied to a financial covenant, or the higher of the Federal Funds Rate plus 0.50% or the prime rate. As a result, Cadence's interest rate 33
expenses associated with this borrowing will vary with market rates. In addition, commitment fees are payable on the unutilized portions of the Three Year Facility at rates between 0.18% and 0.30% based on a pricing grid tied to a financial covenant and on the unutilized portion of the 364-Day Facility at a fixed rate of 0.10%. The 1998 Facility contains certain financial and other covenants. The table below presents the carrying value and related weighted average interest rates for Cadence's investment portfolio and its long-term debt obligations. The carrying value approximates fair value at July 3, 1999. All investments mature in one year or less. <TABLE> <CAPTION> CARRYING AVERAGE VALUE INTEREST RATE ----------- --------------- (IN MILLIONS, EXCEPT FOR AVERAGE INTEREST RATES) <S> <C> <C> Investment Securities: Cash equivalents--fixed rate....................................... $ 35.0 5.13% Short-term investments--fixed rate................................. 33.0 6.08% ----------- Total investment securities...................................... 68.0 5.59% Cash equivalents--variable rate.................................... 103.8 4.61% ----------- Total interest bearing instruments............................... $ 171.8 5.00% ----------- ----------- Debt: Revolving credit facility.......................................... $ -- ----------- ----------- </TABLE> INTEREST RATE SWAP RISK Cadence entered into a 4.8% fixed interest rate-swap in connection with its accounts receivable financing program to modify the interest rate characteristics of the receivables sold to a financing institution on a non-recourse basis. At July 3, 1999, the notional amount was $21.7 million which will be amortized in quarterly installments of $2.2 million through October 2001. The estimated fair value at July 3, 1999 was immaterial. FOREIGN CURRENCY RISK Cadence transacts business in various foreign currencies, primarily in Japanese yen and certain European currencies. Cadence 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 Cadence'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. Cadence 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, net, 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, net. Cadence'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 3, 1999 about Cadence's material forward contracts. The information is provided in U.S. dollar equivalent amounts. The table presents the notional amounts 34
(at contract exchange rates) and the weighted average contractual foreign currency exchange rates. These forward contracts mature prior to July 14, 1999. <TABLE> <CAPTION> NOTIONAL AVERAGE AMOUNT CONTRACT RATE ----------- ------------- (IN MILLIONS, EXCEPT FOR AVERAGE CONTRACT RATES) <S> <C> <C> Forward Contracts: Japanese yen....................................................... $ 54.4 118.93 Euro............................................................... $ (26.3) 1.08 British pound sterling............................................. $ 26.3 1.60 Canadian dollars................................................... $ (5.0) 1.48 Swedish krona...................................................... $ (3.1) 8.23 Hong Kong dollars.................................................. $ 2.0 7.76 </TABLE> The unrealized gain (loss) on the outstanding forward contracts at July 3, 1999 was immaterial to Cadence's condensed consolidated financial statements. Due to the short-term nature of the forward contracts, the fair value at July 3, 1999 was negligible. The realized gain (loss) on these contracts as they matured was not material to the consolidated operations of Cadence. EQUITY PRICE RISK As part of its authorized repurchase program, Cadence has sold put warrants through private placements. Additionally, Cadence has purchased call options that entitle Cadence to buy on a specified day one share of common stock at a specified price to satisfy anticipated stock repurchase requirements under Cadence's seasoned systematic repurchase programs. Cadence repurchases shares of its common stock under stock repurchase programs in order to make sure it has enough shares for issuance under its Employee Stock Purchase Plan (ESPP), and its 1997 Stock Option Plan (the 1997 Plan). As part of these repurchase programs, Cadence has purchased and will purchase call options or has sold and will sell put warrants. This may result in sales of a large number of shares and consequent decline in the market price of Cadence common stock. - Call options allow Cadence to buy shares of its stock on a specified day at a specified price. If the market price of the stock is greater than the exercise price of a call option, Cadence will typically exercise the option and receive shares of stock. If the market price of the stock is less than the exercise price of a call option, Cadence typically will not exercise the option. - Call option issuers may accumulate a substantial number of shares of Cadence common stock in anticipation of Cadence's exercising its call option and may dispose of these shares if and when Cadence fails to exercise its call option. This could cause the market price of Cadence common stock to fall. - Put warrants allow the holder to sell to Cadence shares of Cadence common stock on a specified day at a specified price. Cadence has the right to settle the put warrants with shares of Cadence common stock valued at the difference between the exercise price and the fair value of the stock at the date of exercise. - Depending on the exercise price of the put warrants and the market price of the stock at the time of exercise, settlement of the put warrants with stock could cause Cadence to issue a substantial number of shares to the holder of the put warrant. The holder may sell these shares in the market, which could cause the price of Cadence common stock to fall. - Put warrant holders may accumulate a substantial number of shares of stock in anticipation of exercising their put warrants and may dispose of these shares if and when they exercise their put 35
warrants and Cadence issues shares in settlement of their put warrants. This could also cause the market price of Cadence common stock to fall. The table below provides information at July 3, 1999 about Cadence'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 February 2000 and Cadence has the contractual ability to settle the options prior to their maturity. <TABLE> <CAPTION> 1999 2000 ESTIMATED MATURITY MATURITY FAIR VALUE ----------- ----------- ----------- (SHARES AND CONTRACT AMOUNTS IN MILLIONS) <S> <C> <C> <C> Put Warrants: Shares..................................................... 2.4 1.6 Weighted average strike price.............................. $ 27.11 $ 13.08 Contract amount............................................ $ 65.9 $ 21.1 $ 36.4 Call Options: Shares..................................................... 1.7 1.3 Weighted average strike price.............................. $ 26.87 $ 13.33 Contract amount............................................ $ 45.7 $ 16.6 $ 4.2 </TABLE> 36
PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time Cadence is involved in various disputes and litigation matters that 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. Cadence filed a complaint in the United States District Court for the Northern District of California (the District Court) on December 6, 1995 against Avant! Corporation (Avant!) and certain of its employees for misappropriation of trade secrets, copyright infringement, conspiracy and other illegal acts. On January 16, 1996, Avant! filed various counterclaims against Cadence and Joseph B. Costello, Cadence's former President and Chief Executive Officer (Costello), and with leave of the court, on January 29, 1998, filed a second amended counterclaim. The second amended counterclaim alleges, INTER ALIA, that Cadence and Costello had cooperated with the Santa Clara County, California, 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 Cadence insiders engaged in illegal insider trading with respect to Avant!'s stock. Cadence and Costello 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 Cadence's complaint and stayed the counterclaim pending resolution of Cadence's complaint. The counterclaim remains stayed. On April 19, 1996, Cadence 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 a preliminary 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 CERTIORARI to the United States Supreme Court, requesting a review of the Ninth Circuit Court's decision. The Supreme Court denied that petition without comment. On July 9, 1998, Cadence filed further motions to enjoin Avant!'s Aquarius product line on copyright and trade secret grounds. On December 7, 1998, the District Court issued a further preliminary injunction, which enjoined Avant! from selling its Aquarius product line. Cadence posted a $10 million bond in connection with the issuance of the preliminary injunction. On July 30, 1999, the Ninth Circuit Court of Appeal affirmed the preliminary injunction. 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 related criminal proceedings pending against Avant! and several of its executives. The District Court's December 7, 1998 order lifted that stay in part, allowing the matter to proceed to trial as to certain allegations against Avant! only, but not with respect to certain matters involving the Avant! executives and other individuals against whom criminal charges are pending. Cadence intends to pursue its claims vigorously. On April 30, 1999, Cadence and several of its officers and directors were named as defendants in a lawsuit filed in the United States District Court for the Northern District of California, entitled SPETT V. CADENCE DESIGN SYSTEMS, ET AL, civil action no. C 99-2082. The action was brought on behalf of a class of shareholders who purchased Cadence common stock between November 4, 1998 and April 20, 1999, and 37
alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The lawsuit arises out of Cadence's announcement of its first quarter 1999 financial results. Management intends to vigorously defend the claims. In February 1998, Aptix Corporation (Aptix) and Meta Systems, Inc. (Meta) filed a lawsuit against Quickturn Design Systems, Inc. (Quickturn) in the U.S. District Court, the Northern District of California, alleging infringement of a U.S. patent owned by Aptix and licensed to Meta. Quickturn named Mentor Graphics Corporation (Mentor) as a party to this suit and filed a counter claim requesting the Court to declare the Aptix patent to be unenforceable based on inequitable conduct during the prosecution of the patent. The case is set for trial in mid-2000. On July 21, 1999, Mentor filed suit against Quickturn in the United States District Court, District of Delaware, alleging patent infringement involving Quickturn's Mercury hardware emulation systems. The complaint seeks a permanent injunction and unspecified damages. Cadence intends to vigorously defend the claims. On July 22, 1999, Quickturn and Cadence filed a complaint against Mentor and Meta asking for declaratory relief in the United States District Court for the Northern District of California as well as a Notice of Related Case asking that the action brought by Mentor be consolidated with the above-described action involving many of the same questions of fact and law, APTIX CORPORATION AND META SYSTEMS, INC. V. QUICKTURN DESIGN SYSTEMS, which is pending in the United States District Court, San Francisco Division. Management believes that the ultimate resolution of the disputes and litigation matters discussed above will not have a material adverse effect on Cadence's business, operating results, or financial condition. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Annual Meeting of Stockholders held July 1, 1999, 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.................................................... 192,645,375 1,710,951 H. Raymond Bingham................................................ 192,594,743 1,761,583 Dr. Leonard Y. W. Liu............................................. 192,570,710 1,785,616 Donald L. Lucas................................................... 192,543,283 1,813,043 Dr. Alberto Sangiovanni-Vincentelli............................... 192,612,414 1,743,912 George M. Scalise................................................. 192,621,621 1,734,705 Dr. John B. Shoven................................................ 192,631,354 1,724,972 Roger S. Siboni................................................... 192,421,802 1,934,524 </TABLE> 2. A proposal for the approval of an amendment to the 1995 Directors Stock Option Plan (the Directors Plan) to increase the authorized shares of Cadence Common Stock that can be issued under the Directors Plan by 200,000 shares in each of the next three calendar years (i.e., 2000, 2001 and 2002) and to amend the definition of "change in control" and clarify the treatment of options upon a 38
change in control was approved by a vote of 157,125,427 for, 37,002,859 opposed, and 228,040 withheld. 3. A proposal for the approval of an amendment to the Employee Stock Purchase Plan (the ESPP), as amended, to increase the number of shares of common stock authorized for issuance under the ESPP from 17,500,000 to 23,500,000, an increase of 6,000,000 shares, was approved by a vote of 186,568,325 for, 7,621,463 opposed, and 166,538 withheld. 4. A proposal for the ratification of the selection of Arthur Andersen LLP as independent public accountants for the fiscal year ending January 1, 2000 was approved by a vote of 193,082,230 for, 1,153,796 opposed, and 120,300 withheld. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) The following exhibits are filed herewith: <TABLE> <CAPTION> EXHIBIT NUMBER EXHIBIT TITLE - ----------- ------------------------------------------------------------------------------------ <C> <S> 10.48 Executive Termination and Release Agreement dated May 24, 1999, between Cadence and John R. Harding 10.49 The Registrant's 1995 Directors Stock Option Plan, as amended May 5, 1999 10.50 The Registrant's 1990 Employee Stock Purchase Plan, as amended May 5, 1999 27.01 Financial data schedule for the period ended July 3, 1999. </TABLE> (b) Reports on Form 8-K: On May 26, 1999 and amended on June 15, 1999, the Registrant filed a Current Report on Form 8-K reporting the completion of Cadence's agreement to acquire Quickturn Design Systems, Inc., a Delaware corporation. On December 10, 1998 and amended on December 22, 1998 and January 6, 1999 and May 20, 1999, the Registrant filed a Current Report on Form 8-K reporting Cadence's agreement to acquire Quickturn Design Systems, Inc., a Delaware corporation. On May 6, 1999, the Registrant filed a Current Report on Form 8-K reporting Cadence's press release announcing its first quarter 1999 results and announcing the appointment of H. Raymond Bingham to the position of President and Chief Executive Officer. 39
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. <TABLE> <S> <C> <C> CADENCE DESIGN SYSTEMS, INC. (REGISTRANT) DATE: August 16, 1999 By: /s/ H. RAYMOND BINGHAM ---------------------------------------- H. RAYMOND BINGHAM PRESIDENT AND CHIEF EXECUTIVE OFFICER DATE: August 16, 1999 By: /s/ WILLIAM PORTER ---------------------------------------- WILLIAM PORTER SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER </TABLE> 40