UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

FORM 10-Q

 

 

 

Commission file number 0-15867

 

 

 

 

CADENCE DESIGN SYSTEMS, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

 

 

(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     

 

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

 

Large accelerated filer [ X ] Accelerated filer [    ] Non-accelerated filer [    ]

 

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

 

On September 29, 2007, 268,811,877 shares of the registrant’s common stock, $0.01 par value, were outstanding.

 

CADENCE DESIGN SYSTEMS, INC.
INDEX

 

 

PART I. FINANCIAL INFORMATION

 

 

CADENCE DESIGN SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)

 

ASSETS

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

CADENCE DESIGN SYSTEMS, INC.

CONDENSED CONSOLIDATED INCOME STATEMENTS

(In thousands, except per share amounts)

(Unaudited)

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

CADENCE DESIGN SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

CADENCE DESIGN SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1.  BASIS OF PRESENTATION

 

The Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q have been prepared by Cadence Design Systems, Inc., or Cadence, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, or the SEC. 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 contained in this Quarterly Report comply with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended, for a Quarterly Report on Form 10-Q and are adequate to make the information presented not misleading. These Condensed Consolidated Financial Statements are meant to be, and 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 December 30, 2006.

 

The unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q reflect all adjustments (which include only normal, recurring adjustments and those items discussed in these Notes) 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.

 

Preparation of the 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.

 

Cadence adopted the provisions of Financial Accounting Standards Interpretation, or FIN, No. 48 “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” on December 31, 2006, which was the first day of Cadence’s 2007 fiscal year. FIN No. 48 prescribes a new recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Upon its adoption of FIN No. 48, Cadence applied the provisions of FIN No. 48 to all income tax positions. The cumulative effect of applying the provisions of FIN No. 48 have been reported as an adjustment to the opening balance of retained earnings or other appropriate components of equity or net assets in the Condensed Consolidated Balance Sheet as of the beginning of fiscal year 2007.

 

Cadence adopted the provisions of Emerging Issues Task Force, or EITF, Issue No. 06-03, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” on December 31, 2006, which was the first day of Cadence’s 2007 fiscal year. EITF No. 06-03 allows companies to choose either the gross basis or net basis of income statement presentation for taxes collected from customers and remitted to governmental authorities and requires companies to disclose such policy. Cadence applies the net basis presentation for taxes collected from customers and remitted to governmental authorities.

 

NOTE 2.  STOCK-BASED COMPENSATION

 

Cadence has equity incentive plans that provide for the grant to employees of stock-based awards, including stock options and restricted stock. In addition, the 1995 Directors Plan provides for the automatic grant of stock options to non-employee members of Cadence’s Board of Directors. Cadence also has an employee stock purchase plan, or ESPP, which enables employees to purchase shares of Cadence common stock.

 

Stock-based compensation expense and the related income tax benefit recognized under Statement of Financial Accounting Standards, or SFAS, No. 123R, “Share-Based Payment” in the Condensed Consolidated

Income Statements in connection with stock options, restricted stock and the ESPP for the three and nine months ended September 29, 2007 and September 30, 2006 were as follows:

 

 

Stock Options

 

The exercise price of each stock option granted under Cadence’s employee equity incentive plans is equal to or greater than the market price of Cadence’s common stock on the date of grant. Generally, option grants vest over four years, expire no later than ten years from the grant date and are subject to the employee’s continuing service to Cadence. The options granted under the 1995 Directors Stock Option Plan vest one year from the date of grant. Options assumed in connection with acquisitions generally have exercise prices that differ from the fair value of Cadence’s common stock on the date of acquisition and such options generally continue to vest under their original vesting schedules and expire on the original dates stated in the acquired company’s option agreements. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The weighted average grant date fair value of options granted and the weighted average assumptions used in the model for the three and nine months ended September 29, 2007 and September 30, 2006 were as follows:

 

 

The computation of the expected volatility assumption used in the Black-Scholes pricing model for new grants is based on implied volatility. When establishing the expected life assumption, Cadence reviews annual historical employee exercise behavior with respect to option grants having similar vesting periods. The risk-free interest rate for the period within the expected term of the option is based on the yield of United States Treasury notes in effect at the time of grant. Cadence has not historically paid dividends; thus the expected dividend yield used in the calculation is zero.

 

Restricted Stock

 

The cost of restricted stock awards is determined using the fair value of Cadence’s common stock on the date of the grant, and compensation expense is recognized over the vesting period. Generally, restricted stock awards vest

over four years and are subject to the employee’s continuing service to Cadence. The weighted average grant date fair values for the three and nine months ended September 29, 2007 and September 30, 2006 were as follows:

 

 

Cadence issues some of its restricted stock with performance-based vesting. The terms of these restricted stock grants are consistent with grants of restricted stock described above, with the exception that they vest not upon the mere passage of time, but upon the attainment of certain predetermined performance goals. Each period, Cadence estimates the most likely outcome of such performance goals and recognizes the related stock-based compensation expense. The amount of stock-based compensation expense recognized in any one period can vary based on the attainment or estimated attainment of the various performance goals. If such performance goals are not met, no compensation expense is recognized and any previously recognized compensation expense is reversed. Stock-based compensation expense related to these performance-based restricted stock grants for the three and nine months ended September 29, 2007 and September 30, 2006 was as follows:

 

 

Cumulative effect of change in accounting principle, net of tax

 

During the nine months ended September 30, 2006, a non-cash benefit of approximately $0.4 million for estimated forfeitures of restricted stock previously expensed was recorded as of the SFAS No. 123R implementation date as a one-time cumulative effect of change in accounting principle, net of tax. Pursuant to Accounting Principles Board, or APB, No. 25, “Accounting for Stock Issued to Employees,” stock-based compensation expense was not previously reduced for estimated future forfeitures, but instead was reversed upon actual forfeiture.

 

Employee Stock Purchase Plan

 

Under the ESPP, substantially all employees may purchase Cadence’s common stock at a price equal to 85 percent of the lower of the fair market value at the beginning of the applicable offering period or at the end of each applicable purchase period, in an amount up to 12% of their annual base earnings plus bonuses, subject to a limit in any calendar year of $25,000 worth of common stock. The offering periods under the ESPP that began prior to August 1, 2006 were concurrent 24-month offering periods. Each offering period was divided into four consecutive six-month purchase periods. All offering periods that started before August 1, 2006 continued until they were completed or until they were terminated as provided in the documents governing the ESPP. Participants in the ESPP remained in the 24-month offering periods until these offering periods were completed or until such participant withdrew from the ESPP, whichever was earlier. Effective August 1, 2006, offering periods under the ESPP are six months with a corresponding six month purchase period. New offerings begin on each February 1st and August 1st, and those offerings run consecutively rather than concurrently. Participants were converted to the six-month offering periods starting with the next offering period in which the participants enroll on or after August 1, 2006. Beginning with the August 1, 2007 offering period, all participants are participating in a six-month offering period and all 24-month offering periods have been completed. The purchase dates under the ESPP are January 31st and July 31st of each year.

Shares of common stock issued under the ESPP for the three and nine months ended September 29, 2007 and September 30, 2006 were as follows:

 

 

Compensation expense is calculated using the fair value of the employees’ purchase rights under the Black-Scholes option pricing model. The weighted average grant date fair value of purchase rights granted under the ESPP and the weighted average assumptions used in the model for the three and nine months ended September 29, 2007 and September 30, 2006 were as follows:

 

 

The computation of the expected volatility assumption used in the Black-Scholes pricing model for purchase rights is based on implied volatility. The expected life assumption is based on the average exercise date for the purchase periods in each offering period. The risk-free interest rate for the period within the expected life of the purchase right is based on the yield of United States Treasury notes in effect at the time of grant. Cadence has not historically paid dividends; thus the expected dividend yield is zero.

 

NOTE 3.  INCOME TAXES

 

Cadence adopted the provisions of FIN No. 48 on December 31, 2006, which was the first day of Cadence’s 2007 fiscal year. Cadence applies FIN No. 48 to each income tax position accounted for under SFAS No. 109, “Accounting for Income Taxes,” at each financial statement reporting date. This process involves the assessment of whether each income tax position is “more likely than not” of being sustained based on its technical merits. In making this assessment, Cadence must assume that the taxing authority will examine the income tax position and have full knowledge of all relevant information. For each income tax position that meets the “more likely than not” recognition threshold, Cadence then assesses the largest amount of tax benefit that is greater than 50 percent likely of being realized upon effective settlement with the taxing authority. Cadence reports the difference between the tax benefit recorded for financial statement purposes and the amount reflected in the tax return within income tax receivable, income tax payable, deferred tax assets or deferred tax liabilities.

 

The cumulative effect of adopting FIN No. 48 was reported as an adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets) in the Condensed Consolidated Balance Sheet for fiscal 2007. Cadence recognized a $59.4 million decrease in the net liabilities for unrecognized tax benefits, which was accounted for as an increase to the December 31, 2006 balance of retained earnings. Cadence also recognized a $42.6 million decrease in the net liabilities for unrecognized tax benefits, which was accounted for as a $35.3 million

increase in the December 31, 2006 balance of Common stock and capital in excess of par value and a $7.3 million decrease in the December 31, 2006 balance of Goodwill.

 

Upon adoption of FIN No. 48, Cadence also recognized additional long-term income tax assets of $115.0 million and additional long-term income tax liabilities of $115.0 million to present the unrecognized tax benefits as gross amounts on the Condensed Consolidated Balance Sheet. Cadence also decreased current income tax liabilities by $26.2 million and increased long-term income tax liabilities by the same amount based on its anticipation of the amount of cash payments to be made within one year.

 

As of December 31, 2006, Cadence had $337.2 million of total gross unrecognized tax benefits. Of that total, $232.1 million of unrecognized tax benefits would, if recognized, affect the effective tax rate.

 

Upon adoption of FIN No. 48, Cadence adopted an accounting policy to classify interest and penalties on unrecognized tax benefits as income tax expense. For years prior to the adoption of FIN No. 48, Cadence also reported interest and penalties on unrecognized tax benefits as income tax expense. As of December 31, 2006, the total amounts of accrued interest and penalties were $65.8 million and $10.1 million, respectively.

 

The Internal Revenue Service, or IRS, and other tax authorities regularly examine Cadence’s income tax returns. Cadence’s United States federal income tax returns beginning with the 1997 tax year remain subject to examination by the IRS. Cadence’s California income tax returns beginning with the 2001 tax year (plus any amended tax returns which need to be filed upon the potential settlement of the IRS examination of the tax years beginning with 1997) remain subject to examination by the California Franchise Tax Board.

 

In November 2003, the IRS completed its field examination of Cadence’s federal income tax returns for the tax years 1997 through 1999 and issued a Revenue Agent’s Report, or RAR, in which the IRS proposed to assess an aggregate tax deficiency for the three-year period of approximately $143.0 million. The most significant of the disputed adjustments for the tax years 1997 through 1999 relates to transfer pricing arrangements that Cadence had with a foreign subsidiary. Cadence has filed a protest to certain of the proposed adjustments with the Appeals Office of the IRS where the matter is currently being considered. Cadence believes that it is reasonably possible that the total amount of the unrecognized tax benefits for these transfer pricing arrangements could significantly increase or decrease within the next 12 months if a closing agreement can be reached with the Appeals Office of the IRS to resolve the proposed IRS adjustments to the transfer pricing arrangements. Cadence also believes that it is reasonably possible that the IRS could develop new policies and rules within the next 12 months that could impact the total amounts of unrecognized tax benefits for these transfer pricing arrangements. Because of the uncertain impact of any potential IRS policies and rules and because there is limited historical precedents of relevant tax settlements available, Cadence is currently unable to provide an estimate of the range of the reasonably possible change.

 

In July 2006, the IRS completed its field examination of Cadence’s federal income tax returns for the tax years 2000 through 2002 and issued an RAR in which the IRS proposed to assess an aggregate tax deficiency for the three-year period of approximately $324.0 million. In November 2006, the IRS revised the proposed aggregate tax deficiency for the three-year period to be approximately $318.0 million. The IRS is contesting Cadence’s qualification for deferred recognition of certain proceeds received from restitution and settlement in connection with litigation during the period. The proposed tax deficiency for this item is approximately $152.0 million. The remaining proposed tax deficiency of approximately $166.0 million is primarily related to proposed adjustments to Cadence’s transfer pricing arrangements that it had with foreign subsidiaries and to Cadence’s deductions for foreign trade income. The IRS took similar positions with respect to Cadence’s transfer pricing arrangements in the prior examination period and may make similar claims against Cadence’s transfer pricing arrangements in future examinations. Cadence has filed a timely protest with the IRS and will seek resolution of the issues through the Appeals Office of the IRS.

 

Cadence believes that the proposed IRS adjustments are inconsistent with applicable tax laws and Cadence is vigorously challenging these proposed adjustments. The RARs are not final Statutory Notices of Deficiency but the IRS imposes interest on the proposed deficiencies until the matters are resolved. Interest is compounded daily at rates published by the IRS, which rates are adjusted quarterly and have been between four and ten percent since 1997. The IRS is currently examining Cadence’s federal income tax returns for the tax years 2003 through 2005.

NOTE 4.  ACQUISITIONS

 

During the nine months ended September 29, 2007, Cadence acquired Invarium, Inc., a San Jose-based developer of advanced lithography-modeling and pattern-synthesis technology, and Clear Shape Technologies, Inc., a San Jose-based design for manufacturing technology company specializing in design-side solutions to minimize yield loss for advanced semiconductor integrated circuits. Cadence acquired these two companies for an aggregate purchase price of $75.5 million, which included the payment of cash, the fair value of assumed options and acquisition costs. The $45.7 million of goodwill recorded in connection with these acquisitions is not expected to be deductible for income tax purposes. Prior to acquiring Clear Shape Technologies, Inc., Cadence had an investment of $2.0 million in the company, representing a 12% ownership interest, which had been accounted for under the cost method of accounting. In accordance with SFAS No. 141, “Business Combinations,” Cadence accounted for this acquisition as a step acquisition.

 

In connection with these acquisitions, Cadence recorded an expense of $2.7 million in the three and nine months ended September 29, 2007 for the write-off of acquired in-process technology. The purchase price allocated to acquired in-process technology was determined through established valuation techniques. The acquired in-process technology was immediately expensed because technological feasibility had not been established, and no future alternative use existed. The write-off of acquired in-process technology is a component of operating expenses in the Consolidated Income Statements.

 

The acquired companies’ results of operations and the estimated fair values of the assets acquired and liabilities assumed have been included in Cadence’s Condensed Consolidated Financial Statements from the date of acquisition. Comparative pro forma financial information for these acquisitions has not been presented because the effect on results of operations was not material to Cadence’s Condensed Consolidated Financial Statements.

 

NOTE 5.  GOODWILL AND ACQUIRED INTANGIBLES

 

Goodwill

 

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” Cadence conducts an annual impairment analysis of goodwill, which it completed during the third quarter of 2007. Based on the results of the impairment review, Cadence has determined that no indicators of impairment existed during 2007. For purposes of SFAS No. 142, Cadence operates under one reporting unit. Cadence’s annual impairment review process compares the fair value of its reporting unit to its carrying value, including the goodwill related to the reporting unit. To determine the reporting unit’s fair value, Cadence utilized the market valuation approach in the most recent evaluation.

 

The market approach provides an estimate of the fair value of Cadence based on the total number of shares of Cadence common stock outstanding, multiplied by the price per share. The estimated fair value is then compared to the carrying value of Cadence’s net assets. If the carrying value of Cadence’s net assets is greater than the aggregate market value of its outstanding shares of common stock, additional fair value analyses are performed on the individual intangible assets, including goodwill, to determine if any intangible assets are impaired, and, if so, an impairment charge is recorded.

 

The changes in the carrying amount of goodwill for the nine months ended September 29, 2007 were as follows:

 

Acquired Intangibles, net

 

Acquired intangibles with finite lives as of September 29, 2007 were as follows:

 

 

Cadence acquired intangible assets of $60.7 million during the nine months ended September 29, 2007, of which $27.9 million was acquired in connection with the acquisitions described in Note 4. Of the remainder, $30.7 million is included in Agreements and relationships and $2.1 million is included in Tradenames, trademarks, and patents in the above table. The $60.7 million of acquired intangible assets had a weighted average life of 5 years at the time of acquisition.

 

Acquired intangibles with finite lives as of December 30, 2006 were as follows:

 

 

Amortization of acquired intangibles for the three and nine months ended September 29, 2007 and September 30, 2006 was as follows:

 

 

Amortization of costs from existing technology is included in Cost of product and Cost of services. Amortization of costs from acquired maintenance contracts is included in Cost of maintenance.

Estimated amortization expense for the following fiscal years and thereafter is as follows:

 

 

NOTE 6.  CONTINGENCIES

 

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, mergers and acquisitions, licensing, contracts, distribution arrangements and employee relations matters. At least quarterly, Cadence reviews the status of each significant matter and assesses its potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount or the range of loss can be estimated, Cadence accrues a liability for the estimated loss in accordance with SFAS No. 5, “Accounting for Contingencies.” Legal proceedings are subject to uncertainties, and the outcomes are difficult to predict. Because of such uncertainties, accruals are based only on the best information available at the time. As additional information becomes available, Cadence reassesses the potential liability related to pending claims and litigation matters and may revise estimates.

 

On February 8, 2007, Cadence, Magma Design Automation, Inc., or Magma, Altera Corp., or Altera, and Mentor Graphics Corp., or Mentor filed a complaint in the United States District Court for the Northern District of California against an individual, Narpat Bhandari, or Bhandari, and Vanguard Systems, Inc., or Vanguard. The complaint seeks a declaratory judgment that U.S. Patent No. 5,663,900, or the ‘900 Patent, which discloses an electronic simulation and emulation system and is allegedly owned by Bhandari and Vanguard, is not infringed and is invalid and unenforceable. The Complaint further seeks a declaratory judgment that LSI Logic Corporation, or LSI, has an ownership interest in the ‘900 Patent that precludes Vanguard and Bhandari from asserting the patent without first joining LSI. In March 2007, Cadence, Magma, Altera and Mentor amended the complaint to further plead non-infringement on the basis of obtaining a license to the ‘900 Patent from its co-owner, LSI. In April 2007, Vanguard and Bhandari answered the amended complaint, asserting counterclaims alleging that certain products of Cadence and the other plaintiffs infringe the ‘900 patent. In a case management conference held on May 21, 2007, the court granted the request of Cadence, Magma, Altera and Mentor to bifurcate the case and stay all issues except for the question of LSI’s ownership interest in the ‘900 Patent. Cadence, Magma, Altera and Mentor filed a Motion for Summary Judgment that LSI was a joint-owner and that the license from LSI warranted dismissal of Vanguard and Bhandari’s claim. After briefing, the motion was submitted to the Court on the papers on September 27, 2007. The motion is presently under submission, and no further proceedings are scheduled at this time.

 

On May 30, 2007, Ahmed Higazi, a former Cadence employee, filed suit against Cadence in the United States District Court for the Northern District of California alleging that Cadence improperly classified him as exempt from overtime pay. The suit alleges claims for unpaid overtime under the federal Fair Labor Standards Act and California law, waiting time penalties under the California Labor Code, failure to provide proper earnings statements under California law, failure to provide meal and rest breaks as required by California law, unfair business practices under California Business & Professions Code section 17200, and unpaid 401(k) contributions in violation of the Employee Retirement Income Security Act, or ERISA. Plaintiff seeks to represent a class of current and former Cadence Information Technology employees, although the scope of the purported class is not yet clear. Cadence filed an Answer denying the material allegations of the complaint and raising a number of affirmative defenses. Neither side has commenced discovery, and the court has not addressed the appropriateness of class certification. Cadence intends to defend the case vigorously.

While the outcome of these litigation matters cannot be predicted with any certainty, management does not believe that the outcome of any current matters will have a material adverse effect on Cadence’s consolidated financial position, liquidity or results of operations.

 

Other Contingencies

 

Cadence provides its customers with a warranty on sales of hardware products for a 90-day period. These warranties are accounted for in accordance with SFAS No. 5. To date, Cadence has not incurred any significant costs related to warranty obligations.

 

Cadence’s product license and services agreements include a limited indemnification provision for claims from third parties relating to Cadence’s intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5. The indemnification is generally limited to the amount paid by the customer. To date, claims under such indemnification provisions have not been significant.

 

NOTE 7.  NET INCOME PER SHARE

 

Basic net income per share is computed by dividing net income by the weighted average number of shares of common stock outstanding, less unvested restricted stock during the period. Diluted net income per share gives effect to convertible debt and equity instruments considered to be potential common shares, if dilutive, computed using the treasury stock method of accounting.

 

Cadence accounts for the effect of its Zero Coupon Zero Yield Senior Convertible Notes Due 2023, or the 2023 Notes, in the diluted earnings per share, or EPS, calculation using the if-converted method of accounting. Under that method, the 2023 Notes are assumed to be converted to shares (weighted for the number of days outstanding in the period) at a conversion price of $15.65, and amortization of transaction fees, net of taxes, related to the 2023 Notes is added back to net income.

 

EITF No. 04-08, “Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share,” requires Cadence to include in diluted earnings per share the shares of Cadence’s common stock into which the 1.375% Convertible Senior Notes Due 2011 and the 1.500% Convertible Senior Notes Due 2013, together, the Convertible Senior Notes, may be converted. However, since the Convertible Senior Notes meet the qualification of an Instrument C under EITF No. 90-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” and because cash will be paid for the principal amount of the obligation upon conversion, the only shares that will be considered for inclusion in diluted EPS are those relating to the excess of the conversion premium over the principal amount, using the “if-converted” method of accounting. In the event Cadence’s common stock exceeds $21.15 per share, for the first $1.00 the price exceeds $21.15, there would be dilution of approximately 1.1 million shares. As the share price continues to increase, dilution would continue to occur but at a declining rate. The number of shares included in diluted EPS for the Convertible Senior Notes for the three and nine months ended September 29, 2007 were 0.4 million and 0.1 million, respectively.

The calculations for basic and diluted net income per share for the three and nine months ended September 29, 2007 and September 30, 2006 were as follows:

 

The following table presents the potential shares of Cadence common stock outstanding for the three and nine months ended September 29, 2007 and September 30, 2006 that were not included in the computation of diluted net income per share because the effect of including these shares would have been antidilutive:

 

 

NOTE 8.  STOCK REPURCHASE PROGRAMS

 

In February 2006, the Cadence Board of Directors authorized a program to repurchase shares of Cadence’s common stock in the open market with a value of up to $500.0 million in the aggregate, which program was completed during the nine months ended September 29, 2007. In November 2006, Cadence’s Board of Directors authorized a new program to repurchase shares of Cadence’s common stock in the open market with a value of up to an additional $500.0 million in the aggregate.

 

The shares repurchased under Cadence’s stock repurchase programs during the three and nine months ended September 29, 2007 and September 30, 2006 were as follows:

 

 

As of September 29, 2007, the repurchase authorization remaining under Cadence’s repurchase program totaled $155.4 million.

 

The changes in retained earnings for the three and nine months ended September 29, 2007 were as follows:

 

 

 

 

Cadence initiated a separate plan of restructuring in each year from 2001 through 2005 in an effort to operate more efficiently. The restructuring plans initiated each year from 2001 through 2005, or the 2001 Restructuring, 2002 Restructuring, 2003 Restructuring, 2004 Restructuring and 2005 Restructuring, respectively, were intended to decrease costs through workforce reductions and facility and resource consolidation in order to improve Cadence’s cost structure. The 2001 and 2002 Restructurings primarily related to Cadence’s design services business and certain other business or infrastructure groups throughout the world. The 2003 Restructuring, 2004 Restructuring and 2005 Restructuring were targeted at reducing costs throughout the company. The 2004 Restructuring has been completed and there was no remaining balance accrued for this restructuring as of September 29, 2007.

 

Since 2001, Cadence has recorded facilities consolidation charges, net of credits, of $87.5 million related to space reductions or facility closures of 49 sites. As of September 29, 2007, 28 of these sites had been vacated and space reductions had occurred at the remaining 21 sites. Cadence expects to pay remaining facilities-related restructuring liabilities for all of its restructuring plans prior to 2016.

 

The initial facility closure and space reduction costs included in these restructurings were comprised of payments required under leases, less any applicable estimated sublease income after the properties were abandoned, lease buyout costs and other contractual charges. To estimate the initial lease loss, which is the loss after Cadence’s cost recovery efforts from subleasing all or part of a building, Cadence management made certain assumptions related to the time period over which the relevant building would remain vacant and sublease terms, including sublease rates and contractual common area charges.

 

Each reporting period, Cadence evaluates the adequacy of the lease loss accrual for each plan of restructuring. Cadence adjusts the lease loss accrual for changes in real estate markets or other factors that may affect estimated

costs or sublease income. Cadence also considers executed sublease agreements and adjusts the lease loss accrual if sublease income under the agreement differs from initial estimates.

 

As of September 29, 2007, total accrued restructuring costs were $19.3 million, consisting solely of estimated lease losses related to certain of the restructuring activities initiated since 2001. This amount may be adjusted in the future based upon changes in the assumptions used to estimate the lease loss. Of the $19.3 million, $11.0 million was included in Accounts payable and accrued liabilities and $8.3 million was included in Other long-term liabilities.

 

The activity recorded in each of the restructuring plans for the three months ended September 29, 2007, which is related to payments of remaining lease obligations, net of sublease payments received, and changes in estimates related to lease loss accruals, is presented in the following table:

 

 

The activity recorded in each of the restructuring plans for the nine months ended September 29, 2007, which is related to payments of remaining lease obligations, net of sublease payments received, and changes in estimates related to lease loss accruals, is presented in the following table:

 

 

On October 5, 2007, Cadence completed a lease termination agreement for a facility included in the 2001 Restructuring whereby Cadence paid $8.2 million and was released from all future obligations related to the facility. Cadence recorded a credit to Restructuring and other charges of $7.1 million during the three months ended September 29, 2007, representing the lease loss accrual related to this facility in excess of the amount paid. As of September 29, 2007, the remaining lease loss accrual related to this facility, consisting of the $8.2 million payment made on October 5, 2007, was included in the 2001 Restructuring in the table above.

 

Other comprehensive income includes foreign currency translation gains and losses and unrealized gains and losses on available-for-sale marketable securities, net of related tax effects. These items have been excluded from net income and are reflected instead in Stockholders’ Equity.

 

Cadence’s comprehensive income for the three and nine months ended September 29, 2007 and September 30, 2006 was as follows:

 

 

 

Cadence’s Other income, net, for the three and nine months ended September 29, 2007 and September 30, 2006 was as follows:

 

 

 

In January 2007, Cadence completed the sale of certain land and buildings in San Jose, California for a sales price of $46.5 million cash. Concurrently with the sale, Cadence leased back from the purchaser approximately 262,500 square feet of office space, which represents all available space in the buildings. The lease agreement includes an initial term of two years, with two options to extend the lease for six months each. Cadence is obligated

to make lease payments related to this lease of $0.6 million for the remaining portion of 2007, $2.4 million in 2008 and $0.2 million in 2009.

 

A substantial portion of the gain upon sale was recognized throughout Cadence’s costs and expenses during the three months ended March 31, 2007, and the remaining gain will be recognized over the initial lease term of two years. During the lease term, Cadence is constructing an additional building located on its San Jose, California campus to replace the buildings it sold in this transaction.

 

 

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires disclosures of certain information regarding operating segments, products and services, geographic areas of operation and major customers. SFAS No. 131 reporting is based upon the “management approach”: how management organizes the company’s operating segments for which separate financial information is (i) available and (ii) evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Cadence’s chief operating decision maker is its President and Chief Executive Officer, or CEO.

 

Cadence’s CEO reviews Cadence’s consolidated results within one segment. In making operating decisions, the CEO primarily considers consolidated financial information, accompanied by disaggregated information about revenues by geographic region.

 

Outside the United States, Cadence markets and supports its products and services primarily through its subsidiaries. Revenue is attributed to geography based on the country in which the customer is domiciled. Long-lived assets are attributed to geography based on the country where the assets are located.

 

The following table presents a summary of revenue by geography:

 

The following table presents a summary of long-lived assets by geography:

 

 

One customer accounted for 14% of total revenue during the three months ended September 29, 2007 but no customer accounted for 10% or more of total revenue during the nine months ended September 29, 2007. No customer accounted for 10% or more of total revenue during the three and nine months ended September 30, 2006.

 

As of September 29, 2007, three customers accounted for 34% of Cadence’s Receivables, net and Installment contract receivables. As of December 30, 2006, two customers accounted for 34% of Cadence’s Receivables, net and Installment contract receivables.

 

 

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and notes thereto included in this Quarterly Report on Form 10-Q, or this Quarterly Report, and in conjunction with our Annual Report on Form 10-K for the fiscal year ended December 30, 2006. Certain of these statements, including, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, statements regarding the deployment of our products, statements regarding our reliance on third parties and other statements using words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “should,” “will” and “would,” and words of similar import and the negatives thereof, constitute forward-looking statements. These statements are predictions based upon our current expectations about future events. Actual results could vary materially as a result of certain factors, including but not limited to, those expressed in these statements. We refer you to the “Risk Factors,” “Results of Operations,” “Disclosures About Market Risk,” and “Liquidity and Capital Resources” sections contained in this Quarterly Report, and the risks discussed in our other SEC filings, which identify important risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements.

 

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

 

Overview

 

We develop electronic design automation, or EDA, software and hardware. We license software, sell or lease hardware technology, provide maintenance for our software and hardware and provide design and methodology services throughout the world to help manage and accelerate electronics product development processes. Our broad range of products and services are used by the world’s leading electronics companies to design and develop complex integrated circuits, or ICs, and personal and commercial electronics systems.

 

With the addition of emerging nanometer design considerations to the already burgeoning set of traditional design tasks, complex system-on-chip, or SoC, and IC design can no longer be accomplished using a collection of discrete design tools. What previously consisted of sequential design activities must be merged and accomplished nearly simultaneously without time-consuming data translation steps. We combine our design technologies into “platforms” for four major design activities: functional verification, digital IC design, custom IC design and system interconnect. The four Cadence design platforms are Incisive functional verification, Encounter digital IC design, Virtuoso custom design and Allegro system interconnect platforms. In addition, we augment these platform product offerings with a comprehensive set of design for manufacturing, or DFM, products that service both the digital and custom IC design flows. These four platforms, together with our DFM products, comprise our primary product lines.

 

We have identified certain items that management uses as performance indicators to manage our business, including revenue, certain elements of operating expenses and cash flow from operations, and we describe these items more fully under the headings “Results of Operations” and “Liquidity and Capital Resources” below.

 

Critical Accounting Estimates

 

In preparing our Condensed Consolidated Financial Statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, operating income and net income, as well as on the value of certain assets and liabilities on our Condensed Consolidated Balance Sheets. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. At least quarterly, we evaluate our assumptions, judgments and estimates and make changes accordingly. Historically, our assumptions, judgments and estimates relative to our critical accounting estimates have not differed materially from actual results. Due to our adoption of Financial Accounting Standards Interpretation, or

FIN, No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109” on December 31, 2006, our critical accounting estimate for accounting for income taxes is described below.

 

Accounting for income taxes

 

We provide for the effect of income taxes in our Condensed Consolidated Financial Statements in accordance with Statement of Financial Accounting Standards, or SFAS, No. 109, “Accounting for Income Taxes” and FIN No. 48. Under SFAS No. 109, income tax expense (benefit) is recognized for the amount of taxes payable or refundable for the current year, and for deferred tax assets and liabilities for the tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Under FIN No. 48, only income tax positions that meet the “more likely than not” recognition threshold may be recognized in the financial statements. An income tax position that meets the “more likely than not” recognition threshold shall initially and subsequently be measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon effective settlement with a taxing authority that has full knowledge of all relevant information.

 

We must make significant assumptions, judgments and estimates to determine our current provision for income taxes, our deferred tax assets and liabilities and any valuation allowance to be recorded against our deferred tax assets. Our judgments, assumptions and estimates relating to the current provision for income taxes take into account current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. Changes in tax laws or our interpretation of tax laws, and developments in current and future tax audits, could significantly impact the amounts provided for income taxes in our results of operations, financial position or cash flows. Our assumptions, judgments and estimates relating to the value of our net deferred tax assets take into account predictions of the amount and category of future taxable income from potential sources, including tax planning strategies that would, if necessary, be implemented to prevent a loss carryforward or tax credit carryforward from expiring unused. Actual operating results and the underlying amount and category of income in future years could render our current assumptions, judgments and estimates of recoverable net deferred taxes inaccurate, thus materially affecting our consolidated financial position or results of operations.

 

For further information about our other critical accounting estimates, see the discussion under the heading “Critical Accounting Estimates” in our Form 10-K for the year ended December 30, 2006.

 

Results of Operations

 

We primarily generate revenue from licensing our EDA software, selling or leasing our hardware technology, providing maintenance for our software and hardware and providing design and methodology services. We principally utilize three license types: subscription, term and perpetual. The different license types provide a customer with different terms of use for our products, such as:

 

 

•     The duration of the license; and

 

•     Payment terms.

 

Customer decisions regarding these aspects of license transactions determine the license type, timing of revenue recognition and potential future business activity. For example, if a customer chooses a fixed term of use, this will result in either a subscription or term license. Product revenue recognized in any period is affected by the extent to which customers purchase subscription, term or perpetual licenses, and by the extent to which contracts contain flexible payment terms. The timing of revenue recognition is also affected by the extent to which existing contracts contain flexible payment terms and by changes in contractual arrangements with existing customers. For example, the timing and amount of product revenue that is recognized during a period could be significantly affected when:

 

 

 

The amount of revenue recognized in future periods also depends on, among other things, the size, terms and timing of our:

 

 

•     Additional sales to existing customers; and

 

•     Sales to new customers.

 

The value and duration of contracts, and consequently product revenue recognized, is also affected by the competitiveness of our products.

 

A business implication of a customer’s decision to choose a fixed term of use is that, at the expiration of the license period, the customer must decide whether to continue using the technology and therefore renew the license agreement. Because larger customers generally use products from two or more of our five product groups, rarely will a large customer completely terminate its relationship with us at expiration of the license. See the discussion under the heading “Critical Accounting Estimates” in our Form 10-K for the year ended December 30, 2006 for an additional description of license types and timing of revenue recognition.

 

A substantial portion of our total revenue is recognized over multiple periods. As a result, we do not believe that pricing volatility has been a material component of the change in our revenue from period to period.

 

Revenue and Revenue Mix

 

We analyze our software and hardware businesses by product group, combining revenues for both product and maintenance because of their interrelationship. We have formulated a design solution strategy that combines our design technologies into “platforms,” which are included in the various product groups described below.

 

Our product groups are:

 

Functional Verification:  Products in this group, which include the Incisive functional verification platform, are used to verify that the high level, logical specification of an IC design is correct.

 

Digital IC Design:  Products in this group, which include the Encounter digital IC design platform, are used to accurately convert the high-level, logical specification of a digital IC into a detailed physical blueprint and then detailed design information showing how the IC will be physically implemented. This data is used for creation of the photomasks used in chip manufacture.

 

Custom IC Design:  Our custom design products, which include the Virtuoso custom design platform, are used for ICs that must be designed at the transistor level, including analog, radio frequency, memories, high performance digital blocks and standard cell libraries. Detailed design information showing how an IC will be physically implemented is used for creation of the photomasks used in chip manufacture.

 

System Interconnect:  This product group consists of our printed circuit board, or PCB, and IC package design products, including the Allegro and OrCAD products. The Allegro system interconnect platform offering focuses on system interconnect design platform, which enables consistent co-design of ICs, IC packages and PCBs, while the OrCAD line focuses on cost-effective, entry-level PCB solutions.

 

Design for Manufacturing:  Included in this product group are our physical verification and analysis products. These products are used to analyze and verify that the physical blueprint of the integrated circuit has been constructed correctly and can be manufactured successfully.

Revenue by Period

 

The following table shows our revenue for the three and nine months ended September 29, 2007 and September 30, 2006 and the percentage change in revenue between periods:

 

 

Product and maintenance revenue was higher in the three months ended September 29, 2007, as compared to the three months ended September 30, 2006, primarily because of increased revenue from licenses for Digital IC Design and Custom IC Design products, which was partially offset by decreases in revenue from licenses for Design for Manufacturing, System Interconnect and Functional Verification products. Product and maintenance revenue was higher in the nine months ended September 29, 2007, as compared to the nine months ended September 30, 2006, primarily because of increased revenue from licenses for Digital IC Design and Custom IC Design products which was partially offset by a decrease in revenue from licenses for Design for Manufacturing products.

 

One customer accounted for 14% of total revenue for the three months ended September 29, 2007 but no customer accounted for 10% or more of total revenue for the three months ended September 30, 2006. No customer accounted for 10% or more of total revenue for the nine months ended September 29, 2007 and for the nine months ended September 30, 2006.

 

Revenue by Product Group

 

The following table shows for the past five consecutive quarters the percentage of product and related maintenance revenue contributed by each of our five product groups, and Services and other: